Goldman Sachs’ leveraged buffered notes tied to Russell 2000 may offer enticing entry point

By Emma Trincal

New York, Oct. 20 – Goldman Sachs Group, Inc.’s 0% leveraged buffered notes linked to the Russell 2000 index may offer an attractive entry into the small-caps segment of the market given the recent correction although some worry that that volatility could continue to erode returns. While advisers agreed the product offered a good structure, the appeal of the notes ultimately will reside in one’s outlook on the asset class.

The tenor of the notes is expected to be 18 months, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus 1.5 times the index return, subject to a maximum settlement amount of $1,184.50 per $1,000 principal amount of notes. Investors will receive par if the index falls by 10% or less and will lose 1% for every 1% that the index declines beyond 10%.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that while the structure was “decent,” the notes did not fit his market outlook.

Cap

“It’s a decent structure. It doesn’t look like a bad note. But I wouldn’t do it. I’m underweighting all my small-caps right now. It wouldn’t work for me from a macro standpoint,” he said.

“The deal seems pretty plain-vanilla. It’s a broad, well-known index with leverage on the upside. They’re capping you at 12% per year. Sounds like a lot, but it’s small cap.”

Kunhardt said that the volatility of the Russell 2000 presented some risks and not just on the downside.

“They give you a narrow range between 10% on the downside and 12% on the upside for small-caps. But you’re investing in a volatile asset class. Twelve percent is the historical rate of return for small-caps. You’re getting the leverage but all that means is that you’re going to hit the cap sooner.”

As Kunhardt expects more turbulence in the market, he said he would probably avoid the note.

Volatility

“I just wouldn’t use it because my macro outlook for small caps over the next 18 months is not that great,” he said.

Too much volatility both on the upside and on the downside would make the notes a poor choice for a variety of clients, he said.

“If you’re an aggressive investor who needs small-cap exposure, this looks like it could be a way to do it with some hedging, but if you’re really that much of an aggressive investor, you don’t want the cap and you go long directly. Alternatively, if you’re a less aggressive client you wouldn’t get exposure to small-caps anyway.”

Kunhardt said that he typically likes short-term notes, but that in this case, the tenor “works against” the investor.

“As I’m looking at the next 18 months, I see the equity markets weakening further.”

Markets have been volatile over the past two weeks, he said. But the Russell 2000 index was particularly hit.

“There is a large spread between large-caps and small-caps. Large-caps have not declined year to date but small-caps have,” he said.

For the year, the Russell is down 5.75% while the S&P 500 is up 3% as of Monday’s close.

“Things will get worse before they get better for smaller companies. Even if the economy continues to improve in the short term, the market is controlled by greed and fear and we’ll continue to see an increase in volatility,” he added.

“Small-caps will lead in that direction. They always have. If you get more volatility, it will blow that 10% buffer. It doesn’t mean that 10% is not valuable. But if the market is down 20%, I’m still going to take big losses, I’m better off but I’m still down 10%.

“If volatility is on the upside, I’m going to hit that cap,” he said.

Timing is not everything

As the Russell 2000 recently hit correction territory, some may argue that now is the time to buy the index.

“If you are a money manager into tactical allocation, now is a great time to play small-caps because you’re trying to make money on volatility. But I’m not trying to make money on volatility and I don’t try to time the market. To me, the environment is not conducive for this asset class,” he said.

“If it was on the S&P 500, I would look at it very differently,” he said.

Correction

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the 10% buffer was weak given the volatility seen in the market. On the other hand, the recent decline in the Russell 2000 index offered some potential protection to buyers looking for a lower entry point.

“The market is at a turning point right now. Investors have been concerned with a worldwide economic slowdown; oil prices have plummeted. The market has been very volatile. We’ve seen a big turnaround intraday on Wednesday. Things improved a bit, but people are wondering if it’s a false rally with more correction to come or if we’ve reached the bottom. Is it a temporary pull-down or the beginning of a bear market? The jury is still out on that one,” he said.

The Russell 2000 has just gone through a correction, he said, adding that the benchmark last week was down 12% to 13% off its high of the beginning of July.

A correction is a price decline of at least 10%.

“If you buy the notes right now, you’re getting in at a much safer entry point than three months ago. Everybody said we need a 10% correction. Well, we do have the correction in the small-caps space. With this price decline, it makes me pretty confident to get into this deal at this particular time,” he said.

Getting it done

Kalscheur said that for the most part, the structure of the product was satisfying.

“This is a short-term note. We like that. To us anything less than three years is short term,” he said.

“The index is good. It’s point-to-point. The structure is self-explanatory.”

Goldman Sachs is in Kalscheur’s list of preferred issuers when it comes to structured notes. But he mentioned that he recently had “some issues” after indicating interest in some offerings.

“They would show us a deal and the deal would end up not getting done. It happened a few times. This made us realize that we have to change our process. Either we commit more money or we look at other issuers – firms like JPMorgan, HSBC or Wells Fargo. The terms may not be as good but at least you know they’re going to write.”

Kalscheur, however, said that “we still like Goldman. Their credit spreads are wider than their competitors, which makes the terms more appealing.”

Losses

The weakness in the structure was the buffer, according to Kalscheur.

“The 10% buffer is better than nothing, but this is the Russell 2000. It’s not nearly enough to make me comfortable with the downside protection,” he said.

“If the index can be up 10% to 12% in 18 month, it can be down double-digits quite easily.

“The five-year standard deviation of the Russell 2000 is 18.4%. Statistically speaking, this has a chance of loss because over an 18-month time period, a 10% buffer is not going to cover the standard deviation of the Russell.

“I would rather have a bigger buffer, which may not be available pricing-wise,” he said.

A solution could be to have a “geared” buffer, he said.

“The downside leverage means that you can lose 100%, and because of that, the pricing is usually better; you get more protection,” he said.

“With this 10% buffer, I’m not going to lose 100%. My loss is limited to 90%. It doesn’t seem like a big deal but you would have to see how much protection you get with the geared buffer. You also have to look at the tax treatment. Because the risk of loss is high when you only have 10% of downside protection, I would want to have a definite answer on the tax implications before buying. I want to be able to deduct that loss before entering into this contract.”

Decent upside

The cap offered the advantage of enabling investors to capture “enough” upside, he said.

“It’s pretty compelling. It’s a capped return, and I’m not a huge fan of caps. But the cap is almost 12% annualized. That’s decent. Not great but compelling. Enough for me to consider it,” he said.

“Overall, it’s not a bad offering. The timing is right. The index is down 10% from its peak. It has an actual buffer on the downside. This is a good time to put money to work in small-caps. For the skittish investor, it’s enticing: you’re not going to get all the upside potential but you’ll have some downside protection and it’s short-term. If you want to put some money in the market, it’s a viable option,” he said.

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38147QLC8.

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