GS Finance’s dual directional on S&P MidCap, Russell reduce risk associated with worst-of

By Emma Trincal

New York, Jan. 17 – GS Finance Corp.’s 0% dual directional trigger Performance Leveraged Upside Securities due Feb. 3, 2022 linked to the lesser performing of the S&P MidCap 400 index and the Russell 2000 index caught advisers’ attention for the very high correlation between the two underlying indexes, alleviating some of the risk associated with worst-of payouts.

If each index finishes above its initial level, the payout at maturity will be par plus 200% of the return of the lesser-performing index, capped at par plus 40.7%, according to an FWP filing with the Securities and Exchange Commission.

If either index finishes at or below its initial level but each index finishes at or above its trigger level, 80% of its initial level, the payout will be par plus the absolute value of the return of the lesser-performing index.

If either index finishes below its trigger level, investors will lose 1% for every 1% that the lesser-performing index declines from its initial level.

Dispersion

Investors in worst-of notes are at higher risk when the underliers move in different directions due to the exposure to one asset – the worst performer – and not to a diversified mix of assets, such as a basket. A low or negative correlation increases the chances of breaching a barrier. For instance, if one index rises and the second drops, the negative performance of the first one will not be offset by the gain generated by the other. The dispersion risk is usually what allows the issuer to enhance the terms, sellsiders said.

But what happens when the correlation is near one?

Close to perfect

The two underlying indexes for this note showed a coefficient of correlation of 0.98.

“I’m surprised they could price this with two things that move almost in the same direction. You’re not getting as much risk as the typical worst-of,” said Steve Doucette, financial adviser at Proctor Financial.

The performances of the indexes are tight: both fell by approximately 11% last year. The S&P MidCap 400 index rose by 16% in 2017; the Russell 2000 was up 15%. The year before, the gain was 20% and 21%, respectively. The three-year trailing total return for the S&P MidCap index is at 13.3% and at 14.6% for the Russell 2000, according to Morningstar.

“That makes it a little bit more like a regular plain-vanilla deal,” said Doucette.

The terms remained attractive in his view.

“The 41% cap...that’s a 12% a year compounded. That’s not bad. I kind of like that.

“I can’t imagine a client who would complain very much about it.”

Buffer, please

On the downside, however, Doucette said he would prefer having a buffer than a barrier.

“It’s nice to have the absolute return. But who knows where the market is going to be in three years?” he said.

“I still believe that the odds of outperforming are much better when you have a straight buffer.”

Doucette said he is aware of how difficult, if not nearly impossible, it is to price buffers on absolute return notes.

“I do like the absolute buffer. But I’d have to see what needs to happen if they put a buffer.

“You’d have to give up some leverage.

“Or there may be some adjustments in the cap.”

“Probably the absolute return component would have to go,” he said.

Risk management, cap

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said he liked the terms of the notes, especially the cap close to 41%.

“The fact that you have these two highly correlated indices makes it even more compelling,” he said.

This money manager tends to be cautious with worst-of deals because he finds it hard to assess the risk and to simulate probabilities of return.

“The worst-of in this case is not too much of a concern because of the high correlation,” he noted.

“You don’t have to manage so many different layers; there aren’t so many moving parts.

“This is close to a note tied to one index only. It’s much easier to budget your risk than having to monitor three indices going in different directions.

“How you model risk is key in the way we invest. If you don’t know what your risk is because you don’t know what your asset exposure is going to be, it makes it very difficult to even entertain the idea of buying a worst-of.

“I do like the indices in this note. We are still bullish on domestic equity.

“If I’m confident about the underlying, am I comfortable with the cap? The answer is yes relative to where I think the market is going to be in three years.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent. Morgan Stanley Wealth Management is the dealer.

The notes will price on Jan. 31.

The Cusip number is 36257D162.

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