Deutsche Bank's tracker notes tied to S&P, volatility indexes offer access, hedging strategies

By Emma Trincal

New York, Aug. 29 - Deutsche Bank AG, London Branch's 0% tracker notes due Sept. 10, 2015 linked to a basket of three indexes give investors hedging tools in a prepackaged note, but the underlying strategies do not come cheap, financial advisers said.

The notes offer exposure to one times any gain or loss in the level of the S&P 500 Total Return index, one times any gain or loss in the level of the Deutsche Bank ProVol Hedge index and three times any gain or loss in the level of the Deutsche Bank Equity Mean Reversion Alpha index, according to an FWP filing with the Securities and Exchange Commission.

"That's an example of a potential strategy that would be difficult to replicate outside of a structured product," said Matt Medeiros, president and chief executive of the Institute for Wealth Management. "It would certainly take a lot of management to maintain the correct correlations."

The return of each underlying component is reduced by an adjustment factor of 0.13% per year for the S&P and 1% per year for the other indexes.

The payout at maturity will be par plus the basket return.

The notes will be called at par plus the basket return if the basket level falls below 50.

Emerald

"We own that note," said Steve Doucette, financial adviser at Proctor Financial. "Everything we do is customized. We created it ourselves with Deutsche Bank. We used [the] Emerald Emerging Markets [index], not the S&P. That's the difference."

The term "Emerald" is the abbreviation for the Deutsche Bank Equity Mean Reversion Alpha index. This index, created by Deutsche Bank in 2009, tracks the performance of a strategy of buying daily volatility and selling weekly volatility on the S&P 500 index.

The Emerald Emerging Markets index uses a similar strategy, but it captures the spread between the daily and weekly variance of the iShares MSCI Emerging Markets index fund.

"We like Emerald," said Doucette. "It's a mean reversion type of investment. Typically you might get excess alpha just from that overlay. We look at it as an alpha generator.

"We've used it all along. The Emerald delivered for us a lot of excess return. We made money in 2009 and 2010. We lost a little bit of money in 2011, and that's partly due to the fees. But it's a wonderful tool.

"In a normal market, with the three-times exposure, we expect a 1% to 5% return above fees added to the notes just for carrying it. In an ugly market, the mean reversion strategy should deliver excessive return well beyond that one to five percent."

One of the other index components, the S&P 500 Total Return index, offers a significant advantage, he said, as the index includes the dividend yield of the S&P 500 index, which is 2%.

"You pay those fees, but you get the 2% from the S&P. That's 4% at the end," he said.

Hedge

Doucette said that the ProVol index helps investors mitigate losses when the market turns downward.

"It sits there and doesn't kick in unless the market gets ugly. It's a wonderful tool. It did marvels in 2008 and has been sitting on the sidelines since then. It has pretty good signals. Now of course, if the signals kick in and the signals are wrong, you will get hurt. But it really outperforms."

The ProVol index replicates a strategy designed to generate returns from the expected volatility of the S&P 500 index by taking a daily rebalanced notional long or short position in the Deutsche Bank Short-Term VIX Futures index, which tracks the market expectation of short-term volatility, according to the prospectus.

Long and short exposures are dynamically adjusted based on so-called "signals," which are calculated using three volatility indicators. Those indicators are the probability of being in a high-volatility environment, the three-month implied volatility as measured by the short-term CBOE Volatility index and the steepness of the implied volatility curve, according to the prospectus. The index using the long and short exposures seeks to capture returns from both high- and low-volatility markets.

"That ProVol is a great hedge. It has been doing really great, and adding the Emerald to the equation gives a little bit of alpha," Doucette said.

Even bulls want hedges

Medeiros said that he was still bullish on U.S. equities but that adding hedging tools to a portfolio is a great idea, especially for the upcoming weeks and months.

"From a generic perspective, I continue to like the prospects of the S&P 500 going forward. However, there will obviously be a surge in volatility in the short term given the potential conflict in Syria, the changing of the guard with the Fed, how the potential tapering of the quantitative easing will be perceived and the political battles to come as we approach the budget discussions," Medeiros said.

"We're still optimistic about the market, however. We think earnings will continue to be attractive and that companies will maintain moderate growth rates. We believe that capital will continue to shift from interest rates investments into equity and as such, the obvious recipient will be the S&P.

"But while we're optimistic about the S&P, we also know that there will be turbulence because of the uncertainty. So using some hedging strategies inside the portfolio is appropriate in order to hopefully mitigate some of the volatility that the S&P will face. I like hedging strategies that utilize volatility. Having a prepackaged product using this concept is an interesting idea."

Breakpoints please!

One concern with the notes, despite their appeal, is the cost, Doucette said, pointing to the adjustment factors, which end up eroding the performance at maturity, he said.

"You pay 1% on the Emerald, which is the component with the three-times leverage. So in reality what you're paying is 3%. You're obligated to pay this at maturity. Then you have 1% for each index. That's another 2%. In this particular note they've put 25 basis points in commission. It's a very expensive product," he said.

"But remember you have the dividend yield on the S&P. And the fact that Emerald generates alpha is also a consideration. Theoretically, Emerald will deliver returns after fees. It's a good product. But I'd rather have it for a lower fee."

Doucette suggested the fee be adjusted. Because the notional position in Emerald will be three times the invested amount, investors end up paying much more in fees for this component than for the two others.

"We have a problem with the expense involved with the leverage," he said.

"The fee on the Emerald is 1%. But if you give the issuer $10,000, your exposure is going to be $30,000. So your cost is actually 3%, not 1%.

"We think there should be breakpoints. The fee should gradually go down based on the exposure level.

"I'm sure that if a big RIA gives them $200 million, that RIA will be pressing Deutsche Bank for a little fee concession, and at some point they should. But the issuer would have to come up with a fee schedule and breakpoints based on the overall exposure."

Medeiros said that he would have to do more research on the underlying strategies to comment on the cost.

"But when you start using hedging strategies, it is inherently going to drive up the fees," he said.

Advisers would have to do some "homework" to invest in this type of notes as the underlying indexes reflect complex strategies, he said.

"I would spend a lot of time understanding how the components work together. I'd want to know what's my correlation between these hedges and the S&P," he said.

Deutsche Bank Securities Inc. is the agent.

The notes will price Sept. 4 and settle Sept. 9.

The Cusip number is 25152REG4.

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