JPMorgan’s $560,000 leveraged notes on three ETFs offer uncapped exposure over mid-term

By Emma Trincal

New York, July 18 – JPMorgan Chase Financial Co. LLC’s $560,000 of 0% uncapped accelerated barrier notes due Jan. 8, 2027 linked to the least performing of the SPDR S&P 500 ETF Trust, the SPDR Dow Jones Industrial Average ETF Trust and the iShares Russell 1000 Growth ETF allowed investors to get uncapped leveraged exposure over a little longer than three years. But the use of a worst-of combining three ETFs posed different kinds of risks, according to advisers. One of them expressed concerns over limited upside while the other focused on the downside risk.

If each ETF finishes at or above its initial level, the payout at maturity will be par plus 1.65 times the return of the worst performing ETF, according to a 424B2 filing with the Securities and Exchange Commission.

If any ETF falls but each ETF finishes at or above the 70% barrier level, the payout will be par.

Otherwise, investors will be fully exposed to the decline of the worst-performing ETF.

On the plus side

Steven Foldes, wealth manager and founder at Evensky & Katz / Foldes Financial Wealth Management, objected to the length of the holding period.

But he first pointed to some of the positive aspects of the deal.

“We like JPMorgan. It has a very strong credit. It’s one of the leading banks in the world,” he said.

“It also looks like the 0.3% fee is reasonable given the term of the note,” he added referring to the amount disclosed in the prospectus.

The 1.65 leverage factor was “nice,” but also “necessary” given the “significant” amount of dividend investors had to give up over the three-and-a-half-year period. The SPDR Dow Jones Industrial Average ETF is the highest-yielding of the three underlier with a dividend yield of 1.91%.

The absence of any cap was one of the most favorable features. Yet, Foldes said he would not consider the notes.

“There are two things we don’t like, which would prevent us from going forward,” he said.

“First of all, three-and-a-half years is still a lengthy note for us. We like to buy two years or shorter.

“And secondly, a worst-of on three indices is another issue.”

Dispersion of returns

The coefficients of correlations between the three ETFs range between 0.87 and 0.96 with the lowest one (0.87) found between the SPDR Dow Jones Industrial Average ETF Trust and the iShares Russell 1000 Growth ETF.

“Even though the correlations are high, those indices can show huge disparities in returns. A high correlation only means the indices move in tandem. It doesn’t mean they move at the same pace,” he said.

Case in point: the iShares Russell 1000 Growth ETF is up 34% year to date while the SPDR Dow Jones Industrial Average ETF has only increased by 5.45%.

“This is the dangerous part. The differences in returns are historically high. Having a 1.65x return on 34% is fantastic but having 1.65 times 5.45% is terrible,” he said.

“With three indices, you run the risk of being exposed to a laggard and in this environment, the differences in return are huge.”

When Foldes uses a note with a worst-of payout, he limits the number of underlying indexes to two.

“I’m sure that adding a third one is probably how they managed to get the 1.65x uncapped. But for us the combination of three indices in a worst-of is almost a non-starter,” he said.

Barrier

Another drawback was the misuse of the downside protection, he said.

“The S&P is still 6% below the high of January 2022 and we had a pretty significant decline last year,” he said.

“We still have some headwinds. But the economy appears to be resilient as evidenced by the number of jobs and the low unemployment rate.

“We’re buying at a 6% discount. Having a barrier is probably not the best use of our money.”

Instead of the barrier, Foldes would seek to get exposure to only two indexes in the worst-of. He would also aim at reducing the duration of the notes.

“Having uncapped leverage is wonderful if you can fully take advantage of it,” he said.

Term

A financial adviser’s main concern was, at the contrary, directed toward the downside.

“Normally you need at least five years to see uncapped leveraged upside. Doing it over three-and-a-half years is a nice perk. And the leverage multiple at 1.65 is high. It’s not like they gave you 1.25 or 1.3,” he said.

But shorter durations are more likely to see deeper drawdowns, he added. Looking at back-testing data for each underlying or their equivalent, this adviser found that the durations showing the greatest probabilities of a loss in excess of 30% were comprised between 23 and 27 months.

Probabilities of losses

“This one is a bit longer so I’m not too worried. However, the probability of breaching the barrier over a three-and-a-half-year timeframe is significant,” he said.

His observation was based on back-testing results for three-and-a-half year rolling periods over several decades.

He used data for the Dow Jones industrial average and the S&P 500 index. For the Russell 1000 Growth ETF, he used the Invesco QQQ Trust Series 1 as proxy. This ETF tracks the return of the Nasdaq-100 index.

Risky growth

The Russell 1000 Growth with 450 holdings is a little bit more diversified than QQQ, which has 100 components only, he said.

“But they basically have the same holdings. They’re really very similar. So, I used QQQ as a bogey for my analysis,” he said.

The chances of losing more than 30% were only 0.3% for the Dow and 2.1% for the S&P 500. But the risk of breaching the barrier jumped with QQQ reaching a 6.7% probability.

“A 6.7% chance of breaching. That’s a red flag for me,” he said.

“I know that it’s a bit of a stretch because I’m using QQQ and not the Russell 1000 Growth. However, they’re going to behave very similarly.

“The high volatility of QQQ would dissuade me. A 6.7% chance to lose at least 30% of my principal is a little bit too risky for my blood at this point.

“Only the upside is attractive, not the downside. I would take a pass.”

The notes are guaranteed by JPMorgan Chase & Co.

The agent is J.P. Morgan Securities LLC.

The notes settled on July 10.

The Cusip number is 48133X3Z7.

© 2015 Prospect News.
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