Goldman Sachs' notes linked to S&P Equal Weight Energy enhance small-cap exposure to sector

By Emma Trincal

New York, June 27 - Goldman Sachs Group, Inc.'s upcoming 0% buffered notes linked to the S&P Equal Weight Index - Energy offer access to the energy sector of the S&P 500 index with a twist: an equally weighted indexing approach instead of market-capitalization weighting. Sources said that the use of this type of index enables investors to tap into smaller stocks within the sector.

The tenor of the notes is expected to be 24 to 28 months, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus the index return if the index return is positive, subject to a maximum return of 66% to 77.5%. Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

Equal weight

The S&P Equal Weight Index - Energy is an equally weighted index that consists of common stocks of oil and gas exploration, production, marketing, refining and/or transportation and energy equipment and services companies that comprise the energy sector of the S&P 500 index.

The S&P Equal Weight Index - Energy itself is a subset of the S&P 500 Equal Weight index, which consists of the same 500 stocks as the S&P 500 index, but instead of weighting the holdings by their market capitalization, it weights each stock equally.

"The S&P 500 equally weighted index, unlike the S&P 500, is a size-neutral index," said Bernd Henseler, vice president of structured products at Standard & Poor's.

"An equally weighted index gives a tilt towards smaller companies. It's one way to tap into small-cap stocks."

Alpha search

Using the equal-weight form of index construction as the underlying for a note may also be used to generate alpha, suggested a market participant, saying that many investors view small caps as an asset class that can provide better returns over the long term.

"The S&P 500 equally weighted energy index allocates less to large caps and more to small companies," Henseler said.

"As a result, it is slightly more volatile than the market-weighted version, but you're also getting potentially higher returns."

The S&P 500 Equal Weight Energy has a one-year historic volatility of 37.2% versus 30.2% for the market-cap version of the index, he noted.

"Track records show that equally weighted indexes tend to outperform capital-weighted indexes over the long run."

Buffer

The structure of the notes offers no upside enhancement, but there is 10% downside protection.

Investors have access to the same underlying index via different instruments such as exchange-traded funds. The Rydex S&P Equal Weight Energy ETF is an example, the market participant said.

"But it would not have the same appeal because the ETF doesn't have the downside protection," he said.

"The 10% buffer is not that much, but the cap is quite reasonable. People buying this product opt for more upside potential. They can live with a lower buffer.

"Despite the downside leverage, the 10% buffer offers more protection than what you would have with a barrier, all things being equal."

If the index finished down 25%, investors in the notes would lose 16.67%, according to the prospectus. Compared to a barrier offering the same amount of protection and leading to a 25% loss in the same context, the buffer is much preferable, he said.

"You would probably need to get an 80% or 75% barrier to compare. Getting a 20% or 25% cushion from that barrier looks more appealing except that you lose more if the barrier is breached. Once you hit it, the protection is gone," the market participant said.

A commodities hedge fund manager said that he does not like the oil and energy sector right now because energy production will rise in the United States, dampening prices.

"Obviously you could see oil down 10% in two years and even much more than that and sooner than that," he said.

"However, this index is made of energy stocks, and they behave a little bit differently than commodities. With stocks, everything will be different from company to company with some doing better than others. So it's a little bit hard to tell."

Fees

An industry source said that investors need to look at the fees Goldman Sachs will be charging, which are not yet disclosed in the filing, in order to weigh the product against the ETF.

"You'd have to look at the fee structure to compare," he said.

"But when you buy a Goldman Sachs note, you get exposed to the risk of Goldman Sachs. Maybe there are more fees in the ETF, but perhaps your principal is safer."

The exact maturity date and cap will be set at pricing.

Goldman Sachs & Co. is the underwriter.

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