RBC's trigger notes linked to Vanguard FTSE EM ETF offer defensive play on emerging markets

By Emma Trincal

New York, May 6 - Royal Bank of Canada's 0% trigger performance securities due May 31, 2019 linked to the Vanguard FTSE Emerging Markets exchange-traded fund are designed to give investors exposure to a risky but potentially rewarding asset class with some downside protection, sources said.

If the ETF return is positive, the payout at maturity will be par of $10 plus 108% to 118% of the ETF return. The exact participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the ETF return is zero or negative and the final share price is greater than or equal to the trigger price, the payout will be par. The trigger price will be 60% of the initial share price.

If the final share price is less than the trigger price, investors will lose 1% for every 1% that the final share price is less than the initial share price.

"If you want exposure to the asset class but with a cushion to protect yourself from a pullback, this makes a lot of sense," said Tom Balcom, founder of 1650 Wealth Management.

"The odds of a 40% decline five years from today are pretty slim.

"You have to give up a few things, obviously. The main one is the juicy dividend."

VWO versus EEM

The Vanguard FTSE Emerging Markets ETF, which trades on NYSE Arca under the ticker symbol "VWO," offers a dividend yield of 2.85%. It is about one percentage point more than the S&P 500 index.

"The leverage they give is not going to replace the missing dividends. That's one thing you're going to have to give up," he said.

"But if you're bullish and don't mind missing out on the yield, at least you have the protection and the uncapped upside, which gives you a more conservative way to get exposure to emerging markets."

Balcom noted that the Vanguard FTSE Emerging Markets ETF is less commonly used than the iShares MSCI Emerging Markets ETF (NYSE Arca: EEM) in structured notes offerings.

One of the differences is that the Vanguard FTSE EM ETF does not include South Korea, considered a developed market, according to the prospectus.

"That will eliminate right there Samsung, the top holding in EEM," he said.

"But those two funds have a 100% correlation. The weightings are approximately the same with an overweight in financials followed by IT and energy. If you're bullish on VWO or EEM, you basically have the same investment.

"The VWO is simply not as used as an underlying. It's also probably a little bit less liquid."

'It's been a dog'

Balcom said that emerging markets may appeal to contrarian or value investors after the heavy outflows seen last year.

"People have been afraid of emerging markets because since 2012, it's been a dog," he said.

In 2011, the Vanguard FTSE Emerging Markets ETF lost 21.5%. The following year, the fund posted a 13% gain. But last year, it lost 9.5%. Its performance is flat this year.

"This is an asset class that has considerably underperformed the S&P in the past 16 months," he said.

As a long-term investor, Balcom said he has always maintained some exposure to emerging markets in a 5% to 10% range.

"We like the growth potential of those countries. Obviously, we haven't been happy last year, especially when the S&P was up 30%," he said.

"But given how this asset class has been lagging, now may be a good time to get in. Some firms on the Street are turning bullish again.

"It makes a lot of sense to invest in it if you're a contrarian or just from a pure asset allocation perspective. As most people have been underweight in the asset class, it's a good time to rebalance the portfolio.

"The problem for most investors is that they're scared to death because emerging markets have historically been a very volatile asset class.

"That's why a note like this one makes a lot of sense."

Donald McCoy, financial adviser with Planners Financial Services, agreed.

"It's a decent way of getting the exposure to the asset class with some solid downside protection," he said.

McCoy said the structure offers an attractive risk-reward profile.

Good trade-off

"You're balancing out giving up the yield you would get from owning the fund outright with the 40% range of protection," he said.

"You're getting a little bit more on the upside with the leverage, and it offsets some but not all of the lost dividends.

"As long as the emerging markets index has not dropped by more than 40% five years from now, you're in pretty good shape. The downside risk is pretty minimal in my view because during the course of five years, the fund could drop but you would expect it to rebound too.

"What you're really doing here is betting that the index won't fall by more than 40% at the end of five years and you're getting a 10% upside bonus minus the dividends.

"That seems like a pretty fair trade-off. Because while it's certainly possible that the market would lose 10% five years from now, it's unlikely that it would be down 40% from today's levels."

Protection first

The notes are more designed to protect against the downside than to enhance the returns, he said, which is why he did not see the low leverage factor as much of a drawback.

"The upside leverage kind of offsets what you're giving up in dividends, and you're not paying any cap. Meanwhile you're getting that band of protection," he said.

"It competes nicely with owning the fund outright. One difference though is that you're exposed to the credit risk of the issuer. But it looks like you're getting a strong credit with RBC.

"For investors who are nervous about investing in emerging markets, this is a relatively secure way of getting them in because you have a significant protection, which increases the chances of getting your money back."

The notes are expected to price May 27 and settle May 30.

UBS Financial Services Inc. and RBC Capital Markets, LLC are the agents.

The Cusip number is 78011Q303.

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