JPMorgan’s notes linked to Vanguard FTSE EM ETF introduce uncertainty with fund in transition

By Emma Trincal

New York, Aug. 6 – JPMorgan Chase & Co.’s 0% trigger performance securities due Aug. 31, 2020 linked to the Vanguard FTSE Emerging Markets exchange-traded fund offer attractive terms, but the uncertainties around the underlier as well as the risk associated with China, which will be included as a country component of the fund, make it difficult for advisers to decide whether to invest in the notes or not, buysiders said.

The payout at maturity will be par of $10 plus 135.7% to 145.7% of any fund gain, with the exact participation rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 25% and will be fully exposed to any losses if the fund finishes below the 75% trigger level.

“The terms are decent. We like to see that leverage, and there’s no cap. The barrier seems to be very reasonable over five years,” said Steve Doucette, financial adviser at Proctor Financial.

“The structure is relatively straightforward,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

However, the main issue with the notes, they both said, is the progressive inclusion of a new country in the FTSE index that the Vanguard fund tracks.

An index in transition

In June FTSE announced in a news release that it will include China-A shares in its emerging market index, which so far only offered exposure to Hong Kong shares of Chinese companies, or H-shares.

China A-shares represent stocks of companies in mainland China that trade on either the Shanghai or Shenzhen stock exchange. According to JPMorgan’s prospectus, exposure to China A-shares represents specific risks. Some of the risks, sources added, are associated with Chinese government regulations and interventions.

FTSE decided to increase the China A-shares exposure over a period of time, which could be at least 12 months, according to a paper and press release both issued by the index provider in May.

To do so, FTSE has created a temporary index that already tracks A-shares in China but whose exposure to Chinese incorporated companies will increase progressively over time until the final version of the index, to be called the FTSE Emerging Markets All Cap China A Inclusion index, is completed.

Meanwhile, the Vanguard Group, Inc., sponsor of the fund used in the notes, has transitioned to the new FTSE temporary index. As a result, noteholders will already have exposure to A-shares in China but in a limited initial weighting. The company intends to increase the A-shares weighting from 5% initially to 32%, according to FTSE’s press release.

To reach the target weightings, FTSE will have to reduce the weightings of all the other countries, according to a spokesperson. Such reductions will include Hong Kong, which is currently a component of the index, he noted.

Doucette was unsure whether the progressive exposure to China is a positive for investors or not.

Blood in the street

“You think you want to play China, but you’re going to cost average it by virtue of this temporary index without knowing the methodology used in the transition,” he said.

“If you believe China has hit its bottom, then you don’t want to wait for the weightings to increase. You want to jump all the way in now.

“If you’re not sure, this note is a way to get that exposure, and the increasing allocation is a good thing for you.”

Investors need to have a view on China given the projected growing exposure to this country in the underlying.

“I am a strong believer in reversal to the mean,” he said.

“This market is still the fastest-growing economy in the world. China has been hit so hard it may rebound. It may be a good strategy.”

The Shanghai Shenzhen CSI 300 index, which tracks the performance of China A-shares, has dropped 40% in a little more than three weeks from June 12 to July 8. Since then, it has gained 17%. The market was in bubble mode from March to June, up 55% during that time. For the year, the index’s performance is 6.55%.

Doucette said that the increased exposure to China has to meet the objective of the asset allocation. Such evaluation is hard to make when one does not know how much and how fast the weighting will increase.

“The timing and quality is where you need to make an assessment,” he said.

“If you’re still uncertain about China, if you don’t know whether it’s going to go up or down, it may make great sense to do dollar-cost averaging.

“If it goes down, you’re buying it at a lower price since the exposure gradually increases. ... That’s what I mean by dollar-cost averaging. If it’s up, you’re still buying lower than six months ago.”

Target allocation

Simultaneously investors have to balance two goals with the same instrument: allocating to emerging markets and making bets on China.

“You need to know if this transition is going to interfere with your target allocation. Be sure that it will meet your asset allocation decision,” he said.

“China is the biggest part of emerging markets. If you’re tactically shifting your portfolio to China, does it still meet your big picture goal?”

“From a tactical standpoint, now may be a good time to increase your allocation to China.

“At the same time, if you want true exposure to emerging markets, how big does China need to be?”

Those questions, in his view, do not make the notes unattractive. But they require an adviser to “think it through” before making a decision.

Temporary index

Medeiros was not confident in the index.

“It’s one of those rare occasions when I’m uncomfortable with the uncertainty of the underlying asset class,” he said.

“I would be very apprehensive of locking my money up for five years not knowing what I own.

“This note lost me at the term ‘transition.’

“The reality is you have to make a five-year commitment to an index in transition when you don’t know when and how the transition will take effect. How fast will the exposure to China increase? How will it impact the weightings of the other countries? How much will China[’s] weighting be at the end? What will be the final percentage? There’s too much uncertainty.”

Regulations and risk

In addition, he said he is not eager to get exposure to the stock of Chinese incorporated companies as this market only recently was in dangerous bear market territory.

“I wouldn’t say that I’m bullish on China at the moment.”

The recent market meltdown is not the only reason.

“China has big decisions to make, and those will have a strong impact one way or the other. They may be making a large stimulus injection. They may introduce regulations to normalize the market and make it fair to everybody.

“There are multiple possibilities in terms of interventions in the market. But what may be good for the economy may not be good for the markets and vice versa.

“I would say ... there is a lack of transparent direction for China in terms of its policies and its market.

“So while China is cheap right now, I wouldn’t jump in at this time. I think it’s going to be cheaper.”

J.P. Morgan Securities LLC and UBS Financial Services Inc. are the agents.

The notes will price Aug. 26 and settle Aug. 31.

The Cusip number is 48127V637.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.