RBC’s $1.37 million gears tied to basket of 29 stocks aim to reweight the Dow Jones Industrial

By Emma Trincal

New York, Dec. 4 – Royal Bank of Canada’s $1.37 million of 0% buffer gears due Nov. 30, 2022 linked to an equally basket of 29 stocks are designed to modify the weightings of each constituent of the Dow Jones Industrial except for one stock, which is not included in the underlyings.

The basket stocks are Apple Inc., American Express Co., Boeing Co., Caterpillar Inc., Cisco Systems, Inc., Chevron Corp., Walt Disney Co., DowDuPont Inc., General Electric Co., Goldman Sachs Group, Inc., Home Depot, Inc., International Business Machines Corp., Intel Corp., Johnson & Johnson, JPMorgan Chase & Co., Coca-Cola Co., McDonald’s Corp., 3M Co., Merck & Co., Inc., Microsoft Corp., NIKE, Inc., Pfizer, Inc., Procter & Gamble Co., Travelers Cos., Inc., UnitedHealth Group Inc., United Technologies Corp., Verizon Communications Inc., Wal-Mart Stores, Inc. and Exxon Mobil Corp., according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 1.04 times any basket gain.

Investors will receive par if the basket falls by up to 20% and lose 1% for each 1% decline beyond 20%.

Equally-weighted

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the notes were unusual because they had been obviously created to reshape the exposure to a very commonly used benchmark by changing the weighting methodology of the Dow Jones Industrial.

The benchmark is a price-weighted measure of 30 U.S. blue-chip companies. The underlying basket is an equally-weighted basket of 29 of the 30 stocks included in the Dow Jones Industrial.

“Equally-weighted indices give you more growth potential,” Kunhardt said.

“At the very least, equal-weighting eliminates the bias right off the bat that large companies will do better. Yes, right now mega-cap stocks are outperforming. But smaller-caps have more potential for growth over a reasonable period of time.”

“The Dow is very tech-heavy because you have mega companies like Apple on a limited number of constituents,” he said.

The prospectus warned investors that the basket and the benchmark are different and may not necessarily correlate. The primary reason is the change in the weighting. An additional and more anecdotal reason is that the Dow Jones includes one stock – Visa, Inc. – which is not in the basket. Without identifying the missing stock, the prospectus specifies that the basket consists in 29 of the 30 constituents of the index.

“It’s got my curiosity,” said Kunhardt.

“Why would you drop one company? I don’t know the reason but it’s interesting.”

Growth and safety net

The structure of the notes was attractive, in his view.

“I like the buffer,” he said.

“The leverage is almost insignificant. I’ll basically blow that off since it’s not enough to make up for the dividends.

“More important than the leverage is the equal-weighting as a return enhancement feature. Over time it should perform better.

“But what I do love is the no-cap. It gives you potential for growth with the safety net. What else do you want from a note?”

Bespoke deal

The size of the deal and the fact that it carried no fee led Kunhardt to assume the deal must have been a reverse inquiry.

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

“I suspect it’s a privately-designed note for a private wealth client of UBS,” he said.

“We tried that once. You can design it yourself. They give you the pricing and you decide. But the banks should lower their minimum. They usually ask for at least $1 million. That’s a bit high.”

Diversification

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he liked the methodology behind the trade.

“It’s an equally-weighted basket of the Dow minus Visa. I’m not sure why but it’s okay. I suppose the client did not want exposure to this particular name,” he said.

“I’m a big fan of equal-weight. It reduces the exposure to a particular stock or sector.

The sector breakdown of the Dow Jones Industrial showed that tech stocks constituted nearly a third of the index (31.7% weighting), according to a Nov. 30 report published by S&P Dow Jones Indices.

In the basket, however, none of the five tech stocks can exceed the 3.45% (1/29th) cap.

Leverage was not the strong point.

The 1.04 times leverage is not enough to offset the loss of the 2% dividend yield of the index, he said.

“I usually shoot for at least 1.15% just to get a chance to make up some of the dividends.”

Buffer

But other aspects of the deal were appealing, especially the buffer.

Kalscheur usually looks at back-tested performance. He did not have data on the Dow Jones Industrial, but using statistics relevant to the S&P 500 index he found that this index dropped more than 20% level only 2.3% of the time for any five-year trailing period since 1950.

“The buffer gives me a lot of confidence,” he said.

“There is a risk but it’s very small. You are going to outperform on the downside.

“You also have no cap on the upside.

“This is a nice offering.”

The notes priced on Nov. 17.

The Cusip is 78013F677.

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