Wells Fargo aims CDs linked to SGI WISE US Vol Target 8% at interest in long/short strategy

By Emma Trincal

New York, Oct. 20 - Wells Fargo Bank NA's planned certificates of deposit linked to the SGI WISE US Vol Target 8% index hope to attract conservative investors who want a chance to participate to the equity rally while protecting themselves from an eventual correction, market sources said.

Wells Fargo plans to price CDs due Oct. 30, 2015 linked to the SGI WISE US Vol Target 8% (USD-Excess Return) index on Friday, according to a term sheet. The payout at maturity will be par plus 0.9 to 1.1 times any gain on the index, subject to a floor of zero, with the exact participation rate to be set at pricing.

Long/short vogue

"We definitely see an interest in long/short index underlyings," said a sellsider.

"Another product linked to a long/short index which has been very popular recently was the JPMorgan Chase Bank, NA's CDs linked to the JPMorgan Optimax Market-Neutral index," he added.

This sellsider noted that CDs linked to a long/short index may not be easy for investors to understand.

"This is the second month this CD is being shown. It takes time to build up. You have a new plate, a new meal," he said. But he added that there is a need for such products at this time as investors are looking to reduce volatility through a market neutral approach as well as to limit market risk on the downside.

"I think it's fair to say that after so many people watched their net worth decrease as the Dow dropped from over 14,000 to nearly 6,500, there is definitely tentativeness on the part of some to expose themselves to potential further losses in spite of the rally we have seen this year," said Tony Romero, co-founder and managing partner at Suncoast Capital Group, a deposit brokerage firm in Miami.

Romero said that people who have missed the rally so far may be even more risk adverse because they anticipate a possible correction in the coming months.

"It is precisely these types of investors who may be attracted to a security that protects them from any loss while at the same time allowing them to participate in an equity rally, albeit at a lower participation rate than had they simply owned the underlying index outright," he said.

"Personally I would not be a buyer of this particular security since I am more bullish on the equity indexes but I would not fault those with a more conservative view."

Market neutral

The reference index is based on a proprietary model developed by Société Générale, called the WISE model, which systematically scores the stocks included in the S&P 500 index on a monthly basis according to 12 specific criteria. The SGI WISE US Vol Target 8% index generated by this model and on which the CDs are linked follows a long/short, market-neutral investment strategy which tracks a deemed long position in the stocks that scored within the top 10% of the S&P 500 index and a deemed short position in the stocks that scored within the bottom 10% of the S&P 500 index, with all stock picks based on the WISE model calculations, according to the term sheet.

The purpose of the index is to generate returns, irrespective of the performance of the U.S. equities market, through long positions in the top-scored stocks weighted to short positions in the bottom-scored stocks; additionally, the index seeks to stabilize potential returns by controlling volatility to an 8% volatility target.

The CDs pay no interest during the term. Investors get compensated at maturity by participating in the appreciation, if any, of the underlying index. But the participation rate can be less than 100%.

Adequate participation

The participation rate can be less than 100%, but not lower than 90%, according the term sheet, which warns in its risk section that a participation rate lower than 100% may affect the value of the CD.

"A participation rate of less than 100% is really no big deal," the sellsider said. "If it's at 90% for instance and your index is up 10%, all it means is that you'll get 9% instead of 10%. What really will affect the value of your CD is if the market is down 50% at maturity," he said.

Romero agreed, saying: "In my opinion the participation range as stated seems reasonable."

Fixed-rate versus participation

Another risk listed in the term sheet is that interest payment may be less than the return an investor could earn on other investments, even other CDs.

Romero said that the CD could indeed do worse than a fixed-rate CD, which is his main concern with this offering.

"Once again I notice there is no periodic interest and the depositor must hope that the index just so happens to be significantly higher upon maturity than the initial index," said Romero.

"This type of pricing methodology does not consider any price volatility in the index between the settlement date and the maturity date and both investor and issuer tie their fortunes to the closing index, in effect, they are betting against each other."

Romero took the "Example 1" cited as an illustration of potential payouts in the term sheet.

The example assumed a hypothetical initial index level of 94.8580 and a final index level of 111.7902. The difference between both levels is $178.50 per $1,000 of deposit, which is the payout to investors at the end of six years.

"It gives a return of $178.50 under that index assumption which translates into an annual return of 2.97% on a six-year CD. One can easily achieve higher returns on a simple fixed-rate investment and receive periodic interest payments as well with no risk of a 0% return," said Romero.

Romero said that it makes sense for the issuer to launch such CDs as it provides them with a "favorable cost of funds." But the downside for investors is that they may get paid less than investors holding comparable plain vanilla fixed-rate products.

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