JPMorgan’s notes tied to basket of 50 stocks offer access via big portfolio

By Emma Trincal

New York, Aug. 25 – JPMorgan Chase Financial Co. LLC’s 0% return notes due Oct. 2, 2017 linked to an equally weighted basket of 50 stocks offer access to selected stocks but do not let investors benefit from the traditional optionality offered by most structured products, sources noted.

The notes will be guaranteed by JPMorgan Chase & Co., according to a 424B2 filing with the Securities and Exchange Commission.

Basket of 50 stocks

The 50 basket components, each with a 2% weight, include Accenture plc, Alaska Air Group, Inc., Altria Group, Inc., Amazon.com, Inc., American Airlines Group Inc., Boeing Co., Brown-Forman Corp., CBS Corp., Cummins Inc., DaVita HealthCare Partners Inc., Dow Chemical Co., E.I. du Pont de Nemours and Co., Edwards Lifesciences Corp., Eli Lilly and Co., Equifax Inc., Facebook, Inc., FedEx Corp., Fluor Corp., General Dynamics Corp., Goodyear Tire and Rubber Co., H&R Block, Inc., Harris Corp., Hershey Co., International Paper Co., Intuit Inc., L-3 Communications Holdings, Inc., Lockheed Martin Corp., Mallinckrodt plc, MasterCard Inc., Monsanto Co., Motorola Solutions, Inc., Occidental Petroleum Corp., Philip Morris International Inc., Pitney Bowes Inc., Raytheon Co., S&P Global Inc., Southern Co., Texas Instruments Inc., Textron Inc., Total System Services, Inc., TripAdvisor, Inc., Twenty-First Century Fox, Inc., United Parcel Service, Inc., Varian Medical Systems, Inc., VeriSign, Inc., Vertex Pharmaceuticals Inc., Viacom Inc. and YUM! Brands, Inc.

For each $1,000 principal amount of notes, the payout at maturity will be (a) $1,000 multiplied by (b) one plus the basket return multiplied by (c) 100% to 101%.

Stock picking trend

The structure of the notes – a structure offering a one-to-one exposure with access to a firm’s proprietary equity research is not unique, but the high number of stocks in the index is. Fifty is a record for the year, according to data compiled by Prospect News.

The most well-known basket of stocks used in structured products is the Raymond James’ Best Picks for the upcoming year. In January Bank of Montreal priced the largest stocks-linked note basket offering with $185 million tied to Raymond James Analysts’ Best Picks for 2016. But the basket was relatively small with 15 stock components.

Several issuers, including JPMorgan and Toronto-Dominion Bank have priced notes linked a basket consisting of the 25 stocks included in the MSCI Spain 25/50 index. The ambition of the underlying basket in this case was modest. It was designed to reweight each stock differently than in the index so that none would exceed 5% of the basket.

Firms that have used the concept of stock-picking in some of their offerings include Royal Bank of Canada with its Direct Investment Notes linked to the Top 30 Global Ideas for 2016, which was introduced in late January.

Bank of Montreal also brought to market sector-focused baskets also based on Raymond James research. In April it priced notes linked to as basket of 14 oil stocks for instance, a formula, which was repeated three times after that.

Those products have in common the one-to-one exposure – or delta one – both on the downside and the upside. They usually offer none of the terms which make structured notes attractive to investors such as buffers, barriers and leverage.

Basket, separate account

Advisers are not always happy about this lack of optionality.

“In general, I look for structured notes to get a better predictable outcome,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

“Without having any sort of buffer or downside protection, I would be looking at it to see if there is a fee advantage with this structure versus buying something similar in a separate account,” he said.

Medeiros said comparing costs would be interesting.

“From a general perspective the fees in separate accounts tend to be aggregated amongst the account holders. But you’d have to see,” he said.

Due diligence

For advisers who value active management, such a note may offer advantages over a mutual fund.

Steve Doucette, financial adviser at Proctor Financial, said however that it would help to know the methodology behind JPMorgan’s picks.

Advisers who like to actively manage their clients’ portfolios could use the list of names in the basket as a starting point for their own research.

“I still believe that active management can outperform the market. You can use this list and look at those names. Is there potential for upside, how do these stocks perform in their industry? Is there beta, is there alpha?”

The beta is a measure of volatility. Alpha designates excess return over the benchmark.

Large cap portfolio

The underlying basket offers diversification across nine sectors. The portfolio is overweight industrials with a 30% allocation. It is underweight (one stock per sector) in utilities, energy and financials. Technology and consumer discretionary each carry an 18% weighting. The other sectors are health care (12%), materials (10%) and consumer staples (6%).

The average dividend yield is approximately 1.80%.

Nearly 80% of the portfolio consists in large-cap companies with the rest in mid-cap.

Not another fund

“It might be a good way to get exposure to the market,” said Doucette, while pointing to a JPMorgan mutual fund that invests in U.S. large-cap stocks: the JPMorgan Growth Advantage Fund.

He noted that the basket and the fund had different holdings. For instance the top holding in the fund –Alphabet Inc., formerly Google, was not included in the basket.

Most of the top names in the mutual fund, such as UnitedHealth Group Inc., Waste Connections Inc., Mohawk Industries Inc., the Home Depot Inc., Bristol-Myers Squibb Co. and Gilead Sciences Inc., were not part of the basket.

“I thought the basket could be redundant with the fund, but that’s not the case. These are two different things but they’re both large-cap. You might want to check and see if there is some overlap in there and then compare the fees.”

The expense ratio for the mutual fund is 1.24%.

The fee amount for the notes will not exceed 1% and would be 25 basis points if the notes were to price today, according to the prospectus.

“If you find this basket more cost-efficient, you can certainly look at it as a way to get this large-cap exposure with a minimum of $1,000. You don’t have to buy the 50 stocks and get hit with trading costs,” Doucette said.

“You can do that with the mutual fund too. It may be a bit more in cost but you get the dividends.

“I guess it boils down to how much you believe in JPMorgan’s equity research.”

Unknown filters

Clemens Kownatzki, independent currency and options trader, expressed some objections to the notes.

“I’ve been trying to think of what’s the angle there, how they picked those stocks. Based on traditional basic ratio analysis, I’m not sure what the analysis behind this is,” he said.

The correlations between the stocks appeared to be relatively low, in some instances negative.

“From a diversification point of view, that’s a good thing of course,” he said.

But overall, the portfolio was more volatile than the market with a beta of 1.5.

A stock with a beta of one moves with the market. A beta over one indicates that the stock is more volatile than the overall market.

“It’s a pretty volatile portfolio,” he said.

“They’re not explaining their approach, but I have no problem with that. This basket is their proprietary information. They spent of a lot of time researching those stocks. My concern is that no matter how much time you spend researching stocks, the portfolio can still lose money.

Risk, uneasy hedge

He noticed that “a lot” of the stocks included in the basket had recently hit all-time highs, pointing to Amazon and Facebook as two examples.

“This note is going out one year and we’re at a point when most investors are concerned about interest rates and are wondering how much longer this bull market is going to last,” he said.

“Correlations are low or negative in the basket. That’s fine. But it doesn’t matter in a bear market. When the market crashes everybody is selling and correlation goes to one.

“Since there is no downside protection, you would have to hedge this portfolio yourself. But it’s not an index or a fund. It’s not even three or four ETFs. You have 50 stocks. I find it very difficult to hedge a portfolio like that.”

Kownatzki said that the market is overvalued, which creates more risk on the downside.

“I can’t see the market going up another 20% or 30% from here before we have another correction. In fact I don’t see much upside looking forward.

“That’s why I’d rather have a note with a cap and floor. I would gladly cap my upside for some downside protection.

“Going delta one on a stock portfolio without any easy way to hedge is not something I would find particularly interesting.”

A spokesperson at JPMorgan declined to comment.

J.P. Morgan Securities LLC is the agent.

The notes will price Sept. 26.

The Cusip number is 46646EVB5.

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