JPMorgan’s uncapped leveraged notes on dividend indexes offer low volatility play

By Emma Trincal

New York, June 1 – JPMorgan Chase Financial Co. LLC’s 0% uncapped contingent buffered return enhanced notes due June 30, 2023 linked to the least performing of the S&P 500 Low Volatility High Dividend index and the Euro Stoxx Select Dividend 30 index use a worst-of structure to price a high upside participation and deep barrier with exposure to a low beta strategy. But advisers question the validity of giving up high dividends for those terms.

If each index finishes at or above its initial level, the payout at maturity will be par plus at least 4 times any gain of the lesser-performing index, according to a 424B2 filing with the Securities and Exchange Commission.

The exact participation rate will be set at pricing.

If either index falls but each finishes at or above the buffer level of 50% of its initial level, the payout will be par.

Otherwise, investors will lose 1% for each 1% decline of the lesser-performing index.

The notes are based on low volatility, an investment strategy which not that long ago was still very popular, said Elliot Noma, founder of Garrett Asset Management. One exchange-traded fund – the PowerShares S&P 500 Low Volatility – was particularly in demand two or three years ago among retail investors.

“Those low variance portfolios were all the rage,” he said.

One reason behind the appeal of “low vol” funds was the perception that such assets will outperform in a bear market or at least fare better than the broader market or higher-beta portfolios.

“When you own a high-dividend stock it’s a stock you keep during a selloff, or at least sell last,” he said.

The original appeal of the strategy comes from academic research and is based on the “efficient frontier” strategy, formulated by Harry Markowitz, he noted.

An efficient frontier will be the most optimal part of the risk-return spectrum.

Investors using low volatility are seeking higher risk-adjusted returns over long periods of time.

“For a given amount of volatility you get a maximum return. The portfolio is supposed to give you the best bang for your buck,” he said.

But there is a caveat.

Interest rates a factor

Low volatility strategies work best when interest rates are low, he said.

“When rates are low, that’s when you want to pick up low volatility stocks and lever them up. That’s exactly what the notes are designed to do,” he said.

“Those low vol. funds were extremely popular when rates were at record low levels. That’s exactly the reason why they were pushed.”

But when rates move higher, the strategy loses some of its appeal.

“When interest rates are high, you have to pick up more risk on the curve and be more aggressive,” he said.

“Rates are still pretty low. If you think that rates won’t go up or that they won’t go up very quickly, that’s the optimal strategy. You’d have to have this view if you bought the notes. Otherwise it makes no sense to give up the dividends.”

Contrarian view

Betting on low rates over the next five years seems like a contrarian view, he said.

The notes in today’s market may be shown to retail investors for other reasons than academic theories.

“You can also look at the argument that investors want to be safe,” he said. “Volatility is back. We’ve seen it when the market dropped in February. You’re getting a portfolio with no Facebook, no Amazon. It’s low volatility. It has a 50% downside protection, which is nice. People may feel comfortable with that. They’re nervous about the market right now.”

To be sure, the structure is very defensive, a market participant said, pointing to the four-times leverage, uncapped upside and deep barrier.

“It’s a worst-of of two uncorrelated indices, so that makes the pricing attractive,” he said.

Lack of dividends questioned

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, was not impressed.

“They’re high-dividend indices and you don’t get the dividends. It makes no sense to me,” he said.

Giving up the dividends from the underlying indexes for the above-average leverage was not necessarily a sound tradeoff, he said.

Over the past five years, the S&P 500 Low Volatility High Dividend index posted an annualized total return of 12.32%, according to Standard & Poor’s website as of May 31. The annualized price return is only 7.78% during the same period.

Over the past 10 years, the total return exceeded the price return by more than 5% on an annualized basis.

“When you compound 5% over five years it gets near 30%. You’re giving up a lot of gains.”

Over the past year, the price return was minus 0.29%, significantly lagging the 4.07% total return, he noted.

“Even getting 4x is not going to help you very much when the index is down or flat,” he said.

Kaplan also pointed to sector risks.

The majority of the stocks included in the S&P 500 Low Volatility High Dividend index are REITs, financial and utilities stocks.

“REITs by law have to pay at least 90% of their earnings in dividends. Capital gains are going to be less. People know that and they’re fine with that precisely because they know they’re getting a high dividend. So it’s kind of silly to me to buy a note without this huge portion of the return,” he said.

Both underlying indexes are high-dividend indexes. The U.S. underlier adds a low volatility filter filtering the 50 least-volatile stocks among the 75 highest dividend-yielding companies in the S&P 500 index.

Concentration eyed

The Euro Stoxx Select Dividend 30 index extracts the highest dividend-paying stocks from the Euro Stoxx index.

In both cases the result are two concentrated indexes of 50 and 30 components, respectively.

The Euro Stoxx Select Dividend 30 index has a 38% weighting in bank and insurance stocks and more than 13% in utilities.

“That’s about half of the index concentrated in highly interest-rate sensitive sectors,” said Kaplan.

“When rates go up, those stocks get hit the most.”

The prospectus signaled that the S&P 500 Low Volatility High Dividend index is subject to concentration risk because using two factors – high dividends and low volatility – in order to filter the index will necessarily narrow the number of sectors and industries.

Overall, Kaplan said high-dividend stocks are not particularly cheap right now.

“Bank, utilities stocks are not showing compelling discounts. They’re less overvalued than the rest of the market. But they’re still rich. As a contrarian investor, I’m much more inclined to look into gold miners and some emerging markets although not just now yet.”

Kaplan said that he was not sure why some investors would believe that low volatility stocks have the potential to consistently generate alpha in a down market.

“I don’t know how much better they do. The fact that these strategies didn’t exist a few years ago may have created a brief window of outperformance as everybody was crowding into the new hot trend,” he said.

He would not consider investing in the notes.

“I’m not even convinced that low vol. works as a strategy over long periods of time.

“But giving up the most valuable part of the strategy, which is the dividend that compounds over the years, represents a huge opportunity cost.

“It’s like going to a Kentucky Fried Chicken for the fries and the sauce without getting the chicken,” he said.

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48129MXN1) will price on June 26 and settle on June 29.

© 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.