JPMorgan’s relative performance notes on S&P, S&P Equal Weight offer pairs trading play

By Emma Trincal

New York, Aug. 18 – JPMorgan Chase Financial Co. LLC’s 0% notes due Sept. 20, 2024 linked to the relative return of the S&P 500 Equal Weight index and the S&P 500 index allow investors to be short an index perceived to be overvalued and long one believed to be undervalued.

The relative return is the return of the S&P 500 Equal Weight (the “long index”) minus the return of the S&P 500 index (the “short index”), according to a 424B2 filed with the Securities and Exchange Commission.

If the relative return is positive, investors at maturity will receive par plus at least 120% of the relative return.

If the relative return is flat or negative, investors will receive par.

Magnificent Seven

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments, pointed to the divergence in return between the two underliers.

“During a very long period, the regular S&P has done much better than the Equal Weight S&P. This difference in performance was driven by the AI bubble. If you look at the semiconductors, they’ve really become among the weakest stocks. We’re starting to see the Magnificent Seven move the other way,” he said.

The term “Magnificent Seven” designates seven high-growth, mega-cap stocks that have driven the S&P 500 index rally this year. Those are Meta Platforms Inc., Apple Inc., Amazon.com Inc., Alphabet Inc., Microsoft Corp., Nvidia Corp. and Tesla Inc. This group of seven securities makes for 27% of the S&P 500 index but only 1.43% of the S&P 500 Equal Weight.

The S&P 500 Equal Weight index has gained 3.88% year to date while the S&P 500 index jumped 13.83%.

“As the S&P will be coming down from its bubble, the S&P Equal Weight will do much better. Even if both indices drop, the Equal Weight is likely to lose a lot less than the S&P,” he said.

Pairs trading

The strategy deployed in the note is called pairs trading, explained Kaplan.

“You’re not betting on the direction of the indices. You’re betting on one outperforming the other. The question here is: will the Equal Weight index do better than the S&P? If yes, then you get a positive return. It doesn’t mean that you’re bullish on the Equal Weight index. The Equal Weight does not have to be positive. It just has to be less negative,” he said.

Investors in the notes may get a positive return under three scenarios, he noted.

“The S&P Equal Weight is up more than the S&P.

“The S&P Equal Weight loses less than the S&P.

“The S&P Equal Weight is up, and the S&P is down.”

Kaplan said it was the first “relative performance” note he had ever seen.

“You’re buying the undervalued asset and shorting the overvalued one. It’s an excellent idea. But it’s not an easy concept. The average investor is not familiar with pairs trading,” he said.

Pairs trading is mostly used by professional money managers and hedge funds, he noted.

Correlation

The choice of the two underlying indexes was appropriate and met the “mispricing” condition behind pairs trades.

“You want two assets with similar characteristics. But one asset gets out of line versus the other. You don’t care if it’s up or down. You’re not making a bearish or a bullish bet. You’re just betting on the realignment of the assets,” he said.

For instance, pairs trades can be placed between two currencies; two stocks in the same sector or industry; two rates at different points of the yield curve; or two commodities, for instance gold and silver.

“To increase the odds of success, you want the assets to be closely correlated.”

Close correlations reduce the risk. On the other hand, weak or negative correlations are associated with randomness and therefore, added risk.

The notes offered a relatively low risk profile due to the high correlation between the underlying indexes but also because of the principal-protection. For Kaplan, the principal-protection could be justified from a marketing standpoint.

“Most investors have never heard of pairs trading. If you explain it to them, chances are they’ll be very confused.

“They’ll be more open, more receptive if they know they can’t lose money on the trade.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes were expected to price on Aug. 17 and to settle on Aug. 22.

The Cusip number is 48134AEY7.

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