Citi’s notes on Fidelity Multifactor Yield index 5% ER offer thematic allocation, protection

By Emma Trincal

New York, May 28 – Citigroup Global Markets Holdings Inc.’s 0% market-linked notes due July 6, 2026 linked to the Fidelity Multifactor Yield index 5% ER provide full downside protection based on a rules-based index that may mimic traditional balanced portfolios, an asset manager said.

Equity, bonds, cash

The rules-based index pursues a factor investing strategy while maintaining a volatility target of 5%, according to the prospectus.

The index dynamically allocates its hypothetical portfolio between an equity allocation and a fixed income allocation, which together make up the “base allocation.” Separately, the index allocates to an uninvested allocation, which consists of cash.

The index allocates weight between equity and fixed income in inverse proportion to their respective realized volatilities, according to the filing.

The fixed-income allocation consists of a hypothetical allocation between the 10-year U.S. Treasury Futures Market Tracker index and uninvested cash.

The equity allocation consists of six Fidelity equity factor indexes less a daily excess return deduction at a rate equal to the Federal Funds rate.

The payout at maturity will be par plus at least 100% of any index gain. The exact participation rate will be determined at pricing.

If the index falls, the payout will be par.

Multifactor portfolio

“This is a thematic index that can be used as an asset allocation tool,” said Sam Rosenberg, managing partner at asset management firm Lutetia Capital.

“The allocation process has some similarities with the traditional 60/40 portfolio but with far less volatility given the volatility target rule,” he said.

The 60/40 portfolio is a traditional balanced portfolio, which consists of investing 60% in stocks and 40% in bonds.

The 60/40 model has been criticized of late due to ultra-low interest rates. With the prospect of rising interest rates and inflation, the portfolio is overly exposed to interest rate risk.

“Those rules-based indices are based on risk premium factors,” said Rosenberg.

“What this Fidelity index is trying to achieve is a safe allocation between equity and Treasuries. The key for that is the volatility target at 5%,” said Rosenberg.

“For a non-sophisticated investor, the notes offer a generic, thematic allocation with principal-protection.”

Danger of underinvestment

The index however could significantly underperform the stock market, especially in a bullish market, stated the prospectus in its risk disclosure section.

One reason is the allocation rule between equity and fixed income, which assigns a weight in inverse proportion to the asset class’ volatility. For instance, if the equity allocation is four times more volatile, the fixed income allocation will have to be four times greater. Since stocks are generally more volatile than bonds, the index is likely to be overweight Treasuries, the prospectus said.

Secondly, cash, which produces no return, may constitute a substantial portion of the overall portfolio.

For instance, the fixed income allocation is not just made of bonds but can also include uninvested cash as well. Secondly a large portion of the index may go to the uninvested cash bucket in order to maintain the 5% volatility target.

Performance comparisons

The prospectus compares the annualized performance of the index with that of two major benchmarks – the S&P 500 index and the Bloomberg Barclays U.S. Aggregate Bond index. Both the S&P 500 index and the Bloomberg Barclays index are quoted in their respective excess return versions for comparison purposes.

Over the past year through May 20, the annualized return of the Fidelity Multifactor Yield index 5% ER was 3.46% versus 42.12% for the S&P 500 index ER, the back-tested information showed. However, the Fidelity Multifactor outperformed the Bloomberg Barclays U.S. Aggregate Bond index, which slightly declined by 0.57% for the period.

Over the past three years, the index returned 6.17%, versus 15.98% for the S&P 500 index ER and 4.02% for the investment-grade bond benchmark.

Allocation tool

“You’re not going to get rich with that. But for a registered investment adviser looking for a safe allocation model, this may be helpful,” said Rosenberg.

Making asset allocation, especially in today’s market, is not always easy. The index does it for the advisor, he explained.

Some aspects of the index however were still complex for individual investors, he noted, pointing to the equity allocation.

“The factor investing strategy is another aspect of the methodology. But those six sub-indices make the product somewhat a little bit complicated,” he said.

The six equity factor indices consist of the Fidelity High Dividend index with a 45% weight, the Fidelity U.S. Momentum Factor index with a 15% weight and the Fidelity U.S. Value Factor index, the Fidelity U.S. Quality Factor index, the Fidelity U.S. Low Volatility Factor index, and the Fidelity Small-Mid Multifactor index, each of which with a 10% weight, according to the prospectus.

Bond substitute

An index analyst said the product was a good fit for conservative investors.

“From a risk-return perspective, it’s relevant as a fixed income alternative,” he said.

“Yes, the volatility target limits the performance, but at the same time, it provides a smoother experience.

“It’s a good play if you want equity exposure without putting your capital at risk.”

The equity component of the index enables investors to outperform Treasuries.

“The five-year Treasury yield is 0.79%. That’s not amazing given current inflation expectations,” he said.

Full principal protection

The volatility control of the Fidelity index and many more used as underliers to build defensive structured products is necessary to generate the 100% downside protection, he said.

“Without it, you could never put together that guarantee. You can’t do it on a traditional index alone. And even if you use several indices in a worst-of, there is no way you could do it on a five-year.”

Some advisers tend to overlook the benefit of the principal-protection offered by rules-based underliers, arguing that the algorithms are hard to understand. The algorithms are often called “black boxes.”

This analyst refuted the objection.

“Any index is potentially a black box, even the simplest ones. You just have to read the rules. It’s an approach and everything is explained in the prospectus. You can understand it. You just have to do a little bit of research. But it’s not a black box.”

Citigroup Global Markets Holdings Inc. is the agent.

The notes will price on June 30 and settle on July 6.

The Cusip number is 17329FGP3.

© 2015 Prospect News.
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