RBC’s notes on MSCI World ESG Quality Select Low Volatility 3% Decrement index disappoint

By Emma Trincal

New York, Feb. 10 – Royal Bank of Canada’s 0% notes due Feb. 25, 2027 linked to the MSCI World ESG Quality Select Low Volatility 8% Risk Control 3% Decrement index present little appeal from a profit standpoint due to the modest index performance induced by a low volatility strategy combined with a 3% index markdown, sources said.

If the index return is positive, the payout at maturity will be par plus 1.2 to 1.3 times the index return. The exact leverage factor will be determined at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is flat or negative, investors will be exposed to the losses of the index with a minimum payout of $900 per $1,000 note.

The underlying index is designed to measure the performance of the MSCI World ESG Quality Select Low Volatility index while targeting a volatility level of 8%. A decrement of 3% per annum will be deducted daily from the index performance.

The base index is designed to represent the performance of a strategy that seeks lower risk than the MSCI World index along with improvement in quality, ESG and carbon emission intensity characteristics.

The parent index measures the performance of some large and mid-cap companies across 23 developed markets countries.

Limited gains

“The structure is pretty straightforward. But the underlying is not. You have the volatility control and the 3% dividend cut. Do you really want ESG exposure with these bells and whistles?” said Steve Doucette, financial adviser at Proctor Financial.

“It’s nice to have the leverage and no cap. But by limiting the risk the way they do they’re also eliminating your return.

“That’s a typical example of stuff being sold, not bought.”

The volatility target applied to the index was one factor likely to reduce the performance, he said.

“You’re supposed to get a better risk-adjusted return but you’re not necessarily going to outperform,” he said.

Index family

The underlying index is constructed from the MSCI World ESG Quality Select Low Volatility Index, Net Total Return, which is the “base” index. The base itself derives from the MSCI World index, which is referred to as the “parent” index in the prospectus.

The components of the underlying index and the base index are selected following the sustainable framework defined by the bank.

Annualized returns

The base index does not feature the 8% volatility control strategy and has no decrement fee. It posted an annualized return of 6.75% over the past five years as of Jan. 31, according to MSCI Inc., the index sponsor.

In comparison, the MSCI World index showed an annualized return of 11.28% over the same five-year span.

The annualized return of the MSCI World ESG Quality Select Low Volatility 8% Risk Control 3% Decrement index over the past five years is 5.81% as of Oct. 21, according to MSCI’s latest published data.

“Pretty disappointing returns. It’s nice to get the 90% downside protection except when you don’t need it. If the index doesn’t go anywhere, who cares?” he said.

Synthetic dividend

The 3% decrement, which the prospectus described as a “synthetic dividend,” is a “constant markdown” which also contributes to erode the performance.

The fee of 3% per annum fee is deducted daily from the performance level of the index, guaranteeing that the MSCI World ESG Quality Select Low Volatility 8% Risk Control 3% Decrement index will “underperform the base index in all cases,” the prospectus warned.

“I can’t get too excited about all this. There’s a high price tag for this ESG exposure. And then there’s the fee on the note,” he said.

The deal carries a 3.25% fee, according to the prospectus.

The notes offer another benefit to investors seeking exposure to sustainable strategies: the issuer said in its prospectus that it intends, without being obligated to use proceeds from the notes to fund businesses and projects that meet requirements under its sustainable bond framework.

“Where the proceeds go, who is it for? I guess you don’t really have a say,” he said.

“I’ll take a pass on this one.”

Hot market

A market participant said the popularity of socially and environmentally friendly investing has led banks and asset managers to “push” for a variety of products from ETFs and mutual funds to structured notes and even ratings.

“This market has been growing among a population of millennials making good money who are looking for ways to do something good and save the world,” this market participant said.

“This industry is booming. Look at BlackRock. ESG is their top priority.

“So far it makes sense for a lot of people. The stock market has had record highs three years in a row, and we’ve been in the longest bull market. But when the market stops doing so well and ESG stops performing nicely, people will have a different perspective.”

Sometimes the difference between a broad index and its ESG-version is not significant, he said.

“You have to look under the hood. Compare the S&P 500 with the S&P 500 ESG index. You’ll find the same names.

“The Street lures well-intentioned investors. It’s just a marketing gimmick in my opinion.

“I see the same predatory philosophy around cryptocurrencies. People get lured into Bitcoin for the fast money even though they don’t understand anything about it. They don’t seem to care about the huge price swings. It’s a tulip mania.”

RBC Capital Markets LLC is the underwriter.

The notes will price on Feb. 22 and settle on Feb. 25.

The Cusip number is 78016FDV3.

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