RBC's notes tied to EquityCompass strategy take emotions out of the equity allocation decision

By Emma Trincal

New York, July 12 - Royal Bank of Canada's $7.8 million of 0% direct investment notes due Aug. 8, 2011 linked to the EquityCompass Equity Risk Management Strategy are designed for investors who want to get exposure to U.S. large-cap stocks while reducing the downside risk associated with a severe bear market.

The underlying index was launched in September 2008 by EquityCompass Strategies, a registered investment adviser owned by Stifel Financial Corp.

The underlying strategy uses a set of rules to construct a theoretical portfolio of different combinations of cash and a long or short position in the S&P 500 Total Return index, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be the final value of the portfolio.

If the portfolio value is less than or equal to 50% of the initial investment on any day during the life of the notes, the notes will be called, and the payout will be the value of the portfolio on the first trading day following the call trigger date.

An RBC specialty

"This is RBC's 14th offering of a structured note linked to this index," Michael S. Scherer, vice president of portfolio management at EquityCompass Strategies, told Prospect News, adding that so far, RBC is the only U.S. issuer to have used this index as the underlying of a structured note.

Since its first deal in June of last year, RBC has issued approximately $102 million of such products, according to data compiled by Prospect News.

Scherer said that at times of high uncertainty and rising volatility, when investors have trouble calling the bottom for stocks, a tactical asset-allocation tool allowing them to make systematic, non-emotional decisions via a set of predefined rules can be very valuable. Investors in this context may maximize their chances of exiting the market when the downturn is imminent and may participate in the ensuing rally.

The initial investment in the hypothetical portfolio is $981.00 per $1,000 principal amount of notes. RBC will reduce this by 0.15% on the pricing date and each time the portfolio is reallocated, which occurs monthly. The initial allocation is 5% in cash, or $49.05 per note, and 95% in a long position in the index, or $931.95 per note.

"The rule set is adaptable to changing market conditions and allows investors to dynamically manage their equity exposure. It allows investors to move away in the eventuality of an extremely negative event while giving them to opportunity to capture the benefits of a bull market," he said.

Fundamental and technical

The model on which the index is based is built around two types of indicators: fundamentals and technicals, said Scherer.

The fundamental indicators measure changes in consensus analyst estimates for the S&P 500 in the next 12 months. Two consecutive months of rising earnings will generate a signal that turns the model favorable toward stocks, according to an EquityCompass fact sheet.

The other type of indicator is a proprietary model called the Technical Price Model, said Scherer. It is based on technical analysis.

Scherer said that several asset-allocation models exist in the market but that the EquityCompass Strategy is different than most because of the downside protection it provides.

The index mitigates risk by increasing the cash allocation and the short exposure to stocks, he said.

Severe bear markets

Scherer said that the strategy is not designed to protect investors against any stock market downturn, as it focuses on severe bear markets only.

"We don't try to identify every dip in the market. We look at 35%, 40% or 50% wealth destruction, in other words, levels you've seen in 2008 or at the end of 2001."

In April and May 2009, the allocation defined by the model was all cash, he said.

Starting in July of last year, the model allocated 60% to equity and 40% to cash.

"Right now, we've been fully long the market since September," he said. "We're 5% in cash and 95% long stocks. And we haven't moved away from the market because the earnings estimates are up."

Rational decisions

Another advantage of the index is to help investors avoid investment decisions that are irrational, in particular, too pessimistic or too optimistic.

Peter Rup, chief investment officer at Artemis Wealth Advisors and who is bullish on U.S. stocks, said that market expectations tend to be too pessimistic right now due to heightened uncertainty and volatility. As a result, people are tempted to sell stocks too soon out of fear.

"If the index provider can manage this model skillfully, then it may help investors in this trendless market," he said.

Excessive pessimism

"There is a lot of pessimism and uncertainty out there. For instance, people associate too loosely a healthy employment situation with a bull market. They think that as long as we don't have 4% unemployment, we can't have the S&P 500 at 1,500. But people continue to buy food, transportation, insurance. They may not drive BMWs, but they drive Fords and so be it," Rup said.

"I am bullish on the market because everything is severely undervalued. I want to buy now. I don't want to sell," Rup said.

Good U.S. fundamentals

"Even if we have a technical breakdown at this time, fundamentals of U.S. corporate sector are extremely good," he said.

He cited the U.S. corporate savings rate of almost 7% of GDP as "good" as well as the credit quality and enterprise value of the private sector as "rising, not falling," among other examples.

Rup said models or indexes that take away emotions - positive or negative - from the investment decision may be valuable as long as they use the right indicators.

Some flaws

However, he said that "forward-looking earnings are not necessarily the best measure" to predict future market moves.

"If you anticipate a double-dip recession, then the earnings wouldn't be reliable. It may work if your economic outlook is positive but not the other way around," he said.

"You need to have the correct call fundamentally, then use the technical to make your in and out decisions," he said.

"Right now, stocks are down because the market is expecting disappointing earnings for the second half.

"I disagree. I think growth prospects are good. But we have a down-trending market. There's a tremendous amount of risk aversion in this market because of the uncertainty."

Rup said that rather than future earnings, he prefers to look at price-to-book value.

"I expect the S&P 500 will be 10% to 12% for the year, so the market will have to rally quite a bit from here," he said. "But the economy will continue to grow as companies are 30% undervalued relative to their book value."

RBC Capital Markets Corp. is the underwriter.

Fees are 1.4%.

© 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.