JPMorgan’s CDs tied to JPMorgan Optimax Market-Neutral index offer long/short commodity play

By Emma Trincal

New York, May 10 – JPMorgan Chase Bank, NA’s 0% certificates of deposit due May 31, 2023 linked to the JPMorgan Optimax Market-Neutral index offer commodity exposure with principal protection through a strategy that takes long and short positions in specific commodities in order to maximize returns.

If the index return is positive, the payout at maturity will be par plus 140% to 155% of the index return, according to a term sheet. The exact participation rate will be set at pricing. If the index return is flat or negative, the payout will be par.

The index references the value of a synthetic portfolio of 18 commodity constituents, each of which is a sub-index of the S&P GSCI index and is intended to serve as a benchmark value for a particular commodity. The index employs a strategy that is based on modern portfolio theory and momentum theory. The level of the index reflects the deduction of a fee of 0.96% per year that accrues daily.

Diversifier

“There are many things you can do when you have a lot of money to invest. But for an investor with $10,000 or $100,000 who wants to have a low-risk exposure to commodities, this is one option,” a market participant said.

“Most investors could benefit from commodities exposure because portfolios are overwhelmingly weighted toward equity and bonds.”

Commodities in the past two years have been in bear market territory, making investors averse to the downside risk. The full principal protection offered by the CDs may help cautious investors regain confidence to access the asset class, he said.

“Of course, it’s a seven-year term. But check interest rates. When you offer a payoff linked to the performance of an index, the investor has to exchange the cash-flow stream of a fixed interest rate for a return based on an index. Rates are so low that you have no choice but [to] extend the maturity, especially if you’re going to eliminate the cap,” he said.

Some advisers said the wrapper and the structure are fine but had some issues with the use of the underlying.

Steven Jon Kaplan, founder of TrueContrarian Investments, for instance, had two objections: the embedded commodities futures contracts in the index and the strategy used for the investment.

Contango

“You always have the contango issue when you invest in commodities futures. I prefer to buy stocks of producers,” he said. He was referring to the stocks of oil and gas producing companies for instance.

A market is in contango when the cost of rolling the futures contracts further in time increases.

Rolling can be a cost or a gain depending on the price of the nearby contracts (to be sold) in relation to the further-dated contracts (to be bought). Contango generates a cost due to the negative roll yield as it occurs when the nearby contract is priced lower than the further-dated one.

The index generates a dynamic long/short exposure to commodities through a synthetic investment in up to 18 of the 24 sub-indexes constituting the S&P GSCI index. The portfolio is rebalanced monthly based on a rules-based methodology.

Strategy

Kaplan said he is not comfortable with rules-based indexes as the methodology may not be transparent.

“The rules may be clear, but the result may end up completely random,” said Kaplan.

His main concern is the momentum approach the index relies on.

The momentum strategy seeks to capitalize on trends in the price of the assets. The index assigns weights to the constituents based on their performance in the past 12 months, according to the term sheet.

“I think using long/short exposure in a market that’s extremely undervalued is a mistake. You may end up neutral with zero return,” he said.

“I’d much rather take advantage of these levels and buy low. Commodities have been down so much, you want to stay on the long side right now.”

Backtesting, allocating

Tom Balcom, founder of 1650 Wealth Management, said he avoids proprietary indexes in general.

“We never saw a proprietary index with a bad backtesting. We learned our lesson. We’re steering clear of proprietary indices,” he said.

The investment decisions in the model are indeed based on past returns. Balcom said he prefers to invest in broader indexes because the future is “unforeseen.”

He also raised an allocation question.

“It’s long/short. So should we allocate it to an alternative bucket or to a commodity bucket?”

Since the index is entirely “commodity-based,” the natural inclination would be to allocate the CDs to the commodities portion of the portfolio. But then came the issue of benchmarking the position.

Monitoring

The JPMorgan Optimax Market-Neutral index outperformed the S&P GSCI index over the past year (down 0.90% versus down 32% for the S&P GSCI) and over the past five years (up 1.70% versus down 57.4% for the broad index), according to the Bloomberg website, which publishes the Optimax index performance. For the year to date, however, the JPMorgan index is down 1.80% versus a 3.50% gain for the S&P GSCI fund.

“The comparison is tilted because you’re comparing the long-only benchmark with the long/short algorithm,” said the market participant.

“To do it properly, you would have to take the best sub-indices and then the worst sub-indices and see what the overall long/short performance does.”

That was precisely what made Balcom reluctant to use the index. In general, the difficulty in assessing the return of a proprietary index against a well-known benchmark is one of Balcom’s main objections to smart-beta investing.

“What benchmark do you use? How do you monitor a proprietary index?”

Finally, pricing was a consideration as well.

“When we do a reverse inquiry in the S&P, we have four or five banks competing, each bidding out the pricing. Obviously it’s going to lower the cost for us. When you have a bank issuing a note on their own index, what type of pricing do you think you’re getting?”

J.P. Morgan Securities LLC is the agent. Incapital LLC is distributor.

The CDs will price May 25.

The Cusip number is 48125YV92.

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