JPMorgan’s 1% protected notes tied to Efficiente Plus DS 5 offer diversification, low vol.

By Emma Trincal

New York, July 6 – JPMorgan Chase & Co.’s 1% notes due Jan. 11, 2021 linked to the JPMorgan Efficiente Plus DS 5 Index (Net ER) attracted advisors’ interest for some of the benefits the underlying algorithmic index offers, such as dynamic asset allocation and controlled volatility.

The payout at maturity will be par plus at least 130% of any index gain, with the exact participation rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index falls, the payout will be par.

Interest will be payable annually.

The JPMorgan ETF Efficiente 5 index seeks to provide exposure to a range of asset classes and geographic regions based on the modern portfolio theory approach to asset allocation. The index selects from a basket of 12 ETFs and the JPMorgan Cash Index USD 3 Month. It dynamically allocates those constituents each month based on a rules-based methodology that targets an annualized volatility of 5% or less. The volatility target itself is adjusted daily.

Carl Kunhardt, wealth advisor at Quest Capital Management, said he likes the Efficiente index not just as an investment but as a benchmark.

“The index is well constructed. We did this note before. It is really transparent compared to some of the other proprietary indices that are kind of black boxes. This one is straightforward,” he said.

“We own five to seven of these types of notes. Even though it’s a proprietary index, we’re so familiar with it now. We’ve become very comfortable with it.

“I like the fact that it’s diversified. You have 19 ETFs and several asset classes. You have equity but you also have bonds.”

Alpha ruler

Kunhardt said he uses the Efficiente index as a tool for building his portfolios.

“Whenever you have to construct a portfolio from scratch, you’re only as good as your asset allocation and your security selection. If you pick a series of benchmarks for each asset classes, all the work you did in asset allocation is in your benchmarks. Your only source of alpha, what you rely on is solely your security selection. Your asset allocation is already in the index,” he said.

“What I like with the Efficiente is that it provides a diversified benchmark, one that is built on academic research and it covers all the fundamental asset classes, and by that I mean small, mid and large caps. You have a measuring stick. You have a ruler you can measure your portfolio against. I’m not only measuring my security selection. I’m also measuring how well my judgment in my allocations did relative to this benchmark.”

Clients who purchased Efficiente-based notes in the past tend to be conservative, he said.

Bond substitute

“Most investors need bond exposure but we’re in a type of market right now that is not very conducive to straight fixed income investments. You need equity in your portfolio but you also need the bond allocation to pull down the risk,” he said.

“One way to get that same diversification without having to increase your risk is to use something like this structured note, which actually gives you the 20-year Treasury, the investment-grade, the small caps, the emerging markets, all the asset classes but in a package that targets volatility in less than 5%. That’s bond territory.”

In a document distinct from the prospectus, JPMorgan offered a performance update on the index as of June.

The JPMorgan ETF Efficiente 5 index so far is down 0.2% this year. It showed a 6.67% gain last year preceded by a 2.41% positive return in 2013. In 2012, the index was up 6.90% and it gained 11.62% in 2011, according to this document.

“An 11.62% is full equity return. One can say that 6.90% and 6.67% are also equity returns,” he said.

Kunhardt said that finding an allocation for the notes themselves has not been easy because the underlying index diversifies across several asset classes and asset types.

“It’s interesting. We ended up putting these notes in our alternative investment bucket. It’s not truly a bond. It’s not truly equity. While it uses traditional asset classes they really are derivatives instruments.”

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said the diversification and volatility target made the product unique.

“It’s an asset allocator. It’s definitely not an equity-type of investment. The annualized return is not the main target. It’s the annualized volatility below 5% you want to shoot for. Keeping volatility under check is actually a very nice feature,” he said.

Some drawbacks

He limited his criticism of the deal to a few minor points.

First, he believed the index methodology could have been better described in the prospectus.

“I wish the information they gave us about how they make the allocation decisions would be a little bit more straightforward,” he said.

Second the Efficiente index was still relatively new.

He looked at the comparative historical and hypothetical annualized total returns on the performance documents, which revealed a 5.26% return for the Efficiente index over the past 10 years compared to 5.88% for the S&P 500 Excess Return index and 2.45% for the Barclays Aggregate Bond excess return index.

“We’re only four-and-a-half years into this index. I am always a bit wary about relying too much on backtesting,” he said.

This is because the index was created in October 2010.

Finally the 0.85% fee per annum was considered “a little bit pricey.”

Defensive instrument

“That said it’s not a bad investment,” he added.

“The performance should not be compared to the S&P. The Barclays Aggregate would be a better bogey. “Compared to that, the index over the last five year outperformed with a 6.40% return versus 3.37% for the Bond Aggregate. That’s really not bad.

“Meanwhile the volatility is much closer to the Bond Aggregate. It’s not a bad investment.”

The notes could be “very appealing” for a conservative portfolio given the principal-protection, low volatility as well as the payment of a 1% fixed coupon each year.

“Getting 1% in coupon is better than most CDs,” he said.

“The idea of capping the asset classes to dampen volatility each day is very appealing for investors looking for a defensive play.”

Terms

Kalscheur said that when he first looked at the notes, he was “amazed” and somewhat skeptical.

“You get 1% in fixed interest, participation in an index, 1.3 times leverage, no cap and full principal protection ...How can that be?

“I was amazed. It seemed like a panacea.”

“But when you think about it, there is a reason. They can do that because they’re taking less risk. All those features are cheaper to price. I suppose buying the puts and the calls is cheaper with the low volatility.

Kalscheur would not use the product in an equity allocation even if some of the index constituents are equity ETFs.

“I’m getting less risk, I’m getting my money back, I am getting income and I have a chance to get some good return without taking too much risk. This is a bond substitution strategy.

“I would consider it for some of my conservative clients who are already familiar with structured products. “I might use it on the bond allocation or as a nice addition to a defensive portfolio.”

J.P. Morgan Securities LLC is the agent.

The notes will price on July 6 and settle on July 9.

The Cusip number is 48125UZM7.

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