Investors Seek Rule-Based Indexes to Beat Stock Gains, Diversify

Indexes that sometimes use complex strategies are attracting more interest from U.S. structured note buyers looking to diversify investments and beat this year’s stock gains.

Investors bought $662.8 million of U.S. securities tied to proprietary bank indexes this year through Dec. 6, up 5 percent from the same period a year earlier, according to data compiled by Bloomberg. Last month’s sales of $251.2 million were the most since at least January 2010.

Investors are more willing to pay extra fees for indexes that can use algorithms to try to boost gains or hedge against losses, as issuance of U.S. notes linked to currencies, commodities and interest rates have all dropped in 2013. Notes tied to proprietary indexes often come with embedded costs not found in securities linked to more popular gauges, such as the Standard & Poor’s 500 Index, Bloomberg data show.

“People are looking for that excess return,” said Masi Yamada, head of cross-asset marketing at JPMorgan Chase & Co. in New York. Increasingly, investors are looking for “more quantitative” strategies to get higher yields, he said.

The S&P 500 has risen 24 percent this year through today.

JPMorgan Chase, the year’s second-biggest U.S. structured-note seller, has issued $402.2 million of the securities in 2013, the most of any bank, Bloomberg data show. Its most-popular index in 2013 is tied to commodities, rebalances monthly and can change its members weekly to favor commodities that exhibit the most “backwardation,” where earlier contracts cost more than later deliveries, according to a prospectus.

‘Captive Product’

While even the most widely used indexes are in some sense proprietary, the trading strategies linked to structured notes are typically developed, calculated and marketed by the banks issuing the securities. The indexes use algorithms to pick underlying assets from stocks to volatility futures.

Investors have to realize that they’re buying “a captive product” because only one issuer will provide prices, Bernd Henseler, vice president of structured products at S&P Dow Jones Indices in Toronto, said in a telephone interview. “It’s up to the client to decide, ‘Do they provide me really with an edge, or not?’”

Notes tied to proprietary indexes sometimes have more fees than more common structured notes, Bloomberg data show. JPMorgan’s $2.44 million of securities that were sold Sept. 5, tied to its JPMorgan Volemont Strategy and the S&P 500, charge 0.75 percent a year related to the volatility index, a 0.25 percent “equity deduction” fee and 0.85 percent annually for an “accrued volatility deduction,” according to a prospectus filed with the U.S. Securities and Exchange Commission. Investors may pay daily and monthly fees at times when the index employs futures on the Chicago Board Options Exchange Volatility Index, known as the VIX.

The VIX, which measures price swings for the S&P 500, averaged 14.3 this year, less than the 17.8 last year.

Low Correlations

One advantage of such indexes is that they are designed to have low correlations with other kinds of assets, even in financial crises, Yamada said. “I don’t know if that necessitates complexity, but it generally means creating something that’s not readily available and obvious, otherwise everyone would do it,” he said.

JPMorgan has as many as 500 proprietary indexes globally, he said. Most individual investors who want to track the indexes buy notes or certificates of deposit, while institutional investors generally use total-return swaps, he said.

The bank sold the largest offering tied to a proprietary index in four years on Nov. 22, $234.7 million of five-year notes tied to its JPMorgan Enhanced Beta Select Backwardation Alternative Benchmark Total Return Index, Bloomberg data show.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts with values derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

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