These short-term notes, which trade on the American Stock Exchange as equities, are investment-grade obligations of Citigroup Funding and mature on Jan. 8, 2008. They pay no interest. Instead, the return, in the form of capital gain or loss, is tied entirely to the performance of the benchmark index to which they have been linked.
Contrary to what equity investors are accustomed to, the return here does not depend on the level of stock prices. The only consideration is the gap between the performance of the S&P 100, a large-cap collection, and the small-cap S&P 600 index. If the market declines, even sharply, the return would still be positive if the decline in the S&P 100 is less severe than that experienced by the S&P 600.
Here's how the CBOE Large Cap over Small Cap index, the measure of relative performance relevant to these notes, is calculated:
The index is assigned a value of 100.00 on the start date, Sept. 25, 2006. On any subsequent date, the percent change in the index is equal to the cumulative (since Sept. 29, 2006) percent change in the S&P 100 minus the percent change in the S&P 600. If the S&P 100 rises 7 percent and the S&P 600 falls 2 percent, the percent change in the index would be 9 percent. If the S&P 100 falls 4 percent and the S&P 600 falls 9 percent, the percent change in the index would be 5 percent. If the S&P 100 rises 6 percent and the S&P 600 rises 9 percent, the percent change in the index would be minus 3 percent. The value of the CBOE Large Cap over Small Cap index is 100 multiplied by the cumulative percent change. If the S&P 100 rises 7 percent and the S&P 600 falls 2 percent, the index value would be 109. If the S&P 100 falls 4 percent and the S&P 600 falls 9 percent, the index value would be 105, a positive return even though both large- and small-cap stocks fell. If the S&P 100 rises 6 percent and the S&P 600 rises 9 percent, the index value would be 97, a negative return even though both large- and small-cap stocks rose, thus underscoring that this index measures, not overall market direction, but relative performance between two groups.
That seems straight-forward. Actually, though, structured securities often have odd wrinkles that alter the usual range of probable outcomes. This one is no exception and adds more spice for those who really are committed to a large-cap strategy.
If the index value is above 100 on the maturity date, the percent return on the notes will be 125 percent of the index appreciation. So if the index finishes at 110, the notes will return 12.5 percent, making for a final payoff of $11.25 per share. If the index value winds up even, at 100, on the maturity date, the notes will be worth $10.00, a return of zero. If the index is below 100 on the maturity date, the return will depend on one more factor. If, at any point in time while the notes are outstanding, the index value falls to or below 85, the notes will offer a negative return equal to the decline in the index. If, for example, the index winds up at 82, the notes will be worth $8.20 at maturity. If the index falls to 82 at some point while the notes are outstanding but winds up at 96 at maturity, the notes will be worth $9.60. If the index is below 100 on the maturity date, but did not at any time fall to or below 85, the maturity value of the notes will stay at $10.00. So, for example, if the index stays above 85 at all times and finishes at 88, the notes will be worth $10.00 at maturity.
Probability of success
The marketing adage "past performance does not assure future results" is usually repeated as a warning. These notes are different. Investors here should cross their fingers and hope the adage carries the day.
For much of the recent past, small caps have outperformed large caps, sometimes by very wide margins. In the past three years, there were only nine trading days where the 15-month return (the approximate maturity period of the notes) on the S&P 100 was greater than that of the S&P 600. The good news is that all nine of those days occurred since these notes were issued on Sept. 29, 2006.
Superficially, this looks like a martingale betting strategy -- where one would keep doubling bets after losses reasoning that each defeat brings the player that much closer to victory since in the long run, the average outcome will prevail -- that's finally set to hit pay off. Small caps have outperformed large caps so often in recent years, large caps would, according to this theory, have to prevail now just to align real-world experience with the laws of probability.
That, of course, is not a viable investing strategy. It's not so great for gambling either since the string of doubled-up losses often proves long enough to exhaust a player's bankroll.
Martingales aside, the large-cap-superiority strategy could still have substantive merit.
Many argue that large cap valuations are more favorable now, given the lengthy period of strong small-cap share price performance. That claim is hard to prove since there's so much subjectivity in deciding which stock goes in which group. As one example, consider whether a small cap that soars to become a large cap should remain in the small cap group, and have its elevated valuation counted there, or should it be transferred to the large cap group.
Much more straightforward is the often-observed tendency of investors to favor large-cap stocks when they are nervous about the future. Smaller stocks are often stronger during periods when investors are most optimistic, such as the rallies we saw in 2003-04, as stocks roared back from the early-decade swoon. So far in 2006, overall relative performance between small and large stocks has been pretty much neck-and neck with large issues performing best when investors were most fearful, of oil, of the Middle East, of interest rates, and so forth.
Since summer, small caps have been stronger as the aforementioned fears have receded. This structured note is most suitable for those who see the past few months as a temporary respite and believe that deep down, we're not yet out of the woods on the geopolitical and economic issues that worried investors back in the spring.
At the time of publication, Marc H. Gerstein did not shares of ICZ. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
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