Morgan Stanley's Russia-linked PLUS too risky, analyst says; more ETF-linked products may aid hedging

By Kenneth Lim

Boston, April 18 - Morgan Stanley's recently launched products linked to the Market Vectors - Russia exchange-traded fund (ETF) are riskier than more typical offerings because of the nature of the underlying, structured products analyst Tim Mortimer of Future Value Consultants said.

"The index itself is quite volatile, as you can expect from an emerging market," Mortimer said. "The products are more risky because of the underlying."

Morgan Stanley earlier in the week announced zero-coupon performance leveraged upside securities (PLUS) notes due May 2009 linked to the fund.

At maturity, the PLUS notes will return three times any percentage increase in the underlying share price, capped at a maximum total payout of 120% to 121% of the $10 principal. If the underlying is flat or lower, investors will lose 1% for every 1% decline in the share price.

Morgan Stanley also launched a series of 10% to 12% reverse convertibles due Oct. 28, 2008 with a trigger level at 75% of the initial share level. The coupon will be set at pricing.

If the underlying share price falls below the trigger level during the life of the notes and finishes below its initial level, the payout will be a number of shares of the ETF equal to par of $1,000 divided by the initial share price. Otherwise, the payout will be par.

The Market Vectors-Russia ETF seeks to replicate the price and yield performance of the DAXglobal Russia+ Index, which is made up of a stock basket of the 30 most heavily traded Russia-based companies that are listed in Russia and on global exchanges.

"The underlying itself is tracking the index," Mortimer said. "It's an ETF which takes those stocks and for a management fee tries to track those stocks."

Given the volatility of the fund, the PLUS notes seem unattractive, Mortimer said.

"For the buffered notes, I question the wisdom of this construction a little bit," he said. "There's no downside protection, a maximum return of 20% to 21% over one year. These kinds of structures are mostly for indexes that you don't expect too much from, the more mature indexes. If there's a barrier in there then you can say, well, there's some downside protection."

Mortimer also noted that the notes underperformed the underlying fund over the past year. Based on information provided in Morgan Stanley's product prospectus, shares of the ETF gained 26.4% from April 30, 2007 to April 14, 2008. The maximum yield on the PLUS notes will be capped at 20% to 21%.

The lack of any downside protection is perhaps the biggest sticking point for Mortimer.

"Aside from the historic performance, there's no downside protection," he said. "That would make it a lot more logical product in my mind."

The reverse convertible appears more interesting, Mortimer said.

"Here you have got downside protection, a fair amount," he said. "There's a 10% to 12% coupon, which is a decent coupon, although there are plenty of reverse convertibles that pay higher than that."

Based solely on the coupon level, the reverse convertible could be an alternative to other reverse products with a lower yield, he added.

"Compared to other reverse convertibles that have been issued, possibly there's one such as the one linked to General Electric from Eksportfinans, with a lower coupon," he said. "Just in terms of running coupons side by side, this could make sense."

More products links to ETFs

Mortimer highlighted an increasing trend of linking products to ETFs.

"Linking to ETFs has become quite common rather than linking to indexes," he said.

The decision to link to ETFs could be partly due to a desire among some investors to hedge their structured investments, Mortimer said. Structured products that are linked to indexes could be difficult to hedge against because some indexes are more difficult to replicate, he said.

But if the underlying of the structured product is an ETF, it becomes much easier to hedge using the exchange-traded shares of the fund while taking a position on the same strategy, Mortimer said.

"With structured products linked to the ETF, that hedging problem decreases," he said.

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