Morgan Stanley's PLUS tied to iShares MSCI Japan, precious metals to offer inflation hedge

By Emma Trincal

New York, Feb. 22 - Morgan Stanley's planned leveraged notes linked to a Japanese equity index fund and precious metals offer investors the opportunity to play diverse macroeconomic scenarios while providing above-average gains in a sideways market, a source said.

Morgan Stanley plans to price 0% Performance Leveraged Upside Securities due Aug. 25, 2011 linked to a hybrid basket, according to a 424B2 filing with the Securities and Exchange Commission.

The basket includes the iShares MSCI Japan index fund with a 50% weight, platinum with a 20% weight, silver with a 15% weight and gold with a 15% weight.

The payout at maturity will be par plus double any basket gain, subject to a maximum return of 18.8% to 22.8% that will be set at pricing. Investors will be exposed to any basket decline.

Unusual underlier

"The underlying of those notes is out of the ordinary. Obviously, with so many people worried about inflation, the precious metals component makes sense, and demand is rising for that type of paper," said Jim Delaney, portfolio manager at Market Strategies Management in Township of Washington, N.J.

"But the Japanese stock component is what makes it interesting. Japan has been down for so long, there's been so much written about Japan's lost decade that many are anticipating a stock market rally in Japan."

Delaney said that the mix of commodities and Japanese stocks is attractive because both components of the underlying basket have the potential to hedge one another.

"It's a little bit of a middle of the road kind of deal. The notes are an attractive feature to participate in equities against the precious metals. You can see how the interplay of the two asset classes can give you opportunities for gains in different kinds of economic scenarios," Delaney said.

Inflation, double-dip recession

Delaney said that precious metals may rally in two cases: inflation and a double-dip recession scenario. While in the short run, the inflation scenario may be good for equity, an economic slowdown would have a negative impact on stocks, said Delaney. As a result, the underlying basket offers return potentials in very different, if not opposite macroeconomic outcomes, he said.

Delaney looked at the inflation view first.

"At some level, a certain amount of inflation is good for equities because it increases revenues. Initially, companies can increase prices without having to incur higher costs, at least not in the early stages. But it's temporary. Once inflation takes a hold, labor wants to be compensated and as a result, business costs go up. Companies may not pass all the costs to consumers, so you start to see a margin contraction," said Delaney.

In such circumstances, the precious metals component of the basket would do well but the equity portion would begin to be under pressure, Delaney said.

However the negative impact of inflation on the MSCI Japan component of the basket is likely to be minimal, he said, because it takes time for inflation to reduce corporate margins.

"You would get through the margin expansion phase. It's only after 18 months to two years that you're starting to feel the reverse cycle of margin compression," said Delaney.

Looking at the opposite economic outcome, "another economic downturn," Delaney said that precious metals in this environment would do well but not necessarily stocks.

"If you go through a double-dip recession, people are going to look for ways to preserve their wealth with precious metals. But at the same time, global economies would not be in good shape, and the MSCI Japan may not rally as expected," he said.

While the inflation scenario would benefit the entire basket, at least during the 18-month duration of the notes, the recession situation would probably create a situation where gains in commodities may be offset by equity losses. As a result, one scenario could lead to strong basket gains while the other may show flatter returns, he said.

Well-capped

"The structure works because the leverage compensation makes up for the cap," Delaney said.

"If there is a sideways market, you'll have the benefits of having your yield increase because of the two times leverage."

Given market anticipations, the 20% cap is unlikely to limit the upside too much, Delaney said.

"Very few people think we'll have the kind of market growth over the next year or two as what we've had last year. In that context, it might not be such a bad thing to give up more than 20% if the market is going to go up by 5% or 10%. I could see how fixed-income investors could be attracted to that note," Delaney said.

Do-it-yourself

No matter how well-conceived the underlying investment theme offered by the notes may be, some market participants said that the investors are paying too much in fees for the packaged notes, arguing that they could do better and cheaper on their own using options.

"You can structure these products yourself without paying Morgan Stanley a fee," said Wade Slome, registered investment adviser and president of Sidoxia Capital Management LLC in Newport Beach.

The fees for the notes are 1.71%, according to the prospectus.

Slome said that investors could reproduce a similar instrument using exchange-traded funds.

"You could buy the underlying as a basket of ETFs and buy it on margin to get the double leverage," Slome said.

In order to "remove the leverage on the downside," investors could buy "insurance" through the purchase of puts, he added.

Slome offered the following example: He envisaged an investor buying an ETF portfolio replicating the basket with the same weights using two-to-one leverage.

The investor would sell calls at 120. "If the basket goes above $120, you make money on the underlying and you lose on the calls. That's the equivalent of your 20% cap. The underlying gains offset the losses on the calls," said Slome.

With the premium received from writing the calls, the investor buys puts for the same amount, Slome continued.

"So this doesn't cost me anything. The counterparty gave me $5 for selling the calls. I spend the $5 in buying puts. There is no out-of-the-money expense for this," Slome said.

The puts allow the investor to get some downside protection, he noted.

"You have replicated more or less the same structure, and you have some downside protection plus the same cap. When you look at any structured product that has a cap or a floor, you have to analyze what's behind it, and it's usually some kind of options derivatives," said Slome.

Cost of packaging

Slome said that he favors this ETF portfolio hedged with options over the notes.

"The ETFs would probably cost you about 50 basis points or maybe less. So the notes end up costing you three to four times more in fees," he said. "In addition, as an ETF investor you can collect interests and dividends, which is not the case with the notes."

"If investors don't have the sophistication or the knowledge to structure these portfolios on their own, the notes offer a quick, easy way to do it," Slome said. "But you have to be willing to pay a high fee for the service of packaging the product."

The notes will price and settle in February.

Morgan Stanley & Co. Inc. is the agent.

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