Bank of Montreal, Morgan Stanley to price notes linked to rules-based, proprietary indexes

By Emma Trincal

New York, Sept. 5 – In an effort to appeal to investor appetite for strategy-focused notes, two issuers are planning tracker notes linked to stock-picking strategies defined internally by the issuer via a proprietary index.

Those “smart indexes” used as underliers for the notes pick the reference stocks using quantitative, rules-based methodologies with the objective of generating higher returns.

“The use of those quantitative indexes on structured notes has been a rising trend for a while now. Investors want research,” a market participant said.

“These indexes are designed to facilitate investors’ access to in-house research. They offer an example of investors’ increasing appetite for a bank’s stock-picking model.”

A sellside market professional said, “You’ll be seeing a lot more of these strategies as many firms look to find ways to outperform the S&P 500.”

BMO’s fundamental approach

The first product is Bank of Montreal’s 0% notes due Oct. 9, 2015 linked to the BMO Q-30 Strategy. The strategy creates a hypothetical portfolio of stocks selected from the S&P 500 index based on the strategy’s financial metrics, according to a 424B2 filing with the Securities and Exchange Commission.

The portfolio will initially be an equally weighted basket of the top 30 ranked securities as determined by the strategy. The calculation agent will adjust the stocks included in the portfolio on a daily basis.

The payout at maturity will be the indicative note value on the final valuation date.

The strategy ranks the stocks based on five factors. Two of them – price to earnings and price-to-book value – score better when the metrics are low. For the three other factors – return on equity, price momentum and earnings momentum – the higher the factor, the higher the ranking.

Morgan Stanley’s hedge hunt

The second product is Morgan Stanley’s 0% participation securities due March 2017 linked to the Morgan Stanley SmartInvest Equity Index (Price Return), a quantitative strategy that also picks stocks from the S&P 500 index universe.

The rules-based model selects 40 stocks that are among the more concentrated positions held by hedge funds as reported on their 13F forms. The main requirement for a company to be included in the index is to have a high proportion of shares of the stock owned by hedge funds, according to a 424B2 filing with the SEC. However, the index will assign a higher ranking to companies that are owned by a small number of hedge funds and a lower score when a great number of hedge funds own the stock.

The securities are also subject to other requirements, including a liquidity test. The index is rebalanced quarterly.

Alpha, beta

“These are two proprietary rules-based indexes that investors are looking to use to gain access to a particular strategy as they are trying to outperform the market,” the market participant said.

“The firm creates an index. Based on their model and their selection methodology, they’re trying to give investors a better result than beta.”

Rules-based, quantitative indexes aimed at delivering better returns are often coined “smart beta.” This market participant said it is a misnomer.

“I would be more inclined to call them alternative weighting rated indexes,” he said.

“They’re different than the major indexes that use a market-capitalization method. They use those large benchmarks as their original universe, their starting point. What makes them different is that instead of using market capitalization as a selection factor, they apply a methodology with a set of filters and they rank the stocks accordingly in order to populate their index.”

Ultimately, the term “smart” should apply to the result, not the approach.

“An index is only ‘smart’ when it outperforms the market. So it’s not so much the rules applied but the outcome that makes a difference,” he said.

“From an investor’s standpoint, you have to believe that the strategy and selection criteria used in the index will give you additional value. For the investor the question is simple: does it make sense? Am I comfortable or not?”

Commenting on the two underlying indexes, he said that the BMO strategy is “fairly straightforward,” as the issuer in the prospectus describes the methodology in detail.

“It’s a fundamental investing approach. The methodology described is transparent. They tell you which criteria they use and how they rank it,” he said.

Conviction

The Morgan Stanley model based on hedge fund ownership is different, although no less transparent, he said.

“They’re looking at conviction bets,” he said.

“They chose stocks with the highest hedge fund ownership percentage. But at the same time, they give preference to a fewer number of hedge funds rather than a greater number.

“It means they are not looking at hedge funds getting in and out of a trade but rather they seek those like a Pershing Square for example that invest in a stock and build up a stake in the company over time.”

One problem with the 13F filings is that reporting occurs with a delay, he noted.

“A hedge fund has 45 days to file after the quarter ends. So in theory, you could get in the filing some information that’s 135 days old,” he said.

“But the idea is to find stocks where hedge funds have large positions. If they own 5% or 10%, you can’t trade in and out. They want to track the early process. For instance, a hedge fund wants to target a company either because it has good prospects or because it’s a takeover candidate, whatever the reason. Later on, someone else will follow and very soon more will jump onto the bandwagon until a big crowd ends up owning the stock. By ranking higher a small number of investors, the index can position the investment at the early stage of a rally instead of waiting for the share price to be high because everybody is already in it.”

Growing trend

Investors are likely to pay more attention to those delta-one notes linked to a strategy even though they fail to deliver some of the appealing payout features of structured notes such as buffers and leverage, sources said.

“We’ll see more of those. It’s already happening. The S&P 500 has been up so much, more people are looking for the next idea, the next space where they can find performance,” the market participant said.

But it does not mean that issuers will have an easy time selling those products.

“The issue with those new strategy-focused notes will be how issuers are able to explain the investment rationale versus a vanilla investment in the S&P 500,” the sellside market professional said.

“That said, many of the screening strategies have significantly outperformed the S&P 500 in recent years, so it’s all about the marketers rising above the white noise to articulate the value proposition of the strategies.”

Bank of Montreal’s notes (Cusip: 06366RWK7) are expected to price Sept. 25 and settle Sept. 30. BMO Capital Markets Corp. is the agent.

The Morgan Stanley notes (Cusip: 61758S708) are expected to price and settle in September. Morgan Stanley & Co. LLC is the agent.

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