Morgan Stanley’s trigger PLUS linked to Russell 2000, Dow have effective barrier, advisers say

By Emma Trincal

New York, July 1 – Morgan Stanley Finance LLC’s 0% trigger Performance Leveraged Upside Securities due July 31, 2024 linked to the Dow Jones industrial average and the Russell 2000 index have a place in a long-term portfolio, financial advisers say.

The high leverage makes it easy to hit the cap, which is relatively attractive for a strategic asset allocation, they noted. But more importantly, the barrier on the downside provides a satisfying level of protection, they added.

If each index finishes above its initial level, the payout at maturity will be par plus 400% of the lesser-performing index’s return, subject to a maximum payout that is expected to fall between 57% and 62% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final level of either index is less than or equal to its initial level but the final level of each index is greater than or equal to its trigger level, the payout will be par. For each index, the trigger level is 60% of its initial level.

If the final level of either index is less than its trigger level, investors will be exposed to the decline of the lesser-performing index from its initial level.

Correction

Carl Kunhardt, wealth adviser at Quest Capital Management, said the two most difficult things to assess prior to buying the notes are the timing of the next recession and which of the two indexes will perform worse.

“At this point in the economic cycle it’s impossible to know what the market will be like in five years,” he said.

“We’re due for a market correction. But when?

“We know that we’re late in the cycle. We know that bull markets don’t last forever. They last five years in average. We’re 10 years into a five-year bull cycle.”

At the same time, Kunhardt does not see a recession in the works at the moment.

“All leading indicators are pointing to a positive territory. The economy is very strong. Unemployment is at its lowest in 50 years,” he said.

But this is now, and a lot can happen in five years, he noted.

Picking the worst of

Kunhardt next tried to identify which of the two underlying indexes is likely to be the worst-performing one.

This second question is related to the first one: the timing of the next recession will provide the answer.

“You have the Dow with the mega-cap stocks and the Russell 2000 made of small caps.

“We know that small caps lead. They lead into a downturn, and they lead into a recovery.”

Heading into a recession

In his first assumption, a correction would happen in the near term, over the next one to two years. Since small caps lead in and out of a recession, the small caps would lead the economy out of the downturn cycle first, but at the end, large caps would outperform.

In his “near-term correction” scenario, the Russell 2000 index would therefore be the worst of.

“It’s possible both indexes would be in positive territory after five years. In this case I don’t care who is the worst of. It’s so easy to get the cap. I get my 10% a year anyway,” he said.

He used a hypothetical cap of 60%, close to the mid-range. This level of gain over five years with the 4x leverage would be the equivalent of a 9.85% compounded annualized return, which he rounded out to 10%. This maximum return may be achieved with a very small index increase of 2.85% a year.

Tail end

His second scenario was one in which the correction hits at the end of the five years.

“The small-cap index leads both ways: in and out of a correction. In this case, it’s the Russell that would be taking us into a recession, so the Russell would also be the worst of,” he said.

Either way, the probability of a 40% drop in the Russell 2000 index was small in his view.

“If it was a year-over-year snapshot, 40% can hit pretty quickly,” he said.

“But it’s a point-to-point snapshot. The likelihood of a 40% drop from the level at pricing is going to be very low.

“That said, you could still be down. But then I just get my money back, and I can live with that. The Dow and the Russell are in my portfolio anyway, so I’m still outperforming my long-only exposure.”

Grey area

The only scenario that may be a “concern” would be the one in which the correction happens in the middle of the term.

“If the market has rallied a lot before, you’ll have more ground to make up for the losses. If it happens soon enough, you may have enough time to at least break even,” he said.

“But it’s impossible to identify which one would be the worst of.

“This would be the only grey area scenario. But even then, I don’t believe you can lose 40% over the five years.”

Planner’s philosophy

Kunhardt said the notes were attractive for a financial adviser whose main approach is financial planning and asset allocation.

“I will always have small caps and large caps in my portfolio no matter what the market does. I’m an asset allocator. I don’t believe in market timing,” he said.

“With this note, I have a good chance to get 10% annualized. I also have a 40% protection. The likelihood of being down more than 40% is kind of low. All I may lose is an opportunity.

“From this perspective, which is the perspective of a financial planner, the note works well for me.

“When you’re a financial planner, you’re just trying to hit returns that are in line with your expectations. You’re not trying to maximize returns. You’re trying to protect your principal.”

Testing the barrier

Michael Kalscheur, financial adviser at Castle Wealth Advisors, was also “impressed” by the structure, saying it offered “balance” even though he could have used a higher cap.

“We’re very comfortable with this 60% barrier even though we just hit all-time highs,” he said.

“We think the U.S. market is fairly valued ... not in a bubble like 2007-going-into-2008 and not the dot.com bubble either.”

Prior to making a buying decision, this adviser uses back testing in order to assess the probabilities of return outcomes.

His firm collected five-year rolling period data for the Russell 2000 index and for the Dow Jones industrial average.

The data on the Russell showed that the index dropped more than 40% only three days over five-year rolling periods since 1987. The same test applied to the Dow revealed that the number of days when the index fell by more than 40% was zero based on five-year rolling periods since 1985.

To go back over a longer historical period, he ran his data on the S&P 500 index going back to 1950. In this case he found the same result as with the Russell 2000 index: the barrier would have been breached only three times.

“Five-year rolling periods day-over-day going back to 1950 ... that’s 16,000 observations. And out of those 16,000 observations, only three of them have broken that 40% barrier. I would say this barrier is very good,” he said.

Cap objection

Kalscheur was less enthusiastic about the cap.

If the index is up less than 3% a year, investors will be “capped out,” he said.

“You have to have extremely low expectations.”

A 60% gain over five years is “pretty average,” he added.

Using the same data, he found that the Dow would gain more than 60% in five years 46.3% of the time.

The occurrence for the Russell 2000 index would be 47.1% of the time.

“That 60% return is kind of what you would be averaging over a five-year period,” he said.

Kalscheur’s final assessment was somewhat mixed.

On the one hand, he said the cap was a little bit low.

“I think I would have preferred three times on the upside and a higher cap,” he said.

On the other hand, a cap of nearly 10% a year compounded was much better than the 6% or 7% caps he is accustomed to see among many offerings being priced in the market today.

Most importantly, it appeared that the cap was “fair” given the reliability of the barrier.

Fair trade-off

“Having a good chance of earning 10% a year over five years, with almost zero downside – that’s a compelling argument,” he said.

“If the market is negative, you outperform. If it’s up but below average, you outperform. If it’s hugely bullish, you still get 10% a year.

“As an adviser I’m not going to get fired from any client for getting them 10% a year.”

The four-times leverage was good. It “paid for itself,” as it erased the opportunity cost investors incur for foregoing dividends.

Hedge only

In conclusion, Kalscheur would use the note mostly in a defensive strategy.

“Structured notes are always a trade-off. You trade off some of the upside for some protection. In this case, I could see this fitting very well in a client’s portfolio,” he said.

But the note would have to find its right place.

“I wouldn’t want to do it as a standalone investment because I still think you’re giving up too much upside,” he said.

“But it would be very compelling as a hedge to a long-only exposure. In that way, it provides a very good balance.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on July 26 and settle on July 31.

The Cusip number is 61769HJT3.

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