Morgan Stanley's ETNs linked to S&P 500 Oil Hedged index designed as hedge against inflation

By Emma Trincal

New York, June 30 - Morgan Stanley rolled out a new exchange-traded note designed to reduce the impact of inflation as reflected in oil prices as investors are seeking more sophisticated strategies to hedge against various risks.

Morgan Stanley sold $1 million of 0% ETNs due July 1, 2031 linked to the S&P 500 Oil Hedged index, according to a term sheet.

The notes are tied to a strategic index created in March by Standard & Poor's that seeks to reduce the effects of a rise in inflation as reflected in higher oil prices.

The index provides exposure to the S&P 500 Total Return index and the near-term Nymex West Texas Intermediate light sweet crude and ICE Brent crude oil futures contracts.

Inflation hedge

"The index provides a U.S. large-cap stock portfolio protection against a declining dollar by using oil as a hedge, just like you would use the euro or gold as a hedge against inflation," Alka Banerjee, vice president of global equity and strategy indexes at Standard & Poor's, told Prospect News.

A $100 investment in the ETNs provides a $100 long exposure to the S&P 500 Total Return and a $50 long exposure to each of the two futures contracts. Each exposure is rebalanced on a monthly basis.

Other ETNs linked to oil prices exist in the market, but this product introduces a hybrid exposure to stocks and commodities in its underlying.

"An investment in Morgan Stanley S&P 500 Crude Oil Linked ETNs combines the returns of crude oil futures and large-cap U.S. equities in a single exchange-traded security," Nikki Tippins, head of equity derivatives sales for the Americas at Morgan Stanley, said in a company press release.

She also noted that the firm is building up its new ETN platform after the launch in March of the Cushing MLP High Income Index ETN, Morgan Stanley's first ETN.

The company plans to issue up to $10 million of the S&P 500 Oil ETNs. The remaining $9 million of notes will be sold at varying prices from time to time.

Demand for inflation-hedged products has been widespread among investors, sources noted.

It led S&P to create its S&P 500 Hedged indexes series, which includes the S&P 500 Oil Hedged index.

Earlier this year, UBS launched its Etracs S&P 500 Gold Hedged ETNs. The product offers a similar inflation hedge strategy using another index from the same S&P 500 Hedged series.

The notes combine the returns of investing equal dollar amounts in the S&P 500 Total Return index and long positions in near-term exchange-traded Comex gold futures contracts.

Pair trading

The hedge only protects against adverse movements in the relative value of the dollar as expressed in the dollar price of oil, according to a Standard & Poor's fact sheet on the underlying index.

"Stock market risk is not hedged," the sheet said.

Brad Zigler, research analyst at Hard Assets Investor, said that investors in the notes have a long exposure in both stocks and oil, which means that they should make assumptions on the correlation between the two.

"They have to believe that U.S. stocks and oil will move in tandem," he said.

"I'm sure what S&P had in mind when devising this index was to provide a hedge against inflation. They did it with other indexes such as the S&P 500 Gold Hedged index.

"But from the trading standpoint, you have to reflect on the correlation between oil and stocks. I'm not sure the hedge value of oil is the best because it relies too much on a correlation between stocks and oil prices that keeps on expanding and contracting to varying degrees.

"If you really wanted to hedge against the dollar, gold or the euro would do a better job."

New York asset management firm Factor Advisors, LLC offers an exchange-traded fund that takes a different view, said Zigler. The FactorShares 2X: Oil Bull/S&P 500 Bear ETF provides a long exposure to oil prices and a short exposure to the S&P 500.

He said that the ETF makes sense for investors who see a divergence in the trajectory of oil and U.S. stocks and who worry about a U.S. economic slowdown.

"The Morgan Stanley notes have merit if you believe that oil prices are going to be on the rise and that correlation between oil and stocks will tighten," he said.

"But correlations are not constant. They vary with time. In the short term, the two may move together. But ultimately, inflation is bad for stocks."

The prospectus illustrated the directional risk by pointing to the leveraged exposure provided by the notes.

It reminded prospective buyers that one dollar invested in the notes will give investors one dollar of exposure to the S&P 500 index and one dollar of exposure to the crude oil futures contracts.

"You should be aware that any percentage declines in the S&P 500 Total Return index and in the crude oil futures are additive," warned the prospectus.

As an example, a 40% decline in the S&P 500 index and a 60% decline in the crude oil futures prices would result in a total loss of the investment, the prospectus noted.

Zigler said that investors' decisions to buy the notes also depend on their appetite for risk.

"In a risk-in trade, investors are more likely to commit capital to more speculative trades. That's when they would buy stocks and commodities. So I guess this product falls into this category as you're getting long exposure to two risky asset classes. If you're going to be in a speculative mind and willing to take more risk, then buying those ETNs makes sense," he said.

When the risk is "off," investors are more likely to buy cash or Treasuries, he added.

Betting on growth

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said that he likes the notes as a directional bet but that he would not use them as a hedge against rising prices.

"I like the asset classes that are in the notes," he said. "I like that it's long energy and long U.S. stocks.

"I would look at this note as a growth opportunity because in our view the two asset classes - stocks and energy - will have a nice appreciation over the next couple of years.

"However, I wouldn't invest in the notes as a hedge against inflation. One, we're not factoring in inflation as an issue at all for at least a couple of years. Second, if I wanted a hedge against inflation, I might look at TIPS or currencies instead."

The payout at maturity will be par of $25 plus the index return, which could be positive or negative, minus the tracking fee, which is 0.79% per year, according to the prospectus.

The notes have been approved for listing on NYSE Arca under the symbol "BARL."

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