Morgan Stanley’s trigger return optimization notes linked to India fund show weakness in cap

By Emma Trincal

New York, Jan. 20 – Morgan Stanley’s 0% trigger return optimization securities due Jan. 31, 2018 linked to the WisdomTree India Earnings Fund offer leveraged exposure to one of the most profitable emerging market countries last year, but advisers said the cap does not offer enough upside opportunity.

The payout at maturity will be 1.5 times any fund gain, subject to a 31% to 35% cap, according to an FWP filing with the Securities and Exchange Commission.

An 80% trigger observed at maturity protects investors against market losses on a contingent basis. If the final share price is less than 80% of the initial price, investors will have full exposure to the fund’s decline.

The underlying fund tracks the performance of companies incorporated and traded in India that are profitable and that are eligible to be purchased by foreign investors.

The fund has gained 39% in the past 12 months.

Cap and risk

“The terms are certainly competitive enough, although I would expect a higher cap given that the five-year standard deviation of the underlying is close to 30. I think investors will demand higher caps when taking on this type of risk,” said Dean Zayed, chief executive officer of Brookstone Capital Management.

The annualized cap to be set at pricing for the 31% to 35% range is comprised between 9.5% and 10.5% on a compounded basis.

Duration is also a concern.

“Today’s global economy seems to have a lot of moving parts, including QE, crashing oil prices, the global deflation story and geopolitical risks. In light of these issues, investors should re-evaluate their time horizon on owning certain products as a lot can certainly change over the next three years,” he said.

“Put another way, a three-year term was quite short on a relative basis just a few years ago. Today, given the global economic issues, it seems almost like an eternity.

“Many investors are wary of the next few years, especially given the [length] of this bull market. Most of my clients will not tie up money for three years without a huge potential reward, especially with an underlying that is quite volatile historically.”

Country picking

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, agreed, saying that while the note is “straightforward,” it fails to meet several of his selection criteria.

“First, we’re not interested in trying to pick a single country other than the U.S., especially as it relates to emerging markets,” he said.

“Our emerging markets exposure typically is much more widespread. We view single-country investing a little bit like single-stock picking. You’re betting on something really specific. We try to stay away from that.

“Second issue: three years is a little bit longer than we’d like to go.”

But the third objection is probably the most insurmountable, he said.

Through the roof

“Even assuming that we would invest in a single country and that three years would be for us a reasonable period of time, the idea of a 31% to 35% cap in making a single-country bet clearly tells me that you’re not getting adequately compensated for the risk you’re taking,” he said.

“The 1.5 times is a nice leverage factor, but for an asset class that can go through the roof, a 31% to 35% return does not seem to be enough.

“In 2009, this fund was up 95%, then up 20% the following year. In 2011, it dropped 40% and gained 25% in 2012. It fell 9% in 2013 and had a huge run last year.”

The ETF rose by 31% in 2014.

“When you’re dealing with an asset class that shows that kind of volatility, you don’t want to be capped out.”

Foldes said his firm has a rule of thumb for higher-risk and potentially highly profitable asset classes: a cap of at least 20% per year.

“The 9% or 10% per year they offer is obviously not going to work for us, especially for an asset class like this one that has the potential to explode. A 31% [cap] in three years is way too small. Why would you accept 31% for [a] three-year [note] when you can do that in a year?” he asked.

“So we see issues and obstacles one after the other ... A single-country exposure. The three-year term that’s a little bit too long for us ... The lack of upside potential. ...”

Not a whole lot

In addition, Foldes is not impressed by the trigger price of 80%.

“Having a barrier instead of a buffer after the fund had a return of more than 30% last year seems like a risky proposal. That’s another issue with this deal,” he said.

“If the fund is down 19%, investors get their money back. But if it’s down 21%, they lose 21%.

“You’re not getting a whole lot of downside protection, and you’re not getting a whole lot of upside opportunity.”

There are other risks as stated in the prospectus such as credit risk exposure for three years but also currency risk.

If the dollar strengthens against the Indian rupee, returns will be “adversely affected,” the prospectus warned. The risk should be carefully considered given the strong appreciation of the dollar seen since last year, noted Foldes.

“There are all sorts of moving parts, which is another reason why a barrier, and this one in particular, is not good enough.”

Morgan Stanley & Co. LLC is the agent, and UBS Financial Services Inc. is acting as dealer.

The notes are expected to price Jan. 27 and settle Jan. 30.

The Cusip number is 61764M695.

© 2015 Prospect News.
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