Morgan Stanley's trigger PLUS linked to WisdomTree Japan offer access to unusual, riskier fund

By Emma Trincal

New York, July 5 - Morgan Stanley's 0% trigger Performance Leveraged Upside Securities due July 2015 linked to the WisdomTree Japan Hedged Equity fund are more risky than the average leveraged note and do not offer sufficient upside to make up for the risk, said structured products analyst Suzi Hampson at Future Value Consultants.

But at the same time, investors gain exposure to a not-commonly used underlying, which gives then an alternative to a direct investment in the fund, she noted.

The payout at maturity will be par of $10 plus 150% of any fund gain, up to a maximum return of 33% to 35%, according to an FWP filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

Investors will receive par if the shares fall by up to 20% and will be fully exposed to losses if the fund falls below the 80% trigger level.

The WisdomTree Japan Hedged Equity fund tracks the Japanese equity market but also hedges against fluctuations in the relative value of the yen against the dollar as investors will maximize their returns when the yen weakens relative to the dollar.

Future Value Consultants compares each product with two different averages: same product type and all products recently issued. In this case, the same product category includes all leveraged notes regardless of the downside protection, tenor, upside cap, leverage factor or underlying.

Implied volatility

"If you look at those terms - a 34% cap, or 17% return per annum, a 20% contingent protection - it looks pretty good compared to most leveraged notes out there," Hampson said.

"But most leveraged notes are tied to the S&P 500 or to less volatile underlyings. That makes the difference since the participation, the cap, the barrier, all those terms derive from the underlying."

The one-year implied volatility for this fund is 35%, compared with about 18% for the S&P 500, she said.

"It's been jumping around. This fund's implied [volatility] has been ranging from 30% to 38% in the last few days, and now it's pretty much double the S&P. That's significantly more volatile," she said.

"So even though the terms look good at first, you have to keep in mind that this is not a note tied to the U.S. large-cap stock market. It's a much more volatile asset class. You can't really compare. The range of movement is much larger. As far as the upside, 17% a year is quite good. As far as the downside, you have a greater chance of breaching the barrier."

Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

Higher risk

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The notes have a 5.11 riskmap, compared with an average riskmap of 3.40 for the same product type and 3.90 for all products.

"The riskmap is much higher than the average for this product type. This is due to the volatility. Generally, leveraged notes tend to be linked to less volatile indexes or funds. A majority of the deals are linked to the S&P. Even more volatile underlying like the Emerging Markets fund or the EAFE have a lower volatility than this one," she said.

"The MSCI Emerging Markets fund for instance has an implied volatility ranging between 20% and 22%. If you get a volatile underlying, you'd expect the product to be on the risky end of the scale, riskier than the average product type, which is the case here."

Between the two risk components, the market riskmap was the main factor behind the higher risk, she explained.

Both the credit riskmap and the market riskmap are above average. The credit riskmap is 0.82 versus 0.64 for the average of the same product type, and the market riskmap is 4.29 versus 2.76 for the category average.

"The higher credit risk is a combination of Morgan Stanley's credit risk and a maturity that is slightly longer than the average leveraged note," she said, adding that the product type has an average tenor of one year to 18 months.

"However, credit risk is not contributing that much to the difference in the overall riskmap.

"For the most part, the high riskmap is due to the high market risk. And that's simply because we have an underlying that's much more volatile than average. Investors as a result of this have a greater risk of breaching the barrier and losing capital."

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. For this product, the ideal scenario is bullish.

The notes have a 6.89 return score, compared with an average score of 7.55 for the same product type.

The probability table shows that under the bullish scenario, investors have a 48.8% probability of receiving an annualized return in excess of 15%. The chance of losing more than 15% is 15.4%.

"The upside looks attractive compared to most S&P 500 leveraged products. A return of 17% per annum looks great. But in reality it's not. Given the much higher risk, in order to get an average return score you would have to get a higher return potential than that," she said.

Price score

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score for the product is 6.68 versus 7.69 for its peers.

"It's disappointing, really. It's a lot less than the average," she said.

"We can't blame it on the cap range. The two points [of] difference on the cap between 33% and 35% isn't all that much. We've seen products with many more moving parts, including a much wider cap range and even durations in a range. This is not the case here. Your price score as a result is going to be a fair reflection of the actual pricing.

"However, it's hard to compare this product with others because this particular underlying is not widely used. When looking at pricing, investors also have to take into account the availability of a product. If you want this type of exposure, you don't have many choices. So rather than just considering the score itself, investors have to decide how important it is for them to get access to this particular asset class.

"There is a reason why some less common underlyings will give you a lower price score. Sometimes it's simply about liquidity.

"This particular fund may not be as liquid as the S&P as far as options are concerned with. The S&P 500 options have tight spreads. I imagine this one is not as liquid.

"When you are dealing with an underlying asset that's a little bit unusual, it often makes the options more expensive, which can certainly affect the price score in a negative way.

"Your price score is one point below average. That's a lot. On the other hand, it doesn't need to be priced that competitively because it's an alternative to investing directly in the fund.

"Investors have the choice between putting money in the fund or doing this product in order to have some level of protection and leverage. If they chose the notes, they have to accept the credit risk, the absence of dividends and a cap that limits their returns.

"This product offers a slightly lower risk profile than investing in the fund directly since the barrier at least gives you some level of protection. Even though the riskmap is high, it would be higher if you were to invest in the fund itself or into a pure tracker note."

Overall score

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

The product has a 6.79 overall score versus a 7.62 average score for its peers. The average of all products is 6.77.

"The price score is below average and so is the return score. Obviously, the overall score is also going to be below average," she said.

"This product has a lot of risk. It should offer slightly higher return, but it doesn't.

"However, because we're dealing with an unusual underlying, those scores might not put people off too much if that's the market exposure that they're looking for."

Morgan Stanley & Co. LLC is the agent.

The notes will price in July and settle in August.

The Cusip number is 61762P153.

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