Morgan Stanley’s $1 million dual directional buffered PLUS show great terms, risky ETFs

By Emma Trincal

New York, Sept. 27 – Morgan Stanley Finance LLC’s $1 million of 0% dual directional buffered Performance Leveraged Upside Securities due Sept. 26, 2024 linked to the worse performing of the VanEck Vectors Gold Miners exchange-traded fund and the iShares MSCI Emerging Markets ETF offer nearly perfect terms, but the underlying make advisers uneasy about the investment.

If each ETF finishes above its initial level, the payout at maturity will be par plus 1.5 times the gain of the lesser performing ETF, according to a 424B2 filing with the Securities and Exchange Commission.

If either ETF falls but by no more than the 20% buffer, the payout will be par plus half the absolute value of the return of the lesser-performing ETF.

Otherwise, investors will lose 1% for each 1% decline of the worst performer beyond the 20% buffer.

Not a gold bug

Carl Kunhardt, wealth adviser at Quest Capital Management, liked the terms of the product but not the investment theme.

“Looking at the note, everything is going so well until we get to the two underlying,” he said.

Kunhardt said he does not really appreciate gold.

“In October 2020, our investment committee decided to add 2% of gold in all of our portfolios. We bought the [SPDR Gold Minishares Trust.] One year later, it’s still negative. If you hold gold a hundred years, you’ll do fine. But then you’re dead, so it doesn’t matter.”

Inflation view

Moreover, the two underlying funds had little in common other than supporting a bullish view on inflation.

“They chose two completely different ends of the spectrum for their ETFs. The emerging markets one relies on momentum and inflation. The other is a hedge against inflation. Inflation is what drives a positive correlation. But everything else could drive them in opposite directions. It’s a big rolling of the dice,” he said.

“Basically, you’re playing the correlation game hoping inflation will be high.”

While Kunhardt believes inflation will “stick” and is not “transitory” as the Federal Reserve has declared several times, betting on one macroeconomic development appeared too risky in his view.

“I don’t believe inflation is transitory. We’re increasing our debt in the trillions of dollars, one stimulus package after the next,” he said.

“If you have a fire, it can be transitory. But if you then threw a bucket of gasoline on it, it’s not.

“And yet, I would not invest just based on my take on inflation. It’s just too risky.”

Portfolio allocation

Another concern with the choice of underlying was how they both fit in a diversified portfolio.

“Gold is not always a position in our portfolio. And most of last year, we didn’t have emerging markets. We took it out,” he said.

“When I buy a note, it’s usually on asset classes that I would normally hold in the portfolio regardless of market conditions; in other words, they’re part of my core portfolio. Gold or emerging markets are not positions that I would hold at all times. They’re satellite positions you enter or exit tactically depending on the market.”

The volatility of the two underlying ETFs, while relatively high, was not as much of a concern for this financial adviser.

“To begin with, if I bought a note like this one, I wouldn’t have a large position, possibly 10% of the overall value of the portfolio. Nothing huge,” he said.

“And also, I would put this in an aggressive growth portfolio, a place where adding volatility when necessary is part of the plan.”

One off

Kunhardt’s disappointment with the underlying funds contrasted with his liking of the structure.

“It’s rare to see a buffer with absolute return. It would be better to have 100% of the absolute return but 50% is better than nothing,” he said.

“The 1.5 times is an excellent leverage and having no cap on a three-year is very good too.

“They really hit a home run on the structure.”

Kunhardt said the deal was probably designed for a specific client.

The notes carry a 0.75% fee, according to the prospectus.

“The fee is not bad. It’s a $1 million deal; that’s a small deal.

“It’s probably a customized note created for an institution or large RIA.”

Good terms

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, pointed to positive aspects in the structure. But he was uncomfortable with the correlation and volatility levels.

“This is an interesting and unusual note. But I don’t love it,” he said.

“In terms of credit, I have no problem with Morgan Stanley. Their CDS spreads are reasonably strong.

“The 0.75% commission appears on the low side. That’s good.

“We prefer notes that are a little bit shorter, but three years is not out of the realm.”

He cited four aspects of the structure, which he said were the most attractive – the 1.5 times leverage, the uncapped upside, the 20% buffer and the absolute return feature.

But the negative aspects of the notes offset the positive.

Low correlation

“When you invest in a worst-of, you hope that the two underlying asset classes will have a reasonably high correlation, which is not the case at all here,” he said.

The coefficient of correlation between the two underlying ETFs is only 0.292.

“With such low correlation you could be in a situation where one of the ETFs would be a home run and the other a real dog, in which case you lose not only money but possibly the client too,” he said.

Downside risk

He also expressed concerns about volatility.

“Normally a 20% buffer is something to be excited about but not with these two underlying, which are both very volatile. It would be easy to think about a scenario where each one or both could be down more than 20% over a three-year period,” he said.

Putting the correlation and volatility issues together, investors, he said, “could really get hurt.”

“We don’t have a strong view on any of those two asset classes. But we know you could incur a significant downside.

“So, I would stay away from this.”

If only

Naturally the attractiveness of the product was the corollary of having risky underliers, he noted.

“If the same structure was applied to the S&P and Russell or to the S&P and the Dow, it would be fantastic,” he said.

“But there is no way you could get these terms with the broad indices, so that’s why they picked those two.

“We have no way to predict the direction of gold and emerging markets.

“Interesting terms. But this is really gambling from my perspective.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Monday.

The Cusip number is 61773FZR7.

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