Morgan Stanley's S&P 500-linked note risky despite average entry feature, but still attractive, advisor says

By Kenneth Lim

Boston, July 30 - Morgan Stanley's new average entry return enhanced notes linked to the S&P 500 index are risky but attractive products for investors who are bullish about the U.S. equity markets, an investment advisor said.

Morgan Stanley ties to S&P 500

Morgan Stanley plans to price a series of zero-coupon average entry return enhanced notes due Sept. 22, 2009 linked to the S&P 500.

The notes will base the payout at maturity against the 30-day average closing level of the index following pricing.

At maturity, if the final index level is greater than the initial average level, investors will receive for each note par of $1,000 plus triple the index return, subject to a maximum total return of 22.53%. If the final index level is below the initial average level, investors will lose 1% for every 1% decline in the index.

Pricing is expected around Aug. 1.

Notes fit bullish view

The notes will be attractive to investors who are bullish on the S&P 500, an investment advisor said.

"If I think the S&P 500 is going to do well over the next year, I can buy an index fund that tracks the index and get a 1-to-1 exposure both ways, or I can get a product like this, which has three times the exposure on the upside and only one time the exposure on the downside," the advisor said. "Obviously, as long as the index doesn't go above 22.53%, I'm going to do better."

Beyond comparisons to a direct investment, the note could also outperform risk-free investments, the advisor said.

"Because it's leveraged, if the index goes up by 5% over the course of the year, I get 15% back on my investment, which is well above what I would get if I just put my money in a CD," the advisor said. "It's not a bad payout."

Product could be risky

But the current volatility in the S&P 500 adds to the investment risk, the advisor added.

"The index is very volatile right now," the advisor said. "In fact, volatility has gone up a lot the last month. Now, because there's an initial level that you have to base on, your returns are exposed to the current volatility, which means there's more risk involved."

The averaging may not do much to ease the volatility exposure of the product, the advisor said.

"I don't think it's that significant," the advisor said. "Averaging could reduce some of that volatility, but because it's a 30-day period, I don't think it will make that much of a difference...If they average it over a longer period there would be less volatility, but I don't think it makes that much sense for them to do that, especially for a one-year note."

The product will perform better for investors if the S&P 500 actually goes down during the initial averaging period, the advisor said.

"Obviously if it goes down, your starting point is lower and it's easier for you to end up higher at maturity," the advisor said. "But the opposite could also happen. If the index starts rising in August, chances are your returns will be lower than if they just took today as the starting point, for example. And this is bullish product, so if the S&P 500 goes down after the first 30 days, you experience a loss."

Investors also risk underperforming if the index climbs too quickly, the advisor said.

"If the index goes beyond 22.53%, you underperform," the advisor said.

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