Morgan Stanley’s autocalls on energy ETF, ARK Innovation present high risk, advisers say

By Emma Trincal

New York, Oct. 18 – Morgan Stanley Finance LLC’s contingent income autocallable securities due July 31, 2024 linked to the worst performing of the ARK Innovation ETF and the Energy Select Sector SPDR fund involve sector and timeframe risks, advisers said.

Interest is payable monthly at an annual rate of 10.5% if each ETF closes above its coupon barrier, 70% of its initial level, on the related observation date, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if the shares of the worst performing ETF close at or above their initial price on any monthly observation date after six months.

The payout at maturity will be par if each ETF closes at or above its 60% downside threshold level.

Otherwise, investors will be exposed to the decline of the worst performer from its initial level.

Correlation

Jerry Verseput, president of Veripax Wealth Management, pointed first to the weak correlation between the two underlying, which always increases the odds of a barrier breach with worst-of products.

“There is not much correlation between those two and that’s an issue right there,” he said.

The three-year coefficient of correlation between the two funds is 0.593 with 1 being a perfect correlation.

“The question here is: in a little bit less than three years, can either one of them be down more than 40%?” he said.

ARK Innovation

For Verseput, the answer to the question depended on the ETF. ARK Innovation ETF was a lesser risk, he said.

ARK has come way off its peak.

The ETF closed on Monday at $117. 05, nearly 27% off its Feb. 16 record high of $159.70.

It saw a steep decline at the end of the first quarter. Since March, he noted, the ETF has been in a range.

“I don’t really think this fund could be down 40% three years from now in an environment where there is nothing else than stocks to invest in,” he said.

“It seems reasonably safe.”

Even if inflation was to rise during the term, the ARK ETF should still be holding up, he added.

“With inflation, you want to own the assets that appreciate. Tech stocks are not going to fall 40% within that timeframe. With that income structure, the ETF doesn’t even have to go up. It just shouldn’t drop 40%,” he said.

The coupon is at risk with a price decline of 30% on a given observation date.

“But that’s all right. For something like 10.5%, I’m willing to take a little bit more risk on the coupon, perhaps missing a couple of payments. What I don’t want is losing 40% at the end.

“I’m OK with the 60% barrier with ARK,” he said.

Political risk

The same could not be said of the energy stocks ETF, listed under the ticker “XLE.”

The Energy Select Sector SPDR fund, which hit a 52-week high on Monday, has more than doubled in price in one year.

“With XLE, we are in a bull market. The problem we face is the two-year and nine-month maturity. That’s an odd timeframe,” he said.

“It looks like the issuer wanted the note to expire before the November Presidential Elections. Not a few days before, but still reasonably close in time.

“This would make me a little bit nervous. Energy is so sensitive to political moves. Who knows what could happen then? It’s not impossible to see XLE at that time down 40% from now.”

Supply and demand

The recent bull market in the energy sector added some risk at the entry.

“Last year, during the pandemic, oil companies reduced their investments, they cut production. They shut down. Now that demand for oil is kicking back and oil inventories are still low, crude oil prices have gone up, a good thing for the sector.”

But the situation could change in time.

“I’m not comfortable with the timeframe. The notes mature just ahead of the Elections and energy is very dependent on the political climate. It’s a risk to be in the sector at that time.”

If he decided to keep the structure, he would hold on to the ARK Innovation ETF but look for an alternative to the other underlying.

“I’d want something else than energy, another sector and maybe accept a lower interest rate,” he said.

High-flyers

Tom Balcom, founder of 1650 Wealth Management, was concerned by risks associated with both ETFs.

“There’s very little correlation between the two ETFs. And both are volatile. This is kind of risky,” he said.

The implied volatility for the energy ETF and the ARK Innovation ETF is 28.65% and 31%, respectively.

“You’re looking at an 8.5% coupon. I would have expected a higher rate of return for this kind of risk.”

The ARK Innovation can generate big moves either up or down, he noted.

In 2020, the ETF share price rose 152%.

But starting mid-February, the fund lost a third of its value in a little over two weeks.

“It’s a collection of high-flyer stocks. It had a huge run up, but it also got hit earlier this year. It’s still richly valued. It could drop more in the future,” he said.

Tesla Inc. is the top holding making for 10% of the portfolio. Its share price has doubled in the past year.

The third largest holding is cryptocurrency exchange Coinbase Global Inc., which went public in April with a 5.86% weight.

“The question is how long will it continue to go up? Do the valuations even make sense?” he said.

Balcom said he was not comfortable with the Energy Select Sector SPDR ETF either.

“We have XLE exposure through notes and we had a great year. But this is a tough one to have in the portfolio without hedges.

“There’s a lot of risk involved with both underlying. And I don’t think you are sufficiently compensated for it,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Oct. 26 and settle on Oct. 29.

The Cusip number is 61773F5S8.

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