Morgan Stanley's PLUS with 20%-22% cap tied to Mega 30 feature new large cap benchmark

By Emma Trincal

New York, Oct. 18 - Morgan Stanley's upcoming 0% Performance Leveraged Upside Securities due October 2014 are tied to a new Morgan Stanley index, created last month to give investors access to the top 30 large cap stocks in the U.S. equity market.

The index - the Morgan Stanley Mega 30 Index (Price Return) is employed for the first time in a registered structured note, according to data compiled by Prospect News.

The payout at maturity will be par plus triple any index gain, up to a cap of 20% to 22%, according to an FWP filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

The Morgan Stanley Mega 30 Index (Price Return) is a rules-based equity index Morgan Stanley developed and created in September, according to the filing. It is designed to reflect the performance of 30 mega cap stocks of U.S.-based companies, which are included in one or more U.S. benchmark equity indexes that have the largest market capitalization as determined on a quarterly basis.

A new index

"They may have created this as an alternative to the Dow Jones 30, which is an industrial index," a market participant said.

"By definition, everything 'industrial' excludes high-tech stocks, and those today are the biggest companies in the world. We're talking about Apple, Google, which you don't find in the industrial benchmark. That may be one of the motivations for the investors who would consider exposure to this new index," he said.

The top 10 holdings in the Morgan Stanley Mega 30 index are in decreasing size order: Apple Inc.; Exxon Mobil Corp.; General Electric Co.; Chevron Corp.; International Business Machines Corp.; Microsoft Corp.; AT&T Inc.; Google Inc.; Procter & Gamble Co.; Johnson & Johnson.

In the prospectus, Morgan Stanley specified that its new "price-return" index, by definition does not take into account any ordinary dividends.

"All structured notes are price return indexes. It doesn't make a difference," the market participant said.

Issuers of structured notes typically "strip" investors from the dividends paid by the underlying stocks of a reference index in order to finance the terms of the structure, in particular the purchase of the options, he said.

"The fact that it's a price index doesn't bother me that much," said Michael Kalscheur, financial adviser at Castle Wealth Advisors. "Every structured note we've ever looked at, you don't get the dividends."

Some of the risks involved with an exposure to the Mega 30 are the index's limited history and its strong concentration in large caps, according to the prospectus.

It compared the annual price returns of the S&P 500 versus the Mega Cap 30 in a retrospective simulated calculation going back to March 2002.

The Mega 30 beat the S&P 500 this year to date as of Monday with a 15.6% annual price return versus 14.5% for the S&P 500, according to the simulated and actual data found in another FWP filing filed with the SEC.

The Mega 30 also outperformed the S&P 500 in 2008, recording a 33% loss for that year versus 38% for the S&P 500.

On the other hand, the S&P 500 posted better returns in 2009, up 23.5% against 18% for the Mega Cap 30, as well as in 2010 when it rose by 12.5% in comparison with 8.5% for the Morgan Stanley proprietary index.

The market participant said that the Mega Cap 30 performance compared to that of the S&P reflected the typical difference between large caps and small caps.

"You have here 30 mega cap stocks; that means the largest of the largest, so they are going to perform with a large cap bias. You have a correlation between the two indexes that mirrors the correlation observed between the S&P 500 and the Russell.

"Large caps do better when there is a recession or a selloff while small caps show better returns when the economy or the market is growing.

From March 2002 to date, the filing showed that the S&P 500 index outperformed the Morgan Stanley index with a 2% annual price return versus 0.8% for the Mega Cap 30.

But investors seeking a direct exposure to the very largest U.S. stocks may like the simplicity of the concept behind the Mega Cap 30, Kalscheur said.

"The index is very clean, very straightforward. I like that," Kalscheur said.

"If they package the 30 largest companies and rebalance it quarterly, it's not a big leap to figure out how this thing works. You know exactly what you own, what you don't own. You can tell your client: it's the 30 largest stocks; it's rebalanced quarterly; it has Apple, GE, Exxon, Chevron. The client can say: OK, I understand. Go."

Good points

Kalscheur said that he liked a lot of things about the structure except one: the lack of downside protection.

"I'm fine with the issuer's credit risk. Morgan Stanley is fairly ranked at A-. It's definitely a company that we would consider.

"The cap is not egregiously low. It's a cap - and I never like it - but it gives you enough room on the upside. I usually put my watermark at 10% a year. If I am capped at less than that on the S&P, I'm not interested. Well I have the 10% level with this one.

"And I don't disagree with the market view. If the market is up even a little bit, it's good because the leverage will push it up to the cap.

"My problem is that the product is not defensive enough. There is no buffer, no floor, no anything. This doesn't work for us because we buy structured notes primarily for the downside protection. That's our number one thing," he said.

Downside risk

Kalscheur said that he uses a rule of thumb when evaluating downside risk for an investor in the S&P 500.

"Based on the historical return, the standard deviation of the S&P 500, a good rule of thumb for me is to tell my clients that in a one-year period, the market will be up two times out of three. That means, you can go wrong one third of the time. Over a two-year period, you can easily be down. I almost prefer longer-term deals because it gives you more time to work out problems. A two-year is great but it's not great when you don't have downside protection. Investors are betting the ranch that the index will be up less than 20% in two years, which is OK. But if the market is down 10% you have a problem.

"While I don't disagree with this particular structure, my investment style is too conservative to tolerate the full downside exposure.

"The notes are designed for people who want leverage on the upside and don't mind the downside.

"We're just the opposite.

"If I had to give up something, rather than lowering the cap - this cap is really enticing - I would probably go for a longer duration."

"I would much rather have these notes on a three or four year if you gave me a 10% buffer, for instance," he said.

Yield deficit

For Steve Doucette, financial adviser at Proctor Financial, the main drawback was the upside cap and the lack of dividends.

"If it's a large cap stock, everybody and their mother is buying it for the dividends," he said.

"When you play large caps, you're in for the dividends too because that's where a lot of the returns come from. If you're mildly bullish on large caps and trying to capture some of the returns, you may look at it. But if you can own the index with the dividends, or buy some of those stocks in a basket, why would you do that? And with a cap?

"The S&P 500 has a 2.3% dividend yield. You're going to lose a 2.3% return before you even start. That's if you think the index is hovering a little bit and you want to lever it up. But the cap seems relatively small, especially if you lose 2.3% in dividends. Now your real annual cap is more like 8% or less than 9%.

"I wouldn't go for it.

"I don't really understand why [you would be] stripping out some coupon yield when you can own it directly."

"Even though the three times is appealing, I'd rather tap down the leverage and increase the cap," Doucette said.

Morgan Stanley & Co. LLC is the agent.

The notes will price in October and settle in November.

The Cusip number is 61755S818.

The index was developed by Morgan Stanley & Co. LLC, also the calculation agent.

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