Morgan Stanley's PLUS tied to WisdomTree India Earnings fund to use uncommon underlying ETF

By Emma Trincal

New York, Oct. 8 - Morgan Stanley is using an exchange-traded fund "not seen before" in a planned two-year leveraged product tied to the performance of Indian stocks, said structured products analyst Suzi Hampson at Future Value Consultants.

Investors in Morgan Stanley's 0% Performance Leveraged Upside Securities due October 2012 linked to the WisdomTree India Earnings fund will have a risk/return profile similar to that of equity investors putting money directly into the fund, Hampson said.

Capped and leveraged, the product gives "mildly bullish" investors a way to potentially outperform the fund, she said.

The payout at maturity will be par plus double any fund gain, up to a maximum return of 37% to 43%, according to an FWP filing with the Securities and Exchange Commission.

Investors will share fully in any losses.

Unusual fund

WisdomTree India Earnings fund tracks the performance of Indian companies that are profitable. The ETF's inception date was February 2008. Companies are weighted in the index based on earnings in the prior fiscal year.

According to data compiled by Prospect News, this offering will represent the first use of this underlying for a structured product.

"It's a very unusual product," said Hampson. "Our data goes back to 2008, and we haven't seen it.

"For Indian exposure, we see a lot of currency products, with plays on the Indian rupee. There is an MSCI India ETF, but I don't think we have reviewed any products on this either."

The implied volatility for the ETF is about 25%. But its historical volatility is even greater at 44.77%, Future Value Consultants research showed.

Two volatilities

Hampson said that the discrepancy between the two underlined the need to use implied volatility rather than historical volatility for the calculation of the ratings, a move that is underway at Future Value Consultants but has not materialized yet.

"This may still represent a weakness in our system. In this case, a higher historical volatility than implied volatility simply means that price moves over the past have been greater than what they're expected to be in the future. Investors can look at past performance and many do. But we prefer not to," she said.

Historical volatility is relevant for the calculation of return scores and return outcomes probabilities, she said. But implied volatility, which is the basis for the pricing of calls and puts, should be used for the pricing of the notes, she added.

Cap, no buffer

The product offers a typical combination of cap and leverage. "It's pretty standard," Hampson said, adding that leverage usually applies within the limits of a range.

Yet it is also "common" to see buffers or barriers included in leveraged structures, although it is not the case with this product, she noted.

Asked why an investor would agree to be subject to a cap on the upside without any buffer on the downside, Hampson said, "They get the leverage. That's the reason."

But investors need to be "mildly bullish" on the fund, otherwise the enhanced returns would not be worth having a limit on the gains, she explained.

In addition, the cap is set at an acceptable level, she said, noting that a 37% to 43% cap on a two-year product is about 17% to 19% annually. "That's pretty good," she said.

Equity risk

"The risk profile is the same as investing in the fund," Hampson said. "The investor has to be prepared to lose capital if the fund value falls. The investor also expects small to medium gains in the fund and wants to double returns rather than to get a simple one-for-one payoff. Investing in the PLUS is very similar to a direct investment in the underlying. Earning dividends wouldn't make that much of a difference."

The risk associated with this product is "high," said Hampson, referring to its 7.66 riskmap, Future Value Consultants' rating measuring risk on a scale of zero to 10.

"That's because you don't have any downside protection, which is fairly unusual. It's also because the historical volatility is high compared to the implied - which we calculate our returns and risk off," Hampson said.

In addition, the implied volatility is slightly higher than that of the S&P 500 index, she noted.

"So in this regard, we have a product that is fairly risky. But it's not riskier than a direct investment in the fund, except for the lack of liquidity and the credit risk," Hampson said.

Future Value Consultants calculates probabilities of return outcomes using a Monte Carlo simulation. The performance is modeled based on volatility, dividends and interest rates among other parameters.

The product is characterized by a high probability of losses (42%) and an even greater probability of gains (58%).

"The explanation is the lack of a buffer and the gearing," Hampson said. "You get either a good payoff because of the enhanced return or a poor payoff because there is no barrier or buffer and your fund has a high level of historical volatility."

Additionally, when there is a loss, the odds of "losing a lot" - more than 5% of principal - are great with a 36% probability.

Similarly, there is a high probability, 48%, of generating a substantial gain of more than 15%, Hampson noted.

Volatility is what explains this distribution of probabilities, she said.

"The high volatility means that there is a great chance for the underling fund to move far away from its starting point, either up or down," Hampson explained.

High value

The return score of 5.40 is "pretty average," said Hampson.

The structure is simple, which gives the product a high simplicity score of 8.50.

Finally, the 9.83 value score ranks high on a scale of zero to 10, noted Hampson.

The value rating calculated by Future Value Consultants represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis.

Those ratings lead to an overall score of 7.79, which measures the firm's opinion on the quality of a deal, taking into account costs, structure and risk/return profile. The overall rating is an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"High value and reasonable return will give a good overall score," said Hampson.

The notes (Cusip 61759G422) will price and settle in October.

Morgan Stanley & Co. Inc. is the agent.

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