Morgan Stanley’s dual directional trigger PLUS tied to gold ETF have high cap, modest barrier

By Emma Trincal

New York, Oct. 18 – Morgan Stanley’s 0% dual directional trigger Performance Leveraged Upside Securities due Nov. 5, 2018 linked to the VanEck Vectors Gold Miners exchange-traded fund offer attractive upside potential, but the barrier is too slim given the risk associated with the underlying asset class, a registered investment adviser said.

If the final share price is greater than the initial share price, the payout at maturity will be par of $10 plus 200% of the ETF return, subject to a maximum return of 55.25%, according to an FWP filing with the Securities and Exchange Commission.

If the final share price is less than or equal to the initial share price but greater than or equal to the trigger share price, the payout will be par plus the absolute value of the ETF return. The trigger share price will be 80% of the initial share price.

If the final share price is less than the trigger share price, investors will be fully exposed to the ETF’s decline from the initial share price.

Timing

Jerry Verseput, president of Veripax Financial Management, said he likes absolute return notes. “My second-largest position in my portfolio is an absolute return, but it’s on the Euro Stoxx,” he said.

However, the two-year term of the Morgan Stanley product is a concern.

“On a two-year, you’re trying to time the market,” he said.

“Who’s going to know what the price of gold stock is going to be in two years? It’s not a big enough barrier to protect you.”

Miners

The VanEck Vectors Gold Miners ETF tracks the equity performance of some of the largest gold mining companies in the world. Its top holdings are Newmont Mining Corp., Barrick Gold Corp. and Goldcorp, Inc.

The equity fund is much more volatile than the metal itself, although precious metals and miners are correlated, he noted.

The VanEck Vectors Gold Miners ETF, which trades on the NYSE Arca under the ticker symbol “GDX,” is up nearly 77% for the year. However, the fund had incurred five consecutive years of negative returns starting in 2011, with a 54% decline in 2013 and a 25% loss last year, its two worst recent years since the financial crisis.

“It’s a risky bet because the GDX can easily be down 20% over two years,” he said.

“If I’m going to invest in a proxy for gold, I would much rather have a longer timeframe so I get a more effective downside protection.

“If you go five years on something that volatile, you’re probably going to get a barrier in the order of 50%.”

The absolute return note tied to the Euro Stoxx 50 index in his portfolio is a six-year product with 60% barrier protection and absolute return, he noted. The upside participation rate is 150% with unlimited upside.

Risk

“With this note, the cap is high enough. With a 25% per annum, you’re not going to be too disappointed,” he said.

But the downside risk is problematic for his practice.

“Imagine you are a week from maturity and GDX is down 19%. It only takes 1% to determine your outcome. A week later you either get a big return or a big loss,” he said.

From a registered investment adviser’s perspective, the notes would not be an option.

“It’s not something you would want to show to a client. It’s more speculative,” he said.

“I would have a hard time explaining [to] my clients why they lost 21% on a sector that they probably don’t follow.

“Most investors don’t keep their eyes on gold miners.”

Verseput said the notes offer good upside potential but that the barrier is not large enough, especially on a short timeframe.

Gold

Another reason for his lack of interest in the notes is the underlying investment theme.

“I pretty much stay away from gold. There are so many factors that are involved. It’s kind of a guess,” he said.

Investing in the gold mining stocks is even more complicated because gold and gold stocks do not always move at the same pace. So far this year, gold has rallied 16%, which is considerably less than the notes’ underlying.

Verseput said that investors buy gold for different hedging purposes. He is not convinced that the hedge is working.

For instance, a more effective way to hedge a weakening dollar would be through a basket of currencies rather than with gold, he said. “Equity is a better hedge against inflation than gold,” he argued. And for investors worried about deflation and economic downturns, buying puts on the market would probably be a better option, he added.

“I guess this product is by nature speculative. I could do it for myself but not for my clients. As a general rule though, I am not a big fan of gold because I’ve never viewed it as a useful hedge.”

Low inflation

Wade Slome, president of Sidoxia Capital Management, said he is bearish on gold and would not consider the notes, in part for this reason.

“I don’t trade these things. You’re taking the credit risk, and you could recreate those structures without the fee by using options,” he said.

Slome said he does not see the signs of looming inflation, which is often the rationale behind being bullish on the precious metal.

“We’re generally bearish on gold. The dollar has been strengthening,” he said.

“Gold has been used as insurance against catastrophes or against the risk of a financial meltdown.

“If you’re very bearish on the market and on what the central banks are doing, yes it makes sense.”

But Slome said signs of inflation are not visible, starting with the bond market.

“The 10-year is still low. If inflation was really a problem, interest rates would be materially higher, but they’re down for the year,” he said.

While interest rates have increased over the past month, their levels remain historically low, he noted.

Last year ended with the 10-year Treasury at 2.25%. In the beginning of the year, the government bond yield was at 2%. Today, the yield is 1.74%.

“As long as the Fed remains biased toward higher interest rates, the dollar should remain dynamic and inflation under control,” he said.

Morgan Stanley & Co. LLC is the agent

The notes will price Oct. 31.

The Cusip number is 61766A558.

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