BNP Paribas to price research-based notes linked to Morningstar Ultimate Stock-Pickers index

By Emma Trincal

New York, April 11 - BNP Paribas is readying 0% notes due April 28, 2017 linked to the Morningstar Ultimate Stock-Pickers Target Volatility 7% index, a recently created index designed to give investors access to some of the best stock picks of top managers. It will be the first use of the new index in a note.

Morningstar Inc. announced last month the launch of the new index as part of its Morningstar Ultimate Stock-Pickers index series, which also includes the Ultimate Stock-Pickers (or "base" index) and the Ultimate Stock-Pickers Target Volatility 10.

BNP Paribas has licensed these indexes to serve as benchmarks for new structured notes, according to a Morningstar press release.

"Active indexing presents a unique opportunity to bring active management into a passive structure. Investors are interested in these investable products because they can offer a low-cost source of alpha," Sanjay Arya, senior vice president of Morningstar Indexes told Prospect News.

The index provides variable exposure to the Morningstar Ultimate Stock-Pickers index. The exposure to the base index is adjusted to maintain a target volatility of 7%. The base index invests in up to 60 equities most commonly held by the 26 investment managers followed by Morningstar, according to the term sheet.

Passive, yet active

The index offers a selection of top managers with an overlay of Morningstar equity research, which makes it unique, according to sources.

"We've seen different things from competitors using research to build small baskets of stocks rather than random baskets. Most of the time you invest in such notes relying on the research but the basket is static, while here, we're talking about a dynamic index," said Alexandre Peroux, a structurer in equities and commodity derivatives structuring in North America at BNP Paribas.

An example of such products is Bank of Montreal's $75.26 million of 0% senior medium-term notes, series B, due Jan. 23, 2013 linked to Raymond James Analysts' Best Picks for 2012. The notes priced in January.

But research-based structured notes are usually not accessible via an equity index.

"In general, we see a great deal of interest for equity index-linked products," said Serge Troyanovsky, head of retail distribution, North America for structured products at BNP Paribas.

"What Morningstar did is very interesting because it allows the end client to invest in a research-based index that offers the benefits of a mutual fund while being 100% rule-based," said Peroux.

Efficient pricing

The upcoming notes offer a 125% participation rate on the upside and no cap. The downside is fully protected subject to the issuer's credit risk, according to the term sheet.

A market participant explained how the underlying index facilitated the pricing of an uncapped, leveraged, fully protected note structured around a tenor that is relatively shorter than that of comparable products.

"The underlying index has a target volatility of 7%. It's a limited volatility, and it gives the issuer more leeway on the pricing," he said.

"If you take an index like the S&P 500 with a volatility that can be 10%, 15% or 25%, you have to estimate what volatility will be over the next five-year term.

"In this product, because of the target volatility feature, the volatility is controlled and gives you a more efficient pricing on the options."

The Morningstar Ultimate Stock-Pickers Target Volatility 7 and 10 indexes are similar in construction to the Ultimate Stock-Pickers index but seek to control volatility by moving assets in and out of cash positions to maintain standard deviations of seven and 10, respectively. Morningstar reconstitutes the indexes monthly.

"We're not using the Stock-Pickers Target Volatility 10 this month, but we're planning on launching a note based on this second index in the future," Troyanovsky said.

Seeking alpha

Troyanovsky and Peroux explained the two-step process followed by the Morningstar index team. First, they select the managers. Second, they compile a list of their holdings and examine how many of the selected managers hold the security, how much of it they hold and whether or not managers have been adding to the position.

"The first stage is based on an extensive research that allows Morningstar to select top managers. They select 26 top managers they call 'stock-pickers' based on their performance net of fees. They also look at the stocks for which the managers have the highest conviction based on what they hold, buy or sell," Troyanovsky said.

"Morningstar has its own proprietary fundamental research for these companies. They assign a fair value to each stock. If the fair value assessment lacks certainty, the stock gets a high uncertainty score. Only the stocks with a low or medium uncertainty rating get to be included in the index."

The Ultimate Stock-Pickers index is rebalanced monthly, and the volatility target exposure is monitored daily.

"When you think about it, the monthly rebalancing adds value compared to a 13F filing for instance, which would give you a much more dated picture of the holdings reported by mutual fund managers. It makes sense to do it monthly, and Morningstar can do that because they have the analytical tools to collect and filter the information," Peroux said.

The whole process is designed to produce an index that can outperform the benchmark, Peroux added.

"This index has generated alpha. The base index since Dec. 29, 2005 has outperformed the S&P 500 Total Return index by 241 basis points per annum. The index is diversified across a mix of different investment styles, so you get a pretty representative sample of the investable universe," he said.

A Morningstar spokesperson declined to comment on future plans for the use of this index, in particular whether the research firm had any discussions with issuers to use the index series for an exchange-traded note or an exchange-traded fund.

Troyanovsky and Peroux declined to comment.

"It would be a natural progression to use that type of underlying in an ETN or ETF," the market participant said.

The notes (Cusip: 05567L4L8) will price April 25 and settle April 30. The exact deal terms will be set at pricing.

BNP Paribas Securities is the agent.

As of Feb. 29, the top 10 components of the base index based on portfolio weighting were Lowe's Cos. Inc., Qualcomm, Inc., Philip Morris International, Inc., Charles Schwab Corp., Intel Corp., Procter & Gamble Co., Texas Instruments, Inc., Occidental Petroleum Corp., PepsiCo, Inc. and TE Connectivity Ltd.

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