Download I. “Active” Small/Mid Cap US Equity (SMID) Should Play Second

I. “Active” Small/Mid Cap US Equity (SMID) Should Play Second Stage of Economic Recovery
The GIC believes that the second stage of economic recovery usually means rising rates and stocks. As the US economy recovers, focus on “stock pickers;” managers with proven records of generating alpha and making "active" bets.
Context
Correlations Collapse, Making Active Management More Attractive
• As the global economy grows stronger, correlations are falling between asset classes and securities
• The US economy is moving into a more mature phase of recovery and the Fed's decision to end QE supports this view
• Mario Draghi’s commitment to “do whatever it takes” reduced systemic risk and helped to drive correlations lower
• Active‐manager outperformance made a notable push higher in 2013 after three years of below‐average performance (11% more fund managers outperformed equity indexes compared to 2012)
• The outperformance in 2013 is more impressive if we just look at 2Q 2013 through 4Q 2013 (54% of managers outperformed from 2Q through 4Q, while 47% outperformed for full‐year 2013) • Small‐ and mid‐cap stocks have offered more fertile ground for stock picking given their relatively idiosyncratic characteristics As of September 12, 2014
Investment Thesis
• As a result of falling asset correlations, it makes sense to consider a more active investing approach in equities
• Small‐ and mid‐cap equities should offer opportunities as they are more exposed to an accelerating US economy and less exposed to decelerating emerging market economies
• Use stock market pullbacks as an opportunity to increase exposure to SMID US equities (average market cap <$10 billion)
Mario Draghi Commits to “Do Whatever it Takes”
75
65
55
45
35
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Morgan Stanley & Co. Asset Co‐Movement Indicator 1
10‐Year Average
Rising Active Manager Outperformance Vs. Passive Equity Indexes
As of December 31, 2013 (annual data)
65%
55%
45%
35%
25%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Active Mutual Fund Manager Outperformance
10‐Year Average
Source: Morningstar, Morgan Stanley & Co., Morgan Stanley Wealth Management GIC; (1) Morgan Stanley’s Asset Co‐Movement Indicator Index tracks weekly returns of 16 different asset classes, (e.g., equities, fixed income, commodities, etc.) and how much of their cross‐variation can be explained by a single factor. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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I. “Active” Small/Mid Cap US Equity (SMID) Should Play Second Stage of Economic Recovery
Investment Ideas
Low Performance Dispersion Should Help Stock Pickers
• We favor portfolios and securities that are levered toward the US economic recovery and that have high and growing free cash flow and return on invested capital • Our view that the US economy is entering a more mature phase of recovery suggests that "late‐cycle" sectors should outperform within the US equity market • We prefer energy, domestic industrials, select health care and select technology
• Please contact your Financial Advisor for specific investment ideas
As of August 29, 2014
Key Risks
30%
20%
10%
0%
1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012
S&P 500 Performance Dispersion
• A rapid increase in rates could have negative implications for small‐ and mid‐cap stocks
• Multiples have expanded, making stronger earnings growth critical in 2014
• Change in Fed leadership and confusion surrounding forward guidance may lead to increased volatility in equity markets
• A string of disappointing economic data could raise questions about the strength of the US economic recovery
Source: Russell, FactSet, Morgan Stanley Wealth Management GIC
Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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Index Definitions
S&P 500 INDEX Regarded as the best single gauge of the US equities market, this capitalization‐weighted index includes a representative sample of 500 leading companies in leading industries of the US economy.
Risk Considerations
International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.
Stocks of medium‐sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more‐
established companies.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.
Disclosures
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker‐dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.
The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We and our third‐
party data providers make no representation or warranty with respect to the accuracy or completeness of this material. Past performance is no guarantee of future results.
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© 2014 Morgan Stanley Smith Barney LLC. Member SIPC. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Please refer to important information, disclosures and qualifications at the end of this material.
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