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WEALTH MANAGEMENT INVESTMENT RESOURCES
MARCH 23, 2017
Alternatives Special Report
Wealth Management Investment Resources
ALPER DAGLIOGLU
Managing Director
Morgan Stanley Wealth Management
[email protected]
DANIEL MACCARRONE
Executive Director
Morgan Stanley Wealth Management
[email protected]
ADAM S. LIEBMAN
Executive Director
Morgan Stanley Wealth Management
[email protected]
A Positive Set-Up for Hedge Funds
As with most of active management, investor
sentiment toward hedge funds has been poor in
recent years. We believe disappointing
performance has kept some investors on the
sidelines despite their growing uneasiness with
traditional equity and fixed income investments
so late in the economic cycle. Despite a
challenging 2016 for hedge funds, we did see an
improvement in performance as the year
progressed and have seen better results year-todate. Unfortunately, the structural headwinds such
as heightened competition we discussed in
“Hedge Funds–Is Bad News Good News?”
(Alternatives Special Report, June 14, 2016) have
not changed dramatically. However, some of the
cyclical challenges are abating and should
provide more opportunities for skilled managers.
After a long period of accommodative global
monetary policy and scant fiscal stimulus, the
market environment has shifted. As a result of
these changes, asset correlations are falling and
dispersion in securities is increasing, creating a
positive backdrop for 2017.
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. Please refer to important information, disclosures and qualifications at the end of this material.
ALTERNATIVES SPECIAL REPORT
MARCH 23, 2017
Recent Performance
Despite some of the challenges for hedge funds in 2016,
categories such as event driven and distressed credit were able to
take advantage of the rebound in the energy and materials sectors
and corporate merger-and-acquisition (M&A) activity. Equity
long/short and global macro generated, in aggregate, mixed
returns. The past year can be marked by three distinct periods, and
in each case, many funds struggled with positioning. Most of the
drawdown occurred during the first quarter as the market sold off
into mid-February, largely driven by the collapse in oil prices. The
market rallied strongly later in the quarter, leaving many funds
poorly positioned from exposure and sector standpoints. A similar
pattern emerged after the Brexit referendum in June and the US
election in the fourth quarter. Managers who were positioned
correctly or were nimble enough to capture the ensuing rallies
after the initial sell-offs were in the minority. In sum, it did not pay
to have insurance or hedge against perceived negative outcomes
for risk assets.
Despite the challenging year, we saw an improvement in hedge
fund performance after the first-quarter. We’ve seen evidence of
alpha generation as the outlook for hedge fund strategies has
improved leading up to and following the US presidential election.
Current-year performance began on a positive note, affirming the
view that a more favorable market set-up can set the stage for
better performance.
As can be seen in Exhibit 1, there was a significant difference
in performance between top-performing and bottom-performing
hedge funds in 2016. Both manager and strategy selection were
big contributors to this divergence, which was 12.59% for the
year. Despite mixed performance in aggregate, there were plenty
of managers who produced solid absolute and risk-adjusted returns
when benchmarked more appropriately to core fixed income or
Exhibit 1: Difference Between Top- and
Bottom-Performing Hedge Funds Was
Wide in 2016
HFRI Fund Weighted Composite
One-Year
Three-Year
Five-Year
Return
(%)
Sharpe
Ratio
Return
(%)
Sharpe
Ratio
Return
(%)
Sharpe
Ratio
25th Percentile
11.63
1.33
6.92
0.82
9.74
1.09
50th Percentile
4.99
0.57
3.41
0.34
6.23
0.65
75th Percentile
-0.97
-0.13
0.28
0.00
3.08
0.30
Top vs. Bottom
Quartile
12.59
1.46
6.64
0.82
6.66
0.79
60% equity/40% fixed income portfolios. While the S&P 500
Index ended the year up 11.96%, the MSCI All Country World ex
USA Index was up only 5.01% and bonds posted muted gains with
the Bloomberg Barclays US Aggregate Bond Index up just 2.65%.
In contrast, hedge fund returns as measured by the 50th percentile
of the HFRI Fund Weighted Composite was up 4.99% for 2016.
Favorable Economic and Policy
Backdrop
A number of current economic and policy crosswinds should
favor security selection, and to some extent, market timing.
Managers should be better positioned, given the changing
macroeconomic landscape and a pickup in GDP growth, interest
rates and inflation. These anticipated or realized developments
have recently led to increased dispersion in securities. They may
also lead to higher volatility, which, while has yet to occur, may
bode well for certain hedge fund managers who are able to
capitalize on these shifts.
Markets are currently facing several economic and policy
outcomes that favor active management and hedging. As we move
into the later phases of the economic cycle, risk management
should play a greater role in manager outperformance. During the
past several years, passive strategies have been rewarded on an
absolute and risk-adjusted basis primarily because there have been
limited periods of decline, particularly in US equity markets. The
potential for significant fiscal stimulus including tax reform,
repatriation and infrastructure spending can help drive company
fundamentals creating relative winners and losers for long/short
strategies. Also, a tighter monetary policy could impact a variety
of assets classes globally as the suppression of volatility comes to
an end. For instance, global macro managers who seek to profit
from shifts in interest rates have struggled in recent years given the
lack of rate volatility. Notably, the recent moves in interest rates
and currencies have provided more opportunities for managers.
Cyclical Headwinds Abate
As we mark the eighth-anniversary of the equity bull market,
history tells the next eight years are unlikely to be same as the last.
The stock market’s recovery since the global financial crisis has
been one that can be measured by above-average returns coupled
with below-average volatility. This low-volatility environment
brought with it few deep or prolonged market pullbacks, limiting
opportunities for hedge funds. The utilization of various risk
management techniques or hedging during this relatively calm
period has hurt the performance for active managers. We believe
the active versus passive investment debate is in fact partially a
cyclical one. In the recently published “The Case for Active
Source: Hedge Fund Research, GIMA as of Dec. 31, 2016
Please refer to important information, disclosures and qualifications at the end of this material.
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ALTERNATIVES SPECIAL REPORT
MARCH 23, 2017
Exhibit 2: Periods of Superior Risk-Adjusted Returns for Passive Benchmarks
Are Not Unprecedented—Recall 1983-1988 and 1995-2000
3
Active Outperforms:
17 consecutive interest
rate hikes from 2004 to
2007
Active Outperforms:
Interest rate at a then-record
low of 5%
2
50%
Active Outperforms:
Financial crisis of
2007-2008
40
30
20
1
10
0
0
- 10
-1
- 20
Active Outperforms:
Collapse of the tech bubble, early
2000s recession and 9/11
-2
- 30
Sharpe Ratio of a US 60% Stocks/40% Bonds Portfolio (left axis)
Percentage of Large-Core Managers Outperforming vs. Long-Term Average (right axis)
- 40
Recession
-3
1983
- 50
1986
1988
1991
1993
1996
1998
2001
2003
2006
2008
2011
2013
2016
Note: The Sharpe ratio is calculated by subtracting the risk-free rate—such as that of the three-month US Treasury bill—from the rate of for a
portfolio and dividing the result by the standard deviation of the portfolio. Standard deviation, a proxy for volatility, is a measure of the dispersion of a
set of data from its mean.
Source: Morgan Stanley Wealth Management GIC, Bloomberg as of Dec. 30, 2016
Management” (GIC Wealth Management Perspective, Jan. 11,
2017) the percentage of large-cap core equity managers
outperforming has often moved along with the economic cycle,
with outperformance occurring late in the market cycle as
evidenced in the early 2000’s and leading up to and during the
financial crisis in 2008 (see Exhibit 2).
The prospect of higher interest rates and inflation in the US has
grown in recent months. That means buying assets simply for yield
regardless of valuation, which worked for many years, has become
a riskier strategy. The consequences of higher rates will most
clearly be felt in the bond market, where returns are expected to be
muted across most sectors. Furthermore, the prospect of higher
rates and divergent global monetary policy should lift market
volatility and dispersion across asset classes, some of which we
have already begun to see. Global monetary policy since the
financial crisis has tended to raise correlations and reduce
volatility, presenting challenges for strategies that focus on
bottom-up fundamental investing.
Should volatility rise toward historical levels (see Exhibit 3,
page 4), opportunities for hedge funds are apt to improve as the
ability to protect on the downside and capitalize on security-level
dispersion should increase. Recently, cross-asset correlations have
fallen sharply, which tends to be more common later in market
cycles (see Exhibit 4, page 4). This should bode well for strategies
like global macro and multi-strategy funds which typically allocate
across asset classes and regions.
Fees are another oft-cited headwind. During the past several
years, investors have scrutinized fund fees given low returns
combined with the adoption of better analytical tools such as
factor analysis to help identify how much returns came from the
managers’ value added (alpha) versus market gains (beta). While
fees are always important, weak performance made investors even
more cost-sensitive. In fact, during the past 12 months, hedge fund
managers have begun to soften their attitudes toward fee
reductions—and industrywide, fees are coming down. Anecdotal
evidence from managers and other allocators suggest that there are
a reasonable percentage of large hedge fund investors paying
“below headline” fees.
Undoubtedly, many hedge funds are capitulating on fees lest
they face investor redemptions. According to Hedge Fund
Research (HFR), in 2016 total industry assets increased 4.1% to
$3.02 trillion, a gain driven by positive performance. However,
HFR also cited total industry outflows of $70.1 billion. While
outflows only represented just over 2% of industry assets, it was
the largest outflow from the industry since 2009. We believe this
pressure on hedge funds will enable investors to allocate to
Please refer to important information, disclosures and qualifications at the end of this material.
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ALTERNATIVES SPECIAL REPORT
MARCH 23, 2017
Exhibit 3: Volatility May Continue to
Rise, Creating Potential Mispricings
some of the most successful funds that have previously been
closed to new capital. We continue to have conversations with
managers who are more open to lower fees and we expect this
trend to continue in the near future. The primary value proposition
of most hedge funds should be to deliver some portion of their
returns based on skill or “alpha” and provide diversification
benefits to a client’s overall portfolio. We believe this will become
more attainable in a lower-fee structure combined with a more
favorable market environment.
0.50 % 47.4%
Percent of Days With VIX Above 20
0.45
39.2%
0.40
0.35
0.30
Manager Selection and Current Themes
0.25
0.20
16.7%
16.7%
2015
2016
0.15
0.10
4.4%
0.05
1.2%
0.00
Past 20 Past 10
Years
Years
2013
2014
Source: Bloomberg, Morgan Stanley Wealth Management GIC as of
Dec. 31, 2016
Exhibit 4: Cross-Asset Correlation Has
Plummeted in Recent Months
Morgan Stanley Global Cross-Asset & Regional Index
50 %
45
40
35
30
25
20
15
2003
2005
2007
2009
2011
2013
2015
2017
Source: Bloomberg, Morgan Stanley Research as of March 6, 2017
Although the backdrop of active management has improved,
valuations indicate there may be fewer large and apparent
undervalued opportunities in traditional equity markets (see
Exhibit 5, see page 5). In fixed income, yields remain low and
spreads are generally on the tight side. This suggests lower returns
from traditional stock and bond portfolios as the Global
Investment Committee’s seven-year market forecast calls for
lower returns and more normalized levels of volatility than we
have seen in the 2009-2016 period. We believe this set-up is
positive for manager skill or alpha to be a more significant driver
of returns, a situation that favors hedge funds.
One of the challenges investors face in manager selection is that
when a manager running a strategy outperforms, new investors
tend to pile in. On the other hand, when a strategy is out of favor
or the manager underperforms, investors leave. This isn’t true just
for hedge funds, but for all active management. However, as we
have witnessed through the years, investors often have less
patience with underperforming hedge funds that charge higher fees
and provide less liquidity.
We believe this is one of the reasons that has exacerbated the
weaker performance of many funds of hedge funds. It is rare that
hedge fund managers increase their assets under management
when they are underperforming. However, we do believe in mean
reversion in asset-class returns or the beta to a strategy.
Additionally, for talented managers, we believe there is oftenmean reversion, too. In fact this was evident from 2015 to 2016
when certain factors and strategies fell out of favor but rebounded
in a relatively short period of time. This too is happening in early
2017.
While we would not simply advocate for a “buy low, sell high”
approach to picking hedge funds and can’t exactly time when
mean reversion will occur, we also would not dismiss the notion
that entry points matter. Buying asset class or manager
performance purely on momentum can prove costly if you buy
after the easy money has been made. Previous studies have
demonstrated that the best-performing managers over the longterm (10 years) often spend considerable time in the bottom half or
Please refer to important information, disclosures and qualifications at the end of this material.
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ALTERNATIVES SPECIAL REPORT
MARCH 23, 2017
Exhibit 5: Higher Valuation Means Fewer
Opportunities in Traditional Equity
the Global Investment Committee’s market outlook (see Exhibit
6). In each of these areas, we cite specific strategies that we
believe can succeed given the market environment.
Each of these respective themes focuses on achieving targeted
investment objectives with specific alternative investment
strategies. This means it is not just general strategies, but specific
managers that can help achieve a desired objective. For instance,
under “Portfolio Diversifiers With Low Correlation,” the
investment objective is to beat core fixed income with a similar
level of risk. The benchmark here would be the Bloomberg
Barclays US Aggregate Bond Index which has a 2.57% yield to
worse (as of Feb. 28,) annualized volatility of 4.07% since 1984
and a duration of about six. Here we are recommending certain
relative-value and trading-oriented hedge fund strategies with a
similar low volatility (4% to 6%) and low correlation to equities
(less than 0.3). We believe certain alternative investment managers
can provide viable alternatives to fixed income where risk and
correlation levels are similar—and still offer superior returns.
In the Strike Zone
Source: Bloomberg, Morgan Stanley Wealth Management GIC as of
Dec. 30, 2016
quartile of performance rankings when viewed in rolling threeyear periods. (Joel Greenblatt, “The Big Secret For the Small
Investor, How Expense Ratios and Star Ratings Predict Success,”
Morningstar Fund Spy, Aug. 9, 2010).
GIMA recently published several 2017 Alternative Investment
Themes which we would characterize as opportunities currently
presenting themselves within the hedge fund landscape based on
Baseball Hall-of-Famer Ted Williams was known for waiting
for just the right pitch before he would swing. The same can be
said for the current market backdrop for hedge funds and for active
management in general. We believe market dynamics favor certain
alternative strategies over traditional investments using an
outcomes-oriented approach to manager selection and portfolio
construction. However, discipline and proper execution will be
necessary to produce even if the set-up is just right. 
Exhibit 6: Current Opportunities in Hedge Funds
Portfolio Diversifiers
with Low
Correlation
Managing Global
Volatility
Rising Rates and
Spread Widening
Increase in Dispersion
& Corporate Activity
Reliable Income
Market
Environment
Bond yields remain
historically low,
prospect of rising
interest rates, weaker
absolute and riskadjusted returns from
core fixed income
Volatility remains
below historical
averages, later in the
economic cycle and
cross-asset
correlations have
been falling
Normalization of
interest rates is likely
to hurt longerduration assets and
create additional
fixed income volatility
Correlations have been
falling with diverging
monetary and fiscal
policy. M&A deal volume
remains elevated
Commercial real estate
fundamentals remain
stable with a favorable
economic backdrop as
evidenced by capital
flows and vacancies
Investment
Opportunities
Relative-value,
trading-oriented
strategies that have a
low volatility of 4% to
6% and low
correlation to equities,
less than 0.30, as an
alternative to core
fixed income
Global macro and
managed futures
typically work better
during volatility
spikes and trending
markets across
asset classes
Structured credit
funds can offer
attractive yields with
lower duration and
event-driven
outcomes that are
less dependent on
the market
Equity long/short
managers with
differentiated positioning
and event-driven/activist
funds that can capitalize
on corporate activity
Nontraded real estate
funds offer access to
commercial real estate
with reliable income of
5% to 6% and lower
volatility versus publicly
traded REITs
Source: Morgan Stanley Wealth Management GIMA
Please refer to important information, disclosures and qualifications at the end of this material.
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ALTERNATIVES SPECIAL REPORT
Glossary
ALPHA This
measures the difference between a portfolio’s actual returns
and its expected performance, given its level of risk as measured by Beta.
A positive Alpha figure indicates the portfolio has performed better than
its Beta would predict. A negative Alpha indicates the portfolio’s
underperformance given the expectations established by the Beta. The
accuracy of the Alpha is therefore dependent on the accuracy of the Beta.
Alpha is often viewed as a measurement of the value added or subtracted
by a portfolio’s manager.
BETA This measures a portfolio’s volatility relative to its benchmark. A
portfolio with a Beta higher than 1.0 has historically been more volatile
than the benchmark, while a portfolio with a Beta lower than 1.0 has been
less volatile.
CORRELATION This is statistical measure of how two securities move in
relation to each other. This measure is often converted into what is known
as correlation coefficient, which ranges between -1 and +1. Perfect
positive correlation (a correlation coefficient of +1) implies that as one
security moves, either up or down, the other security will move in
lockstep, in the same direction. Alternatively, perfect negative correlation
means that if one security moves in either direction the security that is
perfectly negatively correlated will move in the opposite direction. If the
correlation is 0, the movements of the securities are said to have no
correlation; they are completely random. A correlation greater than 0.8 is
generally described as strong, whereas a correlation less than 0.5 is
generally described as weak.
DRAWDOWN This
term refers to the largest cumulative percentage decline
in net asset value or the percentage decline from the highest value or net
asset value (peak) to the lowest value net asset value (trough) after the
peak.
SHARPE RATIO This statistic measures a portfolio’s rate of return based on
the risk it assumed and is often referred to as its risk-adjusted
performance. Using standard deviation and returns in excess of the returns
MARCH 23, 2017
of T-bills, it determines reward per unit of risk. This measurement can
help determine if the portfolio is reaching its goal of increasing returns
while managing risk.
Index Definitions
BLOOMBERG BARCLAYS US AGGREGATE BOND INDEX This This
index
tracks US-dollar-denominated investment grade fixed rate bonds. These
include US Treasuries, US -government-related, securitized and corporate
securities.
HFRI FUND WEIGHTED COMPOSITE INDEX This is
a global, equalweighted index of over 2,000 single-manager funds that report to the HFR
database. Constituent funds report monthly net of all fees performance in
US dollar and have a minimum of $50 million under management or a 12month track record of active performance. The HFRI Fund Weighted
Composite Index does not include funds of hedge funds.
MORGAN STANLEY GLOBAL CROSS-ASSET AND REGIONAL INDEX
This index is an average of regional correlations and cross-asset
correlations with components from equity, credit, rates and foreign
exchange assets.
MSCI ALL COUNTRY WORLD INDEX EX USA This is a free-float-adjusted,
market-capitalization-weighted index that is designed to measure equity
market performance in the global developed and emerging markets outside
the US..
S&P 500 INDEX This capitalization-weighted index includes a
representative sample of 500 leading companies in leading industries in
the US economy.
VIX This
is a trademarked symbol for the Chicago Board Options
Exchange Market Volatility Index, a measure of the implied volatility of
the S&P 500 index options.
Please refer to important information, disclosures and qualifications at the end of this material.
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ALTERNATIVES SPECIAL REPORT
MARCH 23, 2017
IMPORTANT DISCLOSURES
The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other
investment or service, or to attract any funds or deposits. Investments mentioned may not be suitable for all clients. Any product discussed herein
may be purchased only after a client has carefully reviewed the offering memorandum and executed the subscription documents. Morgan Stanley
Wealth Management has not considered the actual or desired investment objectives, goals, strategies, guidelines, or factual circumstances of any
investor in any fund(s). Before making any investment, each investor should carefully consider the risks associated with the investment, as discussed
in the applicable offering memorandum, and make a determination based upon their own particular circumstances, that the investment is consistent
with their investment objectives and risk tolerance.
Alternative investments often are speculative and include a high degree of risk. Investors could lose all or a substantial amount of their investment.
Alternative investments are suitable only for eligible, long-term investors who are willing to forgo liquidity and put capital at risk for an indefinite period
of time. They may be highly illiquid and can engage in leverage and other speculative practices that may increase the volatility and risk of loss.
Alternative Investments typically have higher fees than traditional investments. Investors should carefully review and consider potential risks before
investing.
Alternative investments involve complex tax structures, tax inefficient investing, and delays in distributing important tax information. Individual funds
have specific risks related to their investment programs that will vary from fund to fund. Clients should consult their own tax and legal advisors as
Morgan Stanley Wealth Management does not provide tax or legal advice.
Past performance is no guarantee of future results. Actual results may vary. Diversification does not assure a profit or protect against loss in a
declining market.
All expressions of opinion are subject to change without notice and are not intended to be a forecast of future events or results. Further, opinions
expressed herein may differ from the opinions expressed by Morgan Stanley Wealth Management and/or other businesses/affiliates of Morgan
Stanley Wealth Management.
This is not a "research report" as defined by FINRA Rule 2241 and was not prepared by the Research Departments of Morgan Stanley Smith Barney
LLC or Morgan Stanley & Co. LLC or its affiliates.
Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the
performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements. Clients should carefully
consider the investment objectives, risks, charges, and expenses of a fund before investing.
Indices are unmanaged and investors cannot directly invest in them. Composite index results are shown for illustrative purposes and do not
represent the performance of a specific investment.
While the HFRI indices are frequently used, they have limitations (some of which are typical of other widely used indices). These limitations include
survivorship bias (the returns of the indices may not be representative of all the hedge funds in the universe because of the tendency of lower
performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately
reflect the performance of a described style); and limited data (many hedge funds do not report to indices, and the index may omit funds, the
inclusion of which might significantly affect the performance shown. The HFRI indices are based on information self-reported by hedge fund
managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management,
L.L.C. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not
be complete or accurate representations of the hedge fund universe, and may be biased in several ways.
Interests in alternative investment products are offered pursuant to the terms of the applicable offering memorandum, are distributed by Morgan
Stanley Smith Barney LLC and certain of its affiliates, and (1) are not FDIC-insured, (2) are not deposits or other obligations of Morgan Stanley or any
of its affiliates, (3) are not guaranteed by Morgan Stanley and its affiliates, and (4) involve investment risks, including possible loss of principal.
Morgan Stanley Smith Barney LLC is a registered broker-dealer, not a bank.
SIPC insurance does not apply to precious metals, other commodities, or traditional alternative investments.
© 2017 Morgan Stanley Smith Barney LLC. Member SIPC.
Please refer to important information, disclosures and qualifications at the end of this material.
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