why hedge funds

7/28/2019 Why Hedge Funds

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ALTERNATIVE INVESTMENTS

Why Hedge Funds? March 2013

Hedge Funds Overviewo A hedge fund is an alternative investment strategy that is designed to reduce overall portfolio volatility, increase

portfolio diversification and potentially enhance returns.o Hedge funds consist of investments in both domestic and international markets and typically employ

sophisticated trading strategies, using leverage and derivative instruments in their goal to generate alpha.o A fund of hedge funds is a professionally managed portfolio consisting of multiple hedge funds offering

diversification across managers, strategies, styles, and/or sectors.o When considering including hedge funds as a portion of an investors overall portfolio, it is important that an

investor consider the various risks associated with these potentially speculative and illiquid investments, andthat investors have the financial sophistication to be able to understand and assume such risks.1

The Case for Including Hedge Funds in a Traditional Portfolioo Several prior market events such as the credit crisis and technology bubble have demonstrated to investors that

traditional asset allocations may not be sufficient to counterbalance market volatility.o Historically hedge funds have had a low to moderate correlation with traditional asset classes such as stocks and

bonds.2o More recently, many investors have decided to move more of their money into cash in order to reduce market

risk, but this may come at the cost of forgoing potentially higher returns over the long term.3

o The hypothetical portfolio allocation chart below illustrates that over the last twenty years, adding an allocationto hedge funds in a traditional portfolio may help enhance returns while reducing volatility as compared toinvesting 100% in a stock portfolio.

o Including hedge funds in a portfolio of otherwise traditional investments may lead to a more balancedportfolio.4

1 Please refer to the Risk Consideration sections of theAppendix Important Information on pages 5& 6 for more detailed information.2Source: Mark Anson, Handbook of Alternative Assets, (New York: John Wiley & Sons, Inc., 2002), p. 12. And p. 262. Past correlations donot guarantee comparable future correlations. Real results may vary.3Source: Principal Funds Vision Series: Alternative Strategies: Addressing Market Risk An Alternative Approach Feb 2012.

4U.S. Stocks represented by the S&P 500 Index; Bonds represented by the Barclays Aggregate Bond Index; Hedge Funds represented by the

HFRI Fund Weighted Composite Index. Past performance is no guarantee of future results.

90% Bonds, 10%Hedge Funds

90% U.S. Stocks,10% Hedge Fund

100% Bonds

50% Bonds, 50%U.S. Stocks

100% U.SStocks

45% Bonds, 45%U.S. Stocks, 10%

Hedge Funds

6.20%

6.45%

6.70%

6.95%

7.20%

7.45%

7.70%

7.95%

8.20%

8.45%

8.70%

2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%

CompoundAnnualReturn

Annualized Standard Deviation

Hypothetical Portfolio Allocations Using Index Returns 4

J anuary 1992 - December 2012


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Hedge Fund Performanceo Illustrating historical performance and low correlation of the hedge fund industry to traditional investments, the

below graph displays the annualized returns of hedge funds compared to U.S. stocks and bonds over the last 20years.

o The chart below illustrates that through bull and bear market periods, hedge funds have performed well relativeto U.S. stocks due to their ability to capture upside potential while protecting against downside risks.5

o During bull market periods, highlighted by the green shaded portions of the chart below, like October 2002 toOctober 2007, hedge funds generated positive returns but did not capture the full upside market potential, with

the S&P 500 Index returning on a cumulative basis 108.35% and the HFRI HF Index returning 84.36%.o During bear market periods highlighted by the pink shaded portions of the chart below, like the credit crisis

from November 2007 to February 2009, hedge funds provided the downside protection investors were lookingfor compared to U.S. stocks with the S&P 500 Index returning -50.95% compared to the HFRI HF Indexreturning -21.42%.

o The case study chart above shows an example of what would have happened to a hypothetical $1,000investment in hedge funds and traditional U.S. stocks respectively over a 10 year period.

After 10 years, the investment in hedge funds would have increased by 80% to $1,800 while theinvestment in traditional U.S. stocks would have increased by 40% to $1,400.

5Source: Hedge Funds represented by the HFRI Fund Weighted Composite Index; U.S. Stocks represented by the S&P 500 Index; Bondsrepresented by the Barclays Aggregate Bond Index. Past performance is no guarantee of future results.6The hypothetical $1,000 investment is shown for illustrative purposes only. It does not represent the performance for any specific

investment.


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A Measure of Volatilityo Referring to the chart below, using standard deviation as a measure of volatility, hedge fund strategies generally

exhibit less risk over the long term when compared to U.S. stocks. From January 1992 to December 2012 the average annualized volatility of U.S. stocks was 14.83%

compared to hedge funds which were less volatile at 7.00%. Depending on the level of loss an investor may experience during down market periods, it may take a

significant amount of time for the investors portfolio to recover back to pre-market downturn levels. For example, during periods like the credit crisis (November 2007 to March 2009), the S&P 500 Index was

down an average of -34% versus the HFRI Hedge Fund Composite Index which was down only -13%

comparatively. As hedge funds can be less volatile over the long term, they may help reduce an investors recovery time

from a down market.

Morgan Stanley Wealth Management Hedge Fund Platform Capabilities7o The Morgan Stanley Wealth Management Hedge Fund Platform provides clients access to a breadth of hedge

fund opportunities with approximately 100 leading managers across 150+hedge funds.o In 2012 alone, the Morgan Stanley Wealth Management Alternative Investments Group launched 13 hedge

funds (5 single manager hedge funds and 8 multi manager fund of hedge funds) and also secured additionalcapacity for investment into 5 of our most popular funds.

o Morgan Stanley Wealth Management Alternative Investments Research & Due Diligence team employs athorough and rigorous due diligence process wherein managers are screened based on quantitative andqualitative factors, in an effort to identify suitable candidates for Morgan Stanley clients.86

o Please contact your Financial Advisor or Private Wealth Advisor to discuss which investment opportunities may

be appropriate for you.

Qualifications for Investing in Alternative Investmentso When looking to add alternative investments to your holdings, you should be a sophisticated investor and be

able to understand the complex investment strategies sometimes employed, and tolerate the risks and liquidityconstraints of hedge funds.

o To find out if you're qualified to invest in alternative investments, please talk to your Financial Advisor orPrivate Wealth Advisor as eligibility requirements vary greatly when compared to traditional investments.

7As of 12/31/2012.

8A Morgan Stanley affiliate, Alternative Investment Partners, provides due diligence on most third-party single manager hedge funds.

Past performance is no guarantee of future results.


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Appendix - Important Information

Disclosures

This document has been prepared by the Morgan Stanley Wealth Management Alternative Investments Group (AIG) for informationalpurposesonly 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 anytradingstrategy in any jurisdiction.

A HEDGE FUND'S OFFERING MEMORANDUM DESCRIBES THE VARIOUS RISKS AND CONFLICTS OF INTERESTRELATING TO AN INVESTMENT IN THE SPECIFIC FUND AND TO ITS OPERATIONS. YOU SHOULD READ THE OFFERINGMEMORANDUM CAREFULLY TO DETERMINE WHETHER AN INVESTMENT IS SUITABLE FOR YOU IN LIGHT OF, AMONGOTHER THINGS, YOUR FINANCIAL SITUATION, NEED FOR LIQUIDITY, TAX SITUATION, RISK TOLERANCE AND OTHERINVESTMENTS.

The views and opinions contained herein are those of AIG at the time of publication, are subject to change without notice, and may differ materiallyfrom the views and opinions of others at Morgan Stanley Smith Barney, LLC or its affiliates. The conclusions are speculative in nature and are notintended to predict the future of any specific investment strategy. Although information in this document has been obtained from sources believed tobe reliable, Morgan Stanley Smith Barney LLC and its affiliates do not warrant the accuracy or completeness and accept no liability for any director consequential losses arising from its use. Past performance is not necessarily a guide to future performance.

General Alternative Investment Risk ConsiderationsAlternative 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 intended for experienced and sophisticated investors who are willing to forgo liquidity and put capital at risk for anindefinite period of time. Alternative investments may be highly illiquid and can engage in leverage and other speculative practices that mayincrease the volatility and risk of loss. Alternative investments involve complex tax structures, tax-inefficient investing and delays in distributingimportant tax information. Investors should carefully consider the funds objectives, risks, fees and expenses before investing in any fund.

Diversification does not eliminate market risks. Investors should read the entire prospectus carefully before deciding to invest in a particularAlternative Investment.

Hedge Fund Specific Risks

Specialized TradingSpecial investment techniques such as leveraging, short-selling and investing in derivatives, including options and futures, may resultin significant losses.

Diversification RiskWith respect to single manager hedge funds, the manager has complete trading authority and therefore, diversification may be limitedresulting in higher overall risk. With respect to fund of hedge funds, the manager has complete discretion to invest in various sub-funds without disclosure to you. Due to this lack of transparency, there is no way for you to monitor the specific investments made bythe fund or to know whether the sub-fund investments are consistent with the funds historic investment philosophy or risk levels.

Market RiskThe value of securities, commodities, and currencies may fluctuate reflecting a variety of factors, including changes in investor outlook

and political and economic environments.Strategy RiskHedge Funds trade in diverse complex strategies that are affected in different ways and at different times by changing marketconditions. Strategies may at times be out of market favor for considerable periods, with adverse consequences for the portfolio.

Manager RiskAlthough Morgan Stanley Wealth Management Alternative Investments selects advisors it believes are prudent and reliable, advisorscould perform poorly or reach capacity.

Incentive CompensationManagers will, in general, receive performance compensation, which may give the managers incentives to make investments thatcarry more risk or more speculative than might be the case if no performance compensation were paid.

Liquidity RiskFunds of Hedge Funds may have limited redemption dates. Underlying advisors may also have lock-up periods and infrequentredemption dates, thereby limiting the Investment Manager's ability to reallocate assets as market and advisor performance change.

Valuation RiskHedge Funds may trade in esoteric securities, often in illiquid markets. In normal markets it is sometimes difficult to price theseinstruments, causing managers to estimate market values. In stressed markets this problem may be compounded, leaving investorswith an imprecise understanding of the NAV of a multi-strategy portfolio. Valuations for investments for which market quotations arenot available may at times be estimates, which may affect the amount of the Management and Incentive Fees.

Other Risks

Global Investment Committee Allocations: Owing to the characteristics of alternative investments, many asset classes within this assetcategory may not be available to investors at all wealth levels. Asset classes that may generally be unavailable to certain investorwealth levels because of minimum investor asset requirements and/or minimum instrument purchase requirements have blankpercentage allocation weightings.

Private Equity: Private equity funds typically invest in securities, instruments, and assets that are not, and are not expected to become,publicly traded and therefore may require a substantial length of time to realize a return or fully liquidate. They typically have high


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management, performance and placement fees which can lower the returns achieved by investors. They are often speculative andinclude a high degree of risk. Investors can lose all or a substantial amount of their investment. They may be highly illiquid withsignificant lock-up periods and no secondary market, can engage in leverage and other speculative practices that may increasevolatility and the risk of loss, and may be subject to large investment minimums.

Private Real Estate: The private equity real estate asset class may involve special investment considerations, including investor netasset minimum criteria; investment vehicle entry and exit conditions; regulatory, tax reporting and/or compliance requirements; and,suitability guidelines.

Precious Metals: Physical precious metals are non-regulated products. Precious metals are speculative investments, which mayexperience short-term and long-term price volatility. The value of precious metals investments may fluctuate and may appreciate ordecline, depending on market conditions. If sold in a declining market, the price an investor receives may be less than their originalinvestment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may

not be suitable for investors who require current income. Precious metals should be safely stored, which may impose additional costson an investor.

Managed futures investments are speculative, involve a high degree of risk, use significant leverage, are generally illiquid, havesubstantial charges, subject investors to conflicts of interest, and are suitable only for the risk capital portion of an investors portfolio.Managed futures investments do not replace equities or bonds but rather may act as a complement in a well-diversified portfolio.Managed Futures are not appropriate for all investors.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including butnot limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and internationalpolitical and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities incommodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. Inaddition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack ofliquidity, participation of speculators and government intervention.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bonds maturity, the more

sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fullyor partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior tomaturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changesin the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable tomake interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principaland/or interest payments from a given investment may be reinvested at a lower interest rate. High yield bonds are subject to additionalrisks such as increased risk of default and greater volatility because of the lower credit quality of the issues.

Inflation-Linked Securities adjust periodically against a benchmark rate, such as the Consumer Price Index (CPI). They pay a couponequal to the benchmark rate, plus a fixed 'spread' and reset on a periodic basis. The initial interest rate on an inflation linked securitymay be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due tofuture increases in CPI, or the linked reference interest rate. However, there can be no assurance that these increases will occur.REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity,limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

International/Emerging Markets: Foreign investing (including investing in particular countries or groups of countries) involves certain

risks, such as currency fluctuations and controls, restrictions on foreign investments, less governmental supervision and regulation,and the potential for political instability. In addition, the securities markets of many of the emerging markets are substantially smaller,less developed, less liquid and more volatile than the securities of the U.S. and other more developed countries.

Referenced Indices and Sources

The source for index data for the Barclays Aggregate Bond Index and the S&P 500 Index is PerTrac Financial Solutions, LLC(Memphis, TN).Index returns are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returnsreflect reinvestment of any dividends and capital gains, but do not reflect any fees or charges, which would lower performance. Theindices are unmanaged and an investor cannot invest directly in an index.

Barclays Aggregate Bond Index is a market-weighted, intermediate-term bond index of over 6,500 intermediate government bonds,investment grade corporate debt securities and mortgage-backed securities.

S&P 500 is a free-float capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the UnitedStates. The index is designed to measure performance of the broad domestic US economy through changes in the aggregate marketvalue of 500 stocks representing all major industries, belonging to the following sectors: Information Technology, Health Care, Energy,Consumer Staples, Financials, Industrials, Consumer Discretionary, Utilities, Telecommunication Services, and Materials.

HFR Indices are compiled by Hedge Fund Research, Inc. ("HFR"), an industry service provider. They are based on the performanceof hedge funds in various strategies as reported by the hedge fund managers to HFR. 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 returnsof the indices may not be representative of all the hedge funds in the universe because of the tendency of lower performing funds toleave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflectthe performance of a described style); and limited data (many hedge funds do not report to indices, and the index may omit funds, theinclusion of which might significantly affect the performance shown. The HFRI Indices are based on information self-reported by hedgefund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFRAsset Management, L.L.C. Results for funds that go out of business are included in the index until the date that they ceaseoperations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biasedin several ways.


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HFR Fund Weighted Composite Index: Includes over 2000 constituent funds, equal-weighted index, no fund of funds included in theindex, and the constituent funds must have at least $50 million under management or have been actively trading for at least twelvemonths.

Glossary

Alpha: A mathematical value indicating an investment's excess return relative to a benchmark. Measures a manager's value addedrelative to a passive strategy, independent of the market movement.

Correlation: A measure of the degree to which two variables move in the same direction with the same impact on performance,measured in a range of -1.0 to 1.0. A correlation of -1.0 implies that the variables move inversely with one another while a correlationof 1.0 implies that the variables move in exactly the same manner. A correlation of zero implies that there is no relationship betweenthe movements of the variables (therefore implying perfect diversification).

Standard Deviation: A measure of the variation of returns around the mean return. Standard deviation is the most widely usedapproximation of the risk of an individual investment or portfolio.

Strategic Allocation: Refers to the long-term investment weightings for the major asset classes that best fit an investors specificcircumstances, a risk profile including their ability and willingness to tolerate risk, and return objectives, and that take into account theasset returns, standard deviations of returns, and correlations of returns under varying economic and financial conditions.

Tactical Allocation: Incorporates active decisions to overweight or to underweight asset classes in the near-term relative to theirstrategic allocation based on: (i) the current and projected financial and economic environment; (ii) evaluations of risk in global assetmarkets; and (iii) other fundamental, valuation, and psychological, technical, liquidity factors.

2012-PS-1486 (03/2013)

why hedge funds

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