Hedge Funds: An Important Alternative for Your Asset Allocation

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1 Hedge Funds: An Important Alternative for Your Asset Allocation INTRODUCTION Table of Contents Once the domain of mega institutions and only the most sophisticated individual investors, hedge funds are becoming increasingly popular with a broader segment of the investing public: Hedge fund industry assets under management rose to almost $3.2 trillion by November 2015, up from $2.63 trillion only two years before. 1 More than 4,800 institutions allocate a portion of their portfolios to hedge funds, including over half of all pubic pension funds. 1 Between now and 2020, alternative assets are expected to grow to $13.6 trillion, with an estimated $4.6 trillion attributed to hedge funds and funds of hedge funds. 2 2 How Hedge Funds Work 3 All Hedge Funds Are Not the Same 3 Seeking Superior Hedge Fund Managers 4 What Funds Are Available to You? 4 Portfolio Allocation 6 A Word About Eligibility 6 When Is the Right Time to Invest? 1 The 2016 Preqin Global Hedge Fund Report, 2 PricewaterhouseCoopers, Alternative Asset Management 2020: Fast Forward to Centre Stage, page 4, June 26, 2015.

2 Figure 1: Hedge Funds Performance in Bear and Bull Markets The case study below shows an example of what would have happened to a hypothetical $1,000 investment in hedge funds and traditional U.S. stocks, respectively, over a 25-year period. Hedge funds can help reduce portfolio volatility and add important diversification that can enhance performance while reducing risk. Hypothetical Investment in Hedge Funds and U.S. Stocks (April 30, 1991 April 29, 2016),,, Bear Market U.S. Stocks:. % Hedge Funds:. % Bear Market U.S. Stocks:. % Hedge Funds:. %,,, Jun Jan Aug Mar Nov Oct May Dec Jul Feb Sep Nov Jun Jan Aug May Dec Jul Feb Sep Mar Oct Bull Market U.S. Stocks:. % Hedge Funds:. % Nov Jun Jan Aug Mar Oct May Dec Jul Bull Market U.S. Stocks:. % Hedge Funds:. % Hedge Funds U.S. Stocks Source: Hedge funds represented by the HFRI Fund Weighted Composite Index, which is reported net of all fees; U.S. stocks represented by the S&P 500 Total Return Index gross dividends. The hypothetical $1,000 investment is shown for illustrative purposes only. Cumulative index returns specified. Index results are shown for illustrative purposes only and do not represent the performance of any specific investment. Gross index returns reflect reinvestment of any dividends and capital gains. The indexes are unmanaged and an investor cannot invest directly in an index. Past performance is not indicative of future results. Please see the Appendix for important information about the indexes and a glossary of terms. Feb Sep Nov Jun Jan Aug Mar Oct How Hedge Funds Work Alfred Winslow Jones had been a purser on an ocean liner, a sociology professor and a financial journalist before he created what many believe to be the first hedge fund in Jones thought that superior stock selection counted for more than market direction. And so, he bought stock that he believed was going to rise more than the market, and he hedged his positions by shorting stocks that he thought were going to decline more than the market. He also used leverage to enhance potential returns. While Jones hedging approach was the reason these investments were originally called hedge funds, the term may no longer be accurate. Hedge funds may or may not employ these strategies. What they all have in common are the following characteristics: They pursue absolute, as opposed to relative, returns Most money managers measure their performance by comparing it to a specific market index such as the S&P 500 or Russell Hedge fund managers are not tied to the performance of an index. They are free to pursue absolute returns however they wish. They have the potential to capitalize on varying market conditions Traditional large-cap money managers buy portfolios of large-cap stocks with the hope they will increase in value. Hedge fund managers may mix capitalizations, investment styles, economic sectors and geographic locations, if they wish. In addition, they may employ leverage or arbitrage and take positions on both sides of the market, shorting securities or entire sectors to capitalize on declining prices. They are typically structured as limited partnerships Hedge fund managers choose this structure so that they can have the flexibility to invest in whatever securities they wish and employ leverage, short selling and other strategies that generally aren t allowed in mutual funds and other registered investments. A by-product of this approach, however, is limited transparency. Private partnerships are not required to provide their investors with descriptions of holdings, pricing or valuation. To do so, they believe, would jeopardize their competitive edge in a marketplace where many managers are seeking to profit from pricing inefficiencies. In addition, limited partnerships offer less liquidity than traditional investments such as mutual funds. Depending on the hedge fund in which you participate, you may be subject to lock-up periods when you can t redeem your interests under any circumstances and periodic windows of liquidity when you can redeem interests only under specific conditions. Recently, however, hedge funds that are registered with the SEC have been introduced to the investing public. Unlike traditional hedge funds, these partnerships trade in public markets and may offer greater liquidity and transparent pricing. They differ from more traditional investments in a number of other ways: Hedge fund managers, hired for their expertise in a specified area and for their efforts, exact a fee that is higher than those charged by mutual funds. Most hedge funds charge an annual management fee of 1 percent to 2 percent of assets, plus an incentive fee that is imposed only on returns exceeding a specific threshold. Typically, this fee is 20 2 MORgAN STANlEY 2016

3 Hedge FUNDS: an IMPORTANT AlTERNATIve FOR Your ASSET AllOCATION percent, although it can be less or more, depending on the fund. Many hedge fund managers invest their own capital in their funds, thereby providing them with an additional performance incentive and perhaps deterring them from taking undue risks. Some top hedge fund managers require a minimum investment of $1 million to $10 million. Despite such high thresholds, through Morgan Stanley, clients can often gain access to funds at much lower minimum investments. As discussed later, investments in single manager hedge funds may be as low as $100,000 per fund. Additionally, private funds of hedge funds are often available through Morgan Stanley for a minimum investment of $250,000, while funds of hedge funds that are registered with the SEC typically require a minimum of only $50,000 (see What Funds Are Available to You? on pages 4-5). they will go long when they believe a security is at the bottom of its range and undervalued in the marketplace. Distressed Funds focus on companies with turnaround potential. Many may be facing or emerging from bankruptcy and reorganization. Clearly, some of these approaches are riskier than others. What s more, they tend to generate returns that are not highly correlated to each other, so some investors construct a portfolio of hedge funds or participate in funds of hedge funds to achieve greater diversification. Perhaps one of the biggest differences among hedge funds, however, is the manager. Morgan Stanley has developed extensive due diligence capabilities to analyze and evaluate every hedge fund manager offered on our platform. seeking Superior Hedge Fund Managers Morgan Stanley offers an open architecture platform of proprietary and third-party hedge funds and funds of hedge funds for your consideration. Before hedge fund managers and fund of hedge fund managers are selected for inclusion, they undergo a rigorous due diligence process that focuses on investment expertise and operational capabilities. Specifically, that process includes: Quantitative and Qualitative Analysis How have funds performed over time, in various market cycles and versus their peer groups? How much risk did managers assume to achieve their returns? Morgan Stanley due diligence professionals visit managers on-site to interview key personnel and conduct in-depth reviews of investment approaches, portfolio composition, risk management techniques and capacity constraints, as well as organizational depth and stability. Operational Review What risks do funds pose outside of their investment processes? Our ex- All Hedge Funds Are Not the Same Classic equity long-short hedge funds may take positions on both sides of the market, shorting some stocks while taking long positions on others, but they are not the only types of hedge funds available to investors. You can choose from a variety of strategies, some of which include: Event-Driven Funds seek such opportunities for profit as mergers, acquisitions, takeovers (hostile or otherwise), reorganizations and leveraged buyouts. Macro Funds seek to capitalize on major government policy and economic shifts that affect various global markets, including equities, fixed income, commodities and currencies. Often, they are highly leveraged. Relative Value Funds seek to take advantage of gaps in the price of a single security or similar securities. When managers believe that a security is priced at the top of its historical range, they may short the position. Conversely, hedge fund indexes Figure 2: Hedge Fund Strategy Performance Despite the fact that some hedge fund strategies involve considerable risk, many of them have generated risk-adjusted returns that outpace traditional equities. The chart below displays annualized returns and standard deviations for a variety of hedge fund strategies from April 30, 1991, to April 29, As you can see, these strategies offer competitive returns and most outperformed the stock market during this period. All of them achieved their returns with lower standard deviations than stocks, thereby reducing portfolio volatility for investors. Annualized Return HFRI Fund Weighted Composite 9.8% 6.7% HFRI Fund of Funds Composite 6.3% 5.6% HFRI Equity Hedge 10.8% 8.8% HFRI Event-Driven 10.6% 6.5% HFRI Macro 10.3% 7.1% HFRI Relative Value 8.9% 4.3% S&P 500 (U.S. Stocks) 9.3% 14.4% MSCI EAFE (International Stocks) 5.4% 16.4% The returns for the MSCI EAFE Index are in U.S. Dollar. Please see the Appendix for important information about the indexes. Past performance is not indicative of future results. Annualized Standard Deviation Morgan Stanley

4 perts review each manager s infrastructure, controls and business practices to determine whether they meet our demanding criteria. Managers can be eliminated from consideration if our analysis reveals failure to supervise, improper valuation practices, a lack of checks and balances, or inadequate risk and liquidity controls. Approval of New Funds This process begins when investment and operational reviews end. Our manager analysts present the funds that meet their approval to Morgan Stanley s Alternative Investments Product Review Committee. This group consists of senior professionals from such diverse disciplines as legal, compliance and risk. Funds that pass their scrutiny are made available to Morgan Stanley clients. Ongoing Monitoring Once a fund is selected for inclusion on our platform, it is reviewed and evaluated on an ongoing basis for continued investment and operational excellence. Events that could change a fund s status include persistent underperformance, style drift, significant changes to key staff and inadequate operational resources. What Funds Are Available to You? The selection of hedge funds at Morgan Stanley is extensive. Depending on your objectives, ability to meet minimum investment requirements and need for liquidity and diversification, you may choose from the following: Single Manager Hedge Funds Morgan Stanley s platform offers world renowned hedge fund managers specializing in a range of strategies. Liquidity provisions, fees and other terms vary from fund to fund, but typically, minimum investment requirements for direct participation in a single fund can range from $1 million to $10 million. As a result, the firm offers several distinct platforms to help select the right funds for your specific needs and compile a diversified portfolio that complements your other holdings: HedgePremier, an innovative single manager hedge fund access program, enables you to participate in one or more hedge funds at lower investment minimums ($100,000 per fund). We employ a rigorous process to identify, evaluate and select each fund on our platform. This helps us ensure that our clients are introduced only to fund managers whom we believe to be the best in the industry. Custom hedge fund strategies are available to ultra high net worth individuals and institutions (minimum $125 million net worth). Experienced professionals work closely with you to understand your unique needs, and select managers and strategies to complement your overall investment portfolio and help you achieve your goals. This approach offers you access to a variety of underlying managers and often results in reduced fees. Minimum investment requirements for customized portfolios can be $25 million or more. Funds of hedge Funds Funds of hedge funds offer the opportunity to participate in a portfolio of funds with different managers How much of your portfolio should you allocate to alternative investments? Morgan Stanley s Global Investment Committee establishes guidelines that serve as one source for your Financial Advisor s or Private Wealth Advisor s asset allocation advice. The Committee s recent allocation models suggest the following: Portfolios under $25 million Portfolios over $25 million Investment Profile Allocation to Alternatives Allocation to Alternatives Capital Preservation (Model 1) 7% 10% Balanced Growth (Model 3) 14% 20% Opportunistic Growth (Model 5) 20% 25% Ask your Financial Advisor or Private Wealth Advisor for more details and current allocation models at the time you are making your investment decisions. As of April 22, Strategic asset allocation models depicted above are based on Models 1, 3 and 5. Please note there are five asset allocation models ranging from conservative to aggressive (Model 1: Capital Preservation; Model 2: Income; Model 3: Balanced Growth; Model 4: Market Growth; Model 5: Opportunistic Growth). The asset allocation models are subject to change from time to time. The GIC defines alternative investments as the following: REITS, Commodities, Master Limited Partnerships, Hedged Strategies (which include Traditional and 40 Act Alternative Investments including: Hedge Funds, Fund of Funds, Alternative Mutual Funds), Managed Futures, Private Real Estate and Private Equity. For illustrative purposes only. This does not represent individually tailored investment advice. Actual client portfolio will vary based on individual circumstances. 4 MORgAN STANlEY 2016

5 and investment styles. Each fund of funds offers a distinct strategy that can help you diversify your overall portfolio and provide you with an opportunity to earn risk-adjusted and absolute returns. Morgan Stanley s open architecture approach enables you to choose from proprietary and third-party funds of funds. Both comprise funds that typically generate returns with low correlation to one another and traditional securities markets. Funds are monitored on an ongoing basis to assure continued adherence to our rigorous investment and operational due diligence standards. Registered funds of hedge funds are registered with the SEC and are, therefore, subject to the same transparency rules as mutual funds. Registered funds are open to Figure 3: How Hedge Funds Can Make a Difference all Accredited Investors 2 who meet the Morgan Stanley platform minimum investment requirements of $50,000. Registered Funds distribute 1099s for tax reporting purposes; they do not issue K-1s. Private funds of hedge funds are not registered and often impose minimum investment requirements of $250,000 or more. To participate, you must meet SEC Qualified Purchaser criteria. Private fund of funds distribute K-1s for tax reporting purposes. A customized approach to funds of hedge funds selection is available to ultra high net worth investors (minimum $125 million net worth). Either a Morgan Stanley or thirdparty professional will work closely with you to design a portfolio of hedge funds that meets your specific Historically, hedge funds have had a low to moderate correlation with traditional asset classes such as stocks and bonds. The hypothetical portfolio allocation chart below illustrates that over the last 25 years, adding an allocation of hedge funds to a traditional stock or bond portfolio may help enhance returns while reducing volatility as compared to investing solely in a stock or bond portfolio. Hypothetical Portfolio Allocations Using Indexed Returns (April, April, ) Annualized Compound Return (%) 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 45% U.S. Bonds, 45% U.S. Stocks, 10% Hedge Funds 90% Bonds, 10% Hedge Funds 90% U.S. Stocks 10% Hedge Funds 100% U.S. Stocks 50% Bonds, 50% U.S. Stocks 100% Bonds 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% Annualized Standard Deviation (%) Source: Hedge funds represented by the HFRI Fund Weighted Composite Index, net of all fees; U.S. stocks represented by the S&P 500 Total Return Index, gross of dividends; bonds represented by the Barclays U.S. Aggregate Bond Index. Index results are shown for illustrative purposes only and do not represent the performance of any specific investment. Gross index returns reflect reinvestment of any dividends and capital gains. The indexes are unmanaged and an investor cannot invest directly in an index. Past performance is not indicative of future results. Please see the Appendix for important information about the indexes and a glossary of terms. 2 SEC Accredited Investors standards require participants to have a net worth of at least $1 million, with annual income exceeding $300,000 in each of the past two years for married couples and $200,000 for single investors. objectives, time frame and risk tolerance. Minimum investment requirements can be $25 million or more. You should be aware that liquidity is limited in all funds of funds. Furthermore, funds of funds, whether registered or private, typically impose an annual charge of 1 percent to 2 percent in addition to the management and incentive fees charged by their underlying fund managers. Despite these limitations, however, funds of funds offer a convenient way to participate in hedge funds, with a number of distinct advantages namely, access to managers who might not otherwise be available to you, diversification of investment style and strategy, and lower minimum investments. Alternative Mutual Funds and Exchange-Traded Funds A new category of alternative investments has emerged over the past few years. A number of well-known investment management organizations have introduced mutual funds that employ such hedge fund strategies as long-short and market neutral. The difference between these vehicles and their traditional predecessors is potentially lower fees, lower minimum investment requirements, greater transparency and quarterly or daily liquidity. It s a bit too early to determine how well these new products will provide hedge fund benefits to a larger segment of the investing public, especially since many of them have no choice but to sacrifice sources of potential return in favor of the liquidity they offer. Discuss these alternatives thoroughly with your Financial Advisor or Private Wealth Advisor before you invest. MORgAN STANlEY

6 A Word About EligIBIlity Investors participating in hedge funds offered through Morgan Stanley must meet SEC Accredited Investor 1 standards, as well as Qualified Client 2 and Qualified Purchaser 3 standards depending on the fund, as shown in the chart below. Morgan Stanley may impose a qualification standard that may be higher than those required to meet SEC standards. Additionally, individual funds may have their own investment minimum and eligibility criteria. Alternative Investments Eligibility Client Net Worth/Net Investable Asset Minimums Alternative investments are offered only to qualified investors. Client eligibility 4 to purchase alternative investments is typically based on the client s net worth, or as applicable, net investable assets, as shown in the chart below: $1M+ $2M+ $5M+ $125M+ $750M+ managed futures funds Registered fund of hedge funds registered single manager hedge funds Qualified Client 2 private fund of hedge funds private single manager hedge funds private equity funds private real estate funds exchange funds custom Fund OF Hedge Fund SOLUTIons CustoM PRIVATE EQUITY SOLUTIons Accredited Investor 1 Qualified Purchaser 3 Firm-Imposed Standards 5 1 Funds that rely on an Accredited Investor standard generally require a minimum net worth of $1 million for an individual (excluding primary residence), and $5 million for an entity. 2 Funds that rely on a Qualified Client standard require an individual or entity to have a minimum net worth of $2 million, exclusive of primary residence, or have at least $1 million invested under management with the manager of the fund. 3 Funds that rely on a Qualified Purchaser standard must meet Accredited Investor standards, and require minimum net investable assets of $5 million for an individual, and $25 million for an entity. 4 Eligibility does not imply suitability. Speak with your Financial Advisor or Private Wealth Advisor to help determine if alternative investments may be appropriate for you. Please see the Important Disclosures at the end of this publication for additional information. 5 In addition to meeting Accredited Investor and Qualified Purchaser standards, these funds are subject to firm-imposed higher eligibility standards. When Is the Right Time to Invest? Bullish markets can turn the heads of even experienced investors who sometimes forget the bearish markets that preceded them. Hedge funds may not outperform stocks when markets are up, but they can help you reduce volatility and potentially earn greater risk-adjusted returns when markets turn choppy. Lower volatility can translate to superior performance over the long term. Ask your Financial Advisor or Private Wealth Advisor for more information and assistance in determining how to integrate hedge funds into your asset allocation. 6 MORgAN STANlEY 2016

7 Appendix Risks of Traditional Alternative Investments Specialized Trading Special investment techniques such as leveraging, short selling and investing in derivatives, including options and futures, may result in significant losses. Manager Risk Investing in a fund exposes investors to risks particular to that fund manager. These risks can include poor decision-making, key personnel departures or fraud, among others. In the case of a fund of funds, although the investment manager selects managers it believes are prudent and reliable, managers could perform poorly or reach capacity. Investment Process/Model Risk The investment manager s investment process may be heavily dependent on the investment manager s analysis of historical data. No assurance can be given that these analyses will accurately predict future results. Market Risk The value of securities, commodities and currencies may fluctuate, reflecting a variety of factors, including changes in investor outlook and political and economic environments. Strategy Risk Investments in diverse and sometimes complex strategies are affected in different ways and at different times by changing market conditions. Strategies may at times be out of market favor for considerable periods, with adverse consequences for the portfolio. Incentive Compensation Managers will, in general, receive performance compensation, which may give the managers incentives to make investments that carry greater risk or are more speculative than might be the case if no performance compensation were paid. Liquidity Risk Funds of hedge funds may have limited redemption dates. Underlying advisors may also have lock-up periods and infrequent redemption dates, thereby limiting the investment manager s ability to reallocate assets as market and advisor performance change. Valuation Risk Hedge funds may trade in esoteric securities, often in illiquid markets. In normal markets, it is sometimes difficult to price these instruments, causing managers to estimate market values. In stressed markets, this problem may be compounded, leaving investors with an imprecise understanding of the NAV of a multistrategy portfolio. Valuations for investments for which market quotations are not available may at times be estimates, which may affect the amount of the Management and Incentive Fees. Conflicts of Interest Morgan Stanley Smith Barney, LLC or its affiliates (collectively, Morgan Stanley ) engage in or may engage in business (in each case, subject to applicable law) with a particular fund, the general partner, the manager and/or the entities in which a particular fund invests, and, as a result, earns or will earn current or future fees and commissions by providing certain services, including, but not limited to: (i) financing or investment banking services; (ii) lending or arranging credit; and (iii) other financial services. The receipt or prospect of receiving such fees or commissions may present an actual or potential conflict of interest. In addition, in connection with an investment in a particular fund, the manager or its affiliate may receive certain management fees and its general partner may receive carried interest from investors in a particular fund as described in the applicable fund memorandum. Reliance on Industry Data Morgan Stanley utilizes and relies on data and indexes from third parties, and some of these are presented in this presentation. Morgan Stanley does not independently confirm the data and indexes from these third-party sources and does not make any representation as to their accuracy. Nontraditional Alternative Investments, such as mutual funds, may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. Nontraditional investment options and strategies are often employed by a fund s portfolio manager to further a fund s investment objective and to help offset market risks. However, these features may be complex, making it more difficult to understand the fund s essential characteristics and risks, and how it will perform in different market environments and over various periods of time. They may also expose the fund to increased volatility and unanticipated risks particularly when used in complex combinations and/or accompanied by the use of borrowing or leverage. The fund s prospectus will contain information and descriptions of any nontraditional and complex strategies utilized by the fund. You should keep in mind that while mutual funds may at times utilize nontraditional investment options and strategies, they should not be equated with unregistered privately offered alternative investments. Because of regulatory limitations, mutual funds that seek alternative-like investment exposure must utilize a more limited investment universe. As a result, investment returns and portfolio characteristics of alternative mutual funds may vary from hedge funds pursuing similar investment objectives. They are also more likely to have a relatively higher correlation with traditional market returns than privately offered alternative investments. Moreover, hedge funds have limited liquidity and may have long lock-up periods, allowing them to pursue investment strategies without having to factor in the need to meet client redemptions. On the other hand, mutual funds typically must meet daily client redemptions. This differing liquidity profile can have a material impact on the investment returns generated by a mutual fund pursuing an alternative investing strategy compared with a traditional hedge fund pursuing the same strategy. The Securities Investor Protection Corporation ( SIPC ) provides certain protection for customers cash and securities in the event of a brokerage firm s bankruptcy, other financial difficulties, or if customers assets are missing. SIPC insurance does not apply to traditional alternative investments. GLOSSARY OF TERMS Absolute Return Hedge funds are often described as absolute return products because their managers traditionally seek returns greater than zero regardless of market direction as opposed to relative return products, whose managers seek returns greater than market returns. Alternative Investments In addition to hedge funds, alternative investments include public and private offerings, low expense and high expense, liquid and illiquid, long-only and long-short investments such as Master Limited Partnerships ( MLPs ), commodities, real estate, private equity, collectibles and venture capital. Various alternative investment strategies are being utilized by investment managers in other vehicles such as mutual funds and managed accounts. Annualized Return Return calculated is averaged over the time period it is calculating. 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 correlation of 1.0 implies that the variables move in exactly the same manner. A correlation of zero implies that there is no relationship between the movements of the variables (therefore implying perfect diversification). Diversification Spreading investment risk by constructing a portfolio that contains different investments whose returns are relatively uncorrelated. Risk levels can be reduced without a corresponding reduction in returns. Leverage The use of various financial instruments, including credit lines and options, to attempt to enhance returns without increasing investment amount. Rate of Return ( ROR ) The gain (or loss) generated from an investment over a specified period of time. Up ROR: the maximum gain generated from an investment over a specified period of time. Down ROR: the maximum loss generated from an investment over a specified period of time. Relative Return The return that an asset achieves over a period of time compared to a benchmark. The relative return is the difference between the absolute return achieved by the asset and the return achieved by the benchmark. Standard Deviation A measure of the variation of returns around the mean return. Standard deviation is the most widely used approximation of the risk of an individual investment or portfolio. Hedge Fund STRATEGY DESCRIPTIons There are a broad range of available Hedge Fund strategies. Below are some of the most common: Convertible Arbitrage Involves purchasing a portfolio of convertible securities, generally, convertible bonds, and hedging a portion of the equity risk by selling short the underlying common stock. Distressed Securities Invests in, and may sell short, the securities of companies where the security s price has been, or may be, affected by a distressed situation such as a reorganization, bankruptcy, distressed sale and other corporate restructuring. Emerging Markets Involves investing in securities of companies or the sovereign debt of developing or emerging countries. Emerging Markets include countries in Latin America, Eastern Europe, the former Soviet Union, Africa and parts of Asia. Equity Hedge (Equity Long/Short) Comprises a core portfolio of equities (the long portion) hedged at all times with short sales of stocks and/or stock index options. Managers generally maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Equity Market Neutral Seeks to profit by exploiting pricing inefficiencies between related equity securities, potentially reducing market exposure by combining long and short positions. Equity Non-Hedge Funds that are predominately long equities although they have the ability to hedge with short sales of stocks and/or stock index options. Some funds employ leverage to enhance returns. When market conditions warrant, managers may implement a hedge in the portfolio. The important distinction between equity non-hedge funds and equity hedge funds is equity non-hedge funds are less reliant upon hedging. Event Driven Also known as corporate life cycle investing, typically invest in companies when opportunities are created by significant corporate transactions either occurring or anticipated, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. MORgAN STANlEY

8 Fat Tail Risk Fat tails are anomalies in return distributions, where extreme occurrences are more frequent and larger than standard deviation would explain. Fat tails in hedge fund strategies typically produce an asymmetrical risk profile whereby the frequent and larger extreme occurrences tend to occur on the negative side of the return distribution. In other words, standard deviation understates risk. Fixed Income Arbitrage Employs a market-neutral hedging strategy that seeks to profit by exploiting pricing inefficiencies between related fixed income securities while neutralizing exposure to interest rate risk. REFerenCed Indexes Barclays Aggregate Bond Index A market-weighted, intermediate-term bond index of over 6,500 intermediate-term government bonds, investment-grade corporate debt securities and mortgage-backed securities. HFR Indexes are compiled by Hedge Fund Research, Inc. (HFR), an industry service provider. They are based on the performance of hedge funds in various strategies as reported by the hedge fund managers to HFR. While the HFRI Indexes are frequently used, they have limitations (some of which are typical of other widely used indexes). These limitations include survivorship bias (the returns of the indexes 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 indexes, and the index may omit funds, the inclusion of which might significantly affect the performance shown). The HFRI Indexes 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, LLC. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indexes may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways. All data is net of all fees, denominated in U.S. dollars and equal-weighted. The information underlying the indexes and the classification of the underlying funds have not been independently verified by either HFR or Morgan Stanley, and neither HFR nor Morgan Stanley makes any representation as to their accuracy. The specific HFR indexes used in this document are composed of hedge funds following the investment strategies as described below: HFRI Equity Hedge Index (Long/Short Equity) Equity Hedge investing consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. HFRI Event-Driven Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety, including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. HFRI Fund of Fund Index Listing of Top 50 FOF rankings by Rate of Return, Sharpe Ratio and Standard Deviation; sorted by one-, three- and five-year intervals. HFRI Fund Weighted Composite Index Includes over 2000 constituent funds, equal-weighted index, no fund of funds included in the index, and the constituent funds must have at least $50 million under management or have been actively trading for at least 12 months. HFRI Macro Index (Global Macro) Macro involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities. HFRI Relative Value Index Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk-adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction. Morgan Stanley Capital International World (MSCI) An index consisting of approximately 1,500 stocks in 23 countries globally and representing a significant portion of the total market capitalization in those countries. Russell 2000 Index Measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. S&P 500 A capitalization-weighted index of 500 U.S. large-cap stocks. Morgan Stanley Smith Barney LLC ( Morgan Stanley Wealth Management ) IMPORTANT DISCLOSURES You should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information can be found in a fund s confidential offering memorandum or prospectus, which you should read carefully before investing. 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. Certain of these risks may include, but are not limited to: Loss of all or a substantial portion of the investment due to leveraging, shortselling or other speculative practices; Lack of liquidity in that there may be no secondary market for a fund; Volatility of returns; Restrictions on transferring interests in a fund; Potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized; Absence of information regarding valuations and pricing; Complex tax structures and delays in tax reporting; Less regulation and higher fees than mutual funds; and Risks associated with the operations, personnel and processes of the manager. As a diversified global financial services firm, Morgan Stanley Wealth Management engages in a broad spectrum of activities including financial advisory services, investment management activities, sponsoring and managing private investment funds, engaging in broker-dealer transactions and principal securities, commodities and foreign exchange transactions, research publication, and other activities. In the ordinary course of its business, Morgan Stanley Wealth Management therefore engages in activities where Morgan Stanley Wealth Management s interests may conflict with the interests of its clients, including the private investment funds it manages. Morgan Stanley Wealth Management can give no assurance that conflicts of interest will be resolved in favor of its clients or any such fund. Indexes 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. Certain assumptions have been made regarding the historical performance information included herein, and such performance information is presented by way of example only. Statements in this material are stated as of the dates specified herein. No representation or warranty (express or implied) is made or can be given with respect to the accuracy or completeness of the information in this material. No representation is made that the performance presented will be achieved as a result of implementing an investment strategy substantially identical or similar to that described herein or that every assumption made in achieving, calculating or presenting the historical performance information has been considered or stated. Any changes to assumptions could have a material impact on the investment returns that are presented by way of example. Returns for any period may be attributable to certain market conditions, fund size and timing of transaction, which may not be repeated. Diversification does not assure a profit or protect against loss in a declining market. Past performance is no guarantee of future results. Actual results may vary. 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. 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. Investments and services offered through Morgan Stanley Smith Barney LLC Morgan Stanley Smith Barney LLC ALT CRC /16 CS /16