Considering the Alternative

March 2013

The alternative-asset space is growing in both scope and popularity. But before jumping in, Chris Mackay of Private Advisors says, accredited investors need to consider both the risks and the rewards
The traditional portfolio mix of stocks and bonds is increasingly becoming a thing of the past. Hedge-fund assets totaled $2.2 trillion at the end of 2012, according to Hedge Fund Research, and assets in mutual funds with alternative strategies swelled three times in size last year, according to Morningstar. But that doesnt mean allor any alternatives are right for everyone, says Chris Mackay, a partner at Private Advisors, an independent investment firm dedicated to the management of alternative investments. Mackay recently shared his thoughts on alternative assets with Morgan Stanleys Tara Kalwarski. The following is an edited version of their conversation.* Tara Kalwarski: How do you define the alternatives market? Chris Mackay: We characterize alternatives as anything that isn't in the publicly traded traditional markets, [where] fixed income, equities or other assets that are easily accessible to an average investor [are traded]. The big pools of alternatives are real assetscommodities, direct real estate, private equity, private debtand various hedge fund strategies. [Such alternatives] may be investing in assets that are traditional by nature, but they're doing it in a vehicle that has the ability to apply leverage or different structures that you wouldn't be able to have available in a normal, traditional pooled vehicle [like a mutual fund] or a separately managed account. And just as with the traditional markets, certain portions of alternatives are in and out of favor. At certain points in time, less liquid debt will look attractive. At other points in the cycle, long-short equity will have a wind at its back, and then it will have a wind in its face. I think targeting areas for investment within the broader scope of alternatives makes the most sensenot just blindly saying, I want alternatives. The key is to understand how [an investor] is getting compensated for the [additional risk], and if it's appropriate for that investor. Kalwarski: How do you think alternatives should fit into an overall diversified portfolio? Mackay: I think if an investor has the financial means to be investing in this space, the legal ability vs. the practical ability can sometimes [be an issue]. In reality, even someone who is qualified may not be appropriate to invest in a lot of these strategies. As a general rule of thumb, I believe that if you're not doing enough to really make a difference, then don't do anything. A 5% allocation toward alternatives may make you feel better, but it probably won't make a material difference to your return. I think that unless you're able to do [more], both from a means test and a liquidity test, and to understand the strategies from the capability standpoint, then you're

probably better off just staying away. I think the exposure in your portfolio should be significant and meaningful to be worth the commitment to look at these types of strategies. Kalwarski: Do you think the alternative asset class is misunderstood? Mackay: I think everybody looks in the rearview mirror and says, Well, you know, this has done well; this hasn't done well. And it's sometimes hard to separate out what was your real risk going into the investment andon a risk-adjusted basiswhat you are trying to obtain. That's why we try to look at things in a long market cycle. We believe the role of hedge-fund strategies in an overall portfolio is to participate in upwardly moving markets because if you don't take risk, you can't get returnand, more important, to hedge exposure in a downward moving market. I think the part that a lot of people miss is if you do both those things, where you really [potentially] make the money is at the inflection point. Thats because, first of all, if you lose a massive amount on the downside, you need a bigger return to get back. And the second part of that is, emotionally, how many people sell at the worst possible time? It's that inflection point, where you're potentially able to take advantage of the aftermath maybe by redeploying capital, maybe by keeping it exactly where it iswhere you're able to make the best risk-adjusted return by taking advantage of the aftermath of the crisis. And the fact of the matter is that a lot of investors aren't there because they've sold.

Kalwarski: What is your outlook for the alternatives space? Mackay: Without question, there will be other strategies that develop. Forty or 50 years ago, long-short equity was essentially the only strategy in alternatives. Private equity and private debt were there, but within hedge funds, it was really only long-short equity. As time has passed, more and more strategies have evolved. If other securities are created that provide inefficient or less efficient markets, I think that's a great opportunity. If you look at it on both a quantitative and qualitative basis, I think the prospect for alternatives is excellent. And there are two reasons. On the quantitative basis, hedge fund strategies have underperformed their historical averages over the last several years and underperformed public equity and public debt. Just based on that, I think that there will be a reversion to the mean [in which] public equities and fixed income underperform and hedge funds and other alternative structures [potentially] outperform. Now there still will be winners and losers within that group, but I think thats the broad base case. On a qualitative basis, I can tell you from talking to institutional investors and families on a daily basis, there is low appetite for alternatives todaywhich I think is a great contrarian indicator. Generally, I think what the masses are looking at, what everyone wants to do, is usually the wrong decision.

*Unless otherwise noted, the source for all information is Chris Mackay as of February 2013.
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Alternative Investments often engage in speculative investment techniques involving a high degree of risk and are only suitable for long-term, qualified investors. They are generally illiquid, often engage in speculative investment techniques, and may be highly leveraged, thus magnifying the potential for loss or gain. Investors can lose all or a substantial amount of their investment. When looking to add alternative investments to a portfolio, investors should be aware that such investments are for experienced, sophisticated investors who are able to understand the complex investment strategies they ofen employ, and who can tolerate the risks and liquidity constraints involved. Diversification and asset allocation do not assure a profit or protect against loss in declining financial markets. Equity Securities prices may fluctuate in response to specific situations for each company, industry, market conditions, and general economic environment. Companies paying dividends can reduce or cut payouts at any time. International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond's 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, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. The views and opinions expressed herein do not necessarily reflect those of Morgan Stanley. The information and figures contained herein has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Morgan Stanley is not responsible for the information, data contained in this document. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. The material has been prepared for informational or illustrative purposes only and is not an offer or recommendation to buy, hold or sell or a solicitation of any offer to buy or sell any security, sector or other financial instrument, or to participate in any trading strategy. It has been prepared without regard to the individual financial circumstances and objectives of individual investors. Any securities discussed in this report may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. There is no guarantee that the security transactions or holdings discussed will be profitable. This material is not a product of Morgan Stanley & Co. LLC or CitiGroup Global Markets Inc.'s Research Departments or a research report, but it may refer to material from a research analyst or a research report. The material may also refer to the opinions of independent third party sources who are neither employees nor affiliated with Morgan Stanley. Opinions expressed by a third party source are solely his/her own and do not necessarily reflect those of Morgan Stanley. Furthermore, this material contains forward-looking statements and there can be no guarantee that they will come to pass. They are current as of the date of content and are subject to change without notice. Any historical data discussed represents past performance and does not guarantee comparable future results. Indices are unmanaged and not available for direct investment. Tracking No. 2013-PS-151 02/2013 2013 Morgan Stanley Smith Barney LLC. Member SIPC