Custom Investment Outsourcing Strategy Committee Monthly Investment Outlook Members

august 2013

commentary consulting group

Custom Investment Outsourcing Strategy Committee Monthly investment outlook members

GLENN REGAN A Compendium of Insights and (Co-Chair) Recommendations for August 2013 DOUG SCHINDEWOLF (Co-Chair)

FRANCO PIARULLI (Vice Chair) Macroeconomic View Investment Strategy View • Morgan Stanley economists expect the growth • At the broad asset class level, our tactical view CRAIG DOBBS rate of the global economy and the US econo- remains somewhat defensive: overweight to DEAN EISEN my to accelerate during the second half of this alternative investments, underweight to global year and in 2014. ﬁ xed income, and neutral to global equities KEVIN FLANAGAN • The US Federal Reserve is likely to begin and cash. JOHN GRANGER tapering the pace of its securities purchases in • Within ﬁ xed-income, expected rate normaliza- September. tion continues to argue for favoring shorter- GOVIND KILAMBI • The unwinding of three historical buildups duration securities. around the same time is buff eting emerging • We provide several alternative investment JANGHOON KIM market economies. strategies and opportunistic investment ideas FRANK NICKEL III to consider. PAUL RICCIARDELLI This Month’s Feature: Impact Investing (Part 1) MICHAEL ROSLONIEC

ANDREW SLIMMON

The Custom Investment Outsourcing Strategy Committee provides a forum for harnessing the fi rm’s intellectual capital, with MICHAEL WILSON a particular focus on providing investment-related ideas and recommendations. The Committee’s recommendations assist the fi rm’s Financial Advisors in servicing institutional and ultra high net worth investors that have decided to outsource their Chief Investment Offi cer function through the Custom Investment Outsourcing program. consulting group / custom investment outsourcing strategy committee monthly

given the investor community’s rising attention to the responsibility (or irre- sponsibility) of corporations’ business activities and externalities. Beyond CSR as an investment consideration, some investors are committed to “Socially Responsible Investing” (SRI), where investment funds exclude certain businesses or types of business through negative screening. These typically include Impact Investing (Part 1) companies associated with more “im- pure” products, like tobacco or fi re- arms. SRI, however, relies on ethical considerations without regard to fi - nancial factors, and it resides on the fringe of the investment world. Earlier this year, Morgan Stanley to grow, new types of social invest- This brings us to impact investing. Wealth Management commissioned ments that leverage markets and in- In the evolution of social investing, a team of students from the Columbia novation for impact are sprouting from its origins in the “Carnegie mod- University School of International and around it. el” of philanthropy, impact invest- Public Aff airs to conduct an evaluation Business and social investment ing is the latest and most ambitious of impact investing. This is the fi rst of broadly converge in a couple of ways. form. A range of actors today fashion a three-part summary of their fi ndings, The fi rst is through the now-ubiqui- themselves as impact investors, from focusing on how the space is evolving; tous concept of “Social Enterprise,” foundations to for-profi t fi rms. One Part 2 will focus on fi ve sectors that generally defi ned as “businesses such infl uential organization is the are attracting particular investor at- whose primary purpose is the com- Rockefeller Foundation, which has tention and Part 3 will conclude with mon good.”1 The distinguishing fea- collaborated with leaders in fi nance, some thoughts about important con- ture about social enterprises is their philanthropy and development to siderations and future prospects for utilization of business disciplines build the platform for “impact invest- this type of investment. and market forces to advance their ing” – a term originally coined by the social and/or environmental agen- Rockefeller Foundation itself. das. Invariably, social enterprises Another pioneer in the space is History and Evolution never abandon their primary mission, the Acumen Fund, a non-profi t that The ancestor to impact investing which is in some way social (or envi- channels donations and grants to so- is private philanthropy, which traces ronmental). While they often aim to cial enterprises in the form of debt or its origins to Andrew Carnegie in the be fi nancially self-sustaining, they are equity. The Acumen Fund’s primary 19th century. Carnegie was not the – by defi nition – not driven foremost concern is not with generating mar- fi rst to donate portions of his wealth by a fi nancial bottom line. ket-rate returns on their investments, to charity, but he was the fi rst man “Corporate social responsibility” an approach it shares with many im- of signifi cant wealth in America to (CSR) represents the second major pact investors. Increasingly, however, champion prominently the practice of convergence of business and social in- fi rms and funds are entering the space private giving. Spurred by Carnegie, vesting. As consumers become better with expectations of truly competi- private wealth in the 20th century informed and more selective based on tive returns. The total value of capi- would fl ow to universities, libraries, ethical issues tied to corporate activi- tal deployed for impact investments hospitals, and any place that the pub- ties, CSR has become more the rule rose to $4.4 billion in 2011, which was lic and non-profi t sectors left a void. than the exception for businesses. channeled to approximately 2,200 Philanthropists accepted these social Corporations have found that “doing projects.2 The varying types of in- investments as sunk costs that they good” can translate directly to “do- vestments and actors in this emerg- would not retrieve. While this tradi- ing well” – or, at the very least, “doing ing space only enhance the ambiguity tional form of philanthropy continues bad” can directly decrease share value around defi ning impact investing.

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Investing with Impact (continued...)

What Exactly is Impact of philanthropy, in which fi nancial referred to as environmental, social, Investing? returns are expected but not para- and governance (ESG) issues. The no- There is no generally accepted mount in an investment decision, and tion of “social returns” can seem neb- defi nition of impact investing. While they are certainly not market rate. Put ulous. Terms like “student transition most defi nitions of impact investing diff erently, this type of impact invest- rate” or “number of people served” include references to both fi nancial ing prioritizes nonfi nancial (social) are not common features in fi nancial and social returns, the lack of unifor- returns over fi nancial returns. This vocabulary, and can be more diffi cult mity hinges on a particular aspect: fi - particular notion of impact invest- to ascertain. Furthermore, these met- nancial returns. ing, however, is far from universally rics are relatively new and untested, What sorts of fi nancial returns can accepted. A GIIN survey found that and while they are rapidly evolving, at be expected from an impact invest- 65 percent of impact investors ex- present they are underdeveloped next ment? In short, the answer varies by pect market-rate fi nancial returns.4 to their fi nancial equivalents. To de- sector, geography, risk profi le, and Indeed, look no further than Morgan fi ne a successful investment in terms stage of investment. The infl uential Stanley’s own defi nition: “Impact In- of social impact is complex and often Global Impact Investing Network vesting characterizes an investment case-specifi c. Furthermore, it is diffi - (GIIN) does not confront this ques- approach that aims to generate risk- cult to determine what an “adequate” tion directly in its commonly used adjusted fi nancial returns while sup- social impact looks like. While it is not defi nition of impact investing, as porting positive environmental and/ easy to delineate adequacy thresh- “investments made into companies, or social impact.”5 olds, three major tools are emerging organizations, and funds with the in- in the impact investing space to mea- What Constitutes Successful tention to generate measurable social sure social impact: IRIS, PULSE, and and Unsuccessful Investments? and environmental impact alongside a GIIRS. These three impact metrics fi nancial return.”3 The type of fi nan- Impact investors often are one of complement one another and shape cial return is tellingly unclear. two types: “fi nancial fi rst” or “impact what constitutes a successful impact Impact investments span both fi rst.” The former seeks to optimize investment. emerging and developed markets, in- fi nancial return while requiring some iris (Impact Reporting and Invest- volving companies in various phases measure of social and environmental ment Standards) is a set of metrics of their growth, with investors pur- impact (usually by targeting risk-ad- that governs the way companies re- suing a wide range of returns - from justed returns), while the latter seeks port their social and environmental below-market to market-rate. Many to optimize social and environmental performance. Operated by the Global impact investors actively seek to place impact with a fi nancial fl oor, willing Impact Investing Network, IRIS met- capital in businesses that are high-risk to accept a higher risk or below mar- rics span an array of performance and would not therefore receive fund- ket returns in order to create some so- objectives, such as operational and ing from traditional sources. As with cial good. However, impact investors product impact, and include sector- philanthropists, these investors are increasingly reject these types of dis- specifi c standards. It shows, in one seeking to fi ll a basic societal void, but tinctions, as refl ected in an investor snapshot, everything from “operat- through a slightly diff erent approach. survey in 2011. Sixty percent of inves- ing profi t margin” to “communities Often they expect full repayment of tor respondents did not believe that a served.” their equity investments or loans, tradeoff between impact and fi nancial pulse, jointly created by Google though not for a number of years, returns is necessary.6 and the Acumen Fund, is a software and many times companies return for platform that makes it easier for com- Social Impact Indicators second or third rounds of funding. Of- panies to aggregate and benchmark fering this “patient capital” mitigates It is important to establish clearly their own ESG metrics, allowing for enterprises’ early pressure to gener- that the term “social impact” tends to clearer and more simplifi ed reporting. ate fi nancial returns, and instead redi- encompass a broad range of nonfi nan- In turn, it enables fund managers to rects focus to “social” returns. cial information. Thus, any further take the “pulse” of their investments The impact investing described so reference to “social impact” will in- through real-time, accessible, and ac- far refl ects more of an advanced form clude this wider bucket of issues, often tionable metrics that allow managers

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Investing with Impact (continued...)

to identify their portfolio’s high and 1 The Social Enterprise Alliance web- 2012. http://www.morganstanley. low performers quickly.7 site https://www.se-alliance.org/what- com/globalcitizen/pdf/investing-with- giirs (Global Impact Investing is-social-enterprise. impact.pdf. Rating System), a product of the in- 2 “Achievements, Challenges and 6 “Insight into the Impact Invest- dependent, non-profi t, B Lab, is an What’s Next in Building the Impact ment Market” J.P. Morgan/GIIN, 2011 impact ratings and analytics platform Investing Industry” E.T. Jackson and http://www.thegiin.org/cgi-bin/iowa/ that assesses companies and funds on Associates Ltd. (Prepared for the Rock- download?row=334&fi eld=gated_ the basis of their social and environ- efeller Foundation); July 2012; p. XIII. download_1;%29.Could. mental performance. Using IRIS defi - 3 Global Impact Investing Network 7 Acumen Fund website nitions, GIIRS helps investors – and website http://www.thegiin.org/cgi-bin/ http://acumen.org/. other stakeholders – assess the ESG iowa/resources/about/index.html. performance of companies and funds 4 relative to their respective peers. “Perspectives on Progress: All three tools serve to assist im- The Impact Investor Survey” J.P. pact investors in wading through Morgan, January 2013. http:// the complexity of measuring social www.thegiin.org/cgi-bin/iowa/ impact. In eff ect, these services help download?row=489&fi eld=gated_ investors distinguish between tradi- download_1. tional investments and those that are 5 Morgan Stanley Smith Barney “In- truly for impact. vesting With Impact: Creating Finan- cial, Social, and Environmental Value.”

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Economic Commentary

mies that did see strong credit growth recently and will thus have to restrain credit growth or show more prudence in the future. Which Economies Stand to be Buffeted the Most by the Great EM Unwind? If all three unwinds occur more or less simultaneously, no part of the EM world will be “safe.” Brazil, South Af- The Great Emerging rica, Indonesia and perhaps Thailand will be most aff ected by the combination of events. External balance sheet Markets Unwind risks from higher US real rates and a stronger USD by themselves will continue to pressure Turkey and India in addition to these four economies. Weaker growth in China will aff ect Taiwan, Korea, Chile and (to a lesser The following is a lightly edited excerpt unwinding china’s leverage. extent) Peru adversely. Finally, credit from a report published by the Global We identify three channels through growth in Thailand will likely be un- Economics Team of Morgan Stanley which China’s deleveraging is likely wound faster than one might have Research. For additional insights and to aff ect the rest of the emerging mar- otherwise anticipated. details, see “The Great EM Unwind,” kets: 1) The trade of manufactured The Economic Framework August 7, 2013. Please refer to the Dis- goods; 2) The trade of commodities; closures Section of the excerpted report and 3) The impact of a slower Chinese This triple unwind of US QE, Chi- for important information and disclo- economy on the terms of trade. na’s leverage and EM domestic credit sures. unwinding domestic credit aff ects EM capital accounts, current in emerging markets. When accounts and domestic demand re- n the view of the Morgan Stanley loose policy or unrealistic expecta- spectively. IGlobal Economics team (hereaf- tions generate economic momentum unwinding us qe hurts em ter, “we” or “our”), the unwinding of fi nanced by credit growth, the im- capital accounts. Regardless of three historical build-ups around the pact of policy or expectations unwind whether US QE has accounted for the same time is buff eting emerging mar- and subsequent credit unwind hurts bulk of portfolio infl ows into EM or ket (EM)economies. growth signifi cantly. While all EM not, recent and future shocks to US unwinding us quantitative economies faced an external regime real rates and USD raise the risk of a easing (qe): higher real rates of DM fi nancial repression and nega- sudden stop of capital fl ows into EM. and a strong us dollar. QE is tive real US interest rates, not all EM unwinding china’s leverage the one US export that EM economies economies witnessed, allowed or en- hurts em current accounts. will wish did not end. Data in the US couraged a build-up of credit growth. In the pre-crisis decade, China’s re- (recently revised upwards) and the In other words, there is something export model and its strong domestic uncertainty around the succession at idiosyncratic other than just a regime growth helped to improve EM current the Fed (where the FOMC appears to of negative DM real interest rates that accounts. As China deleverages amid be increasingly worried about the net led to the creation of strong credit a weak export cycle, EM economies benefi ts of QE) will likely continue to growth in some economies and not stand to export less to China and are foster the debate about the timing of in others. Strong post-crisis policy therefore likely to see more current QE unwind. Strength in both US real responses, unrealistic expectations account deterioration (with some rates and USD remain the base case. about EM growth that we have ar- exceptions due to terms of trade ef- As a result, EM economies exposed to gued against for over a year now and a fects). The underlying assumption is external balance sheet shocks could regime of low real rates due to factors that China will delever in a reasonably face a sustained and even further other than low DM rates are the most stable manner. A rapid deleveraging tightening of fi nancial conditions. likely suspects. We identify the econo- could unsettle not just the EM world

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Economic Commentary (continued...)

but the global economy as well, rais- savings fall relative to investment (re- However, they all have something going the risk of sudden stops of capital member that the current account bal- ing for them. Indonesia and Turkey fl ows into EM and a global economic ance represents the excess of national do have better domestic fundamen- recession. savings over investment). Higher real tals than many give them credit for, unwinding em domestic rates, as above, could slow down cred- while India’s structural reforms since credit growth hurts domestic it and economic growth. September 2012 are the reason why growth directly. Not all bubbles we have remained constructive on How Will EM Play Out From hurt economic growth, but when the medium-term growth story there. Here? growth is accompanied by a credit Should these three economies play to bubble (i.e., credit growth based on We believe that one or more, but their respective strengths and avoid assumptions that prove unsustainable not necessarily all three, headwinds policy mistakes, the risk of signifi - only ex-post), the impact on growth is will play a dominant role at any one cant negative spillovers can be abat- signifi cant. point in time over the next 12-18 ed. India, for example, could step up months. Over that period, we expect structural reforms rather than fi scal Spillovers Will Matter EM economies to be split into two spending. Indonesia could slow the Where more than one of these fac- “blocs,” good and bad, with a third economy down to an acceptable level, tors is at play, any one shock can spill one where uncertainty hovers like the which lowers its current account defi - over into other parts of the economy proverbial sword of Damocles. cit, and undertake structural reforms in question: under pressure. Economies to strengthen its fundamental growth spillovers from an external where the structural model of growth drivers. Finally, Turkey could use its balance sheet shock. The direct is severely challenged (China, Bra- fl exible monetary policy mechanism impact of higher US real rates and the zil and South Africa – with Russia while indicating better control over indirect impact of a tightening of fi - included but playing out better than credit growth, which would lower its nancial conditions to protect exposed the others) are likely to remain under current account defi cit as well. EM currencies against a stronger USD pressure. While China and (to a lesser Emerging market economies are will add to the tightening we have seen extent) Russia will likely remain un- going through a very tricky phase so far. Higher real rates could trigger a der pressure because of their idiosyn- thanks to the great unwind. While faster unwind of credit growth, hurt- cratic, structural challenges, Brazil many are talking about structural re- ing growth particularly in economies and South Africa are suff ering from forms, the ability or willingness to where that credit growth has been both idiosyncratic, structural issues deliver on such structural reforms is “excessive.” as well as global headwinds that have in shorter supply. The rigidities and spillovers from china dele- tightened fi nancial conditions. unsustainable models of growth that veraging. Weaker current accounts relative winners. On the other are constraining emerging markets will create two further negative spill- hand, economies where domestic are the very source of their promise. overs: 1) they will require more fi - fundamentals are not in question are Should these rigidities and unsustain- nancing, particularly the ones that more likely to benefi t. This includes able models be discarded, emerging move into outright defi cit. Even when not just Mexico the reformer but also markets can again convincingly out- national current accounts remain in structurally clean economies like Po- perform in terms of growth. Unfor- surplus, some sectors of the economy land and the Philippines. tunately, a return to the glory days (particularly the private sector) may the “in-betweeners.” Tighter seems some distance away at the mo- be running a current account defi cit fi nancial conditions have been forced ment. that requires external fi nancing; and upon some EM economies, particu- 2) They will force real rates higher as larly Indonesia, India and Turkey.

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Fixed Income Market Commentary

down that path. Against this backdrop, in order for the Fed to forego tapering plans, economic reports in the coming weeks will need to be weaker than expected. Perhaps more importantly, the August Employment Situation data (scheduled for release on Sep. 6) will need to be weaker than the July report. We believe a repeat of the July data will not stop the Fed from going forward with tapering, a point laid out “You’re Gonna Need a by Morgan Stanley’s economics team as well. From the rates side of monetary policy, at their just-concluded Bigger Boat” July gathering, the FOMC utilized the infl ation part of their dual mandate (continued missing of their 2% objec- tive) to emphasize that increases are nowhere on the policymakers’ radar. Our longer-term outlook for the US This is a lightly edited excerpt from a be one big fi sh in the fi xed income Treasury 10-year yield still calls for an report published by Kevin Flanagan, ocean—the Fed. ascending saw tooth pattern, with the Chief Fixed Income Strategist for Mor- While the tenor of upcoming eco- yield curve steepening over time. For gan Stanley Wealth Management and nomic data will most likely be an inte- the immediate future, we recently el- CIO Strategy Committee member. For gral part of the market’s perceptions evated our broader operating range to additional insights, please see “Basis regarding future Fed policy, even if/ 2%-2.75%. Given the volatile fi xed in- Points,” August 6, 2013. Please refer to when the Fed does begin to taper, come environment we expect to con- the Disclosures section of the excerpted they will still be providing massive tinue, an overshoot of our top should report for important information and amounts of liquidity to the fi nancial not be ruled out. Our new bear case disclosures. system. Next month’s FOMC meeting scenario would put the 10-year yield (Sep 17 & 18) still seems to be the base around the 3% threshold. That said, ith August now upon us, the case for the tapering announcement, until the next jobs report and subse- Wcountdown to a potential Fed but Bernanke has reiterated that even quent FOMC meeting in September, tapering begins in earnest. In honor of when this current round of Quantita- it looks as if intermediate to longer- the annual Shark Week, the Fixed In- tive Easing ends, the Fed “will be hold- dated maturities have found a work- come Strategy team (hereafter, “we” ing its stock of Treasury and agency ing equilibrium level, with the 10-year and “our”) pays homage to perhaps securities off the market and reinvest- yield fl uctuating between 2.45% and one of the greatest movies of all time: ing the proceeds from maturing se- 2.75% over the last few weeks. Jaws. Last month, we highlighted the curities.” In other words, the central One aspect of the investment land- Fed’s communication problem; but bank will keep its balance sheet con- scape that has seemingly gone unno- for all intents and purposes, it appears stant for quite some time. For some ticed is the improvement in the US as if Chairman Bernanke has made perspective, the System Open Market federal budget defi cit. Morgan Stan- progress since then. The US Treasury Account of the Fed – their securities ley’s economists see the fi scal year market now seems to be on a some- holdings – stood at nearly $3.3 trillion (FY) 2013 defi cit shrinking to $650 what similar page with the Fed about as of August 1, 2013. billion, representing 4.1% of GDP. tapering not leading to an earlier start We believe the Fed would certainly In FY 2012, the shortfall came in at of removing their “highly accommo- like to begin the tapering process, but $1.09 trillion, or 7% of GDP. As a re- dative stance of monetary policy.” In also acknowledge the ultimate deci- sult, Treasury was raising too much fact, even if the policymakers were to sion (and its pace) is entirely data cash given the current size of the start the process of reducing their as- dependent. Although the July jobs auction calendar. Thus, at their quar- set purchases following the Septem- report keeps alive the Fed tapering terly press briefi ng, the nation’s debt ber FOMC meeting, there would still debate, we still feel the Fed is heading managers announced they “expect to

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Fixed Income Market Commentary (continued...)

gradually decrease coupon auction sizes over the coming quarter,” with the likely candidates being the 2-yr and 3-yr notes. Treasury offi cials also announced they anticipate auctioning Floating Rate Notes (FRN) in January 2014. Their plan is to provide additional information, such as auction sizes, at their November Quarterly Refunding. According to the FAQ sheet, the FRNs will be a complement to their exist- ing calendar of bill, notes, bonds and TIPS off erings, and will be indexed to the “most recent 13-week Treasury bill auction High Rate.”

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The following charts help to illustrate areas of interest in the global Charts of the Month economy and capital markets.

Chart 1. Comparing the Russell 2000 Index P/E to the Russell Top 200 Index P/E

The chart on the right compares the forward price-to-earnings Ratio: Russell 2000 PE to Russell Top 200 PE (P/E) ratio on the Russell 2000 (Small Cap) Index to that on the (Based on Forward Earnings Estimates) Through Jul-13 Russell Top 200 (Mega Cap) Index. 1.4 1.4

1.3 1.3 During the 12-month period ending in July 2013, US 1.2 1.2 small-cap stocks (Russell 2000 Index) outperformed US mega-cap stocks (Russell Top 200 Index) by about 1.1 1.1

11 percentage points. From a relative valuation perspec- 1 1 tive, small-cap stocks are expensive (although not ex- tremely so) by historical standards, with their forward 0.9 0.9

PE ratio relative to that of mega-cap stocks more than 0.8 0.8 one standard deviation above its long-term average. 0.7 0.7

0.6 0.6 - Custom Investment Outsourcing '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Strategy Committee Source: Thomson Financial ©FactSet Research Systems

Chart 2. Comparing the Russell Large Cap Value Index P/E to the Russell Large Cap Growth P/E

The chart on the right compares the forward price-to-earnings Ratio: Russell Large Cap Value PE to Russell Large Cap Growth PE (P/E) ratio on the Russell 1000 Value Index to that on the (Based on Forward Earnings Estimates) Through Jul-13 Russell 1000 Growth Index. 1 1

0.9 0.9 During the 12-month period ending in July 2013, US large-cap value stocks (Russell 1000 Value Index) out- 0.8 0.8 performed US large-cap growth stocks (Russell 1000 0.7 0.7 Growth Index) by about 9 percentage points. From a 0.6 0.6 relative valuation perspective, large-cap value stocks are a bit expensive by historical standards, with their 0.5 0.5 forward PE ratio relative to that of large-cap growth 0.4 0.4 stocks one standard deviation above its long-term average. 0.3 0.3

0.2 0.2 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 - Custom Investment Outsourcing Source: Thomson Financial ©FactS et Res ear ch S ystems Strategy Committee

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These tables summarize the views of the Custom Investment Outsourcing Tactical Views: Traditional and Strategy Committee regarding which asset classes to tactically overweight Alternative Asset Classes or underweight relative to their strategic allocation in the context of a balanced, moderate risk level portfolio with a time horizon of six to 12 months. A “neutral” view indicates that the Committee recommends a tactical allocation in line with its strategic allocation.

Broad Asset Classes View Rationale Cash Neutral

Global Equity Neutral Without the beneﬁ ts of open-ended quantitative easing by the Fed and historic low bond yields, equity market performance seems likely to be more choppy and two-directional.

Global Fixed Income Underweight We appear to be in the early stages of a normalization process for Fed policy and interest rates. While in progress, the rate back-up will be a drag on performance.

Alternative Investments Overweight In the event of an equity market correction and/or further rise in interest rates, many hedged strategies should perform relatively well.

Global Equities View Rationale US Underweight The market is near an all-time high. Based on a composite of several valuation metrics across the four main regions (US, Europe, Japan, emerging markets), the US market currently ranks third in attractiveness from this perspective. At the capitalization and style levels, we do not have a prefer- ence, but large caps and growth stocks appear a bit more attractive on a relative valuation basis.

International Overweight Although the US market is near an all-time high, developed markets outside the US (as measured by the MSCI World ex US Index) are about 26% below their July 2007 peak. In Europe, economic growth expectations seem likely to gradually improve in the months ahead. In our valuation composite, Europe currently holds the No. 2 ranking, while Japan currently is the least attractive market from a valuation perspective.

Emerging Markets Neutral Following a period of signiﬁ cant underperformance, the emerging markets currently hold the top ranking in our valuation composite. This makes us reluctant to turn bearish at this point; but we are not yet compelled to increase exposure given concern about structural challenges to growth in several economies and the potential for additional currency depreciation.

Global Fixed Income View Rationale US Investment Grade Neutral Within this sector, we continue to recommend a lower-than-benchmark duration given potential capital-loss risks associated with an expected normalization of interest rates; we also favor corpo- rates and securitized debt over governments.

International Investment Grade Neutral Yields are low globally, so we do not believe much additional value accrues from owning non-US bonds beyond a modest diversiﬁ cation beneﬁ t; moreover, non-dollar currency exposure seems likely to be a drag on performance in the quarters ahead.

Inﬂ ation-Linked Securities Underweight With break-even inﬂ ation rates close to their long-term averages, we continue to see better value elsewhere.

High Yield Underweight This sector remains vulnerable to Fed tapering and a correction in risk assets.

Emerging Markets Neutral The recent pullback in the bond market has hit this sector particularly hard, especially local-currency debt. We believe it is too late to turn bearish. Yields and spreads have risen to tempting levels, but until investor conﬁ dence stabilizes the potential for further currency depreciation makes us reluctant to increase exposure just yet.

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These tables summarize the views of the Custom Investment Outsourcing Tactical Views: Traditional and Strategy Committee regarding which asset classes to tactically overweight Alternative Asset Classes or underweight relative to their strategic allocation in the context of a balanced, moderate risk level portfolio with a time horizon of six to 12 (continued...) months. A “neutral” view indicates that the Committee recommends a tactical allocation in line with its strategic allocation.

Alternative Investments View Rationale REITs Neutral Uncertainty about the rate outlook offsets the supportive effects of the ongoing recovery in US property markets and the hunger for yield.

Commodities Neutral Slowing GDP growth in China and prospects for further appreciation of the US dollar suggest that a signiﬁ cant rebound in commodity prices is unlikely.

Hedged Strategies Overweight In what is likely to be a challenging environment as investors assess the implications of a rate-normalization process, we believe alpha opportunities exist at the strategy level (see the strategies with a “Positive” view in the next section).

Managed Futures Overweight This asset class has tended to be among the few that work well in extended periods of challenging capital market conditions.

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These tables provide the Custom Investment Outsourcing Strategy Tactical Views: Hedged Strategies Committee’s preferences among hedged strategies within each of three broad groups.

Relative Value View Rationale Mortgage Arbitrage Positive The fundamentals of US housing continue to improve. Credit-sensitive RMBS remains the most attractive sector geared to the improving housing story. Non-Agency RMBS remains one of the few segments within global credit with positive convexity, due to potential improvements in prepayments, delinquency and default rates, driven by housing strength.

Relative Value Credit Positive Interest rate volatility resulting in liquidation across credit markets has created trading opportunities. Spread-widening during the second quarter has created better value and carry in both structured and corporate credit. European credit offers attractive yield and spread. Spread-widening across CLOs has led to capital structure opportunities.

Equity Market Neutral Positive Declining security correlations should support alpha opportunities. Low systemic exposure should facilitate outperformance during market corrections.

Fixed Income Arbitrage Positive Fed policy uncertainty and resulting volatility in global rates markets provides alpha opportunities to exploit changing views on the policy path. Opportunities include the convergence/ diver- gence of Peripheral vs. Core Europe and Developed Markets vs. Emerging Markets.

Statistical Arbitrage Neutral Retreat of bank proprietary trading desks has left space uncrowded compared with history. As markets move to fundamentals and away from risk on/ risk off, alpha opportunities should arise.

Convertible Arbitrage Neutral The move higher in rates combined with strong equity performance has led to increased new issuance, creating potential trading opportunities. Long volatility nature of the strategy is attractive, as evolving Fed policy should support continued volatility.

Event Driven View Rationale Event Equity/Activist Neutral High cash balances provide opportunities for shareholder-friendly activity. Economic environment supports shareholder intervention. Improving economic backdrop provides tailwind for activists but there is vulnerability to market corrections.

Merger/Risk Arbitrage Neutral Spreads are near historic lows, but high levels of cash on corporate balance sheets combined with cheap credit should encourage M&A volume. Low risk-free rates reduce total return potential.

Event Credit Neutral Recent rise in yields and spread-widening combined with stable credit fundamentals favor managers with strong legacy positions. The CLO market is attractive due to ﬂ oating-rate structures and the retreat of bank balance sheets from the sector. However, low levels of liquidity may lead to episodes of technical selling pressure, as experienced in June.

Distressed Negative Default rates remain low, as most corporations have been effective at addressing near-term debt maturities, leading to a small supply of new distressed opportunities. Opportunities in Europe have diminished because of government intervention and a lack of meaningful de-leveraging by banks.

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This table provides the Custom Investment Outsourcing Strategy Tactical Views: Hedged Strategies Committee’s preferences among hedged strategies within each of three (continued...) broad groups.

Directional (Macro) View Rationale Discretionary Macro Positive Central bank policy uncertainty combined with reduced tail risk allows for high-conviction fundamental trading opportunities in both rates and currency markets. Strategy has ﬂ exibility to adapt to changing market conditions. Structural trends create opportunities for EM-focused managers.

Equity Long/Short Positive Reduced tail risk and declining cross correlation in equity markets create attractive alpha opportunities and attractive absolute returns.

Systematic Macro Positive Trend-following strategies should beneﬁ t from the contrasting direction of central bank policies, resulting in a decline of correlations across asset classes. Medium- and long-term trend managers reduced rates exposure, lessening drag from rate normalization but reducing portfolio beneﬁ t during risk reversals. Short-term trend strategies continue to provide attractive risk reduction attributes and attractive returns in range-bound markets.

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This table provides the Custom Investment Outsourcing Strategy Tactical Views: Illiquid Alternative Committee’s preferences among illiquid alternatives within each of four Investments broad categories.

Private Credit View Rationale Mezzanine/Direct Credit Positive Demand for mezzanine and direct lending to middle markets in the US should remain strong. Limited competition from banks in the US and Europe is leading to outsized illiquidity premiums relative to historical norms and attractive absolute yields.

Real Assets View Rationale Oil & Gas Positive Capital markets remain open to oil & gas companies. Unconventional resource plays remain attractive. The production side of oilﬁ eld services presents opportunities due to the service needs of the unconventional resource plays. Oil and natural gas prices should be supportive of market pricing.

Infrastructure Positive Demand continues to increase for infrastructure assets driven by long-term macro trends. With public sector capital constrained by slow growth in advanced economies and rising social expen- ditures, investment opportunities exist for the private sector. In emerging markets, urbanization (which tends to be less sensitive to a global economic slowdown) will be the key long-term driver of infrastructure demand.

Timberland Neutral Leverage on assets is in sustainable ranges, which will support land values. Improving economic conditions and fair valuation should result in moderate returns.

Agriculture Negative Strong appreciation in land values and lower grain prices should limit returns.

Real Estate View Rationale Non-Core Positive Banks, under regulatory pressure, will create deals to clean up their balance sheets. A sizable amount of real estate debt will be maturing in the quarters ahead, creating opportunities for investors willing to reﬁ nance these loans. Improving economic conditions and attractive available ﬁ nancing may lead to increased returns. Capital from opportunistic funds and sovereign investors is causing increased competition and reduced market capacity. Asian real estate remains a concern, as growing demand is unsustainable and construction speculative.

Core Negative Occupancy rates and rental rates have recovered due to supply remaining controlled, but landlords have had to increase concessions in the form of free rent and/or additional dollars for interior construction to attract tenants. A combination of high valuations and rising interest rates should limit returns.

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Private Equity View Rationale Leveraged Buy-Out (LBO) Neutral An improving economy and available ﬁ nancing will help deal volume and returns. Supply of dry powder is high but declining, as 2007-2008 funds are expiring. The IPO market remains weak. A recovery in the IPO market would increase return prospects.

Venture Capital Negative Despite 2012 being a strong fundraising year, the sector continues to consolidate. A recovery in the IPO market would be supportive; however, M&A will be an attractive exit route.

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The following section highlights perceived opportunities among alternative Alternative Investment Themes investments along with a summary of the rationale that underpins each recommendation.

Theme Rationale 1. Residential Mortgages • Although the S&P Case-Shiller US Home Price Index is well above the low of early 2012, as of May 2013 (the (including whole loans and NPLs) latest available data) it was about 24% below its 2006 peak. • The supply of non-agency securities has shrunk by over $1 trillion. The lack of new supply of non-agency securities supports conditions for price appreciation in the RMBS market and is a strong positive for this strategy.

2. Private Real Estate Debt and • An estimated $1.7 trillion in commercial real estate debt needs to be refi nanced over the next 5 years. How- Equity ever, market participants believe that fi rms will no longer be able to extend the maturity of their debt (“Extend & Amend”). • The CMBS market in its current form will not be able to support this refi nancing activity, as 2011 levels were $31 billion and 2012 activity was only slightly higher. • Properties in non-major markets, as of 1Q 2013 (the latest available data), were about 27% below their late- 2007 peak values according to Moody’s/RCA Commercial Property Price Index. This provides a potentially attractive entry opportunity for new capital.

3. Middle Market Direct Lending • Given the dynamics in the middle market sector, direct lending deals can offer relatively attractive returns.

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The following investments can be considered for the satellite component of Opportunistic Investment Ideas a core/satellite portfolio structure. In order to appear on this list, internal estimates from various sources throughout the ﬁ rm must imply a return potential of 10% or more within the next 18 months.

Idea Rationale Currency - Long USD The Global Currency Research Team from Morgan Stanley Research expects the US Dollar to experience a broad- based appreciation, with an internal composite index potentially increasing by about 18% by 1Q 2015. For additional insights, please see “FX Pulse,” August 8, 2013.

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The data presented below are as of July 31, 2013. Periods greater than Capital Market Benchmark one year are annualized and represent trailing returns as of the date Performance Indices: Traditional Asset Classes listed.

US Equity 1-Month QTD 1-Year 3-Year 5-Year 7-Year 10-Year S&P 500 5.09% 5.09% 25.00% 17.74% 8.26% 6.32% 7.64% Russell 3000 5.48% 5.48% 26.90% 18.10% 8.58% 6.66% 8.14% Russell 3000 Value 5.48% 5.48% 30.98% 17.92% 7.96% 5.06% 8.29% Russell 3000 Growth 5.48% 5.48% 22.68% 18.18% 9.09% 8.14% 7.84% Russell 1000 5.35% 5.35% 26.21% 18.03% 8.49% 6.60% 8.02% Russell 1000 Value 5.40% 5.40% 30.74% 18.00% 7.88% 5.00% 8.20%

Russell 1000 Growth 5.30% 5.30% 21.63% 17.99% 9.01% 8.08% 7.69%

Russell Mid Cap 5.80% 5.80% 32.36% 19.01% 10.07% 8.12% 10.91%

Russell Mid Value 5.33% 5.33% 33.71% 18.73% 10.26% 7.32% 11.15%

Russell Mid Growth 6.22% 6.22% 30.70% 19.28% 9.77% 8.60% 10.22%

Russell 2000 7.00% 7.00% 34.75% 18.71% 9.45% 7.35% 9.60% Russell 2000 Value 6.43% 6.43% 34.14% 17.07% 8.86% 5.78% 9.45%

Russell 2000 Growth 7.56% 7.56% 35.37% 20.32% 9.98% 8.84% 9.62% Global and International Equity MSCI AC World 4.82% 4.82% 21.17% 11.78% 4.37% 4.66% 8.41% MSCI AC World ex US 4.40% 4.40% 17.48% 6.92% 1.26% 3.12% 9.28% MSCI EAFE (Unhedged) 5.28% 5.28% 24.01% 9.11% 1.53% 2.45% 8.45% MSCI Emerging Markets (Net) 1.04% 1.04% 1.93% 1.00% 0.55% 5.75% 13.10% MSCI EAFE Small Cap 6.08% 6.08% 28.15% 11.37% 5.03% 3.66% 11.08% Other Equity S&P North America Natural Resources 5.83% 5.83% 13.45% 9.34% 0.44% 4.38% 12.73% Alerian MLP -0.49% -0.49% 21.58% 17.89% 18.47% 15.75% 16.03% US Fixed Income BC US Treasury -0.11% -0.11% -2.72% 2.85% 4.38% 5.24% 4.60% BC Long US Treasury -1.86% -1.86% -12.93% 5.52% 7.19% 7.48% 6.90% BC 1-3 Year US Treasury 0.16% 0.16% 0.25% 0.79% 1.88% 3.04% 2.67% BC US Treasury Bills 1-3 Month 0.01% 0.01% 0.07% 0.08% 0.20% 1.29% 1.62% BC US Aggregate Bond 0.14% 0.14% -1.90% 3.19% 5.23% 5.41% 4.89% BC US High Yield 1.90% 1.90% 9.49% 10.15% 11.65% 9.17% 9.24% BC US Treasury Inﬂ ation Protected Securities (TIPS) 0.73% 0.73% -5.87% 4.84% 4.67% 5.68% 5.76% S&P/LSTA US Leveraged Loan 1.01% 1.01% 7.13% 6.48% 6.76% 5.27% 5.42% Global and International Fixed Income BC Global Aggregate Bond 1.26% 1.26% -2.09% 2.84% 3.91% 5.13% 5.23% Citi Non-US WGBI (Unhedged) 1.96% 1.96% -4.77% 1.61% 2.92% 4.85% 5.26% Citi Non-US WGBI (Hedged) 0.49% 0.49% 2.43% 3.05% 4.34% 4.38% 4.19% BC Global Treasury 1.34% 1.34% -4.55% 2.00% 3.31% 4.96% 5.45% JP Morgan EM Bond 0.58% 0.58% -3.60% 6.21% 8.26% 7.95% 9.18% JP Morgan GBI-EM (Unhedged) 0.74% 0.74% 0.93% 3.92% 3.35% 7.50% 8.58% Inﬂ ation (as of Jun.philanthropy 30, 2013) Consumer Price Index (CPI) 0.50% 0.20% 1.71% 2.32% 1.32% 2.01% 2.41% Source: Morgan Stanley, Bloomberg

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Unless otherwise indicated, the data presented below are as of July Capital Market Benchmark 31, 2013. Periods greater than one year are annualized and represent Performance Indices: Alternative Asset Classes trailing returns as of the date listed .

Hedge Funds 1-Month QTD 1-Year 3-Year 5-Year 7-Year 10-Year HFRI Event-Driven Total 1.54% 1.54% 13.43% 6.46% 5.13% 5.03% 7.46% HFRI Macro Total -0.11% -0.11% -2.11% 1.23% 1.56% 3.81% 5.15% HFRI Relative Value Total 0.42% 0.42% 8.43% 6.57% 6.12% 6.08% 6.50% HFRI Equity Hedge Total 2.50% 2.50% 13.15% 5.30% 2.73% 3.35% 5.60% HFRI Event-Driven: Distressed/Restructuring 1.41% 1.41% 15.83% 7.66% 5.73% 5.11% 8.19% HFRI RV: Fixed Income-Asset Backed 0.84% 0.84% 12.77% 11.04% 11.51% 9.16% 9.39%

HFRI RV: Multi-Strategy 0.23% 0.23% 8.90% 5.37% 5.24% 3.96% 5.19% Newedge CTA -0.75% -0.75% -5.70% 0.21% -2.02% 0.83% 0.35% HFRI FOF: Conservative 0.58% 0.58% 6.99% 2.94% -0.09% 1.16% 2.77%

HFRI FOF: Diversiﬁ ed 1.12% 1.12% 7.46% 3.29% 0.36% 1.76% 3.62%

HFRI FOF: Strategic 1.83% 1.83% 10.05% 3.67% 0.22% 1.86% 4.30% HFRI FOF: Composite 1.27% 1.27% 7.88% 3.20% 0.19% 1.67% 3.56%

Real Estate Investment Trusts (REITs) MSCI US REIT 0.82% 0.82% 7.81% 15.00% 7.15% 4.42% 10.34% S&P Global REIT 0.70% 0.70% 8.80% 14.21% 5.75% 3.32% 9.61% Commodities Dow Jones-UBS Commodity 1.36% 1.36% -12.42% -1.97% -9.11% -3.63% 2.47% S&P GSCI 4.91% 4.91% 0.63% 4.49% -12.14% -5.33% 1.82%

Real Estate and Liquid Comparisons (as of Jun. 30, 2013) US Real Estate: NCREIF Property N/A 2.87% 10.73% 13.15% 2.80% 5.66% 8.60% NCREIF Timberland N/A 0.93% 9.36% 3.59% 2.05% 5.82% 8.19% NCREIF Farmland N/A 1.97% 20.03% 16.20% 13.23% 14.58% 16.85% MSCI US REIT -1.59% 9.04% 18.28% 7.65% 4.82% 10.82% MSCI AC World -0.23% 17.21% 12.96% 2.86% 4.06% 8.14% S&P 500 2.92% 20.60% 18.45% 7.01% 5.66% 7.30% BC Global Aggregate -2.79% -2.18% 3.56% 3.68% 5.09% 4.79% BC US Treasury Bills 1-3 Month 0.01% 0.07% 0.09% 0.23% 1.35% 1.63% Private Equity and Liquid Comparisons (as of Dec. 31, 2012) Preqin All Private Equity N/A N/A 12.90% 13.30% 4.10% N/A 17.90% Preqin Buyout N/A N/A 15.10% 15.30% 4.50% N/A 24.30% Preqin Venture N/A N/A 7.00% 8.90% 2.00% N/A 5.40% Preqin Mezzanine N/A N/A 10.00% 10.00% 4.00% N/A 10.60% MSCI AC World 16.80% 7.18% -0.62% 8.66% S&P 500 16.00% 10.87% 1.66% 7.10% BC Global Aggregate 4.32% 5.17% 5.44% 5.98% BC US Treasury Bills 1-3 Month 0.08% 0.09% 0.44% 1.69%

Source: Morgan Stanley, Bloomberg, Preqin, National Council of Real Estate Investment Fiduciaries

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which the investment directional process is predicated on (macro): discretion- movements in underly- ary macro Macro ing economic variables strategies seek return and the impact these by expressing a view on have on equity, fi xed anticipated price move- income, hard currency ments of stock markets, and commodity mar- interest rates, foreign kets. Managers employ exchange rates and a variety of techniques, commodities; some de- both discretionary and gree of hedging may be systematic analysis, employed. Macro man- combinations of top agers typically employ down and bottom up a “top-down” global ap- theses, quantitative proach, and often have Hedged Strategy Defi nitions and fundamental ap- the latitude to invest in proaches and long and any markets using any event driven Invest- specifi c development event driven: event short-term holding instruments to partici- ment managers who exogenous to the exist- equity/activist periods. Although some pate in expected market maintain positions ing capital structure. Involves investing in strategies employ rela- movements. in companies cur- opportunities created tive value techniques, rently or prospectively event driven: dis- by signifi cant corporate Macro strategies are directional involved in corporate tressed Also known actions (events), such distinct from relative (macro): equity transactions of a wide as “corporate life cycle” as mergers, acquisi- value strategies in that long/short Consists variety including but investing, involves in- tions, bankruptcy the primary investment of a core holding of not limited to mergers, vesting in opportunities reorganizations, recapi- thesis is predicated long equities hedged at restructurings, fi nancial created by signifi cant talizations, asset sales, on predicted or future all times with varying distress, tender off ers, transactional events, and litigation, among movements in the un- degrees of short sales of shareholder buy- such as spin-off s, others, that potentially derlying instruments, stock and/ or index op- backs, debt exchanges, mergers, acquisitions, create or destroy value, rather than realization tions. Some managers security issuance or bankruptcy reorganiza- and opportunities of a valuation discrep- maintain a substantial other capital structure tions, recapitalizations where the use of equity ancy between securi- portion of assets within adjustments. Security and share buybacks. and/or debt instru- ties. In a similar way, a hedge structure and types can range from ments is a signifi cant while both Macro and commonly employ most senior in the capi- event driven: event component of the equity hedge manag- leverage. tal structure to most credit Involves invest- investment strategy. ers may hold equity junior or subordinated, ing in opportunities securities, the overrid- directional and frequently involve created by signifi cant event driven: merg- ing investment thesis (macro): system- additional derivative corporate actions er/risk arbitrage A is predicated on the atic macro Strategies securities. Event Driven (events), such as strategy driven by cor- impact movements in which invest in a vari- exposure includes a mergers, acquisitions, porate events, in which underlying macroeco- ety of derivative con- combination of sensi- bankruptcy reorganiza- the managers seek nomic variables may tracts, including cur- tivities to equity mar- tions, recapitalizations, to capture the price have on security prices, rencies, interest rates, kets, credit markets and asset sales, and litiga- spread between the as opposed to equity stocks, stock market idiosyncratic, company tion, among others, current market prices, hedge, in which the indicies, derivatives and specifi c developments. that potentially create and those stated in the fundamental character- commodities. These Investment theses are or destroy value, and pending or proposed istics of the company funds build quantitative typically predicated on opportunities where transaction. are integral to invest- models to price deriva- fundamental charac- the use of credit instrument thesis, holding pe- tives and then take long teristics (as opposed ments is a signifi cant directional (macro) riod, concentrations of and short positions in to quantitative), with component of the Investment managers market capitalizations various contracts. the realization of the investment strategy. which trade a broad and valuation ranges of thesis predicated on a range of strategies in typical portfolios.

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relative value with a short position in the investment holding ematical, fundamental, Investment managers the underlying stock or period, the two security or technical analysis in who maintain positions options on the stock. prices will converge to an attempt to deter- in which the invest- a similar value. mine pricing discrep- ment thesis is predi- relative value: ancies. cated on realization of equity market a valuation discrepancy neutral A strategy relative value: relative value: in the relationship be- which seeks to profi t mortgage arbitrage statistical arbi- tween multiple securi- by exploiting pricing A specifi c type of trage A strategy ties. Managers employ ineffi ciencies between fi xed income arbitrage driven purely by quan- a variety of fundamen- related equity secu- that pursues relative titative factor models tal and quantitative rities, minimizing value primarily through to trade equity markets techniques to establish exposure to market risk mortgage or mortgage with neutral net expo- investment theses, and by combining long and derivative securities. sure. security types range short positions. broadly across equity, relative value: fi xed income, deriva- relative value: relative value tives or other security fixed income arbi- credit Attempts to types. trage Involves a long take advantage of rela- position in one fi xed tive pricing discrepan- relative value: income security and cies between debt convertible ar- simultaneously selling instruments, often bitrage Typically a similar fi xed income focusing on the credit involves a long position security with the quality of issuers. Man- in a convertible bond expectation that over agers may use math-

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have a remaining matu- index because their rity of at least one year, inclusion would result regardless of optional- in double-counting. ity, are rated high-yield (Ba1/BB+/BB+ or be- barclays capital us low) using the middle treasury inflation rating of Moody’s, S&P, protected securi- and Fitch, respectively ties (tips) index (before July 1, 2005, The BC US Treasury the lower of Moody’s Infl ation Protected and S&P was used), Securities (TIPS) Index and have $600 million includes all publicly or more of outstanding issued, US Treasury Index Defi nitions face value. infl ation-protected securities that have at s&p 500 index Re- Global Aggregate Bond securities that have a barclays capital least one year remain- garded as the best Index provides a broad- remaining maturity of us treasury bills ing to maturity, are single gauge of the US based measure of the 10 or more years, are 1-3 month index rated investment grade, equities market, this global investment grade rated investment grade, The BC US Treasury and have $250 million capitalization-weighted fi xed-rate debt markets. and have $250 million Bills 1-3 Month Index or more of outstanding index includes a rep- It is comprised of the or more of outstanding includes all publicly face value. resentative sample of US Aggregate, Pan- face value. issued zero-coupon U.S. 500 leading companies European Aggregate, Treasury Bills that have citigroup non-us in leading industries of and the Asian-Pacifi c barclays capital a remaining maturity of world government the US economy. Aggregate Indexes. It us aggregate bond less than 3 months and bond index (hedged) also includes a wide index The BC US more than 1 month, are The Non-US World alerian mlp index range of standard and Aggregate Bond Index rated investment grade, Government Bond The Alerian MLP Index customized subindices covers the US dollar- and have $250 million Index includes all the is a composite of the by liquidity constraint, denominated, invest- or more of outstanding components of the 50 most prominent sector, quality and ment-grade, fi xed-rate, face value. In addition, World Government energy Master Limited maturity. taxable bond market the securities must be Bond Index except Partnerships (MLPs). segment of SEC-reg- denominated in U.S. the United States. The index is calculated barclays capital istered securities. The dollars and must be The index includes all using a fl oat-adjusted, global treasury index includes bonds fi xed rate and nonfi xed-rate bonds with capitalization-weighted index The BC Global from the US Treasury, convertible. a remaining maturity methodology. Treasury Index in- government-related, of one year or longer cludes government corporate, mortgage- barclays capital us and with amounts barclays capital 1-3 bonds issued by invest- backed, asset-backed, treasury index The outstanding of at least year us treasury ment-grade countries, and commercial mort- BC US Treasury Index the equivalent of $25 index The BC 1-3 Year in local currencies, gage-backed securities includes public obliga- million US dollars. US Treasury Index that have a remaining sectors. tions of the US Trea- This index is designed measures the perfor- maturity of one year sury. Treasury bills to directly address the mance of US Treasury or more and are rated barclays capital are excluded by the growing interest in securities that have a investment grade. us high yield index maturity constraint. In and implementation of remaining maturity of The BC US High addition, certain special currency-hedged bond at least one year and barclays capital Yield Index includes issues, such as state and investments by global less than three years. long us treasury publicly issued US local government series investors as a means index The BC Long dollar-denominated, bonds (SLGs), as well of achieving low-risk barclays capital US Treasury Index non-investment grade, as US Treasury TIPS, interest rate diversifi ca- global aggregate includes all publicly fi xed-rate, taxable are excluded. STRIPS tion in their portfolios. bond index The BC issued, US Treasury corporate bonds that are excluded from the Currency-hedged re-

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turns are also reported performance of hedge hfri event-driven: mance of all fund-of- the date that they cease for the overall non-base funds in various strate- distressed/restruc- funds managers that operations. on a monthly basis. gies as reported by the turing index The report to HFRI. All are hedge fund managers HFRI Event-Driven: net of all fees, denomi- hfri fof: strategic citigroup non-us to HFRI. All are net of Distressed/Restructur- nated in US dollars and index The HFRI world government all fees, denominated in ing Index is compiled equal-weighted. Results FOF: Strategic Index is bond index (un- US dollars and equal- by HFRI. . It is based for funds-of-funds that compiled by HFRI. It hedged) The Non-US weighted. Results for on the performance go out of business are is based on the per- World Government funds that go out of of event-driven hedge included in the ap- formance of funds-of- Bond Index includes all business are included in funds that focus on propriate index until funds that strategically the components of the the appropriate index distressed and restruc- the date that they cease allocate to diff erent World Government until the date that they turing investments as operations. types of hedge funds as Bond Index except cease operations. reported by the hedge reported by the fund- the United States. fund managers to hfri fof: conserva- of-funds managers to The index includes all hfri equity hedge HFRI. All are net of all tive index The HFRI HFRI. All are net of all fi xed-rate bonds with total index The fees, denominated in FOF: Conservative fees, denominated in a remaining maturity HFRI Equity Hedge US dollars and equal- Index is compiled by US dollars and equal- of one year or longer Total Index is compiled weighted. Results for HFRI. It is based on weighted. Results for and with amounts by HFRI. It is based funds that go out of the performance of fund of funds that go outstanding of at least on the performance of business are included in funds-of-funds that out of business are in- the equivalent of $25 hedged-equity hedge the appropriate index have a conservative cluded in the appropri- million US dollars. funds as reported by until the date that they bias as reported by the ate index until the date the hedge fund manag- cease operations. fund-of-funds manag- that they cease opera- consumer price ers to HFRI. All are ers to HFRI. All are net tions. index The Consumer net of all fees, denomi- hfri fund-of-fund of all fees, denominated Price Index (CPI) in- nated in US dollars and (fof) indices The in US dollars and equal- hfri macro total cludes monthly data on equal-weighted. Results HFRI FOF Indices are weighted. Results for index The HFRI Eq- changes in the prices for funds that go out of compiled by Hedge funds-of-funds that uity Hedge Total Index paid by urban consum- business are included in Fund Research Inc. go out of business are is compiled by HFRI. It ers for a representative the appropriate index (“HFRI”), an industry included in the ap- is based on the perfor- basket of goods and until the date that they service provider. They propriate index until mance of macro hedge services. cease operations. are based on the perfor- the date that they cease funds as reported by mance of fund of funds operations. the hedge fund manag- dow jones-ubs hfri event-driven only in various strate- ers to HFRI. All are commodity index total index The gies as reported by the hfri fof: diversified net of all fees, denomi- The Dow Jones-UBS HFRI Event-Driven fund of fund managers index The HFRI FOF: nated in US dollars and Commodity Index is Total Index is compiled to HFRI. All are net of Diversifi ed Index is equal-weighted. Results composed of futures by HFRI. It is based all fees, denominated in compiled by HFRI. It for funds that go out of contracts on a diversi- on the performance US dollars and equal- is based on the per- business are included in fi ed basket of com- of event-driven hedge weighted. Results for formance of funds-of- the appropriate index modities traded on US funds as reported by funds-of-funds that funds that diversify until the date that they exchanges. the hedge fund manag- go out of business are their hedge fund expo- cease operations. ers to HFRI. All are included in the ap- sures as reported by the hedge fund re- net of all fees, denomi- propriate index until fund-of-funds manag- hfri relative value search inc (hfri) nated in US dollars and the date that they cease ers to HFRI. All are net total index The indices The Hedge equal-weighted. Results operations. of all fees, denominated HFRI Relative Value Fund Research Inc. for funds that go out of in US dollars and equal- (RV) Total Index is indices are compiled by business are included in hfri fof: composite weighted. Results for compiled by HFRI. It Hedge Fund Research the appropriate index index The HFRI FOF: funds-of-funds that is based on the perfor- Inc. (HFRI), an indus- until the date that they Composite Index is go out of business are mance of relative value try service provider. cease operations. compiled by HFRI. It included in the ap- hedge funds as reported They are based on the is based on the perfor- propriate index until by the hedge fund man-

23 morgan stanley | august 2013 Please refer to important information and disclosures at the end of this material. consulting group / custom investment outsourcing strategy committee monthly

agers to HFRI. All are jp morgan emerg- Australasia, Far East) msci us reit index composite return net of all fees, denomi- ing market bond Index is a free fl oat- The MSCI US Real Es- measure of invest- nated in US dollars and index The JP Morgan adjusted market capi- tate Investment Trust ment performance of a equal-weighted. Results Emerging Market (EM) talization index that is (REIT) Index broadly large pool of individual for funds that go out of Bond Index is a broad, designed to measure and fairly represents agricultural properties business are included in diverse US dollar- the equity market per- the equity REIT oppor- acquired in the private the appropriate index denominated emerging formance of developed tunity set with proper market for investment until the date that they markets debt bench- markets, excluding investability screens to purposes only. cease operations. mark that tracks the the United States and ensure that the index is total return of actively Canada. investable and replica- newedge cta index hfri rv: fixed traded debt instru- ble. The index repre- The Newedge CTA income-asset ments in emerging msci eafe small sents approximately Index calculates the backed index The market countries. cap index The MSCI 85% of the US REIT daily rate of return for HFRI Fixed Income- EAFE Small Cap Index universe. a pool of CTAs selected Asset Backed Index is jp morgan govern- is a free fl oat-adjusted from the larger manag- compiled by HFRI. It ment bond index small market capital- national council of ers that are open to new is based on the perfor- - emerging market ization index that is real estate invest- investment. Selection mance of relative value (unhedged) index designed to measure ment fiduciaries of the pool of qualifi ed hedge funds that focus The JP Morgan Gov- the equity market (ncreif) us real es- CTAs used in construc- on fi xed income-asset ernment Bond Index performance of the tate property index tion of the Index will backed investments as - Emerging Market small capitalization The National Council fo be conducted annually, reported by the hedge (GBI-EM) Index is equities in developed Real Estate Investment with re-balancing on fund managers to representative of the lo- markets, excluding the Fiduciaries (NCREIF) January 1st of each year. HFRI. All are net of all cal currency market in the United States and US Real Estate Property fees, denominated in emerging markets. Canada. Index is a quarterly preqin private US dollars and equal- time series composite equity quarterly weighted. Results for msci all country msci emerging mar- total rate of return indices The Preqin funds that go out of world index The kets index (net) As measure of investment Private Equity Quarter- business are included in MSCI AC World Index The MSCI Emerging performance of a very ly Indices are money- the appropriate index is a free fl oat-adjusted Markets (EM) Index large pool of individual weighted indices that until the date that they market capitalization (net) is a free fl oat-ad- commercial real estate uses fund-level cash cease operations. index that is designed justed market capital- properties acquired in fl ow transactions and to measure equity mar- ization index that is the private market for net asset values for hfri rv: multi-strat- ket performance in the designed to measure investment purposes over 3,900 private eq- egy index The HFRI global developed and equity market perfor- only. uity funds collectively Multi-Strategy Index is emerging markets. mance in the global worth more than $2.7 compiled by HFRI. It emerging markets. This ncreif timberland trillion. Preqin’s Perfor- is based on the per- msci all country series approximates the index The NCREIF mance Analyst database formance of relative world ex us index minimum possible divi- Timberland Index also holds transparent value hedge funds that The MSCI AC World dend reinvestment. The is is a quarterly time net-to-LP performance have multiple strate- ex US Index is a free dividend is reinvested series composite return data for over 5,800 gies as reported by the fl oat-adjusted market after deduction of with- measure of investment private equity funds of hedge fund managers capitalization index holding tax, applying performance of a large all types and geo- to HFRI. All are net of that is designed to the rate to non-resident pool of individual tim- graphic focus. In terms all fees, denominated in measure equity market individuals who do not ber properties acquired of aggregate value, this US dollars and equal- performance in the benefi t from double in the private market represents around 70% weighted. Results for global developed and taxation treaties. MSCI for investment pur- of all capital ever raised funds that go out of emerging markets uses withholding tax poses only. by the industry. business are included in excluding the United rates applicable to the appropriate index States. Luxembourg holding ncreif farmland russell 1000 index until the date that they companies, as Luxem- index The NCREIF The Russell 1000 Index cease operations. msci eafe index The bourg applies the high- Farmland Index is a measures the perfor- MSCI EAFE (Europe, est rates. quarterly time series mance of the 1,000

24 morgan stanley | august 2013 Please refer to important information and disclosures at the end of this material. consulting group / custom investment outsourcing strategy committee monthly

largest companies in russell 2000 value russell midcap in- Index) is a composite the Russell 3000 Index, index The Russell dex The Russell Mid- index of commodity which represents ap- 2000 Value Index mea- cap Index measures the sector returns repre- proximately 89% of the sures the performance performance of the 800 senting an unleveraged, total market capitaliza- of those Russell 2000 smallest companies in long-only investment in tion of the Russell 3000 companies with lower the Russell 1000 Index, commodity futures that Index. price-to-book ratios which represent ap- is broadly diversifi ed and lower forecasted proximately 35% of the across the spectrum russell 1000 growth values. total market capitaliza- of commodities. The growth index The tion of the Russell 1000 returns are calculated Russell 1000 Growth russell 3000 index Index. on a fully collateralized Index measures the The Russell 3000 Index basis with full reinvest- performance of those measures the perfor- russell midcap ment. Russell 1000 companies mance of the 3,000 growth index The with higher price-to- largest U.S. companies Russell Midcap Growth s&p/lsta us lever- book ratios and higher based on total market Index measures the aged loan index forecasted growth capitalization, which performance of those The S&P/LSTA US Lev- values. represents approxi- Russell Midcap com- eraged Loan Index is mately 98% of the panies with higher designed to refl ect the russell 1000 value investable U.S. equity price-to-book ratios largest facilities in the index The Russell market. and higher forecasted leveraged loan market. 1000 Value Index mea- growth values. The It mirrors the market- sures the performance russell 3000 stocks are also mem- weighted performance of those Russell 1000 growth index The bers of the Russell 1000 of the largest institu- companies with lower Russell 3000 Growth Growth index. tional leveraged loans price-to-book ratios Index measures the based upon market and lower forecasted performance of those russell midcap val- weightings, spreads and growth values. Russell 3000 Index ue index The Russell interest payments. companies with higher Midcap Value Index russell 2000 index price-to-book ratios measures the perfor- s&p north america The Russell 2000 Index and higher forecasted mance of those Russell natural resources measures the perfor- growth values. The Midcap companies index The S&P North mance of the 2,000 stocks in this index with lower price-to- America Natural smallest companies in are also members of book ratios and lower Resources Index is an the Russell 3000 Index, either the Russell 1000 forecasted growth val- equity benchmark that which represents ap- Growth or the Russell ues. The stocks are also represents US-traded proximately 11% of the 2000 Growth indexes. members of the Russell securities across the total market capitaliza- 1000 Value index. natural resources section of the Russell 3000 russell 3000 value tor. This index uses Index. index The Russell s&p global reit GICS® to determine 3000 Value Index mea- index The S&P Global a company’s sector russell 2000 sures the performance REIT Index serves as a classifi cation and is a growth index The of those Russell 3000 comprehensive bench- modifi ed-capitalization Russell 2000 Growth Index companies with mark of publicly traded weighted, where a Index measures the lower price-to-book equity REITs listed in stock’s weight is capped performance of those ratios and lower fore- both developed and at a level determined on Russell 2000 com- casted growth values. emerging markets. a sector basis. panies with higher The stocks in this index price-to-book ratios are also members of s&p gsci index The and higher forecasted either the Russell 1000 S&P GSCI Index growth values. Value or the Russell (formerly the Gold- 2000 Value indexes. man Sachs Commodity

25 morgan stanley | august 2013 Please refer to important information and disclosures at the end of this material. consulting group / custom investment outsourcing strategy committee monthly

Important Information & Disclosures

Morgan Stanley Financial Advisors, Graystone Institutional Consulting Di- assumptions may have a material impact on any projections or estimates. rectors and Private Wealth Advisors may use any investment strategy when Other events not taken into account may occur and may signifi cantly affect providing investment advice to clients. These investment professionals the projections or estimates. Certain assumptions may have been made for may use asset allocation recommendations of the Morgan Stanley Wealth modeling purposes only to simplify the presentation and/or calculation of Management Global Investment Committee (GIC) or the Custom Invest- any projections or estimates, and Morgan Stanley does not represent that ment Outsourcing (CIO) Strategy Committee as a resource, but, if so, there any such assumptions will refl ect actual future events. Accordingly, there is no guarantee any strategy will in fact mirror or track these recommenda- can be no assurance that estimated returns or projections will be realized tions. The CIO Strategy Committee is composed of various Morgan Stanley or that actual returns or performance results will not materially differ from Wealth Management investment professionals. Its recommendations will those estimated herein. be targeted to the Custom Investment Outsourcing (CIO) program, a Mor- This material should not be viewed as advice or recommendations with gan Stanley Wealth Management investment advisory program, and may at respect to asset allocation or any particular investment. This information times differ from the recommendations of the GIC. is not intended to, and should not, form a primary basis for any investment Morgan Stanley Research reports are created in their entirety by the decisions that you may make. 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LLC or one of its affi liates are used performance. under license from Morgan Stanley & Co. LLC. Unless otherwise indicated, the author(s) (if any authors are noted) Asset allocation and diversifi cation do not assure a profi t or protect principally responsible for the preparation of this material may receive against loss. compensation based upon various factors, including quality and accuracy of The indices are unmanaged. An investor cannot invest directly in an their work, fi rm revenues (including trading and capital markets revenues), index. They are shown for illustrative purposes only and do not represent client feedback and competitive factors. Morgan Stanley is involved in the performance of any specifi c investment. The indices selected by Morgan many businesses that may relate to companies, securities or instruments Stanley to measure performance are representative of broad asset classes. mentioned in this material. Morgan Stanley retains the right to change representative indices at any This material has been prepared for informational purposes only and is time. not an offer to buy or sell or a solicitation of any offer to buy or sell any Performance of indices may be more or less volatile than any investment security/instrument, or to participate in any trading strategy. Any such offer product. The risk of loss in value of a specifi c investment is not the same as would be made only after a prospective investor had completed its own the risk of loss in a broad market index. Therefore, the historical returns of independent investigation of the securities, instruments or transactions, an index will not be the same as the historical returns of a particular invest- and received all information required to make its own investment decision, ment a client selects. including, where applicable, a review of any offering circular or memo- International investing entails greater risk, as well as greater poten- randum describing such security or instrument. That information would tial rewards compared to US investing. These risks include political and contain material information not contained herein and to which prospective economic uncertainties of foreign countries as well as the risk of currency participants are referred. This material is based on public information as of fl uctuations. These risks are magnifi ed in countries with emerging markets, the specifi ed date, and may be stale thereafter. We have no obligation to since these countries may have relatively unstable governments and less tell you when information herein may change. We make no representation established markets and economies. or warranty with respect to the accuracy or completeness of this material. Alternative investments which may be referenced in this report, includ- Morgan Stanley has no obligation to provide updated information on the ing private equity funds, real estate funds, hedge funds, funds of hedge securities/instruments mentioned herein. funds, private equity, and managed futures funds, are speculative and entail The securities/instruments discussed in this material may not be suitable signifi cant risks that can include losses due to leveraging or other specula- for all investors. The appropriateness of a particular investment or strategy tive investment practices, lack of liquidity, volatility of returns, restrictions will depend on an investor’s individual circumstances and objectives. on transferring interests in a fund, potential lack of diversifi cation, absence Morgan Stanley recommends that investors independently evaluate specifi c and/or delay of information regarding valuations and pricing, complex investments and strategies, and encourages investors to seek the advice tax structures and delays in tax reporting, less regulation and higher fees of a fi nancial advisor. The value of and income from investments may vary than mutual funds and risks associated with the operations, personnel and because of changes in interest rates, foreign exchange rates, default rates, processes of the advisor. prepayment rates, securities/instruments prices, market indexes, operational Investing in commodities entails signifi cant risks. Commodity prices may or fi nancial conditions of companies and other issuers or other factors. be affected by a variety of factors at any time, including but not limited to, Estimates of future performance are based on assumptions that may not be (i) changes in supply and demand relationships, (ii) governmental programs realized. Actual events may differ from those assumed and changes to any and policies, (iii) national and international political and economic events,

26 morgan stanley | august 2013 consulting group / custom investment outsourcing strategy committee monthly

war and terrorist events, (iv) changes in interest and exchange rates, (v) REITs investing risks are similar to those associated with direct invest- trading activities in commodities and related contracts, (vi) pestilence, tech- ments in real estate: property value fl uctuations, lack of liquidity, limited nological change and weather, and (vii) the price volatility of a commodity. diversifi cation and sensitivity to economic factors such as interest rate In addition, the commodities markets are subject to temporary distortions changes and market recessions. or other disruptions due to various factors, including lack of liquidity, par- Because of their narrow focus, sector investments tend to be more vola- ticipation of speculators and government intervention. tile than investments that diversify across many sectors and companies. Physical precious metals are non-regulated products. Precious metals are Principal is returned on a monthly basis over the life of a mortgage- speculative investments, which may experience short-term and long term backed security. Principal prepayment can signifi cantly affect the monthly price volatility. The value of precious metals investments may fl uctuate income stream and the maturity of any type of MBS, including standard and may appreciate or decline, depending on market conditions. If sold in MBS, CMOs and Lottery Bonds. Yields and average lives are estimated a declining market, the price you receive may be less than your original based on prepayment assumptions and are subject to change based on investment. Unlike bonds and stocks, precious metals do not make interest actual prepayment of the mortgages in the underlying pools. The level of or dividend payments. Therefore, precious metals may not be suitable for predictability of an MBS/CMO’s average life, and its market price, depends investors who require current income. Precious metals are commodities on the type of MBS/CMO class purchased and interest rate movements. In that should be safely stored, which may impose additional costs on the general, as interest rates fall, prepayment speeds are likely to increase, thus investor. The Securities Investor Protection Corporation (“SIPC”) provides shortening the MBS/CMO’s average life and likely causing its market price certain protection for customers’ cash and securities in the event of a to rise. Conversely, as interest rates rise, prepayment speeds are likely to brokerage fi rm’s bankruptcy, other fi nancial diffi culties, or if customers’ as- decrease, thus lengthening average life and likely causing the MBS/CMO’s sets are missing. SIPC insurance does not apply to precious metals or other market price to fall. Some MBS/CMOs may have “original issue discount” commodities. (OID). OID occurs if the MBS/CMO’s original issue price is below its stated Bonds are subject to interest rate risk. When interest rates rise, bond redemption price at maturity, and results in “imputed interest” that must be prices fall; generally the longer a bond’s maturity, the more sensitive it is reported annually for tax purposes, resulting in a tax liability even though to this risk. Bonds may also be subject to call risk, which is the risk that interest was not received. Investors are urged to consult their tax advisors the issuer will redeem the debt at its option, fully or partially, before the for more information. scheduled maturity date. The market value of debt instruments may fl uctu- Asset-backed securities generally decrease in value as a result of interest ate, and proceeds from sales prior to maturity may be more or less than the rate increases, but may benefi t less than other fi xed-income securities from amount originally invested or the maturity value due to changes in market declining interest rates, principally because of prepayments. conditions or changes in the credit quality of the issuer. Bonds are subject Investing in foreign emerging markets entails greater risks than those to the credit risk of the issuer. This is the risk that the issuer might be un- normally associated with domestic markets, such as political, currency, able to make interest and/or principal payments on a timely basis. Bonds economic and market risks. are also subject to reinvestment risk, which is the risk that principal and/ Value investing does not guarantee a profi t or eliminate risk. Not all com- or interest payments from a given investment may be reinvested at a lower panies whose stocks are considered to be value stocks are able to turn their interest rate. business around or successfully employ corrective strategies which would Bonds rated below investment grade may have speculative characteris- result in stock prices that do not rise as initially expected. tics and present signifi cant risks beyond those of other securities, including Growth investing does not guarantee a profi t or eliminate risk. The greater credit risk and price volatility in the secondary market. Investors stocks of these companies can have relatively high valuations. Because of should be careful to consider these risks alongside their individual circum- these high valuations, an investment in a growth stock can be more risky stances, objectives and risk tolerance before investing in high-yield bonds. than an investment in a company with more modest growth expectations. High yield bonds should comprise only a limited portion of a balanced Credit ratings are subject to change. portfolio. Morgan Stanley Smith Barney is not incorporated under the People’s Interest on municipal bonds is generally exempt from federal income Republic of China (“PRC”) law and the research in relation to this report is tax; however, some bonds may be subject to the alternative minimum tax conducted outside the PRC. This report will be distributed only upon re- (AMT). Typically, state tax-exemption applies if securities are issued within quest of a specifi c recipient. This report does not constitute an offer to sell one’s state of residence and, if applicable, local tax-exemption applies if or the solicitation of an offer to buy any securities in the PRC. PRC investors securities are issued within one’s city of residence. must have the relevant qualifi cations to invest in such securities and must Treasury Infl ation Protection Securities’ (TIPS) coupon payments and be responsible for obtaining all relevant approvals, licenses, verifi cations underlying principal are automatically increased to compensate for infl ation and or registrations from PRC’s relevant governmental authorities. by tracking the consumer price index (CPI). While the real rate of return is Morgan Stanley Private Wealth Management Ltd, which is authorized guaranteed, TIPS tend to offer a low return. Because the return of TIPS is and regulated by the Financial Services Authority, approves for the purpose linked to infl ation, TIPS may signifi cantly underperform versus conventional of section 21 of the Financial Services and Markets Act 2000, content for US Treasuries in times of low infl ation. distribution in the United Kingdom. Equity securities may fl uctuate in response to news on companies, indus- This material is disseminated in the United States of America by Morgan tries, market conditions and general economic environment. Stanley Smith Barney LLC. Investing in smaller companies involves greater risks not associated with Third-party data providers make no warranties or representations of any investing in more established companies, such as business risk, signifi cant kind relating to the accuracy, completeness, or timeliness of the data they stock price fl uctuations and illiquidity. provide and shall not have liability for any damages of any kind relating to Stocks of medium-sized companies entail special risks, such as limited such data. product lines, markets, and fi nancial resources, and greater market volatility ©2013 Morgan Stanley Smith Barney LLC. Member SIPC. Consulting than securities of larger, more-established companies. Group and Graystone Consulting are businesses of Morgan Stanley Smith With respect to real estate investments, property values can fall due to Barney LLC. environmental, economic or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. 2013-PS-613 7/13

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