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Considering the Alternative March 2013

The alternative-asset space is growing in both scope andpopularity. But before jumping in, Chris Mackay of PrivateAdvisors says, accredited investors need to consider both therisks 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 anedited version of their conversation.*

TaraKalwarski: How do you define the alternatives

market?

ChrisMackay: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


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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 andsays, 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 thematter is that a lot of investors aren't there because they've

sold.

*Unless otherwise noted, the source for all information is

Chris Mackay as of February 2013.

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.

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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 thepotential 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, sophisticatedinvestors who are able to understand the complex investment strategies they ofen employ, and who can tolerate the risks and liquidity constraintsinvolved.

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 economicenvironment. 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 economicuncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, sincethese 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 thisrisk. 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 amountoriginally 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 beenobtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness ofinformation 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 noguarantee 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 asolicitation of any offer to buy or sell any security, sector or other financial instrument, or to participate in any trading strategy. I t has been preparedwithout regard to the individual financial circumstances and objectives of individual investors. Any securities discussed in this report may not besuitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances andobjectives. 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 whoare neither employees nor affiliated with Morgan Stanley. Opinions expressed by a third party source are solely his/her own and do not necessarilyreflect those of Morgan Stanley. Furthermore, this material contains forward-looking statements and there can be no guarantee that they will come topass. 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 availablefor direct investment.

Tracking No. 2013-PS-151 02/2013

2013 Morgan Stanley Smith Barney LLC. Member SIPC

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