InvMgtJournal 2013v3i2

INVESTMENT MANAGEMENT
2013 | VOLUME 3 | ISSUE 2
01 A Letter from Gregory J. Fleming 03 Quality Investing: A Strategy for Uncertain Times
45 Fixed Income Investing in a World of Rising Rates
Jim Caron, Managing Director
Christian Derold, Managing Director Alistair Corden-Lloyd, Executive Director
55 Indias Stealth Game Changer
13 Hedge Fund Benchmarking:
Amay Hattangadi, CFA, Executive Director Swanand Kelkar, Vice President Investment Strategy Tom Wills, CFA, Executive Director Developed World? Ruchir Sharma, Managing Director
Equity Correlation Regimes and Alpha Jerome B. Baesel, Ph.D, Chief Investment Officer (Emeritus) Jos F. Gonzlez-Heres, CAIA, Managing Director Ping Chen, Ph.D, Vice President Steven S. Shin, CFA, CPA, Vice President Tim Drinkall, Executive Director
61 Convertibles: Designing an Optimal
69 Is the U.S. the Breakout Nation of the
39 Frontier Markets: Why Now?
79 About the Authors
Investment Management Journal
United Kingdom (UK): For Business and Professional Investors and May Not Be Used with the General Public. This financial promotion was issued and approved in the UK by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients or Eligible Counterparties only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authoritys rules). IMPORTANT DISCLOSURES: This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations. The document has been prepared as information for investors and it is not a recommendation to buy or sell any particular security or to adopt any investment strategy. Investors should consult their professional advisers for any advice on whether a course of action is suitable. Except as otherwise indicated herein, the views and opinions expressed herein are those of the author(s), and are based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof. Past performance is not a guarantee of future performance. The value of the investments and the income from them can go down as well as up and an investor may not get back the amount invested. Forecasts and opinions in this piece are not necessarily those of Morgan Stanley Investment Management (MSIM) and may not actually come to pass. The views expressed are those of the authors at the time of writing and are subject to change based on market, economic and other conditions. They should not be construed as recommendations, but as illustrations of broader economic themes. All information is subject to change. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.
Morgan Stanley does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. You should always consult your own legal or tax advisor for information concerning your individual situation. Alternative investments are speculative and involve a high degree of risk and may engage in the use of leverage, short sales, and derivatives, which may increase the risk of investment loss. These investments are designed for investors who understand and are willing to accept these risks. Performance may be volatile, and an investor could lose all or a substantial portion of his or her investment. Equity securities are more volatile than bonds and subject to greater risks. Small and mid-sized company stocks involve greater risks than those customarily associated with larger companies. Bonds are subject to interest-rate, price and credit risks. Prices tend to be inversely affected by changes in interest rates. Unlike stocks and bonds, U.S. Treasury securities are guaranteed as to payment of principal and interest if held to maturity. REITs are more susceptible to the risks generally associated with investments in real estate. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments. Morgan Stanley Research reports are created, in their entirety, by the Morgan Stanley Research Department which is a separate entity from MSIM. MSIM does not create research reports in any form and the views expressed in the Morgan Stanley Research reports may not necessarily reflect the views of MSIM. Morgan Stanley Research does not undertake to advise you of changes in the opinions or information set forth in these materials. You should note the date on each report. In addition, analysts and regulatory disclosures are available in the research reports.
A LET TER FROM GREGORY J. FLEMING
July 2013 As we head into the summer of 2013, we recognize the accelerating interest in stock investing in both developed and emerging markets, though at a pace far distant from irrational exuberance. Interest rates still hover at lows around the world, yet opportunities remain in xed income for discerning investors and the next undiscovered market may lie on the frontier of the emerging world. With this backdrop for our latest issue of the Morgan Stanley Investment Management Journal, our Firms top investment professionals provide their insights on a number of themes, which we believe will initiate a wider conversation among our readership. This latest issue also includes pieces that discuss a new approach to quality investing and the consideration of convertibles when designing an optimal portfolio strategy. Other authors explore the potential impact of falling energy costs on Indias economy as well as consider approaches to hedge fund benchmarking. We are particularly excited to share an adaptation from the epilogue of Ruchir Sharmas recently released paperback edition of his best seller, Breakout Nations, on the U.S.s comparatively bright prospects in a slow-growth world. I hope these articles will give you a glimpse of our rms solid intellectual capital. Our commitment to clients remains constant as we seek to provide a collaborative approach that delivers superior investment solutions. Thank you for your continued condence in Morgan Stanley. Sincerely,
GREGORY J. FLEMING
President, Morgan Stanley Investment Management President, Morgan Stanley Wealth Management
Gregory J. Fleming President, Morgan Stanley Investment Management President, Morgan Stanley Wealth Management
INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2
QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES
Quality Investing: A Strategy for Uncertain Times

Executive Summary
The debt-fueled bubble of the last 30 years drove three extraordinarily long economic expansions, each averaging 100 months.1 Preceding this, as far back as the 1850s, expansionary phases averaged just 35 months, spiked only by wars.2 We believe a return to these shorter duration, more modest growth cycles appears likely, punctuated by continued volatility as uncertainty persists through the long process of de-leveraging. We believe striving to safeguard against the risk of signicant loss of capital, and protect against ination or deation by generating steady, resilient growth potential are the two key objectives to help meet the challenges ahead. We suggest that quality companies, typically those with powerful intangible assets, which are innovative, capital light, well managed and can generate strong free cash ows3 from high returns on capital are best placed to help achieve these objectives. Although they are rare, our research suggests these companies can be found across many sectors, allowing the construction of a diversied4 quality portfolio. Our research demonstrates that quality investing has already earned its spurs, has steadily grown and has preserved relative capital during the recent credit
1 2 3
AUTHORS
CHRISTIAN DEROLD
Managing Director Morgan Stanley Investment Management
ALISTAIR CORDEN-LLOYD
Executive Director Morgan Stanley Investment Management
Source: Federal Reserve, Morgan Stanley. Data as of March 31, 2012. Source: Deutsche Bank. Data as of October 31, 2012. Most recent data available used.
A measure of financial performance calculated as operating cash flow minus capital expenditures (capex). Diversification does not protect an investor against a loss in a particular market; however it allows an investor to spread that risk across various asset classes.
4
and sovereign crises.5 Underpinning this strong historical performance, we explore qualitys simple secret, the power of economic compoundingthe potential ability to steadily grow prots and re-invest at incremental high rates of return, combined with relative prot resilience during economic downturns.6 Finally, we believe valuations for quality equities can be compelling both in a historical context, as well as against the broader market.
Over this 30 year period, there was were three excessive periods of uninterrupted growth averaging just over 8 years each time.8 Historically, during the preceding 138 years, economic expansions averaged just three years, only exceeding this in wartime.9 Display 2: Length of U.S. Economic Expansions in Months 1854 to 2012
140 120 100 Months 80 60 40 20 0 Average 1854-1981 Average 1982-2008 Wars The Great Leveraging
De-leveraging Into Shorter, Lower Growth Cycles

For the vast majority of investors and market participants, the last 30 years may make up most, if not all of their investment experience, and marks the duration of the Great Leveraging, demonstrated by the burgeoning total debt-to-GDP ratio of the U.S. and Europe, rising from 150 percent to 400 percent.7 Display 1: U.S. and Europe Total Debt-to-GDP (%)
The Great Leveraging 400 350 300 % of GDP 250 200 150 100 1950 U.S.
Dec Jun Dec May May Jun Aug Jan Mar Jul Mar Oct May Feb 1854 1861 1870 1885 1891 1897 1904 1912 1919 1924 1933 1945 1954 1961
Mar Nov Jun 1975 1982 200910
Source: Deutsche Bank. Data as of October 31, 2012. Most recent data available used.
}
Taking the medicine of de-leveraging is not a short process as Japan knows only too well, having reached a debt-driven peak in 1989, followed by an enduring 15-year de-leveraging.11 Bond markets suggest the rest of the geared12 world may be following the same path.
1960 1970 Europe 1980 1990 2000 2010
Source: Federal Reserve, Morgan Stanley. Data as of March 31, 2012.
8
9 10 5 6 7
Past performance is not indicative of future results. Past performance is not indicative of future results. Source: Federal Reserve, Morgan Stanley. Data as of March 31, 2012.
Current expansion up to end 2012.
Source: BOJ Data (Financial Institutions Accounts) and Nomura. Data as of December 5, 2012.
11 12
Geared: With significant borrowings, % of debt to GDP
Display 3: Current 10yr U.S. and German Bonds Mapped to Historic 10yr Japan Government Bonds
2006 9 8 7 6 Yield 5 4 3 2 1 0 1989 1991 1993 1995 1997 1999 2001 2003 2008 2010 2012 2014 2016 2018 2020 U.S. Recession Started 1st Quarter 2008 Eurozone Recession Started 2nd Quarter 2008 Japans Recession Started 2nd Quarter 1991
thing, but generally it will not last if your assets can be replicated to produce similar, cheaper, or perhaps better, products or services. The easiest assets to replicate are physical, tangible assets. Heavy upstream industry, including steel and mining, are good examples. With the right resources, a competitor, old or new, can buy the assets to create the product. This is why we place great importance on the power of intangibles, hard to replicate assets. Brands are the most recognizable intangible assets. Others include networks, licenses, product patents, or indeed a signicant installed base. For example, global leaders in enterprise-wide computing typically have an extensive barbed hook into their clients technology systems, making it very expensive for them to consider alternatives and ideal for these providers to penetrate their clients with product extensions. Alone, intangible assets do not form the moat. Without innovation, they can prove vulnerable. Failing to recognize the ascendance of digital photography, missing the transition for viewing movies from VHS to DVD to Online to On-demand, or not grasping fast enough the move from a mobile phone to a fully converged device, has produced corporate casualties. Innovation, Advertising and Pricing Power Therefore, second in our list of crucial features is the ability to innovate, advertise and promote, which can lead to pricing power and may be seen through strong gross margins. If you can re-invest in your brands and products to create better, newer, greater perceived need and value, if you ensure your advertising and promotion can capture your clients attention and decision process, and if you can lead your category through innovation, then you can help protect and strengthen your moat. A leading European company in household products and hygiene has generated 30 percent of its revenue from products less than three years old, helping to ensure it maintained its functional premium to private label. Over a three-year period, it produced 1,726 discrete innovations, 40 percent of which were new products, helping it to generate strong gross margins that exceeded its sector average (MSCI World Staples).
10 Year Japanese Government Bond (Bottom Dates) 10 Year US Treasury Bond (Top Dates) 10 Year German BUND (Top Dates)
Source: BOJ Data (Financial Institutions Accounts) and Nomura. Data as of December 5, 2012. Most recent data available used. Past performance is not indicative of future results. Provided for informational purposes only and is not a recommendation to buy or sell any security.
In this context then, we believe a return to shorter-duration expansionary cycles, proled with more modest growth and more frequent setbacks, would seem a natural mean reversion. Companies that can consistently minimize the impact when cycles turn and steadily grow in up-cycles, producing strong economic compounding, may likely be rewarded with greater potential total returns.
What Characteristics Define High Quality Compounders?13

For a company to compound at an attractive rate of return, we believe it must exhibit a number of key features. The Moat First, the company must protect its franchise with a strong economic moat (a phrase coined by Warren Buett.) Over time, superior prots can attract potentially erosive competition. Having a dominant market position is one
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Compounders: Generating earnings from previous earnings
Low Capital Intensity In our view, the third criteria, which feeds back into pricing power and powerful intangible assets, is low capital intensity. The less operating cash ow that is spent on maintaining the xed asset base, we believe the greater the opportunity to allocate cash ows to further investment in potential growth or returns to shareholders. Capital-intensive sectors14, including materials, energy, utilities and telecoms typically spend, on a ten-year average, 12.8 percent of their sales on capital expenditure and convert just 40 percent of their operating cash ow into free cash ow.15 Capital light sectors14, including staples, technology, healthcare, consumer discretionary and industrials, typically spend less than 5 percent of their sales on capital expenditure and convert 59 percent of their operating cash ow into free cash ow.15 Moreover, the volatility16 of the free cash ow generation in the capital intensive sectors is nearly twice that (13.6) of the capital light sectors (7.6).17 In other words, they have historically oered weaker free cash ow generation at greater risk. High Returns on Capital In our opinion, the fourth signal of quality is a high, unleveraged return on capital employed (ROCE)18; that is, the operating prot generated from the operating assets. Naturally, low capital intensity implies a relatively modest physical asset base, and high returns can suggest strong protability. Combining the two helps generate strong free cash ow. Management can then invest in the companys future, helping to protect its moat, and they can return surplus capital to shareholders. Resilience Fifth, we believe that resilience is a crucial high quality marker. Healthcare serves as a good example. Typically,
14 15
demand for medical treatment is not economically sensitive. Healthcare companies have enjoyed historically strong margins supported by intellectual property, brands and specialist sales and marketing networks. They do not require extensive xed assets to produce and market their goods. Therefore, their historical ROCE has not only been high, but also relatively stable. Their earnings resilience (Display 4 ), even in the face of recent patent expiry events, has been clear relative to the broader market. Display 4: MSCI World Healthcare EPS19 vs MSCI World Index EPS - Indexed
350 300 250 % Change 200 150 100 50 0 3/98 3/99 3/00 3/01 3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 3/11 3/12 2/13 MSCI World Healthcare EPS MSCI World
Source: FactSet, MSCI. Data as of February 28, 2013. Past performance is not indicative of future results. Provided for illustrative purposes only and is not a recommendation to buy or sell any security.
MSCI World.
Source: Factset/Worldscope, MSCI World. Data as of March 31, 2013. Volatility: Standard Deviation. Standard deviation is a measure of the dispersion of a set of data from its mean.
16
Conversely, materials companies, on average, have exhibited less resilience and have been much more cyclical. Pricing for their goods is driven by supply and demand. When supply is too great, or demand too low, prices suer. They typically need substantial xed assets to generate sales, which are expensive to maintain, adding another squeeze to cash-ows through relatively high capital expenditure. Display 5 clearly demonstrates the absence of resilience for the sector during economic downturns, relative to healthcare.
Source: Factset/Worldscope, MSCI World. Data as of March 31, 2013.

17 18
ROCE: EBIT/Property, plant, equipment and net working capital
Earnings Per Share (EPS) Next Twelve Months. Earning per share is the portion of a companys profit allocated to each outstanding share of common stock.
19
Display 5: MSCI World Materials EPS19 vs MSCI World Healthcare EPS - Indexed
450 400 350 300 % Change 250
As an example, management of one of the worlds largest carbonated cola companies made an error of judgment in the mid 90s chasing volume at the expense of returns, and diversifying into lower return categories including water. The impact on ROCE20 is clear in the chart below. Display 6: Large Carbonated Cola Company ROCE Fade
140% 120% Return on Capital Employed 100% 80% 60% 40% 20% 0%
200 150 100 50 0 3/98 3/99 3/00 3/01 3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 3/11 3/12 2/13 Material EPS Healthcare EPS
Source: FactSet, MSCI. Data as of February 28, 2013. Past performance is not indicative of future results. Provided for illustrative purposes only and is not a recommendation to buy or sell any security.
Management None of these key features is sucient without a management team that can help protect, adapt, develop and grow a company. Their role is critical in the nal piece of the quality puzzle. Poor management can undermine even the highest quality companies. It is vital that management is not distracted from the long-term task of building and improving the companys intangible assets by the temptation to meet short-term targets, which are often focused on earnings rather than returns. Cuts to advertising and promotion, or research and development budgets, either in absolute terms or as a percentage of sales, can have devastating long-term consequences to brand strength and recognition, which is driven by innovation and customer loyalty. It can also erode pricing power. The other risk stems from unwise allocation decisions for the free cash ow naturally generated by high return operations. Investing at low returns, either through acquisitions or expanding into lower return areas, can undermine the overall quality of the business. The erosion of returns at the expense of short-term prot gains can eventually lead to the permanent destruction of shareholder wealth.
12/93
12/95
12/97
12/99
12/01
12/03
12/05
12/07
12/09
12/12
Source: FactSet, Worldscope. Data as of December 31, 2012. Past performance is not indicative of future results. Provided for illustrative purposes only and should not be deemed a recommendation to buy or sell any security.
Neither recognizing nor responding to technological change, as mentioned earlier, can cause a leader to fall. In the mid 2000s, a world leader in mobile phones, a European company, failed to adapt its products to technological convergence and touch screen development. An emerging mobile phone competitor, heralding from a computing background, and acknowledged for its consumer awareness, introduced a converged, interactive device. This was a game changer. The European companys market position and pricing power crumbled, as the gross margin chart shows.
20
ROCE = Ebit/Net PPE + Net working capital
Display 7: Gross Margin Development Comparison of European Mobile Telephone Manufacturer vs a Competitor
50 45 40 35 30 25 20 3/00 3/01
Why Is Compounding So Important?

In our view, true economic compounder tends to be relatively robust in downturns, with steady protability and limited operating and nancial leverage. Importantly, the resilience of the earnings stream helps drive the resilience of the free cash ow, allowing management to continue to invest in the business or return capital to shareholders. Consumer staples by their nature have typically been good compounders with relatively steady end market demand (eating, drinking, smoking, cleaning, washing, etc.), limited capital intensity, and high returns on capital: a cocktail with the potential to generate strong free cash ow. Recent market shocks, be they the end of the tech boom, the credit crisis or the sovereign debt crisis, had a short-term market price impact on these steady companies, but negligible prot impairment. As illustrated in Display 8, the historical stability of earnings is clear. Display 8: MSCI World Staples EPS21 vs MSCI World EPS
Gross Margin %
3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09
3/10
3/11
3/12 2/13
European Mobile Device Manufacturer
A Competing Technology Giant
Source: FactSet, Worldscope. Data as of February 28, 2013. Past performance is not indicative of future results. Provided for illustrative purposes only and should not be deemed a recommendation to buy or sell any security.
Indexed Performance
Brand abuse is another management red ag. Examples abound. A well-known luxury company from Europe lost control of its brand through licensing. A famous motorbike company went into wine coolers. A European company specializing in disposable writing instruments thought its brand could extend to underwear, and another European household name in international airline travel tried to market its own cola. Getting it right, a European leader in chocolate and coee has been innovating and developing its soluble coee brand for decades, appearing to hit the spot on all the classic P marketing metrics: price, position, place, promotion and product. Their coee brand has aordability (price), convenience (place), and luxury (position), which respects its coee heritage (product), and helping to keep it in the forefront of a consumers decision (promotion).
350 300 250 200 150 100 50 0 3/00 3/01
3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 MSCI World
3/11
3/12 2/13
MSCI World Staples
Source: FactSet, MSCI. Data as of February 28, 2013. Past performance is not indicative of future results. Provided for illustrative purposes only and should not be deemed a recommendation to buy or sell any security.
So too is the historical stability of dividends (see Display 9.)
21
Earnings per share (EPS) Next Twelve Months.
Display 9: MSCI World Staples DPS22 vs MSCI World DPS

350 300 Indexed Performance 250 200 150 100 50 0 3/00 3/01
Are High Quality Companies Concentrated in Certain Sectors?

This paper has discussed the resilient prole of healthcare and consumer staples earnings, as well as their high returns and strong free cash ow generationall markers of quality. However, such a prole is not restricted to these sectors. There is also strong representation from industrials, technology and consumer discretionary. In fact, there has been strong representation from industrials, healthcare, technology and consumer discretionary. Display 11 shows the number of quality companies in the top quartile for high return on capital and operating margin resilience23 over the last 10 years.
3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 MSCI World
3/11
3/12 2/13
MSCI World Staples
Display 11: Number of Companies by Sector in the Top Quartile for Quality24
60 50 40 30 20 10 0 48 48 39 35 31
Display 10: MSCI Staples vs MSCI World Total Return Indexed

350 300 250 % Change 200 150 100 50 0 3/00 3/01 3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 MSCI Staples MSCI World
Number of Companies
Combine the two, and the eect of long term compounding on historical total returns becomes clear, as shown below in Display 10.
17 9
Consumer Staples Healthcare Industrials Discretionary
IT
Telco
Materials
Energy
Universe: MSCI World Index Ex Financials with a year 2000 market cap over $2bn, organized by quartile of 10 year averaged margin stability and ROCE. ROCE: Ebit/(PPE + net working capital) Source: FactSet, Worldscope (excludes financials). Data as of February 28, 2013. Past performance is not indicative of future results. Provided for informational purposes only and should not be deemed an offer or recommendation to buy or sell any security in the sector referenced.
3/11 3/12 3/13
Materials, energy, telecoms and utilities, generally struggle to achieve the characteristics, owing to typically low returns, greater capital intensity, often absent powerful intangible
Margin resilience: (1 - (Standard Deviation of EBIT Margin/Mean EBIT margin))
23
22
Dividends per share (DPS)
24
Ebit Margin Stability: 1-(Standard Deviation/Mean)
assets and usually relatively poor resilience. Naturally, with these sectors not oering the characteristics we look for, they will rarely be present in a quality portfolio. However, these sectors account for less than 25 percent of the World Index, meaning there is scope for the construction of a reasonably diversied portfolio of high quality companies.
Display 12: Top Quartile companies by margin stability and ROCE in 1994 that maintained or improved their ROCE through 2012 (EPS and DPS performance vs the MSCI World Index)
350 300 250 200 150 100 50 0 -50 12/95
Quality investing is not seduced by short-term fads, nor does it live or die by quarterly earnings reports or macro noise. Rather, it aims for long-term resilient returns. Identifying quality is the easy bit. With the wealth of information available, screening can identify historically high return, stable margin companies. What is dicult, what requires the skill of the investor, is identifying those names with the characteristics to maintain or improve potential returns. This is the key to unlocking compounding. Back in 1994, selecting the top quartile set of companies based on margin stability and ROCE, and then selecting those that had kept or improved their returns, would have turned $100 into an average $662 by 2012. This is compared to the broader universe delivering an average $362 for the same period.25 Whats more is the clear historical resilience from quality in down-cycles both from an earnings and dividends perspective.
% Change
Can Quality Work as an Investment Style?
12/97
12/99
12/01
12/03
12/05
12/07
12/09
12/11 2/13
Top Quartile EPS
Top Quartile DPS
MSCI World EPS
MSCI World DPS
Source: FactSet, Worldscope. Data as of February 2013.
Had you selected this top quality quartile in 1994, but excluded whether they had kept or maintained their returns, then the return would have been an average $474, still an improvement over the average return of the universe, but some way behind those names that maintained or improved their returns. This underlines the signicant role resilience can play in producing superior long-term returns. It also can speak to the value of management protecting and developing the franchise, driving focused innovation and allocating capital eectively: in eect, seeking to maintain the compounding prole. Moreover, it emphasizes the importance of active management in quality investing.
Why Consider Quality Now?

Facing the challenges of an ever more uncertain economic climate, it is all the more important to help guard against the risk of permanent loss of capital, the specter of ination or deation, and potential meager growth. With this in mind, we continue to believe now may be a good time to invest in quality equities. In our view, they look attractive relative to expensive bonds, they look attractive relative to their own history, and they look attractive against the broader equity market.
Source: FactSet, Worldscope. Past performance is not indicative of future results and assumes perfect hindsight. Provided for illustrative purposes only and is not an offer to buy or sell any security.
25
10
The U.S. ten-year Government bond yield is 1.95 percent (as of May 16, 2013). Quality companies today, classied as the top quartile of names for ve-year average ROCE and margin stability, have an average free cash ow yield of 5.7 percent.27 Included in this is an average 2.5 percent dividend yield, suggesting a further 3.2 percent was either reinvested or returned to shareholders. Moreover, the equity free-cash ow yield has the ability to potentially grow; the Government bond yield does not. Additionally, the equity free cash ow yield may have sovereign diversication, the Government bond yield does not. A 5.7 percent free cash ow yield, if returned to shareholders in full, would imply a payback period of 17.5 years, three times less than the U.S. Treasury.28 In a sector context, if one considers quality companies in the MSCI World Index as of March 31, 2013, again measured by ROCE and margin stability, those that are in the top quartile generally compared favorably in a PE context relative to their broader sectors. Display 13: MSCI World Index Sector Median P/E
20.0 18.0 16.0 14.0 Price Earnings Ratio 12.0 10.0 8.0 6.0 4.0 2.0 0.0 Energy Materials Industrials Consumer Staples Index Health IT Telco
Conclusion
Driven by the Great Leveraging, the last 30 years has seen remarkable growth, with three periods of unprecedented, and ultimately unsustainable, economic expansion. As we enter a much more uncertain deleveraging world, we may more than likely return to the economic patterns of the past, namely shorter duration, lower growth periods. Facing this environment, we believe quality companies may oer many attractions to investors: Their moats are generally defended. They have pricing power to help protect against ination and steady growth potential to help counter deation. They are generally resilient. They generally advertise, innovate and adapt. Their historically high ROCE2 and low capital intensity can help generate strong free cash ow. They are generally prudently managed. They appear to be attractively priced. Above all, quality companies can have the hallmarks to compound shareholder wealth at potentially attractive rates of return over the long term.
Top Quality Quartile
Source: FactSet, MSCI Ex Financials. As of March 31, 2013. Past performance is not indicative of future results. Provided for informational purposes only and should not be deemed a recommendation or offer to buy or sell any security.
Past performance is not indicative of future results. Keep in mind that stocks are more volatile than bonds.
27
$100 invested with a 5.7% free cash flow yield, fully returned to shareholders, would take 17.5 years (5.7% x 17.5%) to return the principle.
28
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Disclosures The views expressed are those of the authors as May 1, 2013. Their views are subject to change at any time due to market or economic conditions without notice to the recipients of this document. The views expressed does not reflect the opinions of all portfolio managers at MSIM, or the views of the firm as a whole, and may not be reflected in the strategies and products that the Firm offers. This document has been prepared solely for informational purposes and should in no way be considered a research report from MSIM, as MSIM does not create or produce research. Information in this presentation does not contend to address the financial objectives, situation or specific needs of any individual investor. All investments involve risks, including the possible loss of principal. Please be aware that certain asset classes and investments are more volatile than others, such as: Stocks are more volatile than bonds, and Government bonds and Treasury Bills are guaranteed as to the timely payment of principal and interest, if held to maturity. Foreign stocks are more volatile than domestic stocks. Emerging Markets country investments entail greater risks than those generally associated with foreign investments. Past performance is no guarantee of future results. Charts, graphs, and securities referenced herein are provided for illustrative purposes only. This material has been prepared using sources of information generally believed to be reliable but no representation can be made as to its accuracy. Forecasts/ estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Performance of all cited indices is calculated on a total return basis with dividends reinvested, unless noted otherwise. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments. An investor can not invest directly in any index.
Risk considerations There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing. Foreign and emerging markets. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emergingmarket countries are greater than the risks generally associated with foreign investments. There is no guarantee that an investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of market downturns. Separate accounts managed according to a strategy include a number of securities and will not necessarily track the performance of any index. A separately managed account may not be suitable for all investors. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2. Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.
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HEDGE FUND BENCHMARKING: EQUIT Y CORRELATION REGIMES AND ALPHA
Hedge Fund Benchmarking: Equity Correlation Regimes and Alpha

In proposing a unied model that extends the Fama-French ve-factor model by adding a momentum factor and a dichotomous cross-sectional equity-market correlation factor, this article analyzes the eect of realized cross-sectional correlations of the S&P 500 on hedge fund alpha. The use of dichotomous variables to isolate cross-sectional equity-market correlation regimes reveals factor exposures that would otherwise not be detectable using a continuous variable. The model achieves a robust forecasting ecacy rate. We nd strong empirical evidence of idiosyncratic manager-based investment decisions (e.g., security selection, sector rotation, leveraging skills) during low correlation regimes, as evidenced by materially higher alpha, with the converse eect during high correlation regimes. The proposed model can be used as a practical benchmarking tool for hedge fund allocators, particularly when applied to equity-oriented hedge fund strategies. The existence and potential determinants of hedge fund alpha remains a central interest in alternative investment research. This article expands an earlier investigation of the eect of S&P 500 cross-sectional correlation on the alpha characteristics of hedge fund strategies (Baesel et al. [2012]) by removing the S&P 500 index return factor and as an alternative, testing Fama and Frenchs [1993] ve factors plus a momentum factor. This results in a more ecacious model that exhibits, on average, 27 percent points of additional adjusted R 2 values. The central factor for this article continues to be cross-sectional equity correlation, which allows for the isolation of three unique equity-market correlation regimes. The improved model proposed herein also serves as a single, unied performance attribution model that can be used across the four major hedge fund trading strategies in the Hedge Fund Research, Inc. (HFR) database to detect the presence of alpha. The empirical analysis centers on the use of dichotomous variables to isolate correlation regimes using panel data regressions. Over the
AUTHORS
JEROME B. BAESEL, PH.D
Chief Investment Officer (Emeritus) Alternative Investment Partners
JOS F. GONZLEZHERES, CAIA
Managing Director Alternative Investment Partners
PING CHEN, PH.D
Vice President Alternative Investment Partners
STEVEN S. SHIN, CFA, CPA
Vice President Alternative Investment Partners
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period of 19902010, we nd that equity-oriented hedge fund strategies generate approximately twice the alpha during low correlation regimes, relative to normal correlation regimes, and generally lose alpha during high correlation regimes.1 This article investigates the eect of equity-market crosssectional (CS) correlation on the alpha characteristics of hedge fund strategies. We decompose the returns of the four major hedge fund trading strategies in the HFR database, Equity Hedge, Event-Driven, Relative Value, and Macro, using Fama and Frenchs [1993] ve-factor model, a momentum factor, plus an additional equity correlation factoracross three unique equity- market correlation regimes. These hedge fund strategies are generally understood to invest their assets in the following respective asset classes: 1) Equity Hedge invests in equities; 2) Relative Value invests in xed-income and hybrid securities, which have both equity and credit characteristics such as convertible bonds; 3) Event-Driven invests in a combination of equity and xed-income securities, also using equity derivatives for various purposes such as hedging; and 4) Macro invests across all major asset classes. We analyze each of the major HFR hedge fund strategy classications, rather than the individual sub-strategies, to simplify the process of understanding which broad categories of hedge fund strategies may be impacted by the eect of equity-market correlation. We propose a single, unied model that can be applied to each of the four hedge fund strategies. The empirical analysis centers on the introduction of dichotomous variables (commonly referred to as dummy or binary variables) to isolate correlation regimes using panel data regressions. Our methodology measures the intercept term (alpha) of the proposed multi-factor regression model during periods of abnormal equity-market correlation, and thus tests for the presence of various manager basedinvestment decisions (e.g., security selection, sector rotation, leveraging skill) in periods of extreme correlation. We focus on the Standard & Poors 5002 stocks both because of the
Because alpha is herein defined as the intercept of a multi-factor regression model, where the independent factors used are not tradable benchmarks, our reference to alpha is purely a measure of excess return and may not necessarily be attributed to stock-picking skillsalthough it is a probable explanation for equity-oriented hedge fund strategies.
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readily available data and because they constitute a section of the market that most would agree is deemed ecient. Thus, if a managers ability to beat the market (i.e., generate statistically signicant alpha) varies in this sector due to dierential correlation characteristics, we think the idea is easily conjectured to apply to other sectors. We focus on hedge funds as the managers that have the ability to invest both long and short, and to add a range of discretionary investment decisions (e.g., sector rotation, leveraging), thus increasing their ability to make investments consistent with their beliefs. In periods of high correlation in equity markets, traders tend to focus more on macro issues, such as a credit crisis in Europe or changes in interest rates driven by Fed policy. Therefore, the key question traders ask themselves is: Do I want to own stocks or not? In contrast, when the market is not driven by macro factors, there is more time to focus on the micro factors, such as the relative values of the underlying stocks, or asset sectors, in the market. It is important to remember that we are not suggesting that at any one time only one of these motivations is present, but rather that from time to time the market goes through frenzies when many market participants focus on just one major issue. Therefore, when the market is not just driving most stocks up or down, causing increased correlation, there is more focus, at the margin, on looking at the dierences between two companies in one industry or between equity sectors within the asset class. For example, if you are a pairs trader, you are buying the good stock and shorting the bad stock. The same concept applies across industries or other dierentiating factors. It is this divergence of opinion, allowing relative values to adjust, that allows greater prots for those analysts particularly good at looking at the fundamentals of companies. For example, if one stock goes up 10 percent and the other down 10 percent, then the trader earns 20 percent. This is hard to accomplish when, for example, all stocks go up 10 percent or down 10 percent. Because much of correlation is driven by the systematic risk of stocks, there is more opportunity for prot when correlation is low, suggesting that the distribution of residuals (alpha) of individual stocks is wide and thus allowing for more relative value prots. In summary, correlation is a proxy for measuring systematic risk. In a high correlation environment, systematic risk is high as well, and idiosyncratic risk plays a minor role. Therefore, the dierence
Standard & Poors 500 equity index is designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries. Source: Bloomberg.
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between good stocks and bad stocks or between security sectors becomes less signicant. On the contrary, in a low correlation environment, systematic risk is low as well. In the next section, we provide a literature review on the use of multi-factor models and hedge fund return estimation. In the third section, we describe how the data was sourced and processed, and a methodology for testing for the presence of alpha under three unique correlation regimes. In the fourth section, the results are presented. The implications for asset allocation decisions are discussed in the nal section.
They propose alternative models constructed from common and easily tradable benchmark indices. Despite the possible shortcomings, we focus on the original Fama-French factors due to their widely held acceptance. Carhart [1997] expanded the Fama-French [1993] model with a momentum factor to better estimate manager alpha. Carhart investigated the persistence of mutual fund manager alpha by adding an additional factor to the three-factor Fama-French equity model to capture the one-year momentum anomaly revealed by Jegadeesh and Titman [1993]. Carhart concluded that his results did not support the existence of skilled or informed mutual fund managers, because any outperformance was captured by his expanded Fama-French model, which he called the Carhart Model. Fung and Hsieh [2001] also focused on momentum factors and applied them to hedge fund returns using ve momentum factors. The factors were generated from a look-back straddle trading strategy using options on future contracts from ve major asset classes. They argue that much of the previously unexplained variation in returns could be explained via systematic momentum-based strategies that were applied to major markets (bonds, currencies, commodities, interest rates, and equities). Burghardt et al. [2004] described the algorithms of two popular trend following systematic strategies used by Commodity Trading Advisors (CTA) and global macro hedge fund managersmoving average/crossover and range break-outand applied them to the listed futures contracts of ve major asset classes (bonds, currencies, commodities, interest rates, and equities). We use the Burghardt et al. [2004] break-out algorithm over a medium-term range to construct a risk-weighted portfolio on selected individual commodity future contracts, as described in their research note, to arrive at a single momentum factor that we dene as TREND. We believe the outperformance of our breakout trend following factor is likely due to hedge fund managers, especially CTA managers, employing futures contracts, rather than options, when executing a trend-following strategy. Our extension of the Fama-French model uses the full ve-factor model and applies it to hedge fund managers, focusing in particular on the equity-oriented hedge fund strategies. Our objective is to remove the systematic factors (market beta as dened by Fama-French [1993] and alternative betas as described by Fung and Hsieh [2004]) that drive returns. We therefore isolate the presence of managerial
Literature Review
The use of multi-factor return estimation models in hedge fund research (Fung and Hsieh [2004]) expands primarily on Fama and French [1993] results that ve common factors, of which three are equity factors and two are bond factors, seem to explain the average returns on portfolios of stocks and bonds with a high degree of ecacy. These factors are: 1) market risk premium (R MR F); 2) rm size (SMB); 3) book-to-market equity (HML); 4) bond maturity (TERM); and 5) bond default risk (DEF). [Detailed denitions are provided in Appendix A.] Their time-series regressions use excess returns (stock or bond returns minus the one-month U.S. Treasury bill rate) on both the dependent and independent variables. They nd the intercept term to be close to zero after regressing only the three equity factors against portfolios of stocks, thereby capturing nearly all of the common risk factors. They also obtain similar results, albeit with higher R 2 values, when regressing only the two bond factors against portfolios of corporate bonds. Taking all of the factors together,3 regressions of the Fama-French ve-factor model versus excess stock returns have very high explanatory power, as evidenced by an R 2 value of approximately 90 percent (ranging from 87 percent to 97 percent across various 25-stock portfolios that were analyzed).4 Cremers et al. [2010] investigate possible shortcomings of this seminal model, mainly as it relates to the value bias of the Fama-French model due to the disproportionate weight of its factors on small value stocks.
our results suggest that there are at least three stock-market factors and two term-structure factors in returns. Stock returns have shared variation due to the three stock-market factors, and they are linked to bond returns through shared variation in the two termstructure factors Source: Fama-French [1993], p. 6.
3 4
Fama and French [1993], Table 7a, p. 29.
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skill (the unexplained intercept term of the regression) under unique equity-market correlation regimes. By introducing a dichotomous equity correlation factor, we endeavor to decompose further any residual alpha based on the existence of unique equity correlation regimes. We do not create unique customized models for each of the four HFRI hedge fund strategy classications as proposed by Fung and Hsieh [2004]. Instead, we use a single, unied model consisting of seven factors, broken down into three major categories: 1) the ve original Fama-French [1993] factors, of which three are equity and two are bond factors; 2) one momentum factor similar to the combination of the ve momentum factors used by Fung and Hsieh [2001] and as inuenced by Carhart [1997]; and 3) one correlation factor that we introduce de novo as the focus of this article. We then apply the proposed seven-factor model across each of the four HFRI hedge fund strategy classications to be consistent in our investigation of whether correlation has any eect on the four HFRI major hedge fund strategy classications. Because certain hedge fund strategies, Macro in particular, trade in markets other than equities and debt, we also tested for factor exposure to other major commonly traded asset classes, such as commodities, currencies, volatility, and the spot price of gold. Note that these factors are not momentum factors, as previously described, but are rather based on the returns of representative indices of these major asset classes. In summary, we nd that introducing these factors, at best, only marginally improves the explanatory power of our proposed model. In particular, it appears that commodity factors, as represented by the Goldman Sachs Commodity Index and the spot price of gold, add marginal explanatory power to two strategies, Relative Value and Macro, but only by increasing adjusted R 2 values by 2 percent to 3 percent points. (Appendix C provides details of the results.) Therefore, we exclude these additional factors and propose a more parsimonious general model that can be applied to each of the four major HFRI hedge fund strategies. The literature on the interaction between fund performance and equity cross-sectional variation and correlation is quite extensive. Groth and Thstrm [2009] investigate the time-varying nature of correlation among asset classes and apply asymmetric dynamic conditional correlation and dynamic equicorrelation models to the returns of a set of Commodity Trading Advisors (CTAs). The results show that these methods have no advantage over a simple correlation
approach and have no evidence of predictability. We also observe the time-varying nature of cross-sectional equity correlation in the form of three dierent correlation regimes. Bali and Engle [2009] decompose the aggregate stock market portfolio into 10 book-to-market portfolios and then estimate a cross-sectionally consistent slope coecient on the conditional covariance matrix using a multivariate GARCHin-mean framework. They nd evidence that the time-varying conditional covariances can explain the value premium because the average risk-adjusted return dierence between value and growth portfolios is economically and statistically insignicant within the conditional ICAPM framework. This nding is similar to our observation that equity correlations are time varying and aect the excess returns of hedge fund strategies based on the prevailing correlation regime. We nd the work of De Silva et al. [2001] and Connor [2009] most relevant to the undertaking of our article. In their study on the eect of equity-market dispersion (cross-sectional variation) on the alpha characteristics of actively managed mutual funds, De Silva et al. conclude that over the period of 1991 to 2000, on average, cross-sectional variation-corrected alphas are signicantly lower than raw alphas for actively managed mutual funds. Our ndings corroborate this observation, with alpha being reduced upon the introduction of our correlation factor. They also acknowledge that heteroskedasticity is a problem associated with calculating the alphas, leading to statistical ineciency (i.e., non-constant standard errors). They adjust for the heteroskedasticity implicit in non-constant levels of return dispersion using average annual cross-sectional variation in the broad equity market, as represented by the CRSP stock market data set. We also correct for heteroskedasticity using the White [1980] method. Connor expands the work of De Silva et al. to hedge funds. Using CRSP data from 1994 to 2004, Connor nds a positive relationship between market dispersion and the risk-adjusted returns of hedge funds. Connor suggests that market dispersion has a role as an additional risk factor for equity-based hedge funds. Based on our prior research, Chen et al. [2008], we found that the use of regime-based analysis can reveal risk factors that otherwise are not apparent using long-term historical regression analysis. We found evidence of signicant performance dierentials for distressed hedge fund managers when analyzed across three unique states of the credit cycle.
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This combination of antecedent literature, coupled with our prior work, leads us to pursue the hypothesis that alpha for equity-oriented hedge fund strategies may be aected dierently by dispersion-related factors under unique regimes. We propose that by identifying correlation regimes, the otherwise-average alpha can be disaggregated into positive or negative values depending on regime. Finally, in their inuential article on the performance attribution and style analysis of hedge funds, Fung and Hsieh [1998] proposed a 12-factor model consisting of nine asset classes and three dynamic trading strategies that disaggregated what had commonly been referred to as alpha into alternative betas. However, the Fung and Hsieh work did not include more narrow factors such as equity-market correlation and did not approach the analysis from a regime-specic perspective. Buraschi et al. [2012] extend the Fung and Hsieh seven-factor model by adding a return-based and tradable correlation swap factor. They nd that the introduction of this factor adjusts excess return by 4 percent to 8 percent per annum. Our ndings corroborate the eect of diminished excess return during high correlation regimes. Furthermore, after replicating the Fung and Hsieh [2004] seven-factor analysis using factor data downloaded from their website and additional data supplied by the authors, we nd the predictive power of our proposed model to be materially better, across each of the four major HFRI hedge fund strategy classications, as represented by the higher adjusted R 2 values in Exhibit 1.5 (Appendix D provides details of the analysis.) Table 1: Adjusted R2 Values Comparison Table
Fung & Hsieh Seven-Factor Model (2004) Proposed Model Difference in Adj-R 2 (Proposed ModelF&H)
Data Methodology
We construct a data set composed of realized correlations of the constituents of the S&P 500 equity index over the period of January 1990 to December 2010. On a monthly basis, we construct a 500 x 500 correlation matrix and subsequently compute the average correlation among the pairs of matrix constituents over the following multiple trailing periods: 6-month, 12-month, 18-month and 24-month (e.g., the trailing 6-month period is the average of the monthly correlations from time t, to time t-5). We also analyzed implied correlation. We use the CBOE6 S&P 500 Implied Correlation Index as the data set for implied correlations, which measures the expected average correlations of the S&P 500 index using option prices and their respective implied volatilities (implied correlation computation performed by CBOE). The CBOE monthly data is only available over a shorter period, from 2007 to 2010. We also looked at cross-sectional variationthat is, contemporaneous stock dispersion, as an alternative factor that might better explain or reject our hypothesis. We compute monthly cross-sectional variation7 using the 500 individual stocks that comprise the S&P 500 index. The S&P 500 cross-sectional variation data is from 1990 to 2010. Exhibit 3 plots the three correlation variables over time. With the proposed model, the results using implied correlation and cross-sectional variation as independent variables are inferior as compared to the realized correlation factor based on adjusted R 2 values and the number of statistically signicant coecients. We also excluded the CBOE S&P 500 Implied Correlation factor due to its short history of four years. With respect to selecting the appropriate trailing period for computing realized correlations, we chose trailing 6-month periods for the purposes of the analysis because not only did it have the highest number of statistically signicant factors, but it also provides a quicker response to changes in the correlation environment.
1990 to 2010 HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro 69.4% 64.9% 32.7% 23.2% 75.7% 77.8% 56.3% 38.7% +6.3% +12.9% +23.6% +15.5%
Source: http://faculty.fuqua.duke.edu/~dah7/HFData.htm (David A. Hsiehs Hedge Fund Data Library), data is from 1994-2010. We thank Dr. David A. Hsieh for providing the data prior to 1994, which was not available on the website.
5
6 7
Chicago Board Options Exchange.
Cross-sectional variation is calculated as the standard deviation of the returns of S&P 500 constituents at the end of each month.
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Monthly realized correlations between two stocks are calculated as follows: i,j,n = 1 nr 1
r
Display 3: S&P 500 Correlation Variables Over Time

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
ri ri r j rj (1) r r
i
)( )
j
nr = 6 for calculating trailing 6-month correlation; r, r , is the monthly return, average monthly return, and
i i ri j j rj
return standard deviation of stock i over nr months, respectively; r, r , is the monthly return, average monthly return, and return standard deviation of stock j over nr months, respectively. Average trailing 6-month correlations are calculated as follows: avg,n =
n i=2 i-1 j=1
S&P 500 Trailing 6M Average Correlations S&P 500 Cross Sectional Variation CBOE S&P 500 Implied Correlation Index
i,j,n
n (n 1) 2
(2)
n = 500 for the number of member stocks in the S&P 500 Index. The mean realized correlation of the returns of the constituents of the S&P 500 over this period was 19.7 percent, with one standard deviation equal to 11.5 percent (See Exhibit 2.) Display 2: S&P 500 Trailing Six-Month Realized Correlation
70% 60% 50% 40% 30% 20% 10% 0% 1990 + = 31.3% = 19.7%
We assess the performance characteristics of hedge fund strategies using the return data of Hedge Fund Research, Inc.s HFRI indices. We obtained data for the three Fama-French equity factors (R MR F, SMB, HML) from the Kenneth R. French Data Library at the Tuck School of Business at Dartmouth University.8 However, because the two Fama-French bond factors (TERM, DEF) were not available from this source, we created proxies for each of the two bond factors, which we dene as: DURATION as a proxy for the TERM factor, the monthly dierence in return between (1-2): 1) Bank of America Merrill Lynch U.S. Treasuries 710yr Index; and 2) Citigroup 1-Month U.S. Treasury Bill Index. CREDITas a proxy for the DEF factor, the monthly dierence in return between (1-2): 1) Bank of America Merrill Lynch U.S. 50% Corp & 50% HY Index, which is a 50% weighting of the Bank of America Merrill Lynch U.S. Corporate Bond Index (rated Aaa to Baa3 by Moodys) and a 50% weighting of the Bank of America Merrill Lynch High
= 8.2% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ data_library.html.

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Yield Master II Index (rated Ba1 to C by Moodys);9 and 2) Bank of America Merrill Lynch U.S. Treasuries 7-10yr Index. [Appendix A provides detailed presentation of methodology.]
R HFRI_Strategy,t R F,t : Dierence in returns between the HFRI Strategy Index Return; and the risk-free rate (Citigroup 1-Month U.S. Treasury Bill Index); R M,t R F,t : Dierence in returns of all non-nancial stocks in the NYSE, AMEX, and NASDAQ; and the risk-free rate; Dierence in returns between high book-to-market equity stock portfolios; and low book-to-market equity stock portfolios; Dierence in returns between small-stock portfolios; and large-stock portfolios; Dierence in returns between longduration U.S. Treasury bonds (BofA Merrill Lynch U.S. Treasuries 710yr Index); and the risk-free rate; Dierence in returns between corporate bonds (BofA Merrill Lynch U.S. 50% Corporate & 50% High-Yield Index); and long-duration U.S. Treasury bonds; Momentum Factor: Range Break-Out Strategy that compares the current market price with the highest and lowest market prices over the past mid-term period. Rule: If price > mid-term period high, go long; If price < mid-term period low, go short. The rule is applied to the prices of the following major futures markets: bonds, currencies, commodities, interest rates, and equities. See Appendix E for a detailed description of futures markets used. Binary variable indicating a High Correlation environment; Binary variable indicating a Low Correlation environment; Error term, N(0,1)
Methodology and Model Specification

The model proposed herein is a multi-factor regression model designed to place an observation in one, out of three, mutually exclusive correlation regimes. Correlation regime demarcations are based on +/ 1 standard deviation () distances from the long-term mean (). The three regimes are dened as: 1) Low Correlation {1 x ( )} 2) High Correlation {( + ) x +1} 3) Normal Correlation {( ) < x < ( + )} where x is the level of realized correlation. The proposed model relies on the use of dichotomous variables to isolate the three mutually exclusive correlation regimes and assigns the incremental alpha contribution via the respective regime-specic coecients. The degree, or level, of realized correlation of the S&P 500 is hypothesized to enable and inuence alpha. The model (Proposed Model) is specied using the panel regression function in Equation (3), for month t : R HFRI_Strategy,t R F,t = C0 + C1 (R M,t R F,t ) + C2

HMLt:
SMBt: DURATIONt:
CREDITt:
TRENDt:
HMLt + C3 SMBt + C4 DURATIONt+ C5 CREDITt+ C6 TRENDt C7 IHI_Correl,t + C8 ILO_Correl,t + t (3) IHI_Correl,t: ILO_Correl,t: t:
For the period of 1997 to 2010, we use the Bank of America Merrill Lynch US 50% Corporate & 50% High Yield Index. Because pre-1997 data is not available for this index, for the period 19901997, we construct an index of returns based on a 50% weighting to the Bank of America Merrill Lynch US Corporate Index (Bloomberg ticker C0A0) and a 50% weighting to the Bank of America Merrill Lynch High Yield Master II Index (Bloomberg ticker H0A0).
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The Proposed Model decomposes alpha using three unique coecients. The rst alpha coecient (C0) is the standard intercept term of the regression model (i.e., the unexplained portion). The other two alpha coecients (C7 and C8) are
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correlation-related dichotomous variables, which have a value of either 0 or 1, depending on the correlation state. Therefore, when either the C7 or C8 coecient is multiplied by the value of its respective binary variable, the eect is to add or subtract from the intercept term (C0)causing it to shift up or down accordingly, as shown by Equation (4). AlphaTotal =C0 + C7 + C8 (4) C0 : Intercept for regression model C7 : Coecient for IHI_Correl C8 : Coecient for ILO_Correl The value of the HI_Correl dichotomous variable (IHI_Correl) is set to 1 when the trailing 6-month realized correlation is one standard deviation above its historical mean; otherwise it is set to 0. The value of the LO_Correl dichotomous variable (ILO_Correl) is set to 1 when the trailing 6-month realized correlation is one standard deviation below its historical mean; otherwise it is set to 0. The Normal Correlation regime is represented by the condition where the value of the LO_Correl and the value of the HI_Correl independent variables are both equal to 0, thus having no eect on the regression intercept term (C0). Therefore, the use of the proposed mutually exclusive dichotomous variables allows for isolation of the incremental alpha contribution, based on specic correlation regimes. Please refer to Equation (4.)
(Equity Hedge, Event-Driven, and Relative Value) and use the White [1980] method to adjust the data accordingly. The regression results shown throughout the article include Whites heteroskedasticity-consistent estimator on the standard error.
General Observations
Equity Hedge exhibits the highest equity beta12 at +0.48, while Relative Value exhibits the lowest equity beta at +0.04. Event-Driven and Relative Value exhibit the highest bond betas13 at +0.62 and +0.68, respectively. Event-Driven exhibits the highest overall combination of equity and bond betas, at +0.34 and +0.62, respectively. Macro exhibits the highest exposure to the momentum beta14 at +0.33. Equity Hedge is the strategy that most benets from a low correlation environment, with an incremental alpha of +0.71% a month, while Event-Driven is the strategy that is most adversely aected by a high correlation environment, with an incremental alpha of 0.91 percent a month. Relative Value is impacted by correlation, but the impact from the two correlation regimes is opposite and nearly equal, with an incremental alpha of 0.42 percent a month during the high correlation regime and +0.41 percent a month during the low correlation regime. Therefore, the overall impact to
The Durbin-Watson statistics for each of the four hedge fund strategies are shown below (value range of 0 to 4). A value of 0 means perfect positive serial correlation. A value of 4 means perfect negative serial correlation. A value of 2 means no autocorrelation. Generally, a value less than 1 is a cause for concern, which is not the case for any of the data sets. HFRI Equity Hedge = 1.72 HFRI Event-Driven = 1.76 HFRI Relative Value = 1.66 HFRI Macro = 1.72
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Results
As shown in Exhibit 4, Equity-Hedge, Event-Driven, and Relative Value exhibit the best ts, with robust adjusted R 2 values of 76 percent, 78 percent, and 56 percent, respectively. Although the applicability of the model for the Macro strategy is not as eective on a relative basis, it has considerable explanatory power on an absolute basis, with an adjusted R 2 value of 39 percent. In order to assess further the veracity of the models specication, we also test for the presence of autocorrelation and heteroskedasticity in the error terms. Using the DurbinWatson [1950, 1951]10 test for autocorrelation, we nd no material presence of autocorrelation for any of the four hedge fund strategies. Using the Breusch-Pagan [1979]11 test for heteroskedasticity, we do in fact nd the presence of heteroskedasticity in three of the four hedge fund strategies
The P-values for the Breusch-Pagan test of the four hedge fund strategies are shown below: Null Hypothesis (H 0): Homoskedasticity Alternative Hypothesis (H 1): Heteroskedasticity HFRI Equity Hedge = 0.02 (P-value); reject H 0 HFRI Event-Driven = 0.00 (P-value); reject H 0 HFRI Relative Value = 0.00 (P-value); reject H 0 HFRI Macro = 0.56 (P-value); support H 0
11
Applies only to statistically significant equity coefficients (Pvalue 0.05).

12
Applies only to statistically significant bond coefficients (Pvalue 0.05).

13
Applies only to statistically significant momentum coefficient (P-value 0.05).

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Exhibit 4: Proposed Model Specifications

01/1990-12/2010 Estimate Coefficient Intercept C0 R M R F C1 HML C2 SMB C3 DURATION C4 CREDIT C5 TREND C6 HI_Correl C7 LO_Correl C8
HFRI Equity Hedge Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF* HFRI Event Driven Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF* HFRI Relative Value Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF* HFRI Macro Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF* 0.36 0.13 2.80 0.01 38.7% 0.16 0.03 5.62 0.00 0.64 -0.05 0.03 -1.61 0.11 1.57 0.10 0.03 3.12 0.00 0.00 0.36 0.09 4.24 0.00 238 0.19 0.08 2.44 0.01 0.33 0.04 9.13 0.00 -0.59 0.32 -1.85 0.06 0.63 0.39 1.61 0.11 0.43 0.06 6.86 0.00 56.3% 0.04 0.02 2.26 0.02 0.00 0.02 0.02 1.04 0.30 1.67 0.03 0.02 1.35 0.18 0.01 0.24 0.05 4.49 0.00 238 0.44 0.06 7.47 0.00 0.00 0.02 -0.04 0.96 -0.42 0.21 -2.04 0.04 0.41 0.13 3.17 0.00 0.51 0.07 7.60 0.00 77.8% 0.21 0.02 10.96 0.00 0.00 0.03 0.02 1.51 0.13 1.76 0.13 0.02 7.24 0.00 0.04 0.20 0.06 3.64 0.00 238 0.42 0.05 7.62 0.00 0.09 0.02 3.97 0.00 -0.91 0.23 -3.98 0.00 0.28 0.14 2.01 0.04 0.42 0.09 4.70 0.00 75.7% 0.37 0.03 14.60 0.00 0.01 -0.08 0.03 -2.74 0.01 1.68 0.19 0.03 5.83 0.00 0.01 0.10 0.07 1.35 0.18 238 0.23 0.08 2.83 0.00 0.13 0.04 3.20 0.00 -0.24 0.31 -0.77 0.44 0.71 0.23 3.09 0.00
Notes: *Values from left to right represent: Adjusted R 2; Breusch-Pagan test for heteroskedasticity (P-value); Durbin-Watson test for serial correlation (statistic); Durbin-Watson test for serial correlation (P-value); Degrees of Freedom. Bold indicates P-value <0.05.
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Relative Value from correlation is approximately zero over the long-term. On the other hand, Macro is not aected by equity correlation regimes, given the lack of statistical signicance to the correlation factor. Our overall observation is that the equity-oriented strategies (Equity Hedge and Event-Driven) are most impacted by equity correlation regimes. The sign of the HI_Correl alpha coecient is negative across all of the four major hedge fund strategies, indicating that a high correlation environment detracts from hedge fund alpha. We believe that low CS correlation should allow for unusual prots, but high correlation should not necessarily cause unusual losses, although the sign of the coecients suggest they may occur. However, this coecient is only statistically signicant for the Event-Driven and Relative Value strategies. The negative sign is not implied by our hypothesis, but the lack of signicance for the other two strategies (Equity Hedge and Macro) is consistent with the hypothesis. The signicance and magnitude of the negative alpha for Event-Driven strategy, in particular, suggests that market conditions adversely aect the strategy when CS correlations are high. Conversely, the sign of the LO_Correl alpha coecient is positive across all of the strategies, indicating that a low correlation environment does in fact lead to additional alpha. The LO_Correl alpha coecient is statistically signicant for three out of the four strategies (the exception is Macro), with the range of the coecient between +0.28 and +0.71. The value of the LO_Correl alpha coecient is statistically signicant and of highest value for the Equity Hedge strategy, at +0.71 percent a month, more than doubling its average excess return. Event-Driven exhibits a statistically signicant correlation variable under both high and low correlation environments, with a large adverse impact on alpha during the high correlation environment (HI_Correl at 0.91) and a positive impact on alpha during the low correlation environment (LO_Correl at +0.28). These observations, coupled with the highest adjusted R 2 values being observed for the equity-oriented strategies, at 76 percent for Equity Hedge and 78 percent for Event-Driven, support our hypothesis that a low correlation environment improves the odds of generating additional alpha through various manager-based investment decisions (e.g., security selection, sector rotation, leveraging), and vice versa. The Macro strategy is not aected by the level of S&P 500 correlation, as indicated by the lack of statistical signicance
for both the HI_Correl and LO_Correl factors. This nding makes intuitive sense because macro managers are generally not associated with security selection skills. Macro managers typically trade across multiple asset classes, including equities, xed-income, currencies, and commodities. As such, one would expect the strategy to be more aected by cross-market correlations, because managers typically take directional and relative value bets across various asset classes, versus focusing on security selection. HFRI Equity Hedge Over the analyzed period, we observe the following statistically signicant coecients: the alpha-intercept term (R M R F), HML, SMB, CREDIT, TREND, and LO_Correl. The alpha-intercept coecient is +0.42% a month, the beta to the equity market risk premium (R M R F) is +0.37, the beta to the HML factor is 0.08 (indicating a negligible long exposure to growth stocks and short exposure to value stocks), the beta to the SMB factor is +0.19 (indicating a long exposure to stocks with small capitalizations and short exposure to stocks with large capitalizations), the beta to the CREDIT factor is +0.23 (indicating exposure to corporate bond default risk). The beta to the TREND factor is +0.13 (indicating exposure to momentum trading strategies). The High Correlation regime has no eect on alpha. However, during the Low Correlation regime, an additional +0.71 percent a month of alpha is generated, as indicated by the LO_Correl variable, which would be added to the intercept term to generate total alpha of +1.13 percent a month. Equity Hedge is a pure equity-oriented strategy. However, the analysis reveals exposures to both the equity and bond FamaFrench factors, with the equity factors clearly dominating. The strategy exhibits: 1) a collective beta to the three Fama-French equity factors of +0.48 on an absolute basis; and 2) a collective beta to the two French-Fama bond factors of +0.23. Because the CREDIT bond factor has a 50 percent high-yield component, which has embedded beta to the equity markets, it is not surprising to observe the co-existence of both the equity and bond factors for the Equity Hedge strategy.15
Correlation between Citi High-Yield Bond Index and S&P 500 is 56.84%, from 19872010 Source: Altman, E.I. and B.J. Kuehne. Special Report on The Investment Performance and Market Dynamics of Defaulted Bonds and Loans: 2010 Review and 2011 Outlook. New York University Salomon Center Leonard Stern School of Business, 2011, p. 21)
15
22
HFRI Event-Driven We observe the following statistically signicant coecients: the alpha-intercept term, (R M R F), SMB, DURATION, CREDIT, TREND, LO_Correl, and HI_Correl. The alpha-intercept coecient is +0.51 percent a month, the beta to the equity market risk premium (R M R F) is +0.21, the beta to the SMB factor is +0.13, the beta to the DURATION factor is +0.20 (indicating modest exposure to interest rate risk), the beta to the CREDIT factor is +0.42. The beta to the TREND factor is +0.09. During the High Correlation regime, the alpha contribution is 0.91 percent a month, as indicated by the HI_Correl variable, which would result in total alpha of 0.40 percent a month. However, during the Low Correlation regime, an additional +0.28 percent a month of alpha is generated, as indicated by the LO_Correl variable, which would be added to the intercept term to generate total alpha of +0.79 percent a month. Event-Driven is a combination of equity-oriented and xed-incomeoriented strategies, and the Fama-French factor exposures conrm this, because the strategy exhibits relatively high equity and bond betas: 1) the collective beta to the three Fama-French equity factors is +0.34; and 2) a collective beta to the two French-Fama bond factors of +0.62. HFRI Relative Value We observe the following statistically signicant coecients: the alpha-intercept term, (R M R F), DURATION, CREDIT, LO_Correl, and HI_Correl. The alpha-intercept coecient is +0.43% a month, the beta to the equity market risk premium (R M R F) is +0.04. The statistically signicant Fama-French equity beta factors collectively represent a beta of +0.04, which is the smallest, indicating Relative Value to be the most hedged, with respect to equity markets, among the four major HFR hedge fund strategies. This is most likely a result of the dominant Convertible Arbitrage component of the Relative Value strategy, which involves both equity and xed-income securities and is typically managed to be equity marketneutral. We also observe a beta of +0.24 to the DURATION factor and a beta of +0.44 to the CREDIT factor, making it the strategy most exposed to bond markets. Note, for investors investing in this category, many managers claim to hedge interest rate and credit risk. This result suggests they do not do a very good job of removing these risks, although they
seem to benet from it, on average. The beta to the TREND factor is not statistically signicant. During the High Correlation regime, the alpha contribution is 0.42 percent a month, as indicated by the HI_Correl variable, which would result in total alpha being close to zero. However, during the Low Correlation regime, an additional +0.41 percent a month of alpha is generated, as indicated by the LO_Correl variable, which would be added to the intercept term to generate total alpha of +0.84 percent a month. Relative Value is a xed-income oriented strategy, and the Fama-French factor exposures conrm this, because the strategy exhibits: 1) a collective beta to the three Fama-French equity factors of near-zero, at +0.04; and 2) a relatively large collective beta to the two French-Fama bond factors of +0.68. The fact that the strategys total alpha is impacted by equity market correlation is not an intuitive relationship. However, this may indicate cross-correlation between xed-income markets and equity markets during non-normal periods. In other words, equity market correlation may be correlated to xed-income correlation at the more extreme cases. HFRI Macro We observe the following statistically signicant coecients: the alpha-intercept term, (R M R F), SMB, DURATION, CREDIT, and TREND. The alpha-intercept coecient is +0.36 percent a month. The beta to the equity market risk premium (R M R F) is +0.16, the beta to the SMB factor is +0.10. We also observe a beta of +0.36 to the DURATION factor and a beta of +0.19 to the CREDIT factor. The beta to the TREND factor is +0.33 and is the highest among the four major hedge fund strategies, conrming that Macro funds pursue such strategies per its denition. HFR denes the Macro strategy as one that trades a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, xed income, hard currency and commodity markets. Correlation regimes do not aect the Macro strategy, as both the LO_Correl and HI_Correl variables are not statistically signicant. Therefore, the total alpha of the strategy is equal to the alpha-intercept term of +0.36 percent a month regardless of correlation regime.
23
Exhibit 5: Regime-Dependent Hedge Fund Alphas

Coefficient Intercept Normal Correlation Regime AlphaTotal C0 Hi_Correl C7 Lo_Correl C8
HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro Average* High Correlation Regime HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro Average* Low Correlation Regime HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro Average* Difference in Correlation Regimes (Low-Normal) HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro Average*
0.42 0.51 0.43 0.36 0.43 0.18 -0.40 0.00 -0.23 -0.20 1.13 0.79 0.83 0.99 0.92 0.71 0.28 0.41 N/A 0.46
0.42 0.51 0.43 0.36 0.43 0.42 0.51 0.43 0.36 0.43 0.42 0.51 0.43 0.36 0.43 Improvement Multiple 2.68x 1.55x 1.95x N/A 2.06x -0.24 -0.91 -0.42 -0.59 -0.67 0.71 0.28 0.41 0.63 0.46
Notes: *Average includes only statistically significant coefficients. 1) Bold indicates P-value <0.05. 2) Coefficient units are % per month (i.e., 0.42 = 0.42% of alpha per month). 3) Improvement Multiple = AlphaTOTAL(Low Correlation)/Alpha (Normal Correlation). 4) White-adjusted standard errors.
24
Correlation Regime-Dependent Alpha

The intercept term (C0) is the long-term alpha of the strategy under the Normal Correlation regime. The HI_Correl (C7) and LO_Correl (C8) coecients shift the long-term alpha (up or down) depending on the prevailing equity-market correlation environment. In other words, these dichotomous variables represent the marginal alpha contribution to the strategy based on the prevailing correlation regime. Exhibit 5 shows that, on average, total alpha (AlphaTOTAL) is statistically signicant and highest during the Low Correlation regime (+0.92 percent a month). The alpha dierential between the Low Correlation and Normal Correlation regimes, on average, represents a meaningful increase of +0.46 percent a month. The greatest beneciary of this correlation regime dierential is the equity-oriented strategy, Equity Hedge, adding +0.71 percent of alpha a month, while Macro is unaected by correlation regimes. (Refer to Appendix F for time periods associated with dierent correlation regimes.) Persistence Test Finally, we test for the persistence of the equity correlationfactor time series. Persistence indicates the general strength of continuation of the direction of the series. We measure persistence by calculating the Hurst Exponent (HE) using a technique described by Qian and Rasheed [2004] and nd the value of the Hurst Exponent to be 0.69, which indicates a trendreinforcing series. In other words, it is possible for hedge fund managers to take advantage of this phenomenon and attempt to predict correlation trends with some degree of condence.16
Conclusion
As more investors turn to hedge funds as a potential source of alpha, it is essential to select the proper performance attribution model in order to discern alpha from beta. By arriving at the proposed single, unied model, we not only have the ability to better detect alpha but can also compare alpha on a consistent basis across dierent hedge fund strategies. Most importantly, we believe the use of dichotomous variables, to isolate CS equity-market correlation regimes, reveals factor exposures that would otherwise not be detectable using a continuous variable. The proposed model can be used as a practical tool for hedge fund allocators, particularly when applied to equity-oriented hedge fund strategies. We analyze the eect of realized CS correlations of the S&P 500 over the period of 1990 to 2010 and propose a panel regression model that extends the Fama-French ve-factor model by adding a momentum factor and a CS equity-market correlation factor. The model achieves a robust in-sample model t with adjusted R 2 values of 76 percent for Equity Hedge, 78 percent for Event-Driven, 56 percent for Relative Value, and 39 percent for Macro. Most interestingly, we nd strong empirical evidence of idiosyncratic stockpicking skills in equity-oriented hedge fund strategies during the Low Correlation state, as evidenced by an absolute increase in alpha of +0.71 percent a month for Equity Hedge increasing alpha by a multiple of 2.7x. Although bespoke strategy-specic performance attribution models may likely yield higher explanatory power, the general model proposed herein is robust and applicable to the four major hedge fund strategies of HFR. Therefore, it is a practical model that provides a consistent single benchmark for measuring hedge fund alpha. Finally, because equity market CS correlation has varying degrees of impact on hedge fund alpha, by identifying performance drivers under dierent equity-market correlation regimes, investors may gain an edge in maximizing alpha through active rebalancing among the various hedge fund strategies.
HE 0.5 is a random series; HE > 0.5 is trend reinforcing series. The value of HE is between 0 and 1.
16
25
Appendix A
Cross-Sectional Variation Source: Deardors Glossary of International Economics, Alan V. Deardor, University of Michigan, http://www-personal.umich. edu/~alandear/glossary/c.html. The dierences in an economic variable that exist at a point in time comparing dierent economic units, such as consumers, rms, industries, or countries. It is often used to seek evidence of causes of trade, growth, and other behaviors and contrasts with time series variation. Throughout this article, we represent cross-sectional variation as the standard deviation of the population, as shown below: sn =
options on the components of that index, therefore, becomes a measure of the markets expectation of the future correlation of the index componentsthe implied correlation of the index. The signicance of implied correlation is that it reects changes in the relative premium between index options and single-stock options, providing trading signals for a strategy known as volatility dispersion (correlation) trading. Commonly, a long volatility dispersion trade is characterized by selling at-the-money index option straddles and purchasing at-the-money straddles in options on index components. One interpretation of this strategy is that when implied correlation is high, index option premiums are rich relative to single-stock options. Therefore, it may be protable to sell the rich index options and buy the relatively inexpensive equity options. Beginning in July 2009, CBOE began disseminating daily values for the CBOE S&P 500 Implied Correlation Index. The CBOE disseminated two indexes tied to two dierent maturitiesJanuary 2010 (ICJ ) and January 2011 (JCJ ). Both ICJ and JCJ are measures of the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX. Each day, CBOE publishes the index values four times a minute, and provide on its website the market value weights of each of the top 50 stocks in the S&P 500 Index. Historical information dating back to 2007 is also available.
DERIVATION OF THE CBOE S&P 500 IMPLIED CORRELATION INDEX
n i=1
(xi x )2 n
where xi are the observed values and x is the mean value of the observations. CBOE S&P 500 Implied Correlation Index Source: www.cboe.com. Option prices reect the risk of a stock or stock index. The level of risk conveyed by option prices is often referred to as implied volatility. The implied volatility of a single-stock option simply reects the markets expectation of the future volatility of that stocks price returns. Similarly, the implied volatility of an index option reects the markets expectation of the future volatility of that indexs price returns. However, index volatility is driven by a combination of two factors: the individual volatilities of index components and the correlation of index component price returns. Intuitively, one would expect that the implied volatility of an index option would rise with a corresponding change in the implied volatilities of options on the index components. Yet, there are times when index option implied volatility moves and there is no corresponding shift in implied volatilities of options on those components. This outcome is due to the markets changing views on correlation. The relationship between the implied volatilities of options on an index and the implied volatilities of a weighted portfolio of
An index measures the value of a diversied holding of assets. In the case of a stock index such as the S&P 500, the assets are 500 individual stocks that are among the largest and most actively traded in the world. Generally, the variance of such an index is given by: 2 = Index where: i, j = Volatility of ith, jth index components wi, wj = Weight of ith, jth index components ij = Pair-wise correlation of index components
i=1
w2 2 + 2 i i
N1 N
w w
i=1 j>1 i j i j
ij
(2)
26
For the purpose of calculating the CBOE S&P 500 Implied Correlation Index, the weight of an index component is determined as follows: wi = PiSi 50 i=1 PiSi
Appendix B
Proposed Model With Additional Momentum Factors To test for the ecacy of the momentum factors, as described by Fung & Hsieh [2001], we substituted our TREND momentum factor with their momentum factors: 1) Bond Trend; 2) FX Trend; and 3) Commodity Trend to our proposed Model. Two of these three factors (FX Trend and Commodity Trend ) are statistically signicant, but only for Macro. By contrast, our Proposed Model nds the TREND momentum to be statistically signicant for the Equity Hedge, Event-Driven and Macro strategies.
where: Pi = Price of the ith index component Si = Float-adjusted shares outstanding of the ith index component The index is designed to reect the market-capitalization weighted average correlation of the Index components, Average. As such, Equation (2) can be simplied and solved for Average:
Average = 2
w ww
2 Index
N-1 i=1 N i=1 2 i j 2 i N j>i i i
27
Exhibit B1: Proposed Model with Three Additional Momentum Factors from Fung and Hsieh
01/1990-12/2010 Estimate Coefficient Intercept C0 R M R F C1 HML C2 SMB C3 DURATION C4 CREDIT C5 Bond Trend C6 FX Commodity Trend Trend HI_Correl C7 C8 C7 LO_Correl C8
HFRI Equity Hedge Estimate Std. Error t value P-value adj-R /BP test P_value/DW test/DW test P_value/DoF
2
0.48 0.09 5.20 0.00 74.3%
0.37 0.03 14.11 0.00 0.03
-0.07 0.03 -2.40 0.02 1.70
0.19 0.03 5.73 0.00 0.01
0.11 0.07 1.59 0.11 236
0.20 0.08 2.44 0.01
0.00 0.01 -0.43 0.66
0.01 0.01 1.28 0.20
0.01 0.01 1.07 0.28
-0.16 0.31 -0.51 0.61
0.82 0.24 3.46 0.00
HFRI Event-Driven Estimate Std. Error t value P-value adj-R /BP test P_value/DW test/DW test P_value/DoF
2
0.53 0.07 7.61 0.00 76.5%
0.21 0.02 11.32 0.00 0.00
0.03 0.02 1.39 0.16 1.73
0.13 0.02 6.83 0.00 0.03
0.21 0.05 3.83 0.00 236
0.38 0.06 6.30 0.00
-0.01 0.00 -1.34 0.18
0.00 0.00 1.25 0.21
0.00 0.00 -0.62 0.54
-0.78 0.21 -3.68 0.00
0.34 0.14 2.46 0.01
HFRI Relative Value Estimate Std. Error t value P-value adj-R /BP test P_value/DW test/DW test P_value/DoF
2
0.41 0.06 6.46 0.00 56.6%
0.04 0.02 2.27 0.02 0.00
0.02 0.02 1.00 0.32 1.64
0.03 0.02 1.37 0.17 0.00
0.25 0.05 4.69 0.00 236
0.42 0.06 7.00 0.00 236
-0.01 0.01 -1.20 0.23
0.00 0.00 -0.85 0.39
0.00 0.00 0.03 0.98
-0.37 0.19 -1.92 0.05
0.41 0.13 3.19 0.00
HFRI Macro Estimate Std. Error t value P-value adj-R /BP test P_value/DW test/DW test P_value/DoF
2
0.50 0.14 3.49 0.00 30.1%
0.16 0.04 4.46 0.00 0.03
-0.04 0.04 -1.08 0.28 1.71
0.10 0.03 2.87 0.00 0.02
0.39 0.11 3.72 0.00 236
0.14 0.10 1.34 0.18
0.00 0.01 -0.33 0.74
0.03 0.01 3.19 0.00
0.02 0.01 2.19 0.03
-0.46 0.37 -1.26 0.21
0.94 0.38 2.48 0.01
28
Adjusted R2 Values Comparison Table

Fung & Hsieh Model Proposed Model Difference in Adj-R 2 (Proposed F&H)
1990-2010 HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro Note: Bold indicates P-value <0.05. 74.3% 76.5% 56.6% 30.1% 75.7% 77.8% 56.3% 38.7% +1.4% +1.3% -0.3% +8.6%
29
Appendix C
Exhibit C1: Testing for Additional Factors Beyond Equities and Bonds
Fama-French Five Factor Model Plus Correlation Factor
Intercept C0 R M R F C1 HML C2 SMB C3 DURATION C4 CREDIT C5 HI_Correl C6 LO_Correl C7
1/1990 to 12/2010 Estimate Coefficient
2
0.48 0.09 5.19 0.00 74.1%
0.37 0.03 13.98 0.00 0.02
-0.07 0.03 -2.41 0.02 1.72
0.19 0.03 5.75 0.00 0.02
0.10 0.07 1.48 0.14 239
0.18 0.08 2.29 0.02
-0.10 0.31 -0.31 0.76
0.79 0.24 3.35 0.00
2
0.55 0.07 7.84 0.00 76.4%
0.21 0.02 10.52 0.00 0.00
0.03 0.02 1.49 0.14 1.76
0.13 0.02 6.95 0.00 0.05
0.21 0.06 3.64 0.00 239
0.38 0.06 6.46 0.00
-0.81 0.23 -3.48 0.00
0.34 0.13 2.50 0.01
2
0.43 0.06 6.83 0.00 56.5%
0.04 0.02 2.26 0.02 0.00
0.02 0.02 1.04 0.30 1.66
0.03 0.02 1.34 0.18 0.01
0.24 0.05 4.49 0.00 239
0.44 0.06 7.23 0.00
-0.42 0.21 -2.03 0.04
0.41 0.13 3.21 0.00
2
0.50 0.14 3.49 0.00 22.9%
0.16 0.04 4.12 0.00 0.56
-0.04 0.04 -1.05 0.29 1.72
0.11 0.04 2.86 0.00 0.02
0.37 0.11 3.24 0.00 239
0.06 0.12 0.48 0.63
-0.21 0.40 -0.53 0.59
0.85 0.41 2.07 0.04
30
Exhibit C1: Testing for Additional Factors Beyond Equities and Bonds (continued)
Additional Macro Factor (GSCI)
S&P GSCI Total Return Index HI_Correl C6 C7
Intercept C0
R M R F C1
HML C2
SMB C3
DURATION C4
CREDIT C5
LO_Correl C8
2
0.45 0.09 5.10 0.00 77.4%
0.35 0.03 13.44 0.00 0.02
-0.08 0.03 -2.86 0.00 1.78
0.19 0.03 6.07 0.00 0.06
0.09 0.06 1.57 0.12 238
0.15 0.07 2.22 0.03
0.08 0.01 6.03 0.00
-0.04 0.27 -0.14 0.89
0.76 0.23 3.29 0.00
2
0.54 0.07 7.79 0.00 76.6%
0.21 0.02 10.43 0.00 0.00
0.03 0.02 1.38 0.17 1.75
0.13 0.02 6.86 0.00 0.03
0.20 0.06 3.62 0.00 238
0.37 0.06 6.22 0.00
0.01 0.01 1.31 0.19
-0.80 0.23 -3.50 0.00
0.33 0.14 2.42 0.02
2
0.41 0.06 6.71 0.00 58.6%
0.04 0.02 2.05 0.04 0.00
0.02 0.02 0.81 0.42 1.66
0.03 0.02 1.25 0.21 0.00
0.24 0.05 5.16 0.00 238
0.42 0.05 8.15 0.00
0.03 0.01 3.77 0.00
-0.40 0.19 -2.13 0.03
0.39 0.13 2.98 0.00
2
0.49 0.15 3.35 0.00 23.6%
0.15 0.04 3.94 0.00 0.23
-0.04 0.04 -1.20 0.23 1.70
0.10 0.04 2.79 0.01 0.01
0.36 0.12 3.10 0.00 238
0.04 0.12 0.34 0.73
0.03 0.02 1.62 0.10
-0.19 0.40 -0.47 0.64
0.84 0.41 2.02 0.04
31
Additional Macro Factor (DXY)
Intercept C0 R M R F C1 HML C2 SMB C3 DURATION C4 CREDIT C5 DXY C6 HI_Correl C7 LO_Correl C8
HFRI Equity Hedge Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Event-Driven Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Relative Value Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Macro Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF 0.47 0.14 3.36 0.00 24.0% 0.16 0.04 4.38 0.00 0.57 -0.03 0.04 -0.91 0.36 1.70 0.10 0.04 2.79 0.01 0.01 0.41 0.11 3.79 0.00 238 0.07 0.11 0.62 0.53 0.11 0.07 1.61 0.11 -0.11 0.40 -0.27 0.78 0.86 0.40 2.16 0.03 0.42 0.06 6.89 0.00 56.3% 0.04 0.02 2.26 0.02 0.00 0.02 0.02 1.04 0.30 1.66 0.03 0.02 1.35 0.18 0.01 0.25 0.05 4.75 0.00 238 0.44 0.06 7.27 0.00 0.00 0.02 0.09 0.93 -0.42 0.21 -2.00 0.05 0.41 0.13 3.20 0.00 0.54 0.07 7.84 0.00 76.5% 0.22 0.02 10.46 0.00 0.00 0.03 0.02 1.56 0.12 1.77 0.13 0.02 6.95 0.00 0.05 0.22 0.05 3.97 0.00 238 0.38 0.06 6.64 0.00 0.03 0.03 1.08 0.28 -0.78 0.23 -3.44 0.00 0.34 0.13 2.53 0.01 0.48 0.09 5.34 0.00 74.0% 0.36 0.03 13.50 0.00 0.01 -0.07 0.03 -2.42 0.02 1.72 0.19 0.03 5.78 0.00 0.02 0.10 0.07 1.37 0.17 238 0.18 0.08 2.29 0.02 -0.01 0.04 -0.29 0.77 -0.11 0.31 -0.35 0.73 0.79 0.24 3.34 0.00
32
Additional Macro Factor (VIX Level Change)
VIX Volatility Index (LC) C6
Intercept C0
R M R F C1
HML C2
SMB C3
DURATION C4
CREDIT C5
HI_Correl C7
LO_Correl C8
2
0.46 0.09 5.07 0.00 74.4%
0.40 0.03 11.65 0.00 0.01
-0.07 0.03 -2.40 0.02 1.75
0.19 0.03 5.76 0.00 0.03
0.12 0.07 1.75 0.08 238
0.21 0.08 2.55 0.01
0.06 0.04 1.57 0.12
-0.11 0.32 -0.34 0.73
0.76 0.24 3.19 0.00
2
0.54 0.07 7.80 0.00 76.6%
0.23 0.03 8.69 0.00 0.00
0.03 0.02 1.45 0.15 1.78
0.13 0.02 6.94 0.00 0.06
0.21 0.05 4.22 0.00 238
0.39 0.06 7.02 0.00
0.03 0.03 1.00 0.32
-0.82 0.24 -3.47 0.00
0.31 0.14 2.27 0.02
2
0.43 0.06 6.94 0.00 56.7%
0.03 0.02 1.17 0.24 0.00
0.02 0.02 1.09 0.28 1.65
0.03 0.02 1.37 0.17 0.00
0.24 0.05 4.56 0.00 238
0.42 0.05 7.85 0.00
-0.03 0.03 -0.98 0.33
-0.42 0.20 -2.08 0.04
0.42 0.13 3.38 0.00
2
0.48 0.14 3.40 0.00 23.6%
0.20 0.04 4.55 0.00 0.63
-0.04 0.04 -1.08 0.28 1.72
0.10 0.04 2.83 0.00 0.02
0.39 0.11 3.64 0.00 238
0.09 0.11 0.80 0.42
0.07 0.04 1.79 0.07
-0.23 0.39 -0.59 0.56
0.80 0.42 1.92 0.05
33
Additional Macro Factor (GOLD)
Intercept C0 R M R F C1 HML C2 SMB C3 DURATION C4 CREDIT C5 Gold Spot C6 HI_Correl C7 LO_Correl C8
HFRI Equity Hedge Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Event-Driven Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Relative Value Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF HFRI Macro Estimate Std. Error t value P-value adj-R 2 /BP test P_value/DW test/DW test P_value/DoF 0.49 0.14 3.38 0.00 24.7% 0.16 0.04 4.45 0.00 0.06 -0.04 0.04 -1.00 0.32 1.70 0.10 0.04 2.69 0.01 0.01 0.32 0.12 2.76 0.01 238 0.03 0.12 0.23 0.82 0.08 0.03 2.19 0.03 -0.28 0.40 -0.68 0.50 0.78 0.41 1.93 0.05 0.42 0.06 6.84 0.00 57.4% 0.05 0.02 2.46 0.01 0.00 0.02 0.02 1.12 0.26 1.61 0.03 0.02 1.18 0.24 0.00 0.22 0.05 4.25 0.00 238 0.42 0.06 7.42 0.00 0.03 0.01 2.32 0.02 -0.45 0.21 -2.19 0.03 0.37 0.12 3.01 0.00 0.54 0.07 7.81 0.00 76.7% 0.22 0.02 10.78 0.00 0.01 0.03 0.02 1.60 0.11 1.73 0.13 0.02 6.91 0.00 0.02 0.19 0.06 3.25 0.00 238 0.37 0.06 6.25 0.00 0.03 0.01 2.01 0.04 -0.83 0.23 -3.64 0.00 0.31 0.14 2.28 0.02 0.47 0.09 5.15 0.00 74.4% 0.37 0.03 14.18 0.00 0.02 -0.07 0.03 -2.34 0.02 1.69 0.19 0.03 5.58 0.00 0.01 0.08 0.07 1.07 0.28 238 0.17 0.08 2.11 0.04 0.04 0.02 1.92 0.05 -0.13 0.31 -0.42 0.67 0.76 0.24 3.17 0.00
Note: Bold indicates P-value <0.05.
34
Appendix D: Comparison to Fung and Hsieh [2004] Seven-Factor Model

Exhibit D1: Fung and Hsieh [2004] Seven-Factor Model
1/1990 to 12/2010 Estimate Coefficient Intercept C0 Credit Spread C1 Bond Mkt C2 Equity Mkt C3 Size Spread C4 Bond Trend C5 FX Trend C6 Commodity Trend C7
2
-0.61 0.80 -0.76 0.45 69.4%
-0.03 0.19 -0.15 0.88 0.00
0.23 0.09 2.51 0.01 1.64
0.42 0.03 16.64 0.00 0.00
0.32 0.04 9.10 0.00 244
0.00 0.01 -0.64 0.53
0.00 0.01 0.81 0.42
0.01 0.01 0.77 0.44
2
1.01 0.64 1.57 0.12 64.9%
-0.21 0.16 -1.30 0.19 0.00
0.00 0.07 0.04 0.97 1.57
0.29 0.02 12.92 0.00 0.00
0.23 0.02 11.43 0.00 244
-0.01 0.01 -2.10 0.04
0.00 0.00 -0.16 0.88
-0.01 0.01 -1.36 0.17
2
-0.05 0.59 -0.08 0.94 32.7%
0.03 0.17 0.15 0.88 0.00
0.09 0.06 1.62 0.10 1.41
0.12 0.02 4.93 0.00 0.00
0.09 0.02 3.69 0.00 244
-0.01 0.01 -1.83 0.07
-0.01 0.00 -1.59 0.11
0.00 0.00 -1.05 0.29
2
-1.05 0.86 -1.22 0.22 23.2%
0.22 0.19 1.12 0.26 0.00
0.23 0.10 2.27 0.02 1.69
0.20 0.03 6.57 0.00 0.01
0.14 0.03 4.04 0.00 244
0.00 0.01 -0.17 0.87
0.03 0.01 3.40 0.00
0.02 0.01 1.64 0.10
Note: Bold indicates P-value <0.05.
35
Exhibit D2: Adjusted R2 Values Comparison Table

Fung & Hsieh Seven-Factor Model [2004] Proposed Model Difference in Adj-R 2 (Proposed Model - F&H)
1990 to 2010 HFRI Equity Hedge HFRI Event-Driven HFRI Relative Value HFRI Macro 69.4% 64.9% 32.7% 23.2% 75.7% 77.8% 56.3% 38.7% +6.3% +12.9% +23.6% +15.5%
Appendix E
Exhibit E1: Trend Factor: Futures Markets Traded
Asset Classes Equity Bond Interest Rate Commodity Currency
Futures Contracts
S&P 500, NASDAQ US 10 YEAR, US 30 US 3 MONTH, 100, DJ EURO STOXX, YEAR, GERMAN BOBL, EUROPE 3 MONTH, DAX 30, CAC 40, GERMAN BUND, UK 10 UK SHORT STERLING, SWEDISH OMX, YEAR GILT, AUSSIE 10 JAPAN 3 MONTH, FTSE 250, NIKKEI YEAR, JAPAN 10 YEAR AUSSIE 3 MONTH 225, HANG SENG, AUSSIE SPX
CRUDE OIL, NATURAL GAS, HEATING OIL, SUGAR, CORN, COFFEE, COTTON, SOYBEANS, GOLD, SILVER, COPPER
EURO, JAPANESE YEN, SWISS FRANC, BRITISH POUND, AUSTRALIAN DOLLAR, CANADIAN DOLLAR, MEXICAN PESO
36
Appendix F
Exhibit F1: Correlation Regime Time Periods
Correlation Regime N No. Months Low Correlation No. Months High Correlation No. Months Normal Correlation
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Total
1 2 2 2 5 5 1 1 3 1 1 7
Jun-92 Feb-93Mar-93 Jun-93Jul-93 Oct-93Nov-93 May-95Sep-95 Feb-96Jun-96 Dec-99 Feb-00 Sep-00Nov-00 Apr-06 Jul-06 Nov-06May-07
8 1 6 2 1 1 10 8
Jun-90Jan-91 Dec-91 Aug-98Jan-99 Nov-02Dec-02 May-03 Jun-08 Sep-08Jan-09 May-10Dec-10
10 12 2 2 17 4 25 10 1 6 23 4 34 2 3 12 2 1 9
Feb-91Nov-91 Jan-92Jan-93 Apr-93May-93 Aug-93Sep-93 Dec-93Apr-95 Oct-95Jan-96 Jul-96Jul-98 Feb-99Nov-99 Jan-00 Mar-00Aug-00 Dec-00Oct-02 Jan-03Apr-03 Jun-03Mar-06 May-06Jun-06 Aug-06Oct-06 Jun-07May-08 Jul-08Aug-08 Feb-09 Aug-09Apr-10
31
37
179
37
References
Baesel, J.B., J.F. Gonzlez-Heres, P. Chen, and S.S. Shin. The Eect of S&P 500 Correlation on Hedge Fund Alpha. The Journal of Wealth Management, Vol. 14, No. 4 (2012), pp. 93-104. Bali, T., and R. Engle. A Cross-Sectional Investigation of the Conditional ICAPM. Working paper, New York University, 2009. Breusch, T.S., and A.R. Pagan. A Simple Test for Heteroscedasticity and Random Coecient Variation. Econometrica, Vol. 47, No. 5 (1979), pp. 1287-1294. Buraschi, A., R. Kosowski, and F. Trojani. When There Is No Place to Hide: Correlation Risk and the Cross-Section of Hedge Fund Returns. Working paper, Imperial College London, 2012. Burghardt, G., R. Duncan, and L. Liu. What You Should Expect from Trend Following. Research Report, Calyon Financial, 2004. Carhart, M.M. On Persistence in Mutual Fund Performance. Journal of Finance, Vol. 52, No. 1 (1997), pp. 57-82. Chen, P., J.F. Gonzlez-Heres, and S.S. Shin. The Distressed Corporate Debt Cycle from a Hedge Fund Investors Perspective. The Journal of Alternative Investments, Vol. 11, No. 1 (2008), pp. 1-20. Connor, G., and S. Li. Market Dispersion and the Protability of Hedge Funds. Working paper, National University of Ireland, 2009. Cremers, M., A. Petajisto, and E. Zitzewitz. Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation. Working paper, University of Notre Dame, 2010. De Silva, H., S. Sapra, and S. Thorley. Return Dispersion and Active Management. Financial Analysts Journal, Vol. 57, No. 5 (2001), pp. 29-42. Durbin, J., and G.S. Watson. Testing for Serial Correlation in Least Squares Regression I. Biometrika, Vol. 37, No. 3-4 (1950), pp. 409-428. . Testing for Serial Correlation in Least Squares Regression II. Biometrika, Vol. 38, No. 1-2 (1951), pp. 159-179. Fama, E.F., and K.R. French. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Economics, 33 (1993), pp. 3-56.
Fung, W., and D.A. Hsieh. Performance Attribution and Style Analysis: From Mutual Funds to Hedge Funds. Working paper, Duke University Fuqua School of Business, 1998. . The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers. Review of Financial Studies, 14 (2001), pp. 313-341. . Hedge Fund Benchmarks: A Risk-Based Approach. Financial Analysts Journal, 60 (2004), pp. 65-80. Groth, M., and P. Thstrm. Dynamic Conditional Correlation Models in a Multiple Financial Asset Portfolio. The Journal of Alternative Investments, Vol. 12, No. 1 (2009), pp. 8-20. Jegadeesh, N., and S. Titman. Returns to Buying Winners and Selling Losers: Implications for Stock Market Eciency. Journal of Finance, 48 (1993), pp. 65-91. Qian, B., and K. Rasheed. Hurst Exponent and Financial Market Predictability. Paper presented at IASTED International Conference on Financial Engineering and Applications, Cambridge, MA, 2004, pp. 203-209. White, H. A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity. Econometrica, Vol. 48, No. 4 (1980), pp. 817-838.
The views and opinions expressed herein are those of the authors, Jerome B. Baesel, Jos F. Gonzlez-Heres, Ping Chen, and Steven S. Shin, as of the date of this publication and may change in response to changing circumstances and market conditions. Under no circumstances should these views and opinions be construed by any reader as investment advice. These view are not necessarily representative of the opinions and views of any other Morgan Stanley portfolio manager or of the firm as a whole. Keep in mind that forecasts are inherently limited, and no reader should rely on them as an indicator of future performance. The information contained herein should not be deemed as a recommendation to purchase or sell any securities or investments of the types mentioned. No representation or warranty, express or implied, is made or can be given with respect to the accuracy or completeness of the information in this Article. Alternative investments are speculative and involve a high degree of risk, are highly illiquid, and typically have higher fees than other investments.
38
FRONTIER MARKETS: WHY NOW?
Frontier Markets: Why Now?

Executive Summary
The global economy is still ghting to recover from the crisis of 2008, and uncertainty overshadows nancial markets, but the bullish case for frontier markets remains strong. The frontier markets (FM) have posted world-beating growth with moderate ination, and FM stock markets now appear less expensive, with higher dividend yields and lower volatility, than the more developed emerging markets (EM), as shown in Display 2. In 2011, eighteen of the twenty fastest-growing economies in the world were frontier markets, and the median ination rate in these markets was a moderate 5 percent.1 For 2011 to 2015, we believe FM economies can sustain a compounded growth rate of 4.3 percent because they are growing from low bases, with relatively low levels of government debt and manageable scal decits. At that pace, FM countries could add an estimated $1 trillion in GDP over the next ve years, while their total population is expected to grow by more than 78 million over the same period.2 This opportunity is too signicant to ignore. Frontier markets can also oer portfolio managers a strong opportunity to diversify, with a history of low correlations to other markets and low volatility. As illustrated in Display 1, over the past ve years, frontier markets have had a correlation of only 0.76 to emerging markets and 0.77 to developed markets, versus an EM correlation to developed markets of 0.92.3 The thirty main frontier markets have also shown little correlation to each other, because
1 2 3
AUTHOR
TIM DRINKALL
Source: IMF World Economic Outlook. Data as of April 2012. Source: IMF World Economic Outlook. Data as of April 2012. Source: FactSet, MSCI. Data as of September 28, 2012.
39
valuations, economic cycles and development are at dierent levels and stages. This is why we believe in a macro-based, top-down approach that determines which frontier markets to invest in, and which to avoid. Benchmark volatility in frontier markets is half that of emerging markets, at only 11 percent.4 Why is volatility so much lower? It is primarily a function of lower liquidity in Frontier markets, and less foreign investment, specically, hedge fund activity in these markets. Over time, we would expect volatility to increase as these markets become more mainstream. Display 1: Frontier Markets Correlation
0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 GEM Equities 5-Year Average DM Equities Commodities Oil 0.47 0.76 0.77 0.62
Display 2: Frontier Markets Higher Yields, Less Volatility than EM

MSCI Emerging Markets Index Dividend Yields Benchmark Volatility 2.9 22% MSCI Frontier Markets Index 4.5 11%
Source: FactSet, MSCI. Data as of September 28, 2012. Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. Benchmark volatility is represented by standard deviation which is a measure of the dispersion of a set of data from its mean.
The Challenges: Navigating Through Choppy Waters

Strong country analysis is a critical element of investing in frontier markets. No two frontier markets are alike, and to succeed an investor must understand the nuances of the local market, as well as the unique interplay of national and global macro forces in each country. One of the global headwinds is the gathering recession and banking crisis in Europe, which is hurting some frontier markets more than others. Many FM economies in Central Europe depend heavily on exports to the rest of Europe, and are vulnerable to the slowdown in Western Europe. That said, some of these nations made tough policy decisions early in the crisis decisions that have put them in a strong position now. This is the case in Romania, which made sharp cuts in spending as the crisis spread after 2008, and now has room to ease scal policy. The Central Bank of Romania has also been able to loosen monetary policy, as ination has dropped substantially, leaving the country well positioned to weather the ongoing European Union storm. The ability of Romania to launch counter-cyclical policies to support growth has given a strong boost to its stock market, making it the best performer in the Balkan region year to date.6 The Arab Spring is still a macro force, and is of particular importance to FM since the MSCI Frontier Markets Index allocates over 50 percent to the Middle East.7 In the spring of
6 7
Source: FactSet, MSCI. Data as of September 30, 2012. Note: The classifications in Display 2 represent the following: Frontier equities (MSCI Frontier Markets index), GEM equities (MSCI Emerging Markets index), DM equities (MSCI All Country World index), Commodities (CRB Index), and Oil (Brent Oil)
When Morgan Stanley Investment Management (MSIM) rst launched a dedicated FM strategy back in 2007, FM equities were trading at a premium to EM equities, which was largely explained by scarcity value. Now, valuations appear to be favoring FM equities, which have traded at a p/e discount of 15 percent to EM equities, with a dividend yield of 4.5 percent versus only 2.9 percent for EM equities.5
4 5
Source: Sungard APT. Data as of September 28, 2012. Source: FactSet, MSCI. Data as of September 28, 2012. Source: FactSet, MSCI. Data as of September 28, 2012.
Source: FactSet, MSCI. Data as of September 28, 2012. P/e is a valuation ratio of a companys current share price compared to its per-share earnings.
40
2011, we argued that revolutions would envelop the MENA8 dictatorships, but spare the Gulf Cooperation Council (GCC) monarchies that had longer histories, more legitimacy and more nancial resources (due to their oil wealth) to increase social spending and domestic investment. Saudi Arabia announced a massive $125 billion investment program designed to calm the unrest before it happened. Saudi Arabia is now one of the few countries in the region that oers strong growth prospects, and an equity market with more liquidity and diversity than many mainstream emerging markets. Qualied investors can gain access through promissory notes. Looking beyond Saudi Arabia and last spring, hot spots clearly still exist within the area. While we believe the worst of the aftershocks have passed, political developments in the region must be closely monitored. Another key global factor is commodities. Many investors and potential investors in frontier markets believe these markets are highly dependent and correlated to commodity prices, and that this is a key risk for the asset class. While it is true that many FM countries are resource rich and their economies benet from high commodity prices, there are also FM countries who are resource poor and are negatively impacted. Country positioning must take this dynamic into consideration. That said, underlying FM equity markets have a relatively low allocation to commodities. The MSCI EM index has a 24 percent weighing to commodities relative to the MSCI Frontier Market index at only 12 percent, so interestingly, any fall in commodities prices should impact EM equities more.9 The most important FM commodity is oil due to the large oil-producing countries of the GCC, Nigeria, and Kazakhstan. However, as illustrated in Display 3, analyzing the price movements of oil and the FM equity markets has shown a low correlation to the commodity over time.
Display 3: MSCI Frontier Performance vs Oil Price Movements

1,200 600 500 400 800 300 600 200 400 100 0 10/10 10/11 10/12 MSCI Frontier Markets - Price - USD (LHS) Brent Oil, Spot - USD/BBL (RHS) CRB Spot Index (RHS)
1,000
200 10/02 10/03 10/04 10/05 10/06 10/07 10/08 10/09
Source: FactSet. Data as of October 8, 2012.
How to Invest in Frontier Market Equities

Once investors grow comfortable with the idea of adding frontier markets to their portfolio, many struggle with questions about the appropriate allocation and portfolio construction. Do frontier markets qualify as an alternative investment or are they considered an international equity allocation? Can investors get exposure through an EM allocation, or should they consider a dedicated allocation? More importantly, how large an allocation should they make? We have been investing in frontier markets since the early 1990s, before a dierentiation between EM and FM countries was even dened. As the markets evolved and the composition of the MSCI Emerging Markets Index changed, we felt the time was right to make a distinction between the EM and FM worlds. Over the last ve years of managing a dedicated FM strategy, perception of the strategy has shifted from being part of an alternatives allocation to being a core part of an EM allocation. Twelve years ago, our investment team faced the same question regarding a dedicated EM allocation. A paper written by our colleague, Global Emerging Markets Equity portfolio manager Paul Psaila, made the following case:
8 9
Middle East and North Africa.
Source: FactSet Energy and Materials Sector Weights. Data as of September 28, 2012.
41
Misperceptions of performance and investability have led to a signicant underweight in global portfolios. In the medium-term, the (emerging) markets are likely to grow in importance and close the gap between their underlying economics and current index weight. Investors without a dedicated allocation will not be represented in this dynamic asset class. 10
We believe this same argument applies to frontier equities today. Many mainstream EM managers are not equipped to successfully invest in an asset class as broad and dierentiated as frontier markets. A macro-focused, top-down strategy is crucial in order to place the correct country bets, in our view. We believe a strong stock-picking, bottom-up culture is also necessary, helping to ensure that companies in a portfolio have good management teams, implementable strategies, solid balance sheets, and sustainable growth. Finally, when considering an appropriate allocation to frontier markets, a few basic data points should be considered. Frontier Markets currently make up 8 percent of global GDP and have a total market capitalization that exceeds US$1 trillion.11 The MSCI has also launched a combined MSCI Emerging Markets + Frontier Markets Index that allocates 2.7 percent to FM that is based on the current free oat12 of the markets13, but neglects to include the largest, most liquid FM market, Saudi Arabia. It is clear that FM equities is a small but rapidly growing asset class. As some EM countries graduate to developed market status, some Frontier countries will upgrade to the mainstream emerging markets. And markets that are currently o the radar of foreign investors countries like Angola, Cuba, Myanmar and Venezuela, which are now only starting to adopt pro-market reforms may join the FM class. Given the high growth economies, low correlation, low volatility, and current valuations, we suggest an overweight investment to Frontier equities.
Resolving the Emerging Markets Dilemma MSDW Investment Management, Emerging Markets Equity Team; October 2000.
10
Summary
Frontier markets can oer investors a potential to participate in an asset class with a history of high economic growth, low volatility and low correlations. Certainly there are challenges in FM countries today such as the growing malaise in Europe, the spreading Arab Spring as well as the perceived dependency of frontier markets on commodities. By actively investing around these challenges in the frontier markets, we believe the time is right to start building a dedicated allocation and tapping into the opportunities the frontier markets can oer.
Source: IMF World Economic Outlook, MSCI, FactSet. Data as of Data as of April 2012.
11
Shares of a public company that are freely available to the investing public.
12 13
Source: FactSet. Data as of September 28, 2012.
42
Important Disclosures: The views and opinions are those of the author as of October 1, 2012 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers. All information provided is for informational purposes only and should not be deemed as a recommendation. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. Charts and graphs provided herein are for illustrative purposes only. Past performance is not indicative of future results. The indexes do not include any expenses, fees or sales charges, which would lower performance. The indexes are unmanaged and should not be considered an investment. It is not possible to invest directly in an index. Forecasts/ estimates are based on current market conditions, subject to change and may not necessarily come to pass. MSCI Frontier Markets Index. A free float-adjusted market capitalization index that is designed to measure equity market performance of frontier markets. The MSCI Frontier Markets Index consists of 25 frontier market country indices. MSCI All Country World Index. A free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed and emerging markets. MSCI Emerging Markets Index. A free float-adjusted market capitalization weighted index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Net Index currently consists of 21 emerging market country indices. CRB Spot Index, A measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. Brent Oil. major trading classification of sweet light crude oil comprising Brent Blend, Forties Blend, Oseberg and Ekofisk crudes (also known as the BFOE Quotation).
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Foreign and emerging markets. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments. Frontier emerging markets. The risks associated with emerging markets are magnified when investing in frontier emerging market countries, accordingly, investments in the portfolio must be viewed as highly speculative in nature and may not be suitable for an investor who is not able to afford the loss of the entire investment. Derivative Instruments. Derivatives can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolios performance. Small-cap stocks. Stocks of small-sized companies carry special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. A separately managed account may not be suitable for all investors. Please consider the investment objectives, risks and fees of the strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2. Please consider the investment objectives, risks, charges and expenses of the portfolio carefully before investing. The prospectus contains this and other information about the portfolio. To obtain a prospectus, download one at morganstanley.com/im or call 1.800.548.7786. Please read he prospectus carefully before you invest or send money. Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.
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44
FIXED INCOME INVESTING IN A WORLD OF RISING RATES
Fixed Income Investing in a World of Rising Rates

Executive Summary
Many investors today are concerned about xed income as an asset class because interest rates are historically low and may abruptly rise. A common tactic to reduce the risk of rising rates as the economy recovers is to buy shorter maturities and oating rate assets, which is a reasonable tactic to employ during cyclical economic recovery cycles. However, we are experiencing a post-crisis recovery cycle, which is dierent than one of an ordinary cycle variety. As a result, that defensive tactic may not be optimal and we believe it should be modied to reect the unique dynamics of a post-crisis recovery cycle. Counter to historical precedence, we recommend holding assets with maturities of around ve years, rather than two years or less, and owning higher-yielding xed income assets, with the caveat that one actively manages duration exposure in order to reduce the risk of rising rates and isolate income earned from carry.
AUTHOR
JIM CARON
Investing in Fixed Income During a Post-Crisis Recovery Cycle

Fixed income investing in the post-crisis recovery period is poised to be dierent from normal cyclical recovery periods because of the following reasons: The pace at which rates may rise is likely to be slower, lest central banks risk a reversal of post-crisis stimulus. We do not appear to be in a typical boombust cycle that provokes sharp rate hikes, or tightenings, by central banks. In fact, as economies recover, post-crisis policy may initially start by
45
unwinding extraordinary policy-easing measures, such as asset purchases, rather than tightening credit conditions. Credit conditions may improve and spreads may narrow. As a result, spread products, such as high yield, that are less sensitive to interest rates may continue to provide income benets. Short-end rates, meaning two years and less in maturity, are at extremely low levels, and oer neither signicant value nor protection against an economic downturn, or risk-event, because they do not have room to appreciate and oset losses on other risky assets held in a portfolio. Holding slightly longer duration exposure, around ve years, better addresses this issue and oers superior diversication benets to a portfolio. Many investors today are concerned about xed income as an asset class because interest rates are historically low and may abruptly rise. A common tactic to reduce the risk of rising rates as the economy recovers is to buy shorter duration assets. However, in the current environment, this may not be optimal because this recovery comes after a severe nancial crisis and is not of the ordinary cyclical variety. Counter to historical precedence, we recommend maintaining duration exposure of around ve years, rather than reducing to less than two years, and owning higheryielding xed income assets with the caveat that one actively manages duration risk in order to isolate income earned from carry. Eectively, in the initial post-crisis recovery period, we advocate strategies that earn income by isolating carry through active duration management. Traditionally, when xed income investors were worried about rising yields, the common tactic was to reduce risk by investing in shorter duration assets (two years or less.) While this may have worked when central bank policy rates and two year yields were at much higher levels and had room to fall, in the current low-rate policy environment, in fact, close to zero in many cases, we do not think this is an optimal tactic because front-end yields (i.e., those with the shortest maturities) cannot fall much lower. This creates a fundamental problem for a diversied investment strategy, because if economic conditions worsen, or if a global risk event occurs, an investor may not realize gains from short duration investments in xed income that oset losses in other riskier assets (see Display 1.)
Display 1: Front-end Rates at Extremely Low Levels

0.5 0.4 0.3 % Yield 0.2 0.1 0 -0.1 1/1/13 UST 2yr Front-end yields are low and have little scope to decline further
2/1/13 Ger 2Yr
3/1/13 UK 2Yr
4/1/13 Fra 2Yr
5/1/13
6/6/13
Source: Bloomberg. Data as of June 11, 2013.
To be clear, we do not think that long duration strategies are the answer either, simply because those yields are higher and have more room to fall. In our view, the optimal strategy for investing in xed income in the current environment lies somewhere in the middle. We argue that owning assets with slightly longer duration, around ve years instead of two years or less, while actively managing duration risk, could provide superior diversication benets. Buying spread product, such as high yield, with approximately ve-year duration and a lower beta to interest rates therefore provides an attractive opportunity in the current environment. Credit conditions may remain easier for longer. In a typical economic cycle, interest rates tend to rise because policy is tightening in an eort to prevent an economy from overheating. Normally, this would have adverse eects on spread product as credit conditions are purposefully tightened. This time is dierent because economies just went through a nancial crisis and policy rates moved to extremely easy levels that included quantitative easing in order to keep nominal yields low. As the economy recovers from the nancial crisis, immediate and aggressive rate hikes are less likely because there is less risk of overheating. As a result, the goal of the central bank will not be to purposefully tighten credit. In fact, easy credit conditions may continue to benet from policy support and, therefore, improve as the economy distances itself from the crisis. This benets credit products because default risk may remain low or even fall. The pace of rising rates may also be much slower than in ordinary economic recovery cycles. This is because a feedback
46
loop exists that may prevent rates from rising too fast, namely that the early stages of this economic recovery may not be strong enough to sustain sharply higher rates. If that were to occur, it may slow the economy and rates would likely fall back down again. This is an important dierence in the post-crisis recovery versus a typical cyclical recovery. It has implications for investing in the current environment because typically rates rise quickly when the central banks start tightening. Therefore, when making investment decisions for the future, we should dierentiate between a normal cyclical economic recovery and recovery from a nancial crisis. The former tends to see rates rise and credit conditions tighten quickly, while the latter may produce a slower pace toward higher rates and credit conditions may improve instead of tighten. What we have learned during the past few years is that the intent of policy makers may not only dominate asset performance but also may allow investors to anticipate asset performance as long as they can properly measure the policy response function (we refer to this as policy dominance1). We will discuss this in detail in a later section of this paper. But rst, some historical context for interest rate cycles and bond returns over the past 20 years.
levels on bonds were higher, which enabled them to withstand many periods when rates rose. However, this masks some of the internal components of the broad index that drove its history of performance, especially during periods when rates were rising. Let us explain. We isolated three components of the broad index to identify their return contributions: U.S. Treasuries, Investment Grade (IG) Corporates and High Yield (HY). These were chosen because they range from the most interest rate sensitive (U.S. Treasuries) to the least (High Yield) and because they show a comparison between rates and spread contributions to returns (Display 2). We nd that the trend toward lower rates did not always benet bonds. In some instances, lower rates represented stress in the system and caused sharp losses, in both absolute and relative terms, for IG and HY. For instance, during the 2008 nancial crisis, only safe haven U.S. Treasuries beneted from lower rates while IG and HY posted -5 percent and -26 percent returns, respectively. That may be an extreme example, but there were also several periods when rates fell and credit spreads widened, causing a loss in relative performance to benchmark U.S. Treasuries. Display 2: Isolate Carry Income by Actively Managing Duration Risk Especially During Periods When Rates Rise
U.S. Treasury 5-Year Yields (1990 to 2012) Bond Sector Indices vs. UST 5y Yield
70% 60% 50% 40% Returns 30% 20% 10% 0% -10% -20% -30% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Yield
Adding Spread Exposure While Managing Duration Risk A New Cycle for Fixed Income Investing
Looking back over a 23-year history of bond returns, we observe that there were only two negative years for the U.S. Lehman/Barclays Aggregate Index. The rst was in 1994, when the Fed hiked rates 300 basis points (bps) over a 12-month period and the index returned -2.92 percent. The second was 1999, when the Fed hiked rates 175 bps over an 11-month period and the index returned -0.82 percent. The average return, however, over the period was +7 percent.2 The main observations to the consistent performance were not only that rates were trending lower but also because coupon
Policy dominance refers central bank policies that are designed to create stimulus by increasing inflation expectations, which pulls demand forward and ultimately reflates asset prices in an effort to ease financial conditions.
1 2
08 20
90
94
19 96
19 98
20
20
n US Treasury
n US IG Corporate
20
n US HY Corporate
20
US 5y Yield (RHS)
US Treasury, Investment Grade Corporate and High Yield components of the Barclays Capital Aggregate Index. Source: Bloomberg. Data as of December 31, 2012.
Source: Barclays Capital. Data as of stated period.
20
19
19
10 20 20 11 12
92
00
02
04
19
06
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Despite the falling trend in rates, the most interest ratesensitive bonds, U.S. Treasuries (our proxy for duration risk), performed least well, with an average return of 6.8 percent over the period since 1990. IG followed with an average return of 7.8 percent and HY, the least sensitive to interest rates, performed best with an average return of 10.4 percent. However, by naively dividing returns from U.S. Treasuries by spread product returns, we approximate that duration risk accounted for 92 percent of IG returns and 65 percent of HY returns. We make two key observations. First, duration can be a large component of returns, which highlights the importance of actively managing duration risks when rates start rising. Second, spread matters but falling rates are not necessarily correlated with improving fundamentals for spread products. This is because, as observed, duration actually accounted for the majority of their prior performance. Improving fundamentals for spread products is thus derived from other factors, aside from just the interest rate cycle. Central bank policy objectives, the regulatory environment and nancial conditions all greatly help explain the economic cycle for xed income investments and returns. What has changed is that the economic cycle going forward may be more fundamentally positive for spread products even if rates rise, especially if they rise for good reasons that reect economic repair and a lessening of crisis, or default, risks. The current benet to bond investors is that tighter regulations, reduced leverage and policies to spur growth reduce the default risk of bonds. These benets, however, are currently trumped by the low level of absolute yields that cannot absorb much of a rise in rates and preserve a positive return. Therefore, investing in products that earn carry, like High Yield, and isolating the carry component of returns by more active duration management strategies, may be an optimal investment strategy in the post-crisis recovery environment.
Our Approach to Managing Duration Risk An Essential Ingredient to Fixed Income Investing as Interest Rates Rise
Managing duration risk will be critical for bond investors to preserve income and achieve returns as interest rates rise. Our approach to managing this risk is to evaluate optimal reward-to-risk opportunities that quantify the degree to which we should have long or short duration exposure. Our process combines both fundamental econometric and quantitative models to calculate the appropriate duration risk exposure we should have in our portfolio at each point in the post-crisis recovery cycle. Our fundamental models provide insight into yield levels based on forward expectations of economic data. Our quantitative models evaluate what is priced into these forward expectations and employ statistical techniques to derive a fair valuation of yield levels. Finally, we measure the policy response function from central banks and its expected impact on the price level of nancial assets. Combining these models denes our approach to managing duration risk. An essential component of our investment style is the incorporation of central bank policies into our investment decision-making process. As we mentioned in the rst section of this paper, this is critical because the policy response function has been the back-story driving asset performance since the nancial crisis. For example, the strong performance of U.S. assets in 2009 had more to do with support facilities like TARP and TALF3 than it did with economic fundamentals. Similarly, in 2012, risky assets greatly beneted from central banks polices, such as quantitative easing (QE) from the Fed and outright monetary transactions (or OMT) from the European Central Bank (ECB), that eectively reduced risk premiums in spite of worsening economic data. Currently, the Bank of Japan (BoJ) is aggressively easing policy, which is also having a positive eect on asset
Troubled Asset Relief Program (TARP), established Oct. 3, 2008, designed to stem the financial crisis by allowing the US Treasury to buy $700Bn of assets such as commercial and residential mortgages, or any other securities or obligations related to those assets. Term Asset-Backed Loan Facility (TALF) was a program created by the Fed to spur consumer credit lending. Announced on Nov. 25, 2008, the Fed lent up to $1Tr on a non-recourse basis to holders of certain AAArated ABS and recently originated consumer and small business loans.
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performance. Managing risks, positive and negative, as they relate to the policy response function is therefore an essential component to our investment decision making process. When managing duration risk, it is essential to relate asset price returns to both nancial and fundamental variables such that we can map our views on global economic and policy dynamics to a congruent asset allocation decision. Recognizing that these relationships are time-varying econometrically and whose forecasting power is dubious empirically, we once again turn to our policy makers to understand which quantitative tools they employ to monitor developments in the markets. While the relationship between various measures of growth and ination to asset prices can be tenuous, the empirical relationship between anticipated monetary policy, which itself is a function of these macroeconomic variables, appears more robust. That is, macroeconomic and nancial data can have a meaningful and intuitive impact on asset prices if we can anticipate when these releases will cause a change in market participants view on future monetary policies. Our goal is to, therefore, pre-empt these inection points in investor sentiment and to do so using the types of tools that have and will continue to inform our policy-makers stated views. Given our desire to model developments in nancial markets through the lens articulated in central banker speeches and papers, our next steps are to determine which model types can add the most value to our investment process. On a very basic level, we would like to incorporate as much relevant information as possible in mapping our perceived drivers of risk and return to the asset price or target quantity in question while remaining as parsimonious as possible to avoid overtting in sample. Thus our model construction process is driven by our desire to reduce complexity or dimensionality in analyzing asset prices and macroeconomic data. We recognize that data tends to co-move and therefore, can be proxied by a smaller number of composite factors. The strengths in then assessing relations with these composite factors are multifold: a) we allow the data to tell us a story rather than having us impose an unfounded structure; b) we reduce the likelihood that our drivers of asset prices are highly correlated which tends to muddle results; and c) we can have more condence in the out-of-sample implications given the reduced number of estimated parameters required to estimate. In our work, dimension reduction techniques play a critical role in assessing trends in nancial conditions, growth and term-premia.
Of course, there are situations in which we can a priori specify sensible reduced-form relationships, which allow for intuitive explanation and transparency. We must then focus specically on identifying proper causal, rather than just necessarily coincident, explanatory variables for our estimated relationship. Given that we believe that asset prices reect future developments in growth/ination as well as monetary and scal dynamics, we tend to focus on forward-looking survey measures as inputs. Credible survey data tends to accurately track changes in real-time sentiment and reects both quantitative and qualitative factors that investors are grappling with. It is no surprise, therefore, that central banks, from the ECB to the Fed, typically cite survey data as indicative of consumer/investor sentiment towards all facets of economy and/or nancial markets. As such, the use of survey data has become a prominent and notably helpful input into our analyses of asset prices. You cant, however, manage what you cant measure. Thus, we have created quantitative tools to help us measure the policy response function in order to quantify easing or tightening of policy and quantify and which assets might be impacted most. This is how we incorporate our macro analysis into investment decisions across asset classes. We list a number of the tools we use below: Financial Conditions Index: The Financial Conditions Index (FCI) has been developed to measure a central banks policy response function in order to help us make investment decisions that are consistent with their policy objectives. Financial conditions is a broadly-used term by central bankers that believe policy actions inuence economic behavior and should be measured by its impact on nancial assets that reect economic activity. The crux of our model is to estimate the evolution of this composite index, the FCI, by applying a statistical technique, called Principal Component Analysis (PCA), an eective dimension reduction technique on our nancial data series to succinctly explain their variance. In addition, to create a more dynamic model, reecting changes in correlations and volatilities, we exponentially weight our covariance matrix in order to weigh recent nancial market movement more heavily. The intuition here is that policy makers will compare recent nancial market developments in the context of more recent history in order to determine relative changes in monetary policy or stimulus. Using the FCI to help us make investment decisions has taken on added
49
importance in the post-crisis market environment as policy rates approach a zero-bound and central banks have had to rely on non-traditional measures to stimulate the economy. Display 3: Recent Strength in FTSE 100 and Weakness in GBP Has Helped Ease Financial Conditions
MSIM GBP Financial Conditions Index (FCI) in Z-Score Units
7 6 5 4 FCI Index Levels 3 2 1 0 -1 -2 -3 12/06
BoE Special Liquidity Scheme BoE Sells Corporates From APF Additional QE Expansion to GBP 375bln Bear Lehman BoE Launches APF to buy CP and Corporates QE 1 GBP 75bln Covered Bond Purchase Program
Tighter
UK Banking Rescue Scheme
US Debt Ceiling ECB Swap Line Agreement
QE Expansion to GBP 275 bln (+ GBP 75bln)
Easier 12/12 6/13
12/07
12/08
12/09
12/10
12/11
Source: Morgan Stanley Investment Management, Bloomberg, Datastream, Haver Analytics. Data as of June 11, 2013.
Taylor Rule Model: At the core of most policy-makers structural economic model of the economy is a central bank policy response function which quanties the relationship between the level at which the base interest rate is set (policy instrument) and the macroeconomic/monetary targets it is trying to guide towards (policy objectives). We leverage a variety of policy rules, which we collectively label as our Taylor Rule model. In addition, we supplement these specications with a variety of macroeconomic forecasts of policy policymakers and practitioners to derive an implied model path of short rates that, given its inputs, represents a pooled forecast based on many individual models and qualitative assessments. We then compare these results with those communicated by the Fed (communication strategy) and what is priced into the money market curve to gauge the degree of easiness their policy is imparting on the market. Incorporating this into our investment strategy is critical as Fed policy tends to be highly correlated with asset performance. Term Premia Model: The term-structure of government interest rates can provide a wealth of information regarding monetary policy and macroeconomic expectations. In a
risk-averse world, where the future path of interest rates in uncertain, a given interest rate reects both expectations of future interest rates as well as some term premium. The degree or premia priced into a given interest rate varies over time and may reect changes in business cycle or risk aversion.4 The benets of quantifying longer-dated term premia are that it can a) help us measure the added ex-ante compensation we would get for extending duration and b) examine the impact of monetary policy easing on longerdated securities, which can, in turn, impact other asset classes (portfolio-balance channel). Thus, if we would like to isolate the pricing of future short rates from the impact of the pricing of term premia, we require a model that can separate market expectations from term premia. To achieve this we model interest rates under a no-arbitrage framework that enables us to price interest rates relative to each other by using a small number of pricing factors and a functional form of market price of risk (related to the term premia). Given challenges in estimating highly persistent interest rate process (i.e., they do not tend to mean revert), we supplement our pricing factors with survey data such that we can better pin down some of the model parameters. Our work is an adaptation of the model developed by Finlay and Chambers (2008)5, which is an extension of the often-cited Kim-Wright 2005 model still in use and referenced by policy makers at the Fed. Display 4 illustrates our calculation of the term premia for the U.S. Treasury ten-year rate going back to 1990. Notice that throughout this period the ten-year zero rate the level of the U.S. Treasury yield tted by a three-factor t ypically trades above, or at a premium to the level of U.S. Treasury ten-year estimated by the expected level of short-term rates in the future. In other words, the grey line tends to be above the dark green line. However, since the Fed began its extraordinary policy easing, this term premium relationship reversed and declined, as the tted ten-year zero rate trades lower than the level of rates implied by short-term rate expectations. The Fed considers this decline in term premium of longer term interest rates as a form of monetary accommodation. As managers, we incorporate this metric
Kim DH., and A. Orphanides (2005), Term Structure Estimation with Survey Data on Interest Rate Forecasts, Federal Reserve Board Finance and Economics Discussion Series No 2005-48.
4
Finlay R., and M. Chambers (2008), A Term Structure Decomposition of the Australian Yield Curve, Reserve Bank of Australia Research Discussion Paper 2008-09.
5
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through our term premium models as an input into our decisions on how to manage duration risk. Display 4: U.S. Long-End Term Premia Remains At Exceptionally Low Levels
Evolution of 10YR Rates and Corresponding Term Premium
9 8 7 Term Premia (%) 6 5 4 3 2 1 0 -1
98 00 02 94 96 04 06 08 10 6/ 11 6/ 12 6/ 13 90 92 6/ 6/ 6/ 6/ 6/ 6/ 6/ 6/
Display 5: Current Market Pricing of 10 Year US Treasury Yields Appears Stretched

10YR US Yields & FY Model Fit (%)
8 7 6 Yields (%) 5 4 3 2 1 0 12/99
12/01
12/03
12/05
12/07
12/09
12/11
12/13
6/15
10YR Yield: 2.20% Market Implied Yields (%)
Model Yield: 2.42% Survey Forecasted Yields (%)
Standardized Residuals in Z-Score Units

4 3 2 1 0 -1 -2
0 08 4 /0 6 /0 3 9 9 2 5 7 /0 1 /10 12 / 12 12 12 12 12 12 12 12
Average Implied Expected Short Rate (%) 10 Year Fitted Zero Yield (%) 10YR Estimated Term Premia: -0.37%
Z-Score Units
Source: Morgan Stanley Investment Management, BlueChip Economics, Haver Analytics. Data as of June 11, 2013.
6/
6/
6/
Long-Term Government Fair-Value Model: In considering the fair value of a government security, we estimate reduced form relationships between long-term yields and macroeconomic drivers that can provide direct, intuitive insights without imposing complicating structure. This model employs a multivariate dynamic linear regression approach to estimate a stable long-term relationship between short-rate expectations, growth expectations, ination expectations, among other variables, and sovereign yields. The selection of survey and economic variables is rooted in economic intuition and supported by a variety of central bank white papers.6 Inasmuch, we are trying to ascertain the fundamental relationship between yields and forward looking macrovariables that should be directly related to both the anticipated path of short rates and term-premia. The dierence between the model and actual yields, or the residual of the model, is then constructed as a mean-reverting historical time series
See, for example. Bernanke B., V. Reinhardt, and B. Sack Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, Federal Reserve Board Finance and Economics Discussion Series No 2004-48.
6
+1
-1
Std Resid (Z-Score Units): -0.35
Source: Morgan Stanley Investment Management, BlueChip Economics, Bloomberg, Haver Analytics. Data as of June 11, 2013.
Nowcasting Model: With the expansion of global debt markets in size and scope, various segments of debt capital markets have distinct betas or sensitivity to economic growth. As corporate debt investors, the benets of stronger economic growth vis-a-vis improvement in balance sheets are oset by changes in economic incentives to pursue more shareholder friendly action at the expense of debt holders. Further, even in government rates market, the benets of increasing tax receipts can be outweighed by unexpected pressures in ination and ination expectations, which erode the real
12
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/11 12 /1 6/ 2 13
/0
/0
/0
/0
/0
/0
/9
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return related to nominal bonds. Having a real-time handle on current trend growth and business cycle turning points while quantifying the potential impact of dierent economic indicators is an arduous albeit necessary task. One of the tools we consider to this end is the Nowcasting model technique developed by Gianonne, Reichlin and Small (2008)7 and subsequently extended by Banbura and Modugno (2010)8, which oers a parsimonious means of coping with large, asynchronous data sets with missing points to forecast growth by leveraging the latest data releases and the factor structure of the underlying data. The model is casted in a state-space framework and estimated via quasi-maximum likelihood with a Kalman lter which can therefore produce forecasts in the presence of mixed frequency and unbalanced panels. Unlike other GDP estimating models, which attempt to aggregate data into the dierent national account buckets, Nowcasting makes use of the historic co-variability of realtime data, which can be broadly captured in a few factors. In a market where separating economic wheat from cha can be challenging and where coincident measures of growth are released with substantial lag, such models help us distinguish when a current economic surprise could be the start of a trend or a blip on the radar.
Display 6: Nowcasting Model for Q2 2013: Recent Rise in Treasury Yield Belie a More Moderate Growth Story
Evolution of US GDP Nowcast for Q2 2013 As of: 06/11/13
Contribution to Change in Q2 GDP Forecast (%) 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 3/13 4/13 5/13 6/13 n Consumer Condence: -0.04% n External: -0.00% n Housing & Construction: +0.02% n Money: -0.09% n Prices: -0.38% QoQ SAAR GDP % Change
n Budget: +0.00% n Cap Utilization: -0.05% n Consumption: -0.00% n Employment: -0.07% n Financial: +0.42% n GDP: -0.27% n IP: -0.46% n Inventories: -0.01% n New Orders: -0.01% n PMI: -0.45% GDP Forecast: +1.76% (RHS)
Source: Morgan Stanley Investment Management, Haver Analytics. Data as of June 11, 2013.
Giannone, D., L. Reichlin, and D. Small (2006) Nowcasting: The real-time informational content of macroeconomic data, Working Paper Series 633, European Central Bank.
7
Banbura, M., M. Modugno (2010) Maximum likelihood estimation of large factor model on datasets with arbitrary pattern of missing data, Working Paper Series 1189, European Central Bank.
8
In examining Display 6, we can see that the strength in economic releases in Q1 has moderated in Q2, with current Q2 GDP tracking below 2 percent. The line, plotted against the right axis, represents the evolution of our Q2 2013 GDP forecast as we attain more data related to economic activity throughout the quarter; the stacked bars represent how the information contained in dierent data categories released during a given month, have caused our model to revise its estimate for Q2 2013 GDP. The values in the legend correspond to the cumulative eect each release type (considering data released from March 2013 to early June 2013) has had on our GDP forecast. This lull in economic momentum has come at a time when longer term treasury yields jumped meaningfully as markets reassessed the path of short-rates as Fed chairman Bernanke indicated that future easing would conditional on developments in the economy. The jump in the U.S. ten- year Treasury rate (~30 to 35 bps since the end of Q1 2013) would typically be consistent with a higher level of real growth, which can be an important insight for bond investors. Essentially, this re-pricing of risk in the ten-year rate could be considered, among other things, as compensation for increased volatility in nancial markets
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and for the increased relevance of near-term macroeconomic data in the determination of Fed policy. That said, the current benign growth rate would suggest that dramatic decrease in ten-year rates in unlikely, given that it has not been driven by unusually strong data. As to upside risk in rates, current modest price and employment pressures would make a data conditional shift in policy stance unlikely.
investor. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. All investments involve risks, including the possible loss of principal. Charts and graphs provided herein are for illustrative purposes only. Past performance is not indicative of future results. This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy Risk Considerations There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in a portfolio. Please be aware that portfolios may be subject to certain additional risks. Fixed-income securities. Subject to credit and interest-rate risk. Credit risk refers to the ability of an issuer to make timely payments of interest and principal. Interest-rate risk refers to fluctuations in the value of a fixed income security resulting from changes in the general level of interest rates. In a declining interest-rate environment, the portfolio may generate less income. In a rising interest-rate environment, bond prices fall. Diversification does not protect you against a loss in a particular market; however it allows you to spread that risk across various asset classes. Diversification does not eliminate risk of loss. Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.
Conclusion
Managers will need to think about xed income dierently going forward as we enter into a trend toward higher interest rates. No longer should passive xed income investments strategies be expected to produce the same level of consistent returns as it had over the past 30 years. Managers will need to adapt their strategies to one that actively manages duration exposure in order to reduce the risk of rising rates while preserving returns achieved from spread. Our robust set of analytical tools to manage interest rate risk will help us produce consistent returns as yields rise.
Important Disclosures: The views and opinions are those of the author as of June 11, 2013 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers. All information provided is for informational purposes only and should not be deemed as a recommendation. The information herein does not contend to address the financial objectives, situation or specific needs of any individual
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54
INDIAS STEALTH GAME CHANGER
Indias Stealth Game Changer

Much like the proverbial frog that fails to notice a slow increase in the temperature of water in the vessel, markets too at times fail to notice incremental changes. Markets obsess about the next game changer event at the expense of not focusing on more gradual but decisive shifts in other variables. For commentators, a game changer could be an election, a budget or a central bank meeting. However, very few events live up to the hype. In fact, the real game changers are either evident only in hindsight or they build up slowly over time, rarely allowing us the luxury to post a calendar entry reminder. Slowly but surely, we believe trends in the global energy space are gathering momentum and have potentially huge implications for India. Technological advancements facilitating economically viable extraction of shale oil and gas have altered the U.S.s energy landscape meaningfully. After increasing relentlessly for 25 years, the U.S.s external dependence for its energy needs has reduced in the past seven years by a dramatic 11 percent (Display 1). Increasing production of natural gas and oil has meant that U.S. is almost 80 percent self-sucient in its energy consumption. This is a big shift in pattern for the worlds largest consumer of oil that accounts for almost 21 percent of global consumption.1
AUTHORS
AMAY HATTANGADI
SWANAND KELKAR
Vice President Morgan Stanley Investment Management
Source: BP Statistical Review of World Energy June 2012. Data as of December 2011.
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Display 1: US Energy Consumption and Production

1200 1000 million tons oil equivalent 800 600 75% 400 200 0 70% 65% 60% 95% 90% 85% 80% self-sufciency
Display 2: S&P 500 vs. Brent Oil

100 80 60 40 20 0 -20 -40 12/08
1981
1984
1987
1990
1993
1996
1999
2002 2005 2008 Self-Sufciency (RHS)
2011
6/09
12/09
3/10
11/10 Brent Oil
5/11
10/11
4/12
10/12
3/13
Gas Production
Oil Production
S&P 500 Total Return
Source: BP, MSIM. Data as of December 31, 2011.
Source: Bloomberg. Data as of March 2013.
Indeed, some experts are arguing for U.S. energy selfsuciency within a decade. This dynamic is evident in recent oil price behavior. Since the global nancial crisis, U.S. equity markets have, quite counter intuitively, moved in tandem with crude oil prices. But this correlation appears to have broken down of late, as U.S. equity markets have surged but oil prices have languished (Display 2). Until recently, higher U.S. economic growth would create a demand driven increase in oil prices that in turn imposed a tax on consumption, pulling down growth. We are seeing the rst signs of a breakdown in this self-limiting cycle primarily driven by the shale dynamic. Greater self suciency for the largest consumer could mean a prolonged downward drift in oil prices.
The other related change is the divergence in natural gas prices within the U.S. and rest of the world. U.S. domestic prices are at USD 3.5 per million British thermal units (mmbtu)2 while Asia is importing gas for as high as USD 16 per mmbtu. Almost 35 percent jump in natural gas production in the U.S. over the past few years has weighed on domestic U.S. natural gas prices. This may not immediately translate into lower prices globally as the infrastructure for transporting gas takes time to set up. Given the large external energy dependence, US LNG terminals geared to import LNG for regasication are turning redundant as what is now needed is plants that can liquefy gas and load it onto tankers for export. While creating large-scale export facilities could take time, what seems to be happening almost immediately in the U.S. is domestic substitution of coal and oil with cheaply available gas. This dynamic displaces coal and oil as fuels from the domestic energy mix. So the transmission mechanism of the shale revolution in the U.S. may be through higher coal exports and lower oil imports. U.S. coal exports have risen signicantly in the past few years with over 10 percent of the U.S. coal production now exported, as compared to less than 4 percent about six years ago. Similarly, net oil imports have fallen from over 13 million barrels per day (bpd) to 6 million in the same time. (Displays 3 and 4 )
Source: Bloomberg. Data as of February 28, 2013. mmbtu is a unit for measuring energy content.
2
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Display 3: Rising US coal exports

175 Mln short tonnes 155 135 115 9.5% 95 75 55 35 1990 7.5% 5.5% 3.5% 2012 15.5% 13.5% 11.5%
coming in from the new Chinese leadership have highlighted the need for balanced growth with a particular focus on reducing air pollution in the Chinese cities.4 Satellite derived maps for measuring global air pollution5 clearly show that China and especially its industrialized East are amongst the most polluted regions in the world with many Chinese cities recording air pollution readings well above the World Health Organization (WHO) standard (Display 5 ). Display 5: PM2.5 in major Chinese cities (January 2013 average)
350 300 250 200 150 100 50 0 g/m3
1992
1994
1996
1998
2000 2002 2004 2006 2008 Exports/Production (RHS)
2010
Coal Exports (LHS)
Source: US DOE/EIA, Deutsche Bank. Data as of December 31, 2012.
Display 4: U.S. net imports of crude oil and petroleum products

14000 13000 12000 11000 kbpd 10000 9000 8000 7000 6000 5000 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13
Source: MEP, WHO, Deutsche Bank. Data as of January 2013.
Source: EIA, Citi Research. Data as of January 2013.
True, as this may be, what matters especially for coal demand and pricing is China which accounts for almost 50 percent of global consumption.3 In short, when it comes to global demand dominance, China is to coal, what U.S. is to oil. A dierent dynamic is at play here. Various press statements
BP Statistical Review of World Energy June 2012. Data as of December 2011.
3
A recent Deutsche Bank report identies coal burning and automobile emissions as the chief contributors to rising air pollution.6 While stricter emission norms for automobiles have already been proposed, strong disincentives for coal burning could well be round the corner. While slower Chinese growth will itself create a headwind for coal consumption growth, an active policy of disincentives can cause the demand for coal to decelerate even faster. The report estimates that consumption growth for coal in China may turn negative within the next four years, much before what most analysts expect. Of course, natural calamities or
Source: http://www.nasa.gov/topics/earth/features/health-sapping. html, for source and methodology. Retrieved on March 31, 2013. PM2.5 is a measure for atmospheric particulate matter.
5
See, for example, remarks by Premier Li Kiqiang at http://language. chinadaily.com.cn/portal.php?mod=view&aid=32657

4
Source: China: Big Bang Measures to Fight Air Pollution, Jun Ma, March 2013
6
WHO standard
Shijiazhuang
Hangzhou
Guangzhou
Chongqing
Shenzhen
Shenyang
Beijing
Nanjing
Shanghai
Jinan
Urumuqi
Xi'an
Wuhan
Chengdu
Tianjin
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geopolitical risks can cause short term spikes however, our base case scenario calls for subdued prices of oil and coal over the medium term. And that could be the stealth game changer that could reverse Indias economic malaise. What does all this mean for India? Indias economic susceptibility to the problems of widening twin decits (comprising the Current Account Decit (CAD) and Fiscal Decit) has dominated recent discussions.7 The CAD has worsened over the last few quarters, leaving the Indian economy dependent on large and sustained foreign capital ows to fund it. A widening CAD has increased Indias dependence on foreign capital ows to fund it. Since 2008, foreign capital ows (FDI + portfolio ows) have increased signicantly. The ability to attract large and sustained capital ows is Indias biggest challenge and hence vulnerability. At the heart of the CAD, lies the widening trade decit with the latest print at 11.4 percent of GDP.8 While gold imports and policy measures to discourage them have been center-stage, the more important component of CAD is the large energy decit at 7.5 percent of GDP (net oil 6.6 percent plus net coal 0.9 percent). With energy decit alone accounting for two-thirds of the trade decit, lower oil and coal prices in the medium term are godsend for improving the decit. Every 10 percent change in oil and coal prices impacts the trade decit by a signicant 0.65 percent and 0.10 percent of GDP respectively. Extrapolating these trends, it may not be unthinkable to project both the trade and current account decits being lower over the next few years. Even stabilization, if not an outright reduction in the energy import bill will help the scal decit as well through lower fuel subsidy as a share of GDP. In FY13, fuel subsidy is likely to account for 1.0 percent9 of the scal decit at an average price of USD 110 per bbl. Formulaic price hikes in diesel have resulted in under-recovery per liter coming down from Rs. 17/ liter in September 2012 to about Rs. 6.5/liter now. If average oil prices stay where they are currently and even if no further
7 8
BOX 1: INDIAS ACHILLES HEEL HER TWIN DEFICITS
Since the global financial crisis of 2008, Indias combined fiscal deficit (Center + States) has steadily increased from 4.0 percent in fiscal year 2008 to 8.1 percent in fiscal year 2012.10 Apart from the economic slowdown that affected tax revenue growth, counter-cyclical fiscal measures to boost the economy have led to acceleration in the cost heads. One of the main contributors to the increasing deficit has been fuel subsidies. Auto and cooking fuels are sold in the country at administered prices, which are typically lower than the international parity prices. The burden of the difference between the two prices (called under-recovery) is borne by the State owned oil companies and the central subsidy. With rising crude oil prices not being transmitted through commensurate administered price increases, under-recovery has steadily increased, not only in absolute terms but also as a share of GDP. From 0.4 percent of GDP in 2009, fuel subsidy has increased to 1.0 percent in 2012.11 Over the past few months, the Government has instituted a procedure to increase administered diesel prices (Petrol is sold at market prices) and cap the usage of LPG per household. This along with fall in international prices in these products has significantly reduced the under-recovery. A sensitivity analysis of the impact of these changes on the fiscal deficit is shown in the Table below.
CASE 1 CASE 2 CASE 3
Crude price (US$/bbl) Gross FY14E under-recoveries est. (Rs. bn) Government share of subsidies est. (Rs. bn) As a % of FY14E GDP Source: Citi Research Estimates.
90 580 348 0.3%
100 969 581 0.5%
110 1357 720 0.6%
See Box 1 for details.
Source: CEIC, Morgan Stanley India. Three months moving average, annualized. Data as of February 28, 2013.
9
Trend in the Current Account deficit has been similar with the CAD widening from 2.8 percent in 2009 to 5.1 percent in 2012.12 The key contributors have been higher energy imports (predominantly oil and coal) that have increased from US$95.4 billion to US$172.1 billion and higher gold imports that have increased from US$28.6 billion to US$50 billion.13 Relatively inelastic administered prices resulted in demand not adjusting downwards to higher international prices. This is one of the reasons why the CAD has been sticky even in the face of overall economic slowdown. Lower international energy prices help the trade deficit (price effect), just as higher administered prices deters wasteful use (volume effect).
Source: Citigroup. Data as of March 2013. Source: Budget Documents. Data as of December 2012. Source: Citi Research Estimates, RBI and CSO. Data as of December 2012.
12 13
10 11
Source: Company Reports, Budget Documents and CSO. Data as of December 2012.
Source: PPAC, RBI, Ministry of Commerce and Citi Research Estimates.
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diesel price hikes happen, the scal burden of fuel subsidy could be 0.6 percent of GDP in FY14. If oil prices were to reduce by 10 percent, this would fall to 0.3 percent. Finally, lower coal prices over the medium term are benecial to an economy whose coal imports are likely to rise at the fastest clip amongst all developing countries. For all those holding their breath for an economic revival to be steered by big bang reform announcements, real action may be happening elsewhere. Generally, we are skeptical about anything that is touted as game changing but could the imminent prospect of lower energy prices be Indias silver bullet? For all you know, economic improvement might already be underway without much fanfare; after all, this game changer was not marked on your calendar.
Important Disclosures: The views and opinions are those of the authors as of May 2013 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions or all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in the strategies and products that the Firm offers. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. All investments involve risks, including the possible loss of principal. Charts and graphs are provided for illustrative purposes only. Past performance is not indicative of future results. Index returns do not include any expenses, fees or sales charges, which would lower performance. The indexes are unmanaged and should not be considered an investment. It is not possible to invest directly in an index. The information in this report is for informational purposes only, and should in no way be considered a research report from Morgan Stanley Investment Management (MSIM), as MSIM does not create or produce research.
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CONVERTIBLES: DESIGNING AN OPTIMAL INVESTMENT STRATEGY
Convertibles: Designing an Optimal Investment Strategy

What are convertibles and how do they compare to stocks?
Display 1 illustrates the worldwide convertibles market capitalization, as well as the individual countries that issue these securities. This is an asset that clearly has global appeal, and may oer a level of diversication1 that a wide level of investors may seek. Display 1: Global Market Capitalization
Global Market Cap: U.S.$483 billion
U.S.$210 bn (43%) U.S. and Canadian Convertibles Netherlands Germany U.S.$122 bn (25%) European Convertibles Denmark Norway Sweden Finland U.S.$33 bn (7%) Japanese Convertibles AUTHOR
TOM WILLS
Canada United States Mexico Colombia Peru Brazil Chile Argentina
Belgium Switzerland UK France Italy Spain Portugal Austria
India Pakistan South Africa $43 bn (10%) Latin American and African Convertibles and Other New Zealand
China Japan South Korea Hong Kong Taiwan Thailand Philippines Malaysia Singapore Indonesia Australia
U.S. $75 bn (16%) Asian Convertibles
Source: UBS. Data as of December 31, 2012. For illustrative purposes only. Diversification does not protect an investor against a loss in a particular market; however it allows an investor to spread that risk across various asset classes.
1
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Convertible bonds are sometimes overlooked by investors, as it is easy to get confused by the technical terms of a specialized subject. The essential construct of a convertible, however, is really quite straightforward: it is simply a regular corporate bond with an equity option2 attached. So, by investing in a convertible bond, the buyer is eectively giving up a portion of the yield that the bond can earn by re-investing in an equity option. By combining bonds and equity options into one hybrid instrument, the convertible oers yield potential (albeit reduced) and participation in the potential upside of shares. The result is an asymmetric payo to stocks with potential upside of the equity market and a reduced portion of the possible downside. As a hybrid instrument, a convertible bonds behavior can be depicted by graphing it in terms of equity and credit risk as in Display 2. Here, we show a simple diagonal line for stocks where return has a linear relationship to price. We simplify corporate bond return, ignoring yield and changes in yield or spread, by drawing a horizontal line to show that this asset is not dependant on equity price, except in the case of default where clearly the credit and the equity converge to a nil value. The convertible return line is then a combination of the equity and credit return. When equity prices are rising (right hand side of Display 2), a convertibles return typically follows the equity return more closely as the investor can convert into rising shares to make an equity-like return. But when equity prices are falling (left hand side of Display 2), the convertible bond exhibits a kinked payo because the instrument has a lower boundary at its cash redemption value, thereby providing bond-like risk. Of course, in default, convertibles, like equity and credit, will converge to zero. It is this kinked payo pattern that helps to visualize the asymmetric nature of a convertibles potential return.
Display 2: Convertible Bond Behavior

The asymmetric profile of a convertible bond can be attractive to investors
Return
Convertible bond Bond Floor
Equity Value
Equity Price
The equity option has little value. The convertible behaves like an underlying corporate bond
Bond-like
Balanced
The convertible has balanced qualities. This is the optimal point where equity and bond characteristics overlap
The equity option is in the money and so is valuable. The convertible behaves like the equity
Equity-like
Source: MSIM. For illustrative purposes only.
Investors sometimes ask why they should not simply construct their own yield-plus-options payo by separately buying corporate bonds and exchange-listed equity options. The answer is that the options market is generally liquid for large cap stocks and typically for short maturities such as three or six months. The convertibles market oers an opportunity to buy longer-dated four- to ve- year options at wholesale prices. And in an uncertain world, options can be a valuable tool. To prove this point, we can take a recent positive period for stocks, using the year ended December 31, 2012 (see Display 3). In that year, the MSCI World (MSCI) Equity Index rose 16.51 percent while convertibles provided 80 percent of the upside, with the UBS Global 300 (G300) Convertibles Index rising 13.25 percent. But if we extend this analysis for the ve years ended December 31, 2012, we see that the G300 returned 2.59 percent annually and the MSCI returned -0.55 percent. Finally, over the entire 19 years since the inception of the G300, the G300 was up 7.01 percent per year while MSCI stocks rose only 4.32 percent. Furthermore, this higher return was earned with far less volatility as over 19 years the G300 had annualized standard deviation of 11.52 percent vs. 19.34 percent for MSCI stocks.
The Downside of Quantitative Easing, D.L. Thornton, Economic Synopses #34, St. Louis Federal Reserve, 2010.
2
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Display 3: Convertibles vs. Equities: Historically More Return, Less Risk

Convertible Bonds (CBs) have outperformed equities over nearly two decades since the launch of the UBS Global 300 Convertibles Index Annualized Returns: UBS Global 300 Convertibles Index vs. MSCI World Equity Index. Daily data. Priced in USD since January 1, 1994
20 20 15 15 Percent Percent 10 10 5 5 0 0 -5 -5 2.59 2.59 -0.55 -0.55 1 3 1 Yr Yr 3 Yrs Yrs UBS UBS Global Global 300 300 Convertibles Convertibles Index Index 5 10 Yrs 5 Yrs Yrs 10 Yrs MSCI MSCI World World Equity Equity Index Index 13.25 13.25 7.33 7.33 8.13 8.13 7.01 7.01 16.51 16.51
Display 4: Seven Golden Rules

INVESTMENT PROCESS PRINCIPLE RISK GUIDELINE
Delta risk management Credit risk management Duration Management
40 to 50% absolute delta target; within 20% of index Weighted average Investment Grade at all times Target duration of 2 to 4 years Target cheaper than index average 10% ownership limit of any issue Fully hedge currency to minimum 97% accuracy Within 10% of index per region and 5% per sector
4.32 4.32
Fair Value pricing Liquidity Currency Region and Sector exposure
Annualized Risk: UBS Global 300 Convertibles Index vs. MSCI World Equity Index. Daily data. Priced in USD since January 1, 1994.
30 30 25 25 Percent Percent 20 20 15 15 10 10 5 5 0 0 7.05 7.05 13.46 13.46 12.48 12.48 9.78 9.78 23.28 23.28 18.20 18.20 11.52 11.52 19.34 19.34
Equity Risk (Delta) Management Equity risk is typically the most signicant risk contributor in a balanced convertibles portfolio. Fortunately, for the convertibles manager, a single number called delta can be observed for each security that helps to understand this exposure. Delta can be thought of as the probability to exercise, so an at-the-money option would typically have a delta around 50, eectively meaning that there is a 50 percent chance of achieving the conversion price and thereby providing upside potential from equity appreciation. Defensive managers may, for example, buy 20-delta outof-the-money convertibles while more aggressive managers may choose to buy 80-delta in-the-money convertibles. As balanced managers, we believe the sweet spot in convertibles investment is in between because here an investor has the potential to achieve strong participation on any rise in the stock, but be close enough to the bond value to provide downside protection if the equity falls.
1 3 1 Yr Yr 3 Yrs Yrs UBS UBS Global Global 300 300 Convertibles Convertibles Index Index
5 10 5 Yrs Yrs 10 Yrs Yrs MSCI MSCI World World Equity Equity Index Index
Source: Bloomberg. Data as of December 31, 2012. Past performance is not indicative of future results.
Designing an Optimal Investment Strategy

We believe that a balanced convertible investment can best be done by devising a simple construct of guidelines that are clearly laid out and then sticking to that approach in all market conditions. We, therefore, suggest our Golden Rules for convertibles investment (see summary in Display 4 ):
We, therefore, set our rst Golden Rule as targeting a convertibles portfolio with a delta range of 40 percent to 50 percent
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Credit Risk Management Many convertible investors believe that they have created an asymmetric return prole simply by buying a 50-delta portfolio. However, this ignores the crucial consideration of credit risk. For more highly levered companies, the convertible will provide much less asymmetry because if the stock falls materially on bad news, the bond element in the convertible will fall too, as markets begin to question the recovery risk on the debt. Higher yielding convertibles can therefore be good contributors to expected return but of course come at the price of adding to risk at the same time. We therefore believe that a truly asymmetric balanced convertible portfolio requires close attention be paid to credit risk.
Valuation and Pricing Convertible bonds often trade either above or below their fair value. So, if we try to value a convertible by pricing the bond component (largely using the credit spread which we can observe in the market) and adding to that a value for the equity option component (essentially by observing the volatility of the stock) then we might arrive at a fair value which is either above or below the current price of the convertible in the market. This occurs often because of supply and demand factors. For example, when demand for convertibles is high but supply is low, most convertibles will typically trade above their fair value and vice versa. We observe this most often on a regional basis where, for example, in recent years, European investors have wanted more convertibles than there has been supply, so European convertible bonds have been expensive. We also very frequently see benchmark names trade with rich valuations because many managers stick to their benchmarks and unwittingly bid up the price of index names by owning them just to match the index.
Our second Golden Rule is then to try to maintain a weighted average investment grade prole which typically allows for 30 percent to 40 percent of the portfolio in sub investment grade quality securities.
Duration Management The third cornerstone of a truly asymmetric convertibles portfolio is its duration. In general, longer dated convertibles exhibit less convexity because news aecting the stock will also aect even a good credit if repayment of the bond is far in the future. For example, if an investment grade company suers a 20 percent fall in its stock price on a weak earnings outlook, a short-dated convertible priced around par will be relatively unaected as investors will look to repayment of the principal soon. However, if in that same situation, the convertible is a ten-year bond, investors can sell it as the equity prospects are diminished and the opportunity to recover par is a long time away.
Our fourth Golden Rule is simply to carefully consider the technical valuation of each convertible and aim to buy the cheapest portfolio possible.
Liquidity Management Liquidity in all credit markets has been compromised since the credit crisis in 2008 and the convertible bond market is no exception. With less hedge funds active in the space, most owners of convertibles tend to be more buy-and-hold, which means that managers need to take caution buying smaller and less liquid deals for fear of not being able to sell them at a later date without impacting the price. The average issue size in the global convertible market currently is around U.S. $400 million. If a portfolio is U.S. $1 billion in size and has 100 holdings, then the average position will be U.S. $10 million, so this portfolio would own 2.5 percent of the average bond ($10 million/$400 million). But if the portfolio is U.S. $4 billion with 100 holdings, then the average position in now U.S. $40 million which means this portfolio would own a problematic 10 percent of the average security. The size of the portfolio greatly impacts the managers ability to trade eectively in the market.
Our third Golden Rule is then to seek to target the shortest dated convertibles that can be found. Our rule is to seek to have a duration of between 2 and 4 years at all times.
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Our fth Golden Rule is to seek to own a limit of 5 percent of the average market cap of securities in a portfolio, aiming to never own more than 10 percent of any single issue. At current market size, this implies soft-closing a portfolio at U.S. $2 billion because average holdings would be $20 million which is 5 percent of the $400 million average bond.
Currency Management As we will make the case below, we strongly believe that investors should seek to maximize the smaller size of the convertible bond market by investing globally. This does mean, however, that return in any period will be a combination of convertible price changes and currency eects. To deliver a clean convertibles-only return, we therefore believe it makes more sense to hedge all currencies back to a base currency (or additional other currencies, in various hedged currency share classes) so the investor is left with a return that is solely related to convertible bonds and is stated in their preferred currency.
Our seventh Golden Rule is to seek to utilize the whole convertible market and invest where the bonds are. Accordingly, we set a limit of being 10 percent over- or underweight to any region and 5 percent over- or under weight to any sector. We will investigate the merits of this approach in the following two sections, rst by analyzing global supply by region and then using those facts to examine the limitations of a regional approach.
Global Supply Breakdown

As shown earlier in Display 1, the market capitalization of the global convertible market, as of December 31, 2012, was nearly $500 billion, and was comprised of about 1,200 liquid issues.3 Further, we observe the following general market characteristics: Nearly half of the supply is in the Americas, with around 25 percent in each of Europe/Middle East/Africa (EMEA) and Asia, where approximately 20 percent of paper is issued in Emerging Markets. Approximately 50 percent of the universe is Investment Grade (IG) quality but only 35 percent is rated IG by the major agencies Moodys, S&P or Fitch. Another 15 percent of IG quality paper is unrated, as many borrowers issuing only a convertible do not pay the extra fees to have an issue rated (this is acceptable to convertible managers who are often not credit-oriented in their training).4 Since the credit crisis in 2008, global interest rates have collapsed, allowing large, stable IG companies to borrow cheaply in the straight bond market without giving away equity options. Accordingly, the global market for convertibles has migrated from around 60 percent supplied by IG issuers to closer to 50 percent currently.5 Historically, we have also witnessed important dierences among regional sub-markets. The U.S. convertible market, for
3 4 5
Our sixth Golden Rule is to consider hedging all FX exposures with a minimum of 97 percent accuracy. It is not realistic to set this gure closer to 100 percent because asset and currency prices are in constant ux, but we do observe from our experience that a 97 percent accuracy rule can deliver the message well and can help protect investors from their single largest concern when they invest outside their home market.
Region and Sector Management We observe that most managers tend to have a home bias by typically investing materially overweight in their home region. This is likely partly because managers possess local expertise, and partly because their investors will typically demand investment exposure closer to home. However, because the convertible market is only a mid-sized market, we believe investors could materially compromise their long-run opportunity set unless they utilize the whole global market.
Source: MSIM. Data as of December 31, 2012. Source: MSIM. Data as of December 31, 2012. Source: MSIM. Data as of December 31, 2012.
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example, has grown up since the 1960s, funding many smallto mid-cap growth companies that have used convertibles as a tool to help conserve cash and mitigate borrowing costs. In Europe, on the other hand, strong issuance emerged in the past 20 years from larger IG corporations who used the convertible as a balance sheet risk management tool to ne-tune their optimal debt/equity mix. Convertibles were also used where rms had cross-holdings to sell. This gave rise to the exchangeable convertible, which is simply a bond issued by Company A, but converting into the stock of Company B. Asian issuance is the latest to emerge in size, as growth of those economies, combined with unfamiliarity from Western bond investors, has meant that those rms need to nance their growth and look for possible solutions to manage the costs. Given all of the above, we would estimate that around twothirds of the U.S. market is sub- investment grade quality, while two-thirds of the market in the rest of the world is investment grade quality. As the U.S. market comprises nearly half of the total world supply, we arrive at our estimate of 50 percent of IG paper globally.6
would give us a short list of nearly 150 securities which, in our estimation, is more than sucient to invest in 100 names across sectors, regions and credit types. However, if we focus on a limited region such as Europe, the universe of 250 issues only provides around 25 to 35 good ideas, which in our opinion, is not a sucient quantity for a diversied portfolio. Even in the U.S., the universe of 700 bonds only provides 70 to 100 investable ideas which is arguably fairly well-diversied but it does ignore half of the market which we believe includes some very good investment opportunities from across the world. A further issue to be aware of, particularly in the small and mid-cap lead U.S. market, is that as more sub-IG issuers bring paper, fewer convertibles may provide true bond-oor protection if equities should falter. Asymmetry comes from a stable credit that helps support a failing option, but weaker credits will fall if equities perform badly, giving the investor little help managing downside risk. Accordingly, investors in higher-yielding convertible bonds should be aware that they are taking both material equity and credit risk, and, therefore, may not be getting the asymmetry they set out to achieve.
Regional vs. Global Investment

When we perform fundamental analysis, we assess each convertible bond on three key metrics: (i) EQUITY ANALYSIS we examine a range of key equity attributes to assess if the equity has enough potential upside to justify buying the embedded option (ii) C REDIT ANALYSIS we perform detailed fundamental credit research to assess if the credit is acceptable and if the bond prices the credit risk accordingly (iii) T ECHNICAL ANALYSIS - once we have decided whether we like the underlying equity and credit, we still have the nal critical step of assessing if the convertible bond itself is attractive. Here, we look at rich/cheap valuation, delta prole, convexity, duration, yield and other factors. Typically, in our opinion, about 10 to 15 percent of the market looks attractive across all three of these metrics. If we invest across the entire global universe of 1,200 names, that
6
Conclusions
Convertible bonds can be very useful diversifying tools for multi-asset class investors and have historically demonstrated higher risk-adjusted returns than stocks over long periods of time. There are, however, some key lessons for investors to bear in mind when evaluating the asset class, which we discuss below: Invest Globally The convertible market, at roughly U.S. $500 billion in size, is only about half the size of the global high yield bond market so it is therefore very limiting to invest in regional strategies which can not deliver adequate diversication across the full range of sectors, credit qualities, market caps and underlying growth vs. income equity themes.
Source: MSIM. Data as of December 31, 2012.
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Even in the Americas, which is the largest regional market, we would ask any investor, Why look at 700 ideas when you can pick from 1,200? If the answer is because of currency risk, we would simply suggest considering hedging that risk back to U.S. dollars using simple currency forward hedges. Beware of Credit Risk Convertible bonds are usually sold on the basis of delivering a simple message of equity upside and bond protection. However, investors may not be aware that they are not getting adequate bond protection if they are investing in higher yielding bonds. This is particularly true in the U.S. market, where two-thirds of the issuers are below investment grade quality. A corollary of this is that managers of convertibles should demonstrate their credit research capabilities to deliver the message or promise of true asymmetry.
DEFINITIONS
MSCI World (MSCI) Equity Index. The Morgan Stanley Capital International (MSCI) World Index is a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term free float represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The MSCI World Index currently consists of 24 developed market country indices. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends. UBS Global 300 (G300) Convertibles Index. A market capitalization weighted, total return index that tracks the global convertibles market. In the Money. For a call option, when the options strike price is below the market price of the underlying asset. For a put option, when the strike price is above the market price of the underlying asset. Standard Deviation. Applied to the annual rate of return of an investment to measure the investments volatility. Standard deviation is also known as historical volatility. Delta. The ratio of the change in price of an option to the change in price of the underlying asset. Investment Grade. A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Duration. A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Equity Risk. Equity risk is the risk that ones investments will depreciate because of stock market dynamics causing one to lose money. Credit Risk. Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. Convexity. A measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Credit Spread. The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
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The views and opinions are those of the authors as of May 2013 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions or all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in the strategies and products that the Firm offers. All information provided is for informational purposes only and should not be deemed as investment advice or a recommendation. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. Charts, graphs, and mathematical examples provided herein are for illustrative purposes only. Past performance is not indicative of future results. The numbers used for certain assumptions may be materially different from the numbers that would apply in reality to certain variables and are likely to change over time. Index returns do not include any expenses, fees or sales charges, which would lower performance. The indexes are unmanaged and should not be considered an investment. It is not possible to invest directly in an index. There is no guarantee that an investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long- term, especially during periods of downturn in the market. All investments involve risks, including the possible loss of principal. Commodity investments are more volatile than investments in traditional securities, such as stocks and bonds. The value of equity investments are more volatile than the other securities; stocks are more volatile than corporate bonds, and investments in foreign markets entail special risks such as currency, political, economic, and market risks.
The prices of equity securities will rise and fall in response to a number of different factors. In particular, prices of equity securities will respond to events that affect entire financial markets or industries and to events that affect particular issuers. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks generally associated with foreign investments. Investments in currency derivatives (CDs) may substantially change the portfolios exposure to currency exchange rates and could result in losses to the portfolio if currencies do not perform as the Adviser expects. Forward currency exchange contracts and currency futures and options contracts create exposure to currencies in which the portfolios securities are not denominated. The use of CDs involves the risk of loss from the insolvency or bankruptcy of the counterparty to the contract or the failure of the counterparty to make payments or otherwise comply with the terms of the contract. Investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. Credit risk refers to the ability of an issuer to make timely payments of interest and principal. Interest-rate risk refers to fluctuations in the value of a fixed-income security resulting from changes in the general level of interest rates. In a declining interest-rate environment, the portfolio may generate less income. In a rising interest-rate environment, bond prices fall. The information in this report is for informational purposes only, and should in no way be considered a research report from Morgan Stanley Investment Management (MSIM), as MSIM does not create or produce research. Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.
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IS THE U.S. THE BREAKOUT NATION OF THE DEVELOPED WORLD?
Is the U.S. the Breakout Nation of the Developed World?

After World War II, when fear of Hitler was giving way to fear of Stalin, George Orwell rebuked intellectuals for the instinct to bow down before the conqueror of the moment, to accept the existing trend as irreversible. In recent decades, the chattering classes have continued to show the same reex, bowing down before the rise of Japan in the 1980s, of Silicon Valley in the 1990s, and of the big emerging markets known as the BRICs1 in recent years. From 2000 to 2009, as the U.S. share of the global economy declined from 32 to 22 percent, while the emerging market share rose from 20 to 35 percent, many intellectuals came to assume that the big emerging nations led by Brazil, Russia, India, and China were to be the conquerors of the future.2 Not so fast. In the normal course of events, the hot trend of one decade fades in the next, and that is happening now. All the big emerging markets are all falling back to earth. Among the BRICs, only China is growing faster than the emerging market average, and even there the GDP growth rate dropped to below 8 percent last yeardown from an 11 percent pace in the past decade.3 China now looks likely to slow to 5 to 6 percent in the next few years, weighed down by the sheer size and age of its increasingly middle-income economy. India has slowed just as dramatically, Russia and Brazil even more so. It is now possible that Russia, Brazil and South Africa could grow slower than the United States in coming yearsa shocking comedown given the fact that their per capita incomes are much lower. Those who forecast the inevitable rise of the big emerging giants and decline of the West may have to pick new victors.
AUTHOR
RUCHIR SHARMA
1 2 3
BRICs denotes Brazil, Russia, India and China. Source: Building Better Global Economic BRICs, Jim ONeill. November 30, 2011. Source: Haver Analytics. Data as of December 31, 2012.
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The world economy has returned to its normal pattern after an unusually rosy decade. In the 2000s, many nations were recovering from the crises of the 90s, boosted by the tailwinds of easy money pouring out of the United States and Europe and sky high optimism among global investors. As of 2007, nearly every country looked like a winner and only three were in recession. But by the next year, the global nancial crisis had reversed all the tailwinds and restored the normal pattern, in the world economy, which produces just as many losers as winners. These winners are the breakout nations, those most likely to beat the growth rate of rival economies in their per capita income class, and the markets expectations for that class, over the next ve years. In the developing world, the hot economies of the last decade have been replaced by new breakout nations, from the Philippines to Thailand and Nigeria, where new leaders who have a basic grip on economic reform are raising the potential for sustained growth. In the developed world, by most key measures of recovery from the global nancial crisis, France, Italy, and Japan are doing quite poorly, whereas Germany and some Nordic countries seem to be faring better. But the leading candidate for breakout nation of the developed world is the U.S. The markets tend to register these changes faster than pundits do. Since mid-2011, the U.S. has grown fast enough to halt the past decades decline in its share of the global economy. In fact, the U.S. was the only major Western nation to end its losing streak (Display 1).
Display 1: U.S. Share of the World Economy Is Holding Steady

Current USD Share of World GDP
45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1980 1984 EM 1988 Euro area 1992 1996 Japan 2000 2004 2008 2014F
United States
Source: IMF, WEO. Data as of April 2013.
The relative success of the U.S. economy came as such a surprise to investors, what with all the doomsaying of late, that they have driven U.S. stock prices to all-time highs. Meanwhile, the BRIC economies are not living up to their hype, so on average their stock markets, in dollar terms, are trading 40 percent below their historic peaks (Display 2). Display 2: U.S. Stocks Outperform the BRICs
500 450 400 350 300 250 200 150 100 50 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 MSCI BRIC - Price - USD (LHS) 1/11 1/12 600 5/13 1000 800
Down 40% All time high
1800
S&P 500 New all time high
1600 1400 1200
S&P500 - Price - USD (RHS)
Source: MSCI, S&P, FactSet. Data as of May 2013.
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It always makes sense to judge competition by weight class, and the U.S. looks particularly strong in the class of large industrial economies, driven by its traditional advantages, including its ability to innovate and adapt quickly, particularly in applying new technology. Display 3 dramatizes the recent strength of the U.S., compared to Europe. U.S. real GDP has grown for 15 consecutive quarters and is now 3.2 percent above its 2007 peak, while Eurozone real GDP has fallen for six consecutive quarters, and is now 3.3 percent below its 2007 peak. Display 3: The Strength of the U.S. versus Europe
14,000 U.S. Real GDP 2013:1Q $13750 Billion
The Deleveraging Race

First, the U.S. is winning the race to dig its way out of debt. While total U.S. debt (combined government, corporate and household debt) is now strikingly high, at 300 percent of GDP, that is still lower than most rival economies. Moreover, what matters most for economic growth is whether debt is shrinking, and how fast. According to data from Haver Analytics, the U.S. is one of only three major developed economiesalongside Australia and Germanythat since 2008 has lowered its total debt as a share of GDP. Meanwhile, that burden is at or rising in most of the leading European economies as well as in Japan (Display 4 ). This makes the U.S. one of the few developed economies that is even loosely following the path of other developed countries that successfully negotiated similar debt crises, like Sweden and Finland in the 1990s. Display 4: What Matters Is Whether Debt Is Shrinking and How Fast
Total debt to GDP, US versus Europe
700% 600% 500% 400% 300% 200% 100% 0%
13,000
12,000
U.S. real GDP has increased for 15 consecutive quarters, and is 3.2% above its 2007 peak. 10,000 In contrast, Eurozone real GDP 3/98 3/00 3/02 3/04 3/06 3/08 3/10 3/13 has declined for 6 quarters, and is 3.3% below its peak, the same Eurozone Real GDP Seas. Adj. Annual Rate level it rst reached 7 years ago. 2013:1Q 8487 Billion 9000 8500 8000 7500 7000 6500 3/98 3/00 3/02 3/04 3/06 3/08 3/10
11,000
3/13
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Australia Japan Canada Portugal France Spain Germany UK US Greece
Q4 2012 Italy
Source: Bureau of Economic Analysis, FactSet. Source: Eurostat, FactSet. Data as of March 31, 2013.
Of course, it is no secret that the U.S. is younger and more exible than other rich economies, but it is not well understood that these advantages are now propelling a broad advance in Americas competitive position. This progress could largely erase many of the worst U.S. fears, which include mounting debt, high gas prices, the falling dollar, and a shrinking manufacturing industry. Heres how the U.S. really stacks up against the competition, in these critical areas.
Source: Various National Statistics Agencies. Data as of December 31, 2012.
Its worth noting that the U.S.s progress in deleveraging is also improving the competitive position of the U.S. against emerging markets such as China, which now has its own debt bomb. With a total debt burden that has hit 200 percent of GDP and is still rising fast, China arguably faces a bigger
71
challenge than the U.S., because it is harder for nations with a lower per capita income to cope with mounting debt. It is also important to note the key remaining threat to the U.S. growth prospects, which is rising government debt. While total debt is falling, owing to the eorts of households and corporations, government debt is still rising (Display 5 ). Display 5: The Big Threat to the U.S. is Rising Government Debt
Outstanding domestic credit as % of GDP
140% 120% 100% 80% 60% 40% 20% 0% 1947
The Dollar Advantage

The falling value of the dollar over the past decade is another important sign of U.S. competitive exibility, though it has been widely misinterpreted as a symbol of weakness. The dollar is now 25 percent below its peak in real terms (Display 6). Display 6: Dollar Is Very Competitive
160 140 120 100 80 60 40 20 0 -20 1/70 1/75 1/80 1/85 1/90 1/95 1/00 1/05 1/10 2/13
1953
1959
1965
1971
1977
1983
1989
1995
2001
2007
2012
Nominal Effective Exchange Rate - Index Number - Period Average - United States Trendline: Linear with 1st, 2nd standard deviation, trend based
Business
Financial Institutions
Government
Households
Source: IMF, FactSet. Data as of February 2013.
Source: Federal Reserve. Data as of December 2012.
The good news is that falling corporate and household debt reects the exibility of the American system. For example, one big reason for falling household debts is that the U.S. allows banks to force delinquent mortgage holders into foreclosurea threat from which Europeans are still heavily protected. This is brutal but eective, because an economy is hard-pressed to recover when its debt pile is growing. The bad news is that U.S. government debt is not only growing, but it is growing at a point in the economic cycle when it should be shrinking, in order to sustain recovery. The Scandinavian cases show that governments need to start cutting spending and debt roughly four years after the downturn and the U.S. is now many months past this point. If Washington can produce a credible road map to lowering public debt, it could solidify the U.S.s status as the breakout nation of the developed world.
The falling dollar is making U.S. exports more aordable abroad. As a result, the U.S. share of global exports is currently up a full 1.5 percentage points from its all-time low of 7.5 percent, hit in 2008 (Display 7.) Strengthening exports and decreasing oil imports are improving the U.S. trade balance, and have brought down the current account decit from 6 percent of GDP to just 3 percent, which means that the U.S. no longer has to borrow so much from China to fund that decit. Though late night comedians still crack jokes about the U.S. going hat in hand to China, the truth is that Chinas current account surplus is falling and its foreign exchange reserves have all but stopped growingclear evidence that it is taking in fewer dollars and buying less U.S. debt.
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Display 7: U.S. Exports Bounce Off the Bottom

U.S. Exports - Global Share (%)
14% 13% 12% 11% 10% 9% 8% 7% 6% 1/90
U.S. income levels by as much as 3 percent. This advantage is likely to endure for some time, even as the rise of emerging economies justies a shift in reserves to rival currencies. The U.S. surpassed Britain as the worlds largest economy in the 1970s, but British sterling held on to its reserve status for another 50 years. Today, neither the euro nor the yuan pose a serious challenge to the dollar as the worlds preferred currency.
The Manufacturing Renaissance

The competitive dollar exchange rate also fuels the renaissance of manufacturing in the U.S., which reacted much more quickly than Europe or Japan to new competition from the emerging world. In the 2000s, U.S. manufacturers cut back wages, replaced expensive American suppliers with foreign ones, and cut 30 percent of factory jobs, far more than Canada, Europe, or Japan (Display 9). Display 9: The U.S. Cut Its Factory Workforce Aggressively
U.S., Canada, EU 27 and Japan Changes in Manufacturing Employments 2012 versus 2000*
0% -5% -10%
1/92
1/94
1/96
1/98
1/00
1/02
1/04
1/06
1/08
1/10
1/13
Source: IMF
For all the talk about the dollars demise, its international status has not slipped in decades. The dollar share of global foreign exchange reserves has held steady at more than 60 percent (Display 8.) Display 8: Dollars Status Has Not slipped
Share of Total Global Reserves
100%
80%
-15% -20% -25% -30%
60%
40%
20%
-35%
U.S.
Canada
European Union
Japan
0%
Q1 99 USD
Q1 00
Q1 01 EUR
Q1 02
Q1 03 GBP
Q1 04 JPY
Q1 05
Q1 06 Other
Q1 07
Q1 08
Q1 09
Q1 10
Q1 11
Q1 Q4 12 12
Source: U.S. Census Bureau, Canada Statistics, Eurostat, Japan Statistics Bureau. Data as of December 31, 2012. * 2012 versus 2002 for Japan. Q1-Q3 2012 for European Union.
Source: IMF. Data as of December 31, 2012.
The reserve status of the dollar confers real benets, including the boost provided by cheap borrowing costs. Berkeley economist Barry Eichengreen estimates that this boost has eectively raised
U.S. companies also moved more quickly than developed world rivals to restrain wages and other costs (Display 10), and boosted the productivity of remaining workers by using new technology. The U.S. now generates annual manufacturing
73
output roughly equal to that of China, but the U.S. does it with a workforce one-tenth as large. Display 10: U.S. Manufacturing Cost Cuts
U.S. Manufacturing Plants* Changes in Costs of Inputs, Fuel and Compensation As Ratio to Shipments Average of 2010 and 2011 Versus 2007 and 2000
1.0% 0.5% 0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% Cost of Inputs n Versus 2007 Fuels and Electricity n Versus 2000 Wages Fringe Benets
Display 11: U.S. Factories Shift to Emerging World Suppliers

U.S. Intermediate Goods Imports* From Developed and Developing Countries as a Share of Manufacturing Shipments 2000, 2007 and 2011
8% 7% 6% 5% 4% 3% 2% 1% 0%
2000 n Developed Economies
2007 n Developing Economies
2011
Source: UN Comtrade, U.S. Census Bureau, Empirical Research Partners Analysis. Data as of December 31, 2011. * Comprised of 21: Industrial supplies not elsewhere specified, primary; 22: Industrial supplies not elsewhere specified, processed; 42: Parts and accessories of capital goods (except transport equipment); 53: Parts and accessories of transport equipment.
Source: Annual Survey of Manufacturing, U.S. Department of Commerce. Data as of December 31, 2011. * Excluding Oil Refineries and Metal Manufacturers.
Compared to their European rivals, U.S. companies have done more to incorporate inexpensive new emerging world sources for intermediate goods into their supply chains, as shown in Display 11.
All these cost cuts were tough, but the result was that U.S. manufacturers were able to defend their share of global manufactured exports. Even as Chinas share grew signicantly over the last decade, it grew almost entirely at the expense of Europe, not the U.S. By 2011, U.S. manufacturers had put themselves in position to make a comeback as employers, creating 200,000 jobs in each of the last two years, the best showing since the 1990s. Meanwhile, Europe and Japan, which resisted the market-driven reforms, continued to lose manufacturing jobs or saw no change. For the rst time since World War II, the manufacturing share of the U.S. economy has increased for three consecutive years (Display 12.) In all, that share has risen by a total of nearly one percentage point to 11.9 percent in 2012.
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Display 12: U.S. Manufacturing Puts Together Three-Year Run

U.S. Manufacturing as % of total GDP (Year to Year point change)
1.6 1.2 0.8 Chg. y/y (%) 0.4 0 -0.4 U.S. Manufacturing Comeback! 12/31/2012 = 0.4 1st 3 in a Row in Postwar Era
Display 13: Growing U.S. Energy Self-sufficiency

1200 1000 800 MTOE 600 80% 400 200 0 70% 60% 50% 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 n Oil (LHS) n Gas (LHS) Self Sufciency (RHS) 120% 110% 100% 90%
-0.8 -1.2 -1.6 -2.0 1948 1956 1964 1972 1980 1988 1996 2004 2012
Source: BP. Data as of December 31, 2011.
Source: Bureau of Economic Analysis. Data as of December 31, 2013.
The Energy Revolution

The manufacturing boom is closely tied to the U.S. energy revolution. Energy, which until recently was seen as an obstacle to U.S. prosperity, has been transformed into a U.S. competitive advantage. After falling for 25 years, the share of the U.S. energy supply that comes from domestic sources has been rising since 2005, from 65 percent to around 77 percent, aided by increasing production of oil and particularly of natural gas (Display 13).
The energy boom provides a major boost to American competitive strength, starting with the impact on the trade decit. Five years ago, most analysts expected the U.S. to be a leading importer of natural gas, to the tune of $100 billion a year by 2012. Here we are in 2012, and the U.S. is now the leading producer of natural gas, having recently overtaken Russia for the No. 1 spot (Display 14 ), and a budding energy exporter as well. Display 14: U.S. Overtaking Russia as Leading Producer of Natural Gas
Gas Production (million tonnes oil equivalent)
600 550 500 MTOE 450
400 350 300 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 US Russian Federation
Source: BP. Data as of December 31, 2011.
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The U.S. energy revolution is now helping to promote the comeback of manufacturing, by lowering energy costs. The increasing production of natural gas from previously unreachable reserves trapped in shale rock has driven down U.S. natural gas prices to one of the lowest rates in the world (Display 15.) Display 15: U.S. Natural Gas Prices Are Highly Competitive
20
The Technology Edge

The U.S. energy revolution is driven by its growing technology edge. As entrepreneur Peter Thiel has argued, the question after any major slowdown in global growth is always, what is the next growth driver? The answer is usually a major advance in technology, which is most likely to emerge in a nation like the U.S. that promotes innovation. However large the impact of digital technology will be on economic productivity (and we believe it will be signicant), it is likely to be disproportionately large in the leading economies, particularly the U.S. As wages rise in emerging-market countries, they are starting to automate and digitize their manufacturing plants, but nations like Brazil, Russia, India, and China remain well below the global average on automation measures, such as number of robots per employee (Display 16 ). Display 16: Technology in Factories
15
10
0 1/08 5/08 9/08 1/09 5/09 9/09 1/10 5/10 9/10 1/11 5/11 9/11 1/12 5/12 9/12 1/13 5/13 US UK Europe Japan
Robots per 10,000 workers, Japan benchmarked at 100

120 100 80 100 100 100 100
Source: NYMEX. Platts. ICE. GS Global ECS Research. Data as of May 2013.
The low U.S. natural gas prices help explain why manufacturers are relocating to Iowa and Texas. The textile industry was one of the rst to leave the developed world, but recently a large textile and clothing manufacturer turned history around by moving from Mexico to Texas to take advantage of lower energy costs. Here, too, the U.S. advantages are traceable to the basic exibility and adaptability of the system. Often, potential competitors lack the large supplies of water required for blasting gas out of shale rock, or the clear land-use laws and ready nancing that make the revolution possible in the U.S. As a result, the U.S. now has a huge lead in fracking technology, with 425 gas drilling rigs in operation versus about 30 in Europe.4
60 40 20 0
55
55
30 15 15 8
US A Ge rm an y
an
Ch ina
zil
ia Ind
Fra nce
na da Th aila nd
Ko rea
esi a
S.
Ca
n Robot density in the auto industry
Source: International Federation of Robotics, Goldman Sachs. Data as of December 31, 2012.
Source: Baker Huges. Data as of February 2013.
Now, as factories come to rely more heavily on digital technology than on cheap labor, the edge in manufacturing shifts from developing nations like China back to developed nations like the U.S. As developing nations such as China grow richer, their customers will demand the kind of custom-designed products made in the most advanced factories, which are emerging rst in the U.S. and the West.
76
Ind
on
Ru ssi
Bra
Jap
The U.S. is strong across the board in technology, but it is in the eld of softwarethe ideas that drive the emerging knowledge economythat the system produces its greatest advantages and generates the most wealth. While a multinational consumer electronics corporation employs fty thousand people and has a market cap that has risen vefold over the last ve years, the Taiwan companies that make gadgets for this consumer electronics corporation employ millions but have seen their stock prices stagnate for lack of pricing power. The U.S. strength in technology largely explains why nine of the worlds 10 largest companies, by market cap, are American companies. Display 17: Top 10 Companies by Global Market Cap
Rank Company Country Market Cap ($ bn)
Display 18: U.S. Still Dominates R&D Spending

Gross R&D expenditures, 2009 (world total $1276bn)
US 32% EU 23% Japan 11% China 12% S. Korea 4% Rest of world 18%
Source: Bruegel. Data as of December 2009.
1 2 3 4 5 6 7 8 9 10
Exxon Mobil Apple Google Microsoft Berkshire Hathaway Wal-Mart PetroChina Johnson & Johnson General Electric Chevron
US US US US US US China US US US
$406 $403 $303 $283 $278 $263 $251 $246 $240 $239
The technology edge is also mitigating the biggest threat to the competitive position of the U.S.: the debt burden. U.S. companies have been able to increase prots and pay down debt largely because they have been sharply increasing productivity. In many emerging markets such as China, where companies generate prot mainly by increasing revenue as opposed to increasing productivity, corporate prot margins remain low and debts remain stubbornly high. Since it is likely that global economic growth will remain sluggish and volatile for the foreseeable future, the ability of U.S. companies to generate income in hard times is likely to be another enduring advantage.
The U.S., Breakout Nation?

In a global economy now dened by competing forms of capitalism, the U.S. brand appears to be winning. The biggest risk by far is the government debt, because the U.S. government lags well behind its households and companies in beginning the painful deleveraging process. In coming years, the high U.S. government debt burden is likely to slow GDP growth to around 2.5 percent, but that is likely to be fast enough to lead the rich world. The U.S. wont be the only success story in the West: Germany has much less of a debt problem than France, Spain is moving much faster to pare down labor costs than Italy, and so on. The same is true in the emerging world: though all the BRICs are slowing, new stars are emerging or re-emerging, from Mexico to the Philippines. The world economy has entered an era that will be very tough, but also very fair in the
Source: Bloomberg. Data as of May 16, 2013.
In technology, the hardware is easy to replicate, which in turn cuts prot margins, while the software is highly protable so long as it continues to evolve. The U.S. lead in software and other digital technology stems directly from its heavy investment in R&D, compared to emerging and developed rivals.
77
sense that there is no global tailwind for any nation, rich or poor, now that the easy money and sky optimism of the last decade is gone. The winners of the coming decade will take their mantra from a Latin proverb: If there is no wind, row.
This material is current as of the date specified, is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. The opinions in this newsletter do not contend to address the financial objectives, situation or specific needs of any individual investor. All information provided is for informational purposes only and should not be deemed as a recommendation to buy or sell securities in the sectors shown above. It is not a solicitation, or an offer to buy or sell any security or investment product. These comments are not necessarily representative of the opinions and views of any Morgan Stanley portfolio manager or of the firm as a whole. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. The forecasts in this piece are not necessarily those of Morgan Stanley Investment Management, and may not actually come to pass. Foreign and emerging markets. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.
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ABOUT THE AUTHORS
About the Authors

Jerome B. Baesel, Ph.D.
Chief Investment Officer (Emeritus)
Jim Caron
Managing Director
Jerry served as the founding Chief Investment Ocer of Morgan Stanley Alternative Investment Partners (Morgan Stanley AIP) Fund of Hedge Funds group. Prior to the formation of Morgan Stanley AIP in 2000, he served nine years with the Weyerhaeuser Pension Fund Investment Group as Managing Director for Liquid Markets. Prior to joining Weyerhaeuser, he was a General Partner at Princeton Newport Partners, a hedge fund focusing on quantitative arbitrage strategies. In the mid-1980s, while at Princeton Newport, he led the development of an aliated fund, OSM Partners, a fund-of-funds strategy which invested in hedge funds. He holds a B.S. in Economics from California State University at Fullerton and both a M.S. and Ph.D. in Finance with a focus on investments from UCLA. He served as a tenured Professor of Finance at the University of California at Irvine.
Jim is a portfolio manager and senior member of the MSIM Global Fixed Income team and a member of the Asset Allocation Committee focusing on macro strategies. He joined Morgan Stanley in 2006 and has 21 years of investment experience. Prior to this role, Jim held the position of global head of interest rates, foreign exchange and emerging markets strategy with Morgan Stanley Research. He authored two interest rate publications, the monthly Global Perspectives and the weekly Interest Rate Strategist. Previously, he was a director at Merrill Lynch where he headed the U.S. interest rate strategy group. Prior to that, Jim held various trading positions. He headed the U.S. options trading desk at Sanwa Bank, was a proprietary trader at Tokai Securities and traded U.S. Treasuries at JP Morgan. Jim received a B.A. in physics from Bowdoin College, a B.S. in aeronautical engineering from the California Institute of Technology and an M.B.A in nance from New York University, Stern School of Business.
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Ping Chen, Ph.D.

Vice President
Tim Drinkall
Executive Director
Ping is a quantitative analyst for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds, focusing on the quantitative analysis of hedge funds and portable alpha portfolios. She joined Morgan Stanley AIP in 2006 and has six years of industry experience. Ping received a B.S. in computer science from Tsinghua University, China. She also received an M.S. in knowledge discovery and data mining as well as a Ph.D. in civil and environmental engineering from Carnegie Mellon University. Ping is a CFA Level III candidate. Alistair Corden-Lloyd
Executive Director
Tim is a portfolio manager for the Frontier Emerging Markets strategy. He joined Morgan Stanley in 2007 and has 18 years of investment experience. Prior to joining the rm, Tim was a fund manager at Gustavia Capital where he was responsible for two funds investing in Emerging Europe. He has been working with Emerging Markets since 1992; Tim began his investment banking career with Creditanstalt Securities as an analyst based in Budapest, Hungary and was later promoted to head of Polish equity research in Warsaw, Poland. In 1997 he joined Deutsche Bank in London as director and head of Emerging Europe equity research. Tim received a B.A. in nance from Indiana University and an M.B.A. in international business from George Washington University. Jos F. Gonzlez-Heres, CAIA
Managing Director
Alistair is a member of the International Small Cap Value team. He joined Morgan Stanley in 1997 and has 12 years of investment experience. Alistair also formed part of a large cap global research team contributing at a sector level up until 2005. Prior to joining the rm, Alistair worked in the luxury goods industry for ve years. He received a B.Sc. in geography from Kingston University, an M.B.A. from the Graduate School of business, University of Cape Town and an M.Sc. in computer science from Kent University. Christian Derold
Managing Director
Christian is a portfolio manager for the London-based International Equity team. He joined Morgan Stanley in 2006 and has 21 years of investment experience. Prior to joining the rm, Christian was director of research at Millgate Capital, a long short equity hedge fund. Prior to this, he worked at the State of Wisconsin Investment Board where he managed the Boards international equity portfolio. Christian received an M.A. in business administration from the University of Economics and Business Administration in Vienna, Austria.
Jos is a portfolio manager for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds group and is a member of AIPs Fund of Hedge Funds Investment Committee. He is responsible for event-driven and corporate credit trading strategies, including distressed investments, long /short credit, capital structure arbitrage, equity special situations and merger arbitrage. He joined Morgan Stanley AIP in 2001 as a senior research analyst and has 19 years of industry experience. Prior to joining the rm, Jos was chief executive ocer of a privately held software company, and has seven years of investment banking experience at both Bear Stearns and Prudential Securities. He also worked at IBM Credit Corporation as a corporate nance analyst and at IBM as a design engineer. Jos received a B.S. in electrical engineering from Northwestern University and an M.B.A. from the Yale School of Management. Additionally, he also holds a U.S. and an international patent for his prior work on algorithms and has published several research articles related to hedge funds and distressed debt in The Journal of Alternative Investments, The Journal of Wealth Management, and The Journal of Fixed Income. Jos holds the Chartered Alternative Investment Analyst designation.
80
ABOUT THE AUTHORS
Amay Hattangadi, CFA

Executive Director
Steven Shin, CFA, CPA

Vice President
Amay is an investment team member focusing on India. He joined Morgan Stanley in 1997 and has 16 years of investment experience. Previously, he was a portfolio administrator. Amay received a Bachelor of Commerce degree from the University of Mumbai. He is an Associate Member of the Institute of Chartered Accountants of India. He holds the Charted Financial Analyst designation. Swanand Kelkar
Vice President
Swanand is an analyst covering India equities within the Global Emerging Markets Equity team based in Mumbai. He joined Morgan Stanley in 2007 and has nine years of investment experience. Prior to joining the rm, Swanand worked in the equity investment department at HSBC Asset Management. He received his Bachelors degree in commerce from the University of Mumbai and an M.B.A. from the Indian Institute of Management, Ahmedabad. Swanand is also an associate member of the Institute of Chartered Accountants of India. Ruchir Sharma
Steven is a quantitative analyst for the Morgan Stanley Alternative Investment Partners Hedge Fund group, focusing on the quantitative analysis of hedge funds and portable alpha portfolios. He joined Morgan Stanley AIP in 2004 and has 12 years of industry experience. Prior to joining the rm, Steven was a business development associate at FMC Technologies. Previously, he was an investment banker at UBS PaineWebber and a nuclear engineer ocer for the U.S. Navy Submarine Force. Steven received a B.S. in electrical engineering from the University of Illinois at Urbana-Champaign and an M.B.A. from the Yale School of Management. Steven is a Certied Public Accountant and holds the Chartered Financial Analyst designation. Tom Wills, CFA
Executive Director
Managing Director
Ruchir is Head of Emerging Markets and global macro at Morgan Stanley Investment Management. He joined Morgan Stanley in 1996 and has 19 years of investment experience. Prior to joining the rm, Ruchir worked with Prime Securities (Delhi), a non-banking nancial services rm, where he helped run the rms foreign exchange business. He has been a contributing editor with Newsweek and has frequently penned essays for publications such as The Wall Street Journal, Financial Times, New York Times, Foreign Aairs and The Economic Times. Ruchir has also authored the book, Breakout Nations: In Pursuit of the Next Economic Miracles, which is an international bestseller.
Tom is a portfolio manager of the Global Convertible Bond strategy. He joined Morgan Stanley in 2010 and has 15 years of investment experience. Prior to joining the rm, he was a senior fund manager of global convertibles at Aviva Investors. Tom received a B.Comm in nance from the University of Toronto, and an M.B.A. from Oxford University. Tom is also a Canadian Chartered Accountant and a Chartered Financial Analyst.
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2013 | Volume 3 | Issue 2

Please direct any comments or questions about the Morgan Stanley Investment Management Journal to: Bob Scheurer, Managing Editor info@morganstanley.com
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INVESTMENT MANAGEMENT

2013 | VOLUME 3 | ISSUE 2

45 Fixed Income Investing in a World of Rising Rates

Jim Caron, Managing Director

Christian Derold, Managing Director Alistair Corden-Lloyd, Executive Director

55 Indias Stealth Game Changer

13 Hedge Fund Benchmarking:

61 Convertibles: Designing an Optimal

69 Is the U.S. the Breakout Nation of the

39 Frontier Markets: Why Now?

79 About the Authors

Investment Management Journal

A LET TER FROM GREGORY J. FLEMING

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES

Quality Investing: A Strategy for Uncertain Times

Managing Director Morgan Stanley Investment Management

Executive Director Morgan Stanley Investment Management

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

De-leveraging Into Shorter, Lower Growth Cycles

Mar Nov Jun 1975 1982 200910

Source: Federal Reserve, Morgan Stanley. Data as of March 31, 2012.

Current expansion up to end 2012.

Geared: With significant borrowings, % of debt to GDP

QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES

What Characteristics Define High Quality Compounders?13

Compounders: Generating earnings from previous earnings

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

Source: Factset/Worldscope, MSCI World. Data as of March 31, 2013.

ROCE: EBIT/Property, plant, equipment and net working capital

QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES

ROCE = Ebit/Net PPE + Net working capital

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

Why Is Compounding So Important?

3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09

European Mobile Device Manufacturer

A Competing Technology Giant

350 300 250 200 150 100 50 0 3/00 3/01

MSCI World Staples

So too is the historical stability of dividends (see Display 9.)

Earnings per share (EPS) Next Twelve Months.

QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES

Display 9: MSCI World Staples DPS22 vs MSCI World DPS

Are High Quality Companies Concentrated in Certain Sectors?

MSCI World Staples

Display 10: MSCI Staples vs MSCI World Total Return Indexed

Consumer Staples Healthcare Industrials Discretionary

Dividends per share (DPS)

Ebit Margin Stability: 1-(Standard Deviation/Mean)

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

Can Quality Work as an Investment Style?

Top Quartile EPS

Top Quartile DPS

MSCI World EPS

MSCI World DPS

Source: FactSet, Worldscope. Data as of February 2013.

Why Consider Quality Now?

QUALIT Y INVESTING: A STRATEGY FOR UNCERTAIN TIMES

Top Quality Quartile

INVESTMENT MANAGEMENT JOURNAL | VOLUME 3 | ISSUE 2

HEDGE FUND BENCHMARKING: EQUIT Y CORRELATION REGIMES AND ALPHA

Hedge Fund Benchmarking: Equity Correlation Regimes and Alpha

JEROME B. BAESEL, PH.D