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May 27, 2020
Alternative Risk Premia: Seeing the Whole Picture
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May 27, 2020

Alternative Risk Premia: Seeing the Whole Picture


Insight Article

Alternative Risk Premia: Seeing the Whole Picture

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May 27, 2020

 
 

Alternative risk premia (ARP) is a newly coined industry category. While a convenient catchall term, it belies the heterogeneity of these strategies which can be risk-seeking, risk-mitigating and anywhere in between. Recent press has thrown a spotlight on ARP strategies, but it fails to tell the whole story.

 
 

The COVID-19 pandemic has taken a devastating human toll around the globe, resulting in an unprecedented hit to supply and demand and roiling markets. At the same time, we’ve seen significant volatility in oil, initially because of disputes between the Middle East and Russia and later because demand weakness has forced certain oil positions into negative pricing. The confluence of these events has resulted in seismic shifts across asset classes with levels of volatility not seen since 2008. (Display 1) Attendant dispersion within asset classes has led to performance challenges across investment strategies, and as a group ARP strategies were not immune.

 
 
 
DISPLAY 1: Historical Volatility Levels
 

Source: Bloomberg as of May 7, 2020

 
 

Recent press1 has suggested ARP didn’t “do their job,” judging this highly diverse category of strategies indiscriminately. When assessing performance of ARP, it’s important to remember what they are and what they’re not. They are factor-based sources of return derived from long/short strategies that are accessible in a liquid, transparent, low-cost format. Their job is providing investors with cost-effective ways to fine-tune their portfolio exposures. They are not (necessarily) designed to be defensive. There is a misperception that all risk premia are uncorrelated or negatively correlated to equities. This is true for some ARP, but many are designed to be pro- cyclical, thriving in benign, low-volatility environments.

Two Things Drive Dispersion Among Providers

The results for any one ARP product are closely tied to its underlying mix of ARP strategies. The fact that some popular ARP products lost money during the recent market turmoil is largely indicative of how they allocated across strategies. For instance, it seems that some of the larger players in the space had products that were overweight pro-cyclical strategies, which traded down as the pandemic unfolded. Some of this exposure may have been unintended, with allocators underestimating the shared risk between their strategies and markets. But, by and large, these products are run by experienced allocators who intentionally positioned them to perform well in bull market conditions. Not surprisingly, products with more defensive biases recently performed very well and exactly as expected.

However, even with a strategy mix designed to perform well in a crisis, providers achieve different results depending on how they implement the strategies. When discussing ARP performance, it’s important to remember that we generally reference averages representing the results of a broad range of providers. Small differences in provider implementation strategy can lead to wide dispersion, especially during highly volatile periods. Looking at the recent performance of Multi-Asset Trend illustrates this point. (Display 2) Multi-Asset Trend strategies use lookback periods to signal whether an asset is “trending” up or down, and then they invest long upward-trending assets and short downward-trending assets. Shorter- term (higher frequency) lookbacks tend to outperform in rapid shocks, while longer-term lookbacks tend to outperform in benign periods. Multi- Asset Trend providers who emphasized long-term trend in their products likely underperformed those that emphasized higher frequency signals. While we generally consider Multi-Asset Trend to be a defensive strategy, we saw a great deal of dispersion among providers during the crisis some of which can be explained by their strategies relating to lookback implementation.

 
 
 
DISPLAY 2: Multi-Asset Trend Peer Group Performance Dispersion (February – March 2020)
 

Source: AIP Hedge Fund Solutions Team. Data as of May 8, 2020.

 
 

Managing Expectations About Individual Premia

Relationships among premia and traditional markets can be described as tendencies because the correlations are not perfect. Nonetheless, these tendencies exist and for certain strategies are quite robust. When assessing performance, the right question to ask is: Did this particular risk premium behave in this crisis as it has tended to behave in prior crises?

To answer this question and set performance expectations, we split performance of the equity market (less U.S. Treasury rate) into quintiles, with Quintile 1 representing strongest equity performance and Quintile 5 representing weakest. We then observed the premium’s average historical returns during each quintile, mapping its stability over time in order to provide context for assessing more recent behavior. Display 3 provides an example using FX Carry in G10 Currencies premium. What we see here is that FX Carry performs well in bull markets (Q1) and very poorly in bear markets (Q5) over the five-year and 10-year periods (royal blue and aqua blue bars). The red points represent the average weekly results for the premium from February – April 2020. The red line is the slope of the relationship across the quintiles over the same three months, and the green and purple lines represent the slope of the relationship across the quintiles over the last five and 10 years, respectively. The closer the lines are, the more reliable their relationship to those types of conditions is. In this case, the short-term relationship is nearly identical to the long-term historical relationship. In other words, FX Carry did not “fail” any more than “equities” failed in the COVID-19 crisis. It merely behaved as it always has relative to equity markets.

 
 
 
DISPLAY 3: Performance of FX G10 Carry Premium Across Performance Quintiles
 

Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.

 
 

No Major Surprises

Using this same methodology, Display 4 summarizes the February – April 2020 performance of some of the most popular ARP strategies against their long-term behavior. (While commodity strategies comprise a large part of the ARP universe, we excluded them from this table because they have much weaker tendencies and unstable relationships to equity markets. They have been highly impacted during the COVID-19 crisis because of the volatility of oil prices.) That certain ARP have recently disappointed from an absolute return perspective should come as no surprise. For example, one would have expected Volatility Carry premia, which seek to harvest returns by going short volatility, to perform poorly during a spike in volatility.

 
 
 
DISPLAY 4: Performance Expectations vs. Reality
 

Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.

 
 

Low Beta is the one defensive strategy that recently underperformed its historical relationship to the markets (Display 5). Low Beta tends to be defensive and has performed well in recent years, including the 2011 and 2018 sell-offs. However, it struggled in March and April 2020 when some high-beta technology names continued to outperform because of market nuances related to the COVID-19 crisis.

 
 
 
DISPLAY 5: Low Beta Performance in Historical Context
 

Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.

 
 

Conclusion

Recent market turmoil has refocused investor attention on the importance of asset allocation and portfolio construction. It is our view that ARP have a unique role to play, delivering very specific exposures in a liquid, transparent and cost-effective way. Of course, it is critical to bear in mind that no investment is without risk. Investors must understand the correlations— especially stress correlations (coskew)— among ARP, their market sensitivities and their risk profiles, not just their return potentials. Having weathered this storm, investors now have additional data points on the resiliency of ARP during “extreme” periods that can be used for future modelling and more robust asset allocation decision-making.

We are in unprecedented times and expect a protracted period of uncertainty, volatility and heightened market risk. In times like these, investors need access to targeted and liquid strategies that provide specific exposures across a range of asset classes. With their liquidity, tradability and heterogeneity, ARP may be more valuable than ever.

 
patrick.reid
Managing Director
AIP Hedge Fund Team
 
eban.cucinotta
Managing Director
AIP Hedge Fund Team
 
 
 
 

DISCLAIMERS

The views expressed herein are only those of Morgan Stanley AIP Hedge Fund Team (“AIP Hedge Fund Team”) and are subject to change at any time due to changes in market and economic conditions. The views and opinions expressed herein are based on matters as they exist as of the date of preparation of this piece 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. The data used has been obtained from sources generally believed to be reliable. No representation is made as to its accuracy.

Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the investment team, are subject to change and may not actually come to pass. These views do not represent views of other investment teams at MSIM or those of Morgan Stanley as a whole. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment.

Certain information contained herein constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements.

Past performance is not indicative of nor does it guarantee comparable future results.

This piece has been prepared solely for informational purposes and is not an offer, or a solicitation of an offer, to buy or sell any security, instrument or interest in any fund or investment vehicle or to participate in any trading or other investment strategy.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

Persons considering an alternative investment should refer to the specific fund’s offering documentation, which will fully describe the specific risks and considerations associated with a specific alternative investment.

Morgan Stanley AIP GP LP, its affiliates and its and their respective directors, officers, employees, members, general and limited partners, sponsors, trustees, managers, agents, advisors, representatives, heirs, successors and executors shall have no liability whatsoever in connection with any person’s or entity’s receipt, use of or reliance upon any information in this piece or in connection with any such information’s actual or purported accuracy, completeness, fairness, reliability or suitability.

Alternative investments are speculative and include a high degree of risk. Investors could lose all, or a substantial amount of, their investment. Alternative investments are suitable only for long-term investors willing to forgo liquidity and put capital at risk for an indefinite period of time. Alternative investments are typically highly illiquid—there is no secondary market for private funds, and there may be restrictions on redemptions or the assignment or other transfer of investments in private funds. Alternative investments often engage in leverage and other speculative practices that may increase volatility and risk of loss. Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors.

This is a summary of various risks associated with investing in alternative risk premia. This summary is not, and is not intended to be, a complete enumeration or explanation of the risks involved. The recipient should consult with its own advisors before deciding whether to invest in these strategies. In addition, to the extent that the investment program of such a portfolio changes and develops over time, additional risk factors not described here may apply. Only a recipient who understands the nature of the investment, does not require more than limited liquidity in the investment and has sufficient resources to sustain the loss of its entire investment should consider making the kind of investments described herein.

Global Pandemics. 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. Market values can change daily due to economic and other events (such as natural disasters, epidemics and pandemics, terrorism, conflicts and social unrest) that affect markets generally, as well as those that affect particular regions, countries, industries, companies or governments. It is difficult to predict when events may occur, the effects they may have (e.g. adversely affect the liquidity of the portfolio), and the duration of those effects.

General Risks of Derivatives. An alternative risk premia portfolio could use various derivatives and related investment strategies, as described below. Derivatives may be used for a variety of purposes including hedging, risk management, portfolio management or to earn income. Any or all of the investment techniques described herein may be used at any time and there is no particular strategy that dictates the use of one technique rather than another, as the use of any derivative by a portfolio is a function of numerous variables, including market conditions.

A derivative is a financial instrument the value of which depends upon (or derives from) the value of another asset, security, interest rate or index. Derivatives may relate to a wide variety of underlying instruments, including equity and debt securities, indices, interest rates, currencies and other assets. Certain derivative instruments that a portfolio may use and the risks of those instruments are described in further detail below. A portfolio may also utilize derivatives techniques, instruments and strategies that may be newly developed or permitted as a result of regulatory changes, to the extent such techniques, instruments and strategies are consistent with a portfolio’s investment objective and policies. Such newly developed techniques, instruments and strategies may involve risks different than or in addition to those described herein. No assurance can be given that any derivatives strategy employed by a portfolio will be successful.

The risks associated with the use of derivatives are different from, and possibly greater than, the risks associated with investing directly in the instruments underlying such derivatives. Derivatives are highly specialized instruments that require investment techniques and risk analyses different from other portfolio investments. The use of derivative instruments requires an understanding not only of the underlying instrument but also of the derivative itself. Certain risk factors generally applicable to derivative transactions are described below.

Derivatives are subject to the risk that the market value of the derivative itself or the market value of underlying instruments will change in a way adverse to a portfolio’s interests. A portfolio bears the risk that the adviser may incorrectly forecast future market trends and other financial or economic factors or the value of the underlying security, index, interest rate or currency when establishing a derivatives position for a portfolio.

Derivatives may be subject to pricing (or mispricing) risk. For example, a derivative may become extraordinarily expensive (or inexpensive) relative to historical prices or corresponding instruments. Under such market conditions, it may not be economically feasible to initiate a transaction or liquidate a position at an advantageous time or price.

Many derivatives are complex and may be valued subjectively. The pricing models used by a portfolio to value derivatives may not produce valuations that are consistent with the values a portfolio realizes when it closes or sells an over-the-counter (“OTC”) derivative. Valuation risk is more pronounced when a portfolio enters into OTC derivatives with specialized terms because the market value of those derivatives in some cases is determined in part by reference to similar derivatives with more standardized terms. Improper valuations can result in increased payment requirements to counterparties, over-and/or under-collateralization, and/or a loss of value to a portfolio.

Using derivatives as a hedge against a portfolio investment subjects a portfolio to the risk that the derivative will have imperfect correlation with the portfolio investment, which could result in a portfolio incurring substantial losses. This correlation risk may be greater in the case of derivatives based on an index or other basket of securities, as the portfolio securities being hedged may not duplicate the components of the underlying index or the basket may not be of exactly the same type of obligation as those underlying the derivative. The use of derivatives for “cross hedging” purposes (using a derivative based on one instrument as a hedge on a different instrument) may also involve greater correlation risks.

While using derivatives for hedging purposes can reduce a portfolio’s risk of loss, it may also limit a portfolio’s opportunity for gains or result in losses by offsetting or limiting a portfolio’s ability to participate in favorable price movements in portfolio investments.

Use of derivatives for non-hedging purposes may result in losses which would not be offset by increases in the value of portfolio securities or declines in the cost of securities to be acquired. In the event that a portfolio enters into a derivatives transaction as an alternative to purchasing or selling the underlying instrument or in order to obtain desired exposure to an index or market, a portfolio will be exposed to the same risks as are incurred in purchasing or selling the underlying instruments directly as well as additional risks associated with derivatives transactions, such as counterparty credit risk.

The use of certain derivatives transactions, including OTC derivatives, involves the risk of loss resulting from the insolvency or bankruptcy of the counterparty to the contract or the failure by the counterparty to make required payments or otherwise comply with the terms of the contract. In the event of default by a counterparty, a portfolio may have contractual remedies pursuant to the agreements related to the transaction, but there is no guarantee that the portfolio will be able to enforce such contractual remedies in a timely manner, or at all.

While some derivatives are cleared through a regulated central clearinghouse, many derivatives transactions are not entered into or traded on exchanges or in markets regulated by the CFTC or the SEC. Instead, such bi-lateral OTC derivatives are entered into directly by a portfolio and a counterparty. OTC derivatives transactions can only be entered into with a willing counterparty that is approved by the adviser. Where no such counterparty is available, a portfolio will be unable to enter into a desired OTC transaction.

A portfolio may be required to make physical delivery of portfolio securities underlying a derivative in order to close out a derivatives position or to sell portfolio securities at a time or price at which it may be disadvantageous to do so in order to obtain cash to close out or to maintain a derivatives position.

As a result of the structure of certain derivatives, adverse changes in, among other things, interest rates, volatility or the value of the underlying instrument can result in losses substantially greater than the amount invested in the derivative itself. Certain derivatives have the potential for unlimited loss, regardless of the size of the initial investment.

Certain derivatives may be considered illiquid and therefore subject to a portfolio’s limitation on investments in illiquid securities.

Derivatives transactions conducted outside the United States may not be conducted in the same manner as those entered into on U.S. exchanges, and may be subject to different margin, exercise, settlement or expiration procedures. Brokerage commissions, clearing costs and other transaction costs may be higher on foreign exchanges. Many of the risks of OTC derivatives transactions are also applicable to derivatives transactions conducted outside the United States. Derivatives transactions conducted outside the United States are subject to the risk of governmental action affecting the trading in, or the prices of, foreign securities, currencies and other instruments. The value of such positions could be adversely affected by foreign political and economic factors, lesser availability of data on which to make trading decisions, delays in a portfolio’s ability to act upon economic events occurring in foreign markets, and less liquidity than U.S. markets.

Currency derivatives are subject to additional risks. Currency derivatives transactions may be negatively affected by government exchange controls, blockages and manipulations. Currency exchange rates may be influenced by factors extrinsic to a country’s economy. There is no systematic reporting of last sale information with respect to foreign currencies. As a result, the available information on which trading in currency derivatives will be based may not be as complete as comparable data for other transactions. Events could occur in the foreign currency market that will not be reflected in currency derivatives until the following day, making it more difficult for a portfolio to respond to such events in a timely manner.

OTC Options. Unlike exchange-traded options, which are standardized with respect to the underlying instrument, expiration date, contract size and strike price, the terms of OTC options generally are established through negotiation between the parties to the options contract. Unless the counterparties provide for it, there is no central clearing or guaranty function for an OTC option. Therefore, OTC options are subject to the risk of default or non-performance by the counterparty to a greater extent than exchange-traded options.

Additional Risks of Options Transactions. The risks associated with options transactions are different from, and possibly greater than, the risks associated with investing directly in the underlying instruments. Options are highly specialized instruments that require investment techniques and risk analyses different from those associated with other portfolio investments. Options may be subject to the risk factors generally applicable to derivatives transactions described herein, and may also be subject to certain additional risk factors, including:

  • The exercise of options written or purchased by a portfolio could cause a portfolio to sell portfolio securities, thus increasing a portfolio’s portfolio turnover.
  • A portfolio pays brokerage commissions each time it writes or purchases an option or buys or sells an underlying security in connection with the exercise of an option. Such brokerage commissions could be higher relative to the commissions for direct purchases of sales of the underlying securities.
  • A portfolio’s options transactions may be limited by limitations on options positions established by the SEC, the CFTC or the exchanges on which such options are traded.
  • The hours of trading for exchange-listed options may not coincide with the hours during which the underlying securities are traded. To the extent that the options markets close before the markets for the underlying securities, significant price and rate movements can take place in the underlying securities that cannot be reflected in the options markets.
  • Index options based upon a narrower index of securities or other assets may present greater risks than options based on broad market indexes, as narrower indices are more susceptible to rapid and extreme fluctuations as a result of changes in the values of a small number of securities or other assets.
  • A portfolio is subject to the risk of market movements between the time that an option is exercised and the time of performance thereunder, which could increase the extent of any losses suffered by a portfolio in connection with options transactions.

Foreign  Currency  Forward  Exchange  Contracts  and   Currency  Futures.  A portfolio may enter into foreign currency forward exchange contracts. Unanticipated changes in currency prices may result in losses to a portfolio and poorer overall performance for a portfolio than if it had not entered into foreign currency forward exchange contracts. At times, a portfolio may also enter into “cross-currency” hedging transactions involving currencies other than those in which securities are held or proposed to be purchased are denominated. Forward contracts may limit gains on portfolio securities that could otherwise be realized had they not been utilized and could result in losses. The contracts also may increase a portfolio’s volatility and may involve a significant amount of risk relative to the investment of cash. While a portfolio seeks to hedge against its currency exposures, there may be occasions where it is not viable or possible to ensure that the hedge will be sufficient to cover a portfolio’s total exposure.

Additional Risk of Futures Transactions. The risks associated with futures contract transactions are different from, and possibly greater than, the risks associated with investing directly in the underlying instruments. Futures are highly specialized instruments that require investment techniques and risk analyses different from those associated with other portfolio investments. Futures may be subject to the risk factors generally applicable to derivatives transactions described herein, and may also be subject to certain additional risk factors, including:

  • The risk of loss in buying and selling futures contracts can be substantial. Small price movements in the commodity underlying a futures position may result in immediate and substantial loss (or gain) to a portfolio.
  • Buying and selling futures contracts may result in losses in excess of the amount invested in the position in the form of initial margin. In the event of adverse price movements in the underlying commodity, security, index, currency or instrument, a portfolio would be required to make daily cash payments to maintain its required margin. A portfolio may be required to sell portfolio securities, or make or take delivery of the underlying securities in order to meet daily margin requirements at a time when it may be disadvantageous to do so. A portfolio could lose margin payments deposited with a futures commodities merchant if the futures commodities merchant breaches its agreement with a portfolio, becomes insolvent or declares bankruptcy.
  • Most exchanges limit the amount of fluctuation permitted in futures contract prices during any single trading day. Once the daily limit has been reached in a particular futures contract, no trades may be made on that day at prices beyond that limit. If futures contract prices were to move to the daily limit for several trading days with little or no trading, a portfolio could be prevented from prompt liquidation of a futures position and subject to substantial losses. The daily limit governs only price movements during a single trading day and therefore does not limit a portfolio’s potential losses.
  • Index futures based upon a narrower index of securities may present greater risks than futures based on broad market indexes, as narrower indexes are more susceptible to rapid and extreme fluctuations as a result of changes in value of a small number of securities.

Warrants. Warrants are equity securities in the form of options issued by a corporation that give the holder the right, but not the obligation, to purchase stock, usually at a price that is higher than the market price at the time the warrant is issued. A purchaser takes the risk that the warrant may expire worthless because the market price of the common stock fails to rise above the price set by the warrant.

Rights. A portfolio may purchase rights for equity securities. If a portfolio purchases a right, it takes the risk that the right might expire worthless because the market value of the common stock falls below the price fixed by the right.

General Risks of Swaps. A portfolio may enter into swaps directly or indirectly (including through Risk Premia Investments). The risks associated with swap transactions are different from, and possibly greater than, the risks associated with investing directly in the underlying instruments. Swaps are highly specialized instruments that require investment techniques and risk analyses different from those associated with other portfolio investments. The use of swaps requires an understanding not only of the underlying instrument but also of the swap contract itself. Swap transactions may be subject to the risk factors generally applicable to derivatives transactions described above, and may also be subject to certain additional risk factors. In addition to the risk of default by the counterparty, if the creditworthiness of a counterparty to a swap agreement declines, the value of the swap agreement would be likely to decline, potentially resulting in losses.

In addition, the U.S. government has enacted legislation that provides for new regulation of the derivatives market, including clearing, margin, reporting and registration requirements, which could restrict a portfolio’s ability to engage in derivatives transactions or increase the cost or uncertainty involved in such transactions. The European Union (and some other countries) are implementing similar requirements, which will affect a portfolio when it enters into a derivatives transaction with a counterparty organized in that country or otherwise subject to that country’s derivatives regulations.

For example, the U.S. government and the European Union have adopted mandatory-minimum margin requirements for OTC derivatives. The AIP Hedge Fund Team expects that a portfolio’s transactions will become subject to variation margin requirements under such rules in 2017 and initial margin requirements under such rules in 2020. Such requirements could increase the amount of margin a portfolio needs to provide in connection with its derivatives transactions and, therefore, make derivatives transactions more expensive.

These and other new rules and regulations could, among other things, further restrict a portfolio’s ability to engage in, or increase the cost to a portfolio of, derivatives transactions, for example, by making some types of derivatives no longer available to a portfolio or otherwise limiting liquidity. A portfolio may be unable to execute its investment strategy as a result. The costs of derivatives transactions are expected to increase as clearing members raise their fees to cover the costs of additional capital requirements and other regulatory changes applicable to the clearing members become effective. These rules and regulations are new and evolving, so their potential impact on a portfolio and the financial system are not yet known. While the new rules and regulations and central clearing of some derivatives transactions are designed to reduce systemic risk (i.e., the risk that the interdependence of large derivatives dealers could cause them to suffer liquidity, solvency or other challenges simultaneously), there is no assurance that they will achieve that result, and in the meantime, as noted above, central clearing and related requirements expose a portfolio to new kinds of costs and risks.

Interest Rate Swaps, Caps, Floors and Collars. A portfolio may enter into interest rate swaps, which do not involve the delivery of securities, other underlying assets or principal. Accordingly, the risk of loss with respect to interest rate and total rate of return swaps includes the net amount of interest payments that a portfolio is contractually obligated to make. A portfolio may also buy or sell interest rate caps, floors and collars, which may be less liquid than other types of swaps.

Currency Swaps. Currency swap agreements may be entered into on a net basis or may involve the delivery of the entire principal value of one designated currency in exchange for the entire principal value of another designated currency. In such cases, the entire principal value of a currency swap is subject to the risk that the counterparty will default on its contractual delivery obligations.

Credit Default Swaps. A portfolio may be either the buyer or seller in a credit default swap. As the buyer in a credit default swap, a portfolio would pay to the counterparty the periodic stream of payments. If no default occurs, a portfolio would receive no benefit from the contract. As the seller in a credit default swap, a portfolio would receive the stream of payments but would be subject to exposure on the notional amount of the swap, which it would be required to pay in the event of default. The use of credit default swaps could result in losses to a portfolio if the adviser fails to correctly evaluate the creditworthiness of the issuer of the referenced debt obligation.

Combined Transactions. Combined transactions involve entering into multiple derivatives transactions instead of a single derivatives transaction in order to customize the risk and return characteristics of the overall position. Combined transactions typically contain elements of risk that are present in each of the component transactions. Because combined transactions involve multiple transactions, they may result in higher transaction costs and may be more difficult to close out.

Other Instruments and Future Developments. A portfolio may take advantage of opportunities in the area of swaps, options on various underlying instruments and swaptions and certain other customized “synthetic” or derivative investments in the future. In addition, a portfolio may take advantage of opportunities with respect to certain other “synthetic” or derivative instruments that are not presently available but that may be developed to the extent such opportunities are both consistent with a portfolio’s investment objective and legally permissible for a portfolio.

Morgan Stanley does not render tax advice on tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used with 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. Clients should always consult with a legal or tax advisor for information concerning their individual situation.

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