GLOBAL INVESTMENT COMMITTEE

MARCH 2015

Asset Allocation Special Report

MICHAEL WILSON

Volatility Can Lead to Opportunity

Chief Investment Officer Morgan Stanley Wealth Management

When 2014 began, one of our most strongly held views was

LISA SHALETT Head of Investment & Portfolio Strategies Morgan Stanley Wealth Management ZACHARY APOIAN Senior Asset Allocation Strategist Morgan Stanley Wealth Management MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management

2015: The Revival of Global Diversification During the past five years, the tried-and-true approach of building globally diversified portfolios with multiple asset classes and turning to active managers for security selection has flat-out failed. Last year, in particular, nonUS allocations disappointed, with weaker-than-expected GDP growth exacerbated by a late-in-the-year 15% surge in the US dollar. Although these results are disappointing, the Global Investment Committee believes strongly that investors who presume the approach built around global diversification and broad asset allocation is broken are misreading the situation. As we discuss, now is exactly the wrong time to be abandoning globally diversified portfolios.

Please refer to important information, disclosures and qualifications at the end of this material.

ASSET ALLOCATION SPECIAL REPORT

Introduction Undoubtedly, it was unprecedented monetary policy that largely rescued the domestic US economy from the Great Recession that began six years ago. By 2014, real GDP growth was a fairly normal 2.5%, unemployment was down to 5.6%, job creation was the best it has been since 1999 and inflation was benign. The same extraordinary monetary policy had a powerful impact on financial markets during the recovery years, producing above-average returns in both US large-cap stocks and US Treasuries, alongside below-average volatility—a combination that has easily bested most other asset classes. This was especially true in 2014, when the extreme “skewness” of asset-class performance hit a crescendo. A balanced US portfolio composed of 60% S&P 500, 35% Barclays US Aggregate Bond Index and 5% three-month US Treasury bills delivered total returns of 10.3%, while most global asset allocators delivered one-third of the return (see Exhibit 1). Thus, now, disappointed investors seem to be questioning the value of global diversification as an approach for portfolio construction and risk management.

Although it is tempting to assume recent performance is a “new normal” in which investors are best served by concentrating exclusively in a narrow set of US assets, the Global Investment Committee (GIC) feels strongly that now is exactly the wrong time to be abandoning globally diversified portfolios. Not only do we believe the normalization of Federal Reserve policy will lead to more typical markets that are best managed with broadly diversified strategies, but we see 2014 performance as marked by extreme anomalies that are likely to be reversed soon. Specifically, 2014’s markets were characterized by: (1) an extraordinary decoupling of bond yields from economic fundamentals; (2) a high concentration of stock market performance in defensive sectors; and (3) a sharp geographic skewing of market returns toward the US at the same time that the US dollar was rapidly appreciating. These unique factors exacerbated what was already a challenging year for actively managed funds, which faced challenges navigating the low-volatility environment, and commodities, which saw a more than 50% price decline even though there was no global recession—an event that has occurred only one other time in the past 50 years. Among traditional active funds tracked

Exhibit 1: Global Asset Allocation Failed in 2014’s Highly Skewed Markets 12%

40% 10.3% 30

10

29.6%

8 20

6

5.1% 13.7% 2.9%

10

2.8%

6.0%

4 2

0

0 -1.8%

-3.7%

-2

-5.7%

-10 -4 -17.0%

-20 30-Yr. US S&P 500 Treasury

Barclays Emerging Japanese European Commodities Market US Bond Equities Equities Aggregate Equities

-6 US Global World GIC Benchmark Benchmark Tactical Allocation Peer Model 4 Group Mean

Note: For emerging market equities, returns based on MSCI EM Index; for Japanese equities, MSCI Japan Index; for Europe, MSCI Europe Index; and for commodities, Bloomberg Commodity Total Return Index; US benchmark portfolio is 60% S&P 500, 35% Barclays US Aggregate Bond Index and 5% Ryan Labs 3-Mo. US Treasury Index; Global benchmark is 50% MSCI All Country World Index, 45% Barclays US Aggregate Bond Index and 5% Ryan Labs 3-Mo. US Treasury Index. GIC Tactical Model 4 is a portfolio comprising 4% cash, 20% US equity, 22% international equity, 21% investment grade fixed income, 5% high yield, 8% emerging market debt, 3% real estate investment trusts, 3% commodities, 3% master limited partnerships, 9% hedged strategies and 2% managed futures; world allocation peer group mean is calculated by Morningstar. © 2015 Morningstar, Inc. All rights reserved. Used with permission. This information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Source: Bloomberg, Morningstar, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014 Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

2

Exhibit 2: Risk-Adjusted US Equity and Bond Returns Have Been Extraordinary

18 %

2.0 1.6 1.2 0.8 0.4 0.0

Exhibit 3: Interest Rates Have Decoupled From US GDP Growth

Sharpe Ratio: Risk-Adjusted Performance Past Five Years (2010-2014) Prior 15 Years (1994-2009)

1.61

2.5x

1.17

16

10-Year US Treasury Yield Nominal US GDP (four-year moving average)

14 12

3.5x

0.62 0.33

0.56 0.45

10 0.37 0.23

0.30 0.20

8

0.32 0.13

0.04 (0.11)

-0.4

6 4 2 0 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Jan. 30, 2015 *Ex precious metals Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014

by Morningstar, only about one-fifth outperformed benchmarks while the long-run average is about 45%. Like so many cyclical phenomena in financial markets, sometimes the pain is most severe just as things are about to change. How quickly investors have forgotten the 2000s, during which US stocks returned almost nothing while commodities, emerging markets and international stocks were the winners. Here, too, the GIC is confident that 2015 will be a year in which the faith and fidelity of building globally diversified portfolios is vindicated. The combination of powerful liquidity provisions from the European Central Bank and the Bank of Japan, a strong US dollar, economic reflation, and normalization in market volatility and the shifting wealth dynamics emanating from low oil prices should all be factors that drive the Great Rebalancing.

2014: The Failure of the Asset Allocators During the past five years, the tried-and-true approach of building globally diversified portfolios with multiple asset classes and turning to active managers for security selection has flat-out failed. Last year, in particular, non-US allocations disappointed, with weaker-than-expected GDP growth exacerbated by a late-inthe-year 15% surge in the US dollar. A paltry one-fifth of active managers beat their benchmarks. Alternative investments, especially hedge funds, delivered returns that failed to beat even bonds as volatility was, until late last year, at historic lows. In fact, investors who blindly invested only in the US, using passive vehicles for large-cap stocks and broad-based bonds, would have handily outperformed asset allocators in both nominal and riskadjusted terms. In 2014, that differential was particularly stark, with most allocators delivering total returns of 2% to 4% (see Exhibit 1) while the balanced portfolio of 60% S&P 500, 35% Barclays US Aggregate Bond Index and 5% three-month Treasury bills delivered 10.3%. Although these results are disappointing, the GIC believes strongly that investors who presume the approach built around

global diversification and broad asset allocation is broken are misreading the situation. The impact of the Federal Reserve’s Quantitative Easing (QE) has been profound, creating a skewed environment in which the risk-adjusted returns of US stocks and US bonds have been extraordinary (see Exhibit 2). Not only have returns swamped those in other asset classes, but even versus their own history they have been two-to-three-times better this cycle than during the prior 15 years. With the Fed now through its tapering program and poised to adopt a tightening bias, we believe this extreme tailwind to US core assets will abate. With that normalization, the other anomalies of 2014 should also reverse.

2014: Yields Decouple From Economic Fundamentals At the start of 2014, US stocks had just completed a superb year, up more than 33%. This performance was mainly fueled by a strengthening economic recovery and ample earnings growth. In anticipation of the Fed tapering QE, Treasury yields backed up above 3% from 1.72% and investors largely expected these trends to continue into 2014. To virtually everyone’s surprise, bonds strengthened and yields plummeted, with the benchmark 10-year US Treasury yield dropping back to 2.17% by the end of 2014. Even more amazing was the stunning performance of the 30-year US Treasury—the yield fell from more than 4% to less than 2.5% and the total return approached 30%. This was the second time in three years long bonds had achieved that level of return. While bond investors often benefit from a shift in market-risk regimes or deteriorating macroeconomic data, what made 2014 an anomaly was that neither of these conditions persisted. Usually, the 10-year Treasury yield correlates with nominal GDP growth rates within a band (see Exhibit 3). However, after a terrible firstquarter GDP report sullied by bad weather, US GDP accelerated for much of 2014. While growth averaged 3.9% between April and December, yields continued to fall. The 10-year yield trailed growth by slightly more than 1% at the end of 2013—a difference observed in 40% of months since 1981 (see Exhibit 4, page 4).

Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

3

Exhibit 4: Gap Between US GDP and Interest Rates Is at a Historic Spread GDP Growth (trailing four years)

Exhibit 5: Yield Curve Is Unusually Flat Given the Current Point in the Cycle

Year-End Year-End January 2013 2014 2015 4.07% 3.87% 3.87%

90 % 80

10-Year US Treasury Yield

3.03%

2.17%

1.64%

70

Difference

1.04%

1.69%

2.23%

60

40%

2%

0%

50

Percentage of Periods Since Sept. '81 Rate Peak with Larger Differences

Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Jan. 30, 2015

Furthermore, not only did the level of yields surprise investors, but the anomalous slope of the yield curve also sent mixed signals to the market (see Exhibit 5). Typically, a flattening yield curve— a reduction in the spread between the yields on two-year and 10year US Treasuries—signals that the business cycle is peaking, while in 2014 our fundamental indicators suggested, at best, a midcycle level of activity. Further complicating matters was the simultaneous collapse in commodity prices, especially oil, which weakened inflation expectations. This historic decoupling between yields and GDP could be partially justified by the supply/demand dynamics in global bond markets (see The GIC Weekly, Feb. 17, 2015), deflation fears in Europe and Japan and very low rates outside the US in anticipation of QE in other global markets. However, it posed problems for portfolio managers and asset allocators who try to manage risk based on the macroeconomic environment and long-term correlations. Generally, long-duration US Treasuries have acted as safe assets and the ultimate diversifier to risk assets, allowing investors to earn returns through yield in periods during which equities are suffering setbacks. Conversely, as the economy strengthens, as it did in 2014, these long-duration bonds typically sell off as stocks rise. However, in 2014, the price of 30-year US Treasuries and US stocks, which are typically negatively correlated, became highly correlated. Specifically, correlations betweens 30-year US Treasury prices that averaged -0.3 since 2000 were 0.48 in 2014. Given history, it was prudent and predictable for asset allocators to sell their long bond positions but, given the unexpected decoupling, this proved hugely costly to investor returns.

2014: Defensive Stocks and Yield Substitutes Dominate A second anomaly in 2014 was the extreme concentration and skewness of performance within the stock market toward typically defensive sectors and other so-called bond substitutes. Again, while utilities, real estate investment trusts (REITs) and consumer staples sometimes lead markets, it is usually when earnings growth is poor, fundamentals are deteriorating and interest rates are falling. Conversely, 2014 was a year characterized by solid corporate earnings growth of roughly 7%, as well as a 6% expansion in the market’s price/earnings multiple—a development associated with

-1.0 %

MS US Economic Cycle Indicator (left axis) 10-Yr./Two-Yr. Yield-Curve Slope (right axis, inverted)

-0.5 0.0 0.5 1.0

40 1.5

30

2.0

20

2.5

10 0 1990

3.0 1993

1996

1999

2002

2005

2008

2011

2014

Note: MS Cycle Indicator, 100=Expansion, 0=Recession. The Morgan Stanley US Cycle Indicator measures the deviation from historical norms for macro factors including employment, credit conditions, corporate behavior and the yield curve. Source: Morgan Stanley & Co. Research, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014

higher real interest rates and benign inflation. Earnings revisions were normal should not have provoked such marked risk aversion among investors. Still, here also market behavior was counterintuitive as, in 2014, the least economically sensitive companies (as measured by equity beta) delivered the highest returns—and they did so by a huge margin of nearly two to one versus high-beta companies (see Exhibit 6, page 5). Utilities were up a staggering 29.0% in 2014, pushing their relative valuations to the market to 50-year extremes while REITs were up 30.5% even though they were among the decade’s best-performing asset classes and even though residential and commercial real estate trends were uneven. Valuations apparently took a back seat to the relative attractiveness of their dividend yields—4.8% for utilities and 5.2% for REITs. Not only were winning returns unusually concentrated in a few sectors, but poor returns were equally clustered around the victims of the oil-price decline, with energy stocks off more than 25%. A handful of multinationals exposed to the risks of a stronger US dollar also rapidly repriced by more than 15% in the final quarter of the year. Evidence of the difficulty of the environment for stock pickers can be seen in the lack of a spread in performance between the long and short positions of hedge funds (see Exhibit 7, page 6).

2014: US Decouples The final anomalous challenge for asset allocators and portfolio managers in 2014 was the sharp divergence in stock market performance across regions. While US economic performance was improving, other markets were not. In Japan, investors grappled with the ill-timed consumption tax; in Europe, economic sanctions related to Russia’s incursions into the Ukraine stifled any momentum in the nascent recovery; and, in China, local

Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

4

2015: Why It May Be Different

Exhibit 6: In 2014, Returns of Low-Beta Companies Beat High-Beta Companies

As the Fed normalizes its role in the capital markets this year, we believe it will mark the beginning of the Great Rebalancing. In essence, we see the laggards of the last five years catching up while the leaders fade on a relative basis. In particular, we see changing monetary policies, currencies and energy prices improving global growth prospects via wealth transfers from energy producers to energy importers and deflationary economies starting to import inflation through their weaker currencies. Beyond already stimulative policy in the Euro Zone, Japan and China, the first six weeks of 2015 have seen rate cuts in Canada, Denmark, India, Indonesia, Peru, Sweden and Turkey. Also this year, the Swiss National Bank abandoned its three-year-old peg of the Swiss franc to the euro. Economic surprise indexes are turning positive in Europe and Japan while indicators in the US appear to have rolled over from a peak. Japanese and European companies are seeing an improvement in earnings upgrades relative to downgrades while negative revisions in the US are now implying that S&P 500 profit growth this year will be only 1% to 2%. Adam Parker, Morgan Stanley & Co.’s chief US equity strategist, thinks the negativity in profit forecasts may be excessive and his estimates still call for 7%-to-8% earnings growth. Even so, with both Europe and Japan emerging from recessions, operating leverage is likely to be significant and could support earnings growth of 12% and 14%, respectively. Within the US market we see rotations occurring as well. Large-cap multinationals are likely to face the headwinds of a strong US dollar and a 30%-to-40% decline in energy-related capital spending while defensive, interest rate-sensitive sectors such as utilities and REITs face the threat of higher rates when the Fed ultimately hikes them. On the flip side, beneficiaries of a stronger job market and lower energy prices

2014 Performance of 1,500 Largest US Stocks by Beta Quintile

16%

14.5%

13.6%

14 12 10

7.6%

8

6.8%

6

4.6%

4 2 0 Q1 (20% lowest beta stocks)

Q2

Q3

Q4

Q5 (20% highest beta stocks)

Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014

policymakers focused on anticorruption reforms ahead of growth stimulus. The energy industry’s supply shock created a new group of winners and losers, transferring wealth to energy consumers from energy producers. The emerging market countries were challenged by the potential repercussions from the pending shift in Fed interest rate policy, which could restrict their access to foreign capital. The implication was an extreme relative outperformance of US markets versus other regions (see Exhibit 8, page 7). In particular, the GIC has often noted the extraordinary price performance of the US versus Europe during the past six years. Performance divergence of this magnitude has occurred only four times in the past 70 years and has never persisted for a seventh year in a row. All this was further complicated by the appreciating US dollar, which shaved, on average, another 2.3 percentage points from 2014 returns for unhedged US investors in globally diversified balanced portfolios.

Exhibit 7: Hedge Fund Managers Also Had Difficulty Outperforming in 2014 20% 16.7%

Long, Short and Total Alpha, Based on Equity Long/Short Global Positions vs. MSCI All Country World Returns Worst Year of Alpha Post Crisis

14.5%

15

11.8%

9.8% 10.1%

9.7%

10

7.3% 5.5%

4.6%

5

2.5%

2.3%

4.6%

4.2%

2.0%

0.0%

0

-5 -4.9%

'09

'10

'11

'12

'13

'14

'09

-4.2%

'10

-4.4%

'11

'12

'13

'14

'09

'10

'11

'12

'13

'14

-10 Long Alpha = Long Appreciation - MSCI

Short Alpha = MSCI - Short Appreciation

Total Alpha = Long - Short Appreciation

Source: Morgan Stanley Prime Brokerage, Bloomberg, FactSet, Morgan Stanley Wealth Management GIC as of Jan. 30, 2015 Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

5

Exhibit 8: US Outperformance of Non-US Markets Near Historic Highs 40 %

US vs. Rest of World Relative Performance*

Exhibit 9: “Lost Decade” of the 2000s Shows the Value of Asset Allocation MSCI Emerging Markets

30

Global High Yield

20

Russell 2000 Value

10 0

84.7%

Five-Year US Treasury

84.1%

Russell 2000 Index

-20

should lead outperformers and finally, we see the jobs recovery finally beginning to drive middle-class consumption and the housing sector. All told, this is a scenario in which globalized portfolios may benefit, the pickup in volatility can be exploited by hedge funds and active stock pickers can draw from a larger opportunity set. As broad global, active and risk-managed portfolios remain the cornerstone of prudent wealth management, we believe 2015 will

109.9%

Barclays US Aggregate

Russell 1000 Value

*Difference between total returns of the S&P 500 and the MSCI All Country World Index ex US Source: FactSet, Bloomberg as of Dec. 31, 2014

121.4%

Barclays TIPS

-10

-30 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

162.0% 128.4%

MSCI EAFE

41.3%

Cumulative Return January 2000 to December 2009

27.7% -9.1%

17.0%

S&P 500 -20

0

20

40

60

80

100 120 140 160 180

Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014

revalidate the role of asset allocators. It’s important not to overemphasize recent performance when investing for the long term. The “lost decade” (the 2000s) for the S&P 500 is a telling contrast to today and shows us that over time, markets are mean reverting (see Exhibit 9). In the long run, diversified portfolios have provided the most consistent and stable investment results over time (see Exhibit 10, page 7). 

Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

6

Exhibit 10: Asset-Class Returns Show Active Rebalancing Is Important* 2004

2005

2006

2007

2008

REITs

EM Equities

REITs

EM Equities

38.0%

34.0%

43.7%

40.2%

Managed Futures 13.6%

EM Equities

Commod.

EM Equities

Commod.

27.0%

21.4%

32.1%

16.2% Inflation-Linked

DM Int'l Equities 21.7%

REITs

16.7%

15.4% DM Int'l Equities 15.2%

Inflation-Linked

EMD

MLPs

15.0%

US Equities

REITs

MLPs

32.4%

14.7%

13.8%

DM Int'l Debt

MLPs

EM Equities

EMD

High Yield

MLPs

US Equities

EM Equities

11.7%

76.4%

20.2%

9.2%

19.6%

27.6%

13.7%

US Debt

High Yield

REITs

US Debt

EM Equities

Managed Futures 11.1%

6.0%

7.7%

MLPs

REITs

13.0%

5.2%

59.4%

20.0%

7.8%

MLPs

MLPs

Inflation-Linked

REITs

Commod.

Inflation-Linked

26.1%

12.7%

-8.7%

16.8%

7.6%

US Equities

DM Int'l Debt

EMD

41.3% DM Int'l Equities 33.9%

19.1% DM Int'l Equities 18.2%

US Equities

DM Int'l Debt

EMD

15.1%

6.0%

18.0%

US Equities

High Yield

High Yield

US Equities

High Yield

-9.7%

Hedged Strategies 10.3%

Diversified Portfolio -25.7%

Diversified Portfolio

High Yield

11.8%

6.3%

DM Int'l Debt

US Equities

11.6% US Equities 10.9%

REITs 29.8%

Hedged Strategies -21.4%

MLPs

Commod.

MLPs

DM Int'l Equities 24.0% Diversified Portfolio 15.1% Hedged Strategies 8.8%

High Yield 13.7% EMD 10.5%

7.9%

4.9%

Hedged Strategies 10.4%

Managed Futures 7.6%

High Yield

Inflation-Linked

US Debt

3.6% Managed Futures 2.8%

26.5% EMD 25.9%

Inflation-Linked

4.8%

-1.9%

3.5%

5.2%

US Debt

High Yield

Inflation-Linked

Inflation-Linked

DM Int'l Debt

6.5% US Equities

2.4%

5.5%

US Debt

Inflation-Linked

US Debt

High Yield

REITs

DM Int'l Debt

4.3% Managed Futures 0.9%

-0.5%

4.3%

3.2%

-48.9%

DM Int'l Debt

Commod.

REITs

EM Equities

-9.4%

2.1%

-4.7%

-53.6%

3.7% Managed Futures -4.8%

US Debt 5.9%

US Debt

0.7% EM Equities

MLPs

17.6%

DM Int'l Equities 5.2%

MLPs

18.9%

Hedged Strategies 11.5%

6.7% Diversified Portfolio 6.4%

10.2%

-35.6%

-36.9%

4.8% Diversified Portfolio 4.8%

-2.1%

DM Int'l Equities 9.8%

US Equities

US Equities

Managed Futures -4.3%

23.6%

EMD

2.2% Managed Futures

7.7%

US Debt

Hedged Strategies 4.4%

Commod.

7.0%

7.3% REITs

EMD

6.2%

11.8%

-26.9%

8.2%

2.1%

16.0% Diversified Portfolio 12.0%

8.0%

EMD

Inflation-Linked

Commod.

DM Int'l Debt

3.1% US Equities

8.9% High Yield

Diversified Portfolio

EMD

-37.0% DM Int'l Equities -43.4%

US Debt

14.8% Diversified Portfolio 12.7%

Diversified Portfolio

6.6% Managed Futures 5.6%

9.1% Hedged Strategies 6.9%

10-Yr. Annualized

2014

13.9%

11.2%

EMD

2013

MLPs

DM Int'l Equities 10.8%

Hedged Strategies 6.9%

2012

35.9%

15.8%

13.2%

2011

82.9%

Diversified Portfolio 15.5%

Diversified Portfolio 13.0%

2010

EM Equities

11.9% Diversified Portfolio 8.6%

High Yield

DM Int'l Equities 26.7%

2009

7.0%

Hedged Strategies -5.7%

Hedged Strategies 4.8%

US Debt

REITs

US Debt

6.5%

-8.1% DM Int'l Equities -12.2%

4.2%

-5.6%

-1.4%

DM Int'l Debt

Inflation-Linked

DM Int'l Debt

0.5%

-6.0%

Commod.

Commod.

EMD

-13.3%

-1.1% Managed Futures -1.8%

-8.3%

DM Int'l Equities -4.5%

Commod.

Commod.

Commod.

-9.5%

-17.0%

-1.9%

Inflation-Linked 6.5% Managed Futures 6.4% Hedged Strategies 4.2%

EM Equities -19.2%

4.8%

-2.0%

0.0%

DM Int'l Debt

EM Equities

-3.0%

Managed Futures 3.5% Hedged Strategies 3.0% DM Int'l Debt 2.6%

*Indexes used: Barclays US Aggregate Bond for US bonds; Citi 3-Month T-Bill for cash; Barclays Global Majors ex US for developed market bonds; Barclays Universal Inflation-Linked for inflation-linked bonds; Barclays Global High Yield for global high yield; JP Morgan EMBI for emerging markets; S&P 500 for US stocks; MSCI EAFE IMI for international stocks; MSCI EM IMI for emerging markets stocks; FTSE EPRA/NAREIT Global for REITs; DJ-UBS Commodity Index for commodities; Barclay TOP 50 for managed futures; Alerian MLP for MLPs, HFRI Fund of Funds Composite for hedged strategies. Diversified portfolio is 25% S&P 500, 10% Russell 2000 Index, 15% MSCI EAFE Index, 5% MSCI EME Index, 25% Barclays US Aggregate Bond Index, 5% Citi 3-Mo. T-bill Index, 5% HFRI Fund of Funds Composite, 5% DJ-UBS Commodity Index, and 5% FTSE EPRA/NAREIT Global Index. Source: FactSet, Morgan Stanley Global Wealth Management GIC as of Feb. 4, 2015; managed futures as of Dec. 31, 2014

Please refer to important information, disclosures and qualifications at the end of this material.

March 2015

7

Index Definitions ALERIAN MLP INDEX This

is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalizationweighted methodology, is disseminated realtime on a price-return basis and on a total-return basis.

BARCLAYS CAPITAL GLOBAL HIGH YIELD INDEX (HEDGED) INDEX This index provides

This index seeks to replicate the composition of the managed futures industry with regard to trading style and overall market exposure. The largest investable trading-advisor programs, as measured by assets under management, are selected for inclusion in the index. BARCLAYHEDGE BTOP50 INDEX

This index measures monthly return equivalents of yield averages that are not marked to market. The 3Month Treasury Bill Indexes consist of the last three 3-Month T-Bill issues.

CITIGROUP 3-MONTH T-BILL INDEX

a broad-based measure of the global high yield fixed income markets. Currency exposure is hedged to the US dollar.

DOW JONES-UBS COMMODITY INDEX This index comprises futures contracts on physical commodities. These include energy, base metals, precious metals and agricultural commodities.

BARCLAYS CAPITAL GLOBAL MAJORS INDEX EX US This is an index tracking government

FTSE EPRA/NAREIT GLOBAL INDEX This

bonds issued by Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, the UK and the US. BARCLAYS CAPITAL US AGGREGATE BOND INDEX This index represents securities that are

SEC-registered, taxable and dollardenominated. The index covers the US investment grade fixed-rate bond index, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. BARCLAYS CAPITAL US TREASURY US TIPS INDEX This is an unmanaged index that consists

index reflects trends in real estate equities worldwide. Relevant real estate activities are defined as the ownership, disposure and development of income-producing real estate.

HFRI FUND OF FUNDS COMPOSITE INDEX This is an equal-weighted index of 650 hedge funds with at least $50 million in assets and 12 months of returns. Returns are reported in US dollars and are net of fees. JP MORGAN EMERGING MARKET INDEX (LOCAL CURRENCY, UNHEDGED) This index tracks debt

index captures large, mid and small cap representation across 16 developed markets countries in Europe.

MSCI JAPAN INDEX (IMI) This index is designed to measure the performance of the large-, midand small-cap segments of the Japanese market. With 1,134 constituents, the index covers approximately 99% of the free float-adjusted market capitalization in Japan. RUSSELL 1000 VALUE INDEX This

index measures the performance of those Russell 1000 companies with lower price/book ratios and lower forecasted growth. This index measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

RUSSELL 2000 INDEX

RUSSELL 2000 VALUE INDEX This index is a market-weighted total return index that measures the performance of companies within the Russell 2000 Index having lower price/book value ratios and lower forecasted growth rates.

MSCI ALL COUNTRY WORLD INDEX This free-

S&P 500 INDEX Regarded as the best single gauge of the US equities market, this capitalizationweighted index includes a representative sample of 500 leading companies in leading industries of the US economy.

BARCLAYS CAPITAL UNIVERSAL GOVERNMENT INFLATION-LINKED BOND INDEX (UNHEDGED) INDEX This index combines the

MSCI ALL COUNTRY WORLD EX US INDEX This

contracts and reflects the returns on a fully collateralized investment in the Bloomberg Commodity Index. This combines the returns of the Bloomberg Commodity Index with the returns on cash collateral invested in 13 week (3 month) US Treasury Bills.

MSCI EUROPE INDEX (IMI) This

RYAN LABS 3-MO. US TREASURY INDEX This

of inflation-protected securities issued by the US Treasury.

BLOOMBERG COMMODITY TOTAL RETURN INDEX This index is composed of futures

index captures large-, mid- and small-cap representation across 21 emerging markets countries.

issued in local currencies by emerging market governments. float-adjusted market capitalization index captures large-cap and mid-cap representation across 23 developed markets and 21 emerging markets.

Barclays Capital World, Euro and Emerging Market government indexes to measure the performance of the major developed and emerging government inflation-linked bond markets.

MSCI EMERGING MARKETS INDEX (IMI) This

is

an index of three-month US Treasury bills.

is a free-float-adjusted, market-capitalizationweighted index that is designed to measure equity market performance in the global developed and emerging markets outside the US. MSCI EAFE INDEX The Morgan Stanley Capital International Europe, Australia, Far East (MSCI EAFE) Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed market countries within Europe, Australia and the Far East.

Please refer to important information, disclosures and qualifications at the end of this material.

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Glossary ALPHA Alpha

is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance with a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

BETA Beta

is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model, a model that calculates the expected return of an asset based on its beta and expected market returns.

SHARPE RATIO This

ratio is calculated by subtracting the risk-free—such as that of the 10year US Treasury bond—from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. VOLATILITY This is

a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

Please refer to important information, disclosures and qualifications at the end of this material.

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Risk Considerations MLPs Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Individual MLPs are publicly traded partnerships that have unique risks related to their structure. These include, but are not limited to, their reliance on the capital markets to fund growth, adverse ruling on the current tax treatment of distributions (typically mostly tax deferred), and commodity volume risk. The potential tax benefits from investing in MLPs depend on their being treated as partnerships for federal income tax purposes and, if the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value. MLPs carry interest rate risk and may underperform in a rising interest rate environment. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments; this deferred tax liability is reflected in the daily NAV; and, as a result, the MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.

Duration Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Alternative investments which may be referenced in this report, including private equity funds, real estate funds, hedge funds, managed futures funds, and funds of hedge funds, private equity, and managed futures funds, are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and risks associated with the operations, personnel and processes of the advisor. Managed futures investments are speculative, involve a high degree of risk, use significant leverage, have limited liquidity and/or may be generally illiquid, may incur substantial charges, may subject investors to conflicts of interest, and are usually suitable only for the risk capital portion of an investor’s portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering documents carefully for additional information, including charges, expenses, and risks. Managed futures investments are not intended to replace equities or fixed income securities but rather may act as a complement to these asset categories in a diversified portfolio. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be suitable for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Please refer to important information, disclosures and qualifications at the end of this material.

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Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companies paying dividends can reduce or cut payouts at any time. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time. REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction.

Disclosures Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future

Please refer to important information, disclosures and qualifications at the end of this material.

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performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the material in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. If your financial adviser is based in Australia, Dubai, Germany, Italy, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Dubai: Morgan Stanley Private Wealth Management Limited (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA; Germany: Morgan Stanley Private Wealth Management Limited, Munich branch authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Bundesanstalt fuer Finanzdienstleistungsaufsicht; Italy: Morgan Stanley Bank International Limited, Milan Branch, authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, the Banca d'Italia and the Commissione Nazionale per Le Societa' E La Borsa; Switzerland: Bank Morgan Stanley AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the “Municipal Advisor Rule”) and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. This material is disseminated in the United States of America by Morgan Stanley Wealth Management. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. © 2015 Morgan Stanley Smith Barney LLC. Member SIPC.

Please refer to important information, disclosures and qualifications at the end of this material.

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