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The Importance of Strategic Partnerships

The Importance of Strategic Partnerships. Owen Thomas President, Morgan Stanley Investment Management November 14, 2007.

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The Importance of Strategic Partnerships

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  1. The Importance of Strategic Partnerships Owen Thomas President, Morgan Stanley Investment Management November 14, 2007 This presentation is for educational purposes only and is to be used exclusively at the SACRS Conference on November 14, 2007. It is not to be reproduced or redistributed. This material has been prepared using sources of information generally believed to be reliable but no representation can be made as to its accuracy. Information in this presentation does not necessarily address the financial objectives, situation or specific needs of any individual investor nor does it necessarily pertain to any Morgan Stanley product. These comments are not necessarily representative of the opinions and views of the firm as a whole.

  2. Agenda • Plan Sponsor Overview • Portfolio Construction • Implementation Considerations • Opportunities in the Current Market Environment • The Importance of Strategic Partnerships

  3. Section 1 – Plan Sponsor Overview

  4. Meeting Target Returns Managing Risk Navigating Current Market Volatility Scarce alpha in the traditional approach Growing acceptance of alternatives Emergence of new portfolio management techniques such as the separation of “alpha vs. beta” More tools to understand and mitigate risk Plan Sponsor Challenges Challenges Considerations Importance of strategic partnerships between plan sponsors, asset managers and consultants (1) Bill McHugh and Barbara Heubel, “Insights – Pension Investment Strategies for a New Playing Field,” JPMorgan, December 2006 p 5.

  5. Have Led to a Growing Acceptance of Alternatives… Percentage of Public Funds Anticipating an Increase (Decrease) in Strategic Allocations, by Asset Class (%) Source:Insights – Pension Investment Strategies for a New Playing Field, JPMorgan, December 2006

  6. Alternatives “Buzz” Increasing Texas Teachers to Move $38 Billion CIO’s alternatives allocation would catapult plan into public fund vanguard “The Teacher Retirement System of Texas, guided by new CIO T. Britton Harris IV, could have the largest percentage allocation to alternative investments of any public pension plan in the U.S. if a proposal to overhaul the $106 billion system’s investment program is approved.” “This 35% allocation to alternative investments would be the largest… [of] any major U.S. public plan, according to data from Pensions & Investments’ 2006 annual survey of the 200 largest retirement systems…” Pensions & Investments, April 30, 2007 Boeing Moves 27% to Alternatives “The argument du jour is that investment in alternatives represents a diminution, not an escalation, of risk. Boeing’s Schmid is betting the intelligent use of alternatives will allow him to reach for incremental return and actually moderate his portfolio’s overall risk levels.” “Boeing has also implemented an enhanced risk management overlay strategy for rebalancing and portable alpha, and added market-neutral strategies and a global tactical asset-allocation program that will grow to $2.3 billion…” PlanSponsor, June 2007 Alternatives Help Give Endowments Big Boost “Increased allocations to alternative investments helped boost investment returns of foundations from 7.9% in 2005 to an average 13.7% last year according to the latest Commonfund Benchmarks Studies by the Commonfund Institute…” Hedge Fund Daily, June 14, 2007 Alternatives Drive PSERS Performance “The Pennsylvania Public School Employees’ Retirement System (PSERS) has seen a 16.23% gain for the fiscal year to date, following strong performance from its property and private equity investments. [Its] private real estate investments returned 34.25%, while its US and non-US equity portfolios each gained 10.08% and 19.41% respectively…” www.pensionsnews.com, June 11, 2007 Pension Funds Flocking to Alternative Investments “According to a survey from Watson Wyatt, alternative assets run by the largest 99 pension fund alternatives managers is now at nearly $600bn...” www.pensionsnews.com, June 14, 2007

  7. Section 2 – Portfolio Construction

  8. A Traditional Portfolio Illustrative example Traditional Portfolio 100% Traditional Domestic Bonds 30.0% Domestic Equity 70.0% Past performance is no guarantee of future results. The estimated returns or projections are provided by way of example only. There can be no assurance that estimated returns or projections can be realized or that actual returns or performance results will not be materially lower than those estimated herein. The expected returns do not reflect the performance of any Morgan Stanley Investment Management investment. The estimated returns or projections are based on the research, analysis and opinions of the authors and on Morgan Stanley’s propriety models and various assumptions, and any changes to such models and assumptions could have a material impact on the returns set forth herein.

  9. Portfolio A: 90% Traditional, 10% Alternatives Illustrative example Portfolio A 90% Traditional, 10% Alt Alternatives 10.0% Domestic Bonds 27.0% Domestic Equity 63.0% Past performance is no guarantee of future results. The estimated returns or projections are provided by way of example only. There can be no assurance that estimated returns or projections can be realized or that actual returns or performance results will not be materially lower than those estimated herein. The expected returns do not reflect the performance of any Morgan Stanley Investment Management investment. The estimated returns or projections are based on the research, analysis and opinions of the authors and on Morgan Stanley’s propriety models and various assumptions, and any changes to such models and assumptions could have a material impact on the returns set forth herein.

  10. Portfolio B: 60% Traditional, 40% Alternatives Illustrative example Portfolio B 60% Traditional, 40% Alt Domestic Bonds 18.0% Alternatives 40.0% Domestic Equity 42.0% Past performance is no guarantee of future results. The estimated returns or projections are provided by way of example only. There can be no assurance that estimated returns or projections can be realized or that actual returns or performance results will not be materially lower than those estimated herein. The expected returns do not reflect the performance of any Morgan Stanley Investment Management investment. The estimated returns or projections are based on the research, analysis and opinions of the authors and on Morgan Stanley’s propriety models and various assumptions, and any changes to such models and assumptions could have a material impact on the returns set forth herein.

  11. Portfolio A (90% Traditional, 10% Alternatives) Portfolio B (60% Traditional, 40% Alternatives) Traditional Plan (100% Traditional) Improving the Efficient Frontier Illustrative example Portfolios A, B and Traditional—the Efficient Frontier Past performance is no guarantee of future results. The estimated returns or projections are provided by way of example only. There can be no assurance that estimated returns or projections can be realized or that actual returns or performance results will not be materially lower than those estimated herein. The expected returns do not reflect the performance of any Morgan Stanley Investment Management investment. The estimated returns or projections are based on the research, analysis and opinions of the authors and on Morgan Stanley’s propriety models and various assumptions, and any changes to such models and assumptions could have a material impact on the returns set forth herein.

  12. Section 3 – Implementation Considerations

  13. Key: 25th Percentile Median 75th Percentile Manager Selection Is Critical in the Alternatives Space… 1 Return Quartile Dispersion – Private Equity & Hedge Funds vs. Traditional • Sources: Malkiel, Burton G. and Saha, Atanu, “Hedge Funds: Risk and Return,” Working Paper #104, Princeton University, Department of Economics, Center for Economic Policy Studies. Data for ten years ending 2003. Private equity data from Venture Economics, 2000, for the period 1969 to 1999.

  14. Commodities Broad universe including energy, metals, agriculture Emerging Markets Debt Bonds issued by governments and corporates in developing economies Asset Class Strategy / Universe Private Equity Direct equity stakes in private companies (venture capital, buyouts, distressed) Hedge Funds Generally unconstrained investment funds High Yield Debt Non-investment grade bonds (ratings BB+ and below) Real Estate Both direct listed real estate investments (e.g., REITS) Senior Loans Purchase of companies’ senior debt (through syndication, securitization) Currency Long/Short strategy seeking absolute return through currency trading Long/Short Strategies Market Neutral / GTAA Volatility VIX Index – priced off volatility in equity index derivatives Infrastructure Investment in public goods and services (e.g., toll roads, water, communication systems) Emissions Investment in newly established EU carbon dioxide emissions permits Freight Investment in freight capacity for worldwide shipping Especially as the Depth and Breadth of Alternative Investment Options Continues to Grow

  15. 43 10 15 11 21 A Framework to Build an Alternatives Allocation Efficient Portfolio Weights 100 Asset Classes Weights (%) 90 Global Macro Hedge Funds 80 Private Equity Real Estate 70 Senior Loans 60 Senior Loans Weights (%) Real Estate 50 40 Global Macro Private Equity 30 20 Hedge Funds 10 0 Lower Expected Returns Higher Source: Morgan Stanley Investment Management Research • Past performance is not necessarily a guide to future performance. This analysis requires the use of quantitative models that make assumptions on risks and returns in the forecast horizon, and are no guarantee of results achieved in reality. Please also refer to the important risk disclosure at the beginning of the presentation. • For illustrative purposes only.

  16. Traditional Approach β Select beta exposures first, then look for alpha α Find alpha first, then transport it to desired beta Portable Alpha Approach Some Are Considering the Separation of Alpha and Beta Decisions… “..seeking outperformance in traditional asset classes by packaging diversified alpha sources with efficient beta exposure…” (1) (1) Source: Morgan Stanley Investment Management.

  17. Risk Exposure as a Function of Allocation to an Asset Class Volatility ofEach Asset Class Correlations of Asset Classes Driven by Links to Economic Factors,e.g., Inflation and Growth And Implementing A Robust Approach to Risk Management…

  18. Correlations Are Driven by Economic Factors Old risk view: Examine correlations by asset class—fixed income, equity and alternatives New risk view: Examine correlations by asset class and impact of growth and inflation expectations Source: Morgan Stanley analysis

  19. Risk Assessment: A Real Life Scenario Portfolio Allocation Economic Factor Exposure Real Estate3.4% Inflation Below Expectations 36.0% Growth Above Expectations 55.8% Corp / MtgSpread 24.7% Equities U.S.46.6% Gov’t Bonds34.1% Equities Int’l,Developed15.6% Inflation Above Expectations 2.0% Currency15.6% Growth Below Expectations 6.2% Illustrative Example

  20. Section 4 – Opportunities in the Current Market Environment

  21. It’s Been a Rough Few Months for Some…

  22. The Sub Prime Issues Have Led the Market Downward ABX 07–01 January 19, 2007 – November 6, 2007 Source: JPMorgan

  23. The Dollar Is Under Pressure…. USD to Euro USD to Sterling January 6, 2007 – November 12, 2007 January 6, 2007 – November 12, 2007 Source: Bloomberg

  24. While China and Emerging Markets Accelerate Hong Kong Hang Seng Index China A Shares January 2, 2007 – November 12, 2007 January 2, 2007 – November 12, 2007 Composite Index Source: Bloomberg

  25. Equity Returns Weathered the Turmoil, Until Recently S&P 500 Index January 2, 2007 – November 12, 2007 Source: Bloomberg

  26. Opportunities and Risks Remain Opportunities • Distressed Assets • Mezzanine Financing Risks • US Dollar • China Equity Markets

  27. Section 5 – The Importance of Strategic Partnerships

  28. Portfolio Architecture • Performance portfolio construction • Alpha / beta separation • Model portfolio development • Manager evaluation Pension and Government Finance • Integrated Pension Solutions • Risk budgeting / allocation • Pension obligation bondexpertise • Actuarial expertise Risk Management and Modeling Research and Innovation • Research ideas • Product innovation • Joint research projects • Embedded beta analyses • Liquidity / tail risk analyses • Liability hedging • Structured solutions Inside a Strategic Partnership

  29. Pension and Government Finance • Provide holistic pension solutions • Set risk budget based on objectives • Reduce implicit risks in portfolio • Allocate risk efficiently • Increase likelihood of meeting objectives • Actuarial analysis

  30. Portfolio Architecture • Develop efficient, high performance portfolios • Focus on separating alpha and beta • Develop diversified beta strategies • Create custom hedge fund portfolios • Provide portable alpha expertise • Create and deliver broadly diversified portfolios of alternatives

  31. Risk Management and Modeling • Analyze risk on several dimensions • Portfolio level (explicit betas) • Manager level (alpha vs. beta) • Factor risks (embedded betas) • Optimize portfolios considering • Tail risk (event risk) • Illiquidity risk • Potential economic scenarios

  32. Research and Innovation • Continue thought leadership • Develop new ideas • Create innovative solutions • Conduct joint research projects

  33. Plan Sponsor AssetManager Conclusion: The Importance of Strategic Partnerships Considerable Change Is Occurring in Asset Management • Act as an advisor to plan sponsors, trustees and their consultants in identifying and addressing their most pressing issues in a changing environment • Portfolio Architecture: Identify investment solutions to help meet return objectives. Advise on implementation goals for alternatives and new portfolio architecture • Risk Management and Modeling: Address portfolio risks such as factor risks, liquidity risk, event risk and optionality • Research and Innovation: Educate trustees and staff on emerging portfolio management techniques by providing transparent investment insight Consultant

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