Reading 27: Asset Allocation to Alternative Investments

Question 1

Risk Factor Based Asset Allocation

Answer 1

Implementation hurdles are a limitation of risk-based approaches. While the risk-based approach explicitly defines target exposures to different quantitative risk factors (such as equity, duration, and credit spreads), it is not explicit as to how these target risk factor exposures are best achieved using the asset classes available to the manager. Risk factor-based approaches
to asset allocation can be applied to develop more robust asset allocations.

Question 2

Traditional Approach

Answer 2

Primary limitations include overstating the portfolio diversification and obscure the primary drivers of risk.

Question 3

Mean Variance Optimisation

Answer 3

Mean–variance optimization typically over-allocates to the private alternative asset classes, partly because of underestimated risk due to stale pricing and the assumption that returns are normally distributed. Can be fixed by imposing limitations. Alternative investments can be illiquid, have valuation issues, have option like returns, causing them not to have normal distributions so MVO can be limited.

Question 4

Liquidity Planning

Answer 4

Liquidity planning should take into account that under a scenario in which public equities and fixed-income investments are expected to perform poorly, general partners may exercise an option to extend the life of the fund.

Question 5

Return Enhancing Investments

Answer 5

Private equity and private credit can be viewed as return enhancing (risk increasing). Real assets may be seen as risk reducing and thus lower returns. Real assets hedge for inflation. Hedge funds can fall anywhere on the spectrum depending on strategy. Precious metals or govt bonds are seen as safe havens.

Question 6

Hedge Funds

Answer 6

L/S and short biased somewhat reduce portfolio’s overall equity beta but are expected to increase returns through alpha. Merger arbitrage or global macro may be less correlated with traditional assets. Have gates which are maximum amounts for redemption. But liquidity provisions are usually less strict that for private equities, real estate, and real assets. Liquidity for investors can be overstated as hedge funds have side pockets of large holdings that investors cannot redeem.

Question 7

Private Equity

Answer 7

Limited diversification as public and private equity are exposed to similar risk factors. Main function of private equity is to increase returns.

Question 8

Private Credit

Answer 8

Distressed debt has risk return profile more like equity because factors specific to the issuer effect it more than interest rate movements.

Question 9

Alternatives

Answer 9

Typically offer higher returns than bonds but have higher correlation with equities than bonds. There is a trade off with long term horizon of lower volatility or greater returns. Alternatives tend to overestimate diversification benefits due to smoothed SD (appraisal based, survivorship based, backfill bias).

Question 10

Risk Factor Based Approach

Answer 10

Defining asset classes by statistically estimating their sensitivities to risk factors identified by managers. Can show some alternative classes are correlated with equities so can detect overestimation of diversification. Highlights primary drivers of portfolio risk, unlike traditional. Risk factors can be sensitive to the period used and may be difficult to communicate to decision makers. Additional step of translating optimised risk exposure to an asset allocation. Return sensitivity to some risk factor exposures might not be stable over time.

Question 11

Private Equity

Answer 11

Limited partners (investors) commit capital and general partner will call this down over 3-5 years. LPs must meet these capital calls, and can invest the undrawn capital liquid investments to reduce the opportunity cost of holding it in cash. Usually they invest it in the public asset class equivalent to the private asset class. Distributions can be made during the call down period. Not all capitals is required to be called down.

Question 12

Alternative Investments

Answer 12

Based on the premise that managers can create value through active management. Not suitable for investors whose philosophy is grounded on price-efficency of markets.

Question 13

Managing Liquidity for Call Downs

Answer 13

Forecast models to project cash flows to and from a fund. Annual capital calls and distributions that may be used to fund the capital calls. Implementing an allocation to alternative investments required time and estimating for returns because 20% now will not be the same as 20% in future.

Question 14

Multiple on Invested Capital

Answer 14

Divides the value of the funds underlying investments less distributions by total invested capital. This strips out the effects of cash flows that effect the IRR.

Question 15

Undertaking for Collective Investment in Transferable Securities (UCITS)

Answer 15

The regulation of UCITS does limit investment choice. Compared to traditional limited partnership investments, UCITS have better liquidity.

Question 16

Direct Lending

Answer 16

Direct lending, though not liquid, provides income. Direct lending investments are income-producing speculative-grade investments that produce returns similar to high-yield credit investments.

Question 17

Serial Correlation

Answer 17

The test of serial correlation would reveal if the series were artificially smoothed through appraisals. Data that is artificially smoothed would have understated risk.

Question 18

Alternative Investments Measurement

Answer 18

An appropriate benchmark is difficult to establish for an alternative investments program because its performance depends greatly on active management by the managers chosen. The performance of an alternative investment program should be evaluated in the context of stated goals, rather than measured against a benchmark. Also, published indices are often inconsistent with each other in the way they define various alternative investment strategies.