Reading 18 - Asset Allocation to Alternative Investments

Question 1

What is the role of adding private equity to a portfolio?

Answer 1

Increase returns

For a portfolio of public equity securities, an allocation to private equity has limited diversification potential because public and private companies face essentially the same risk factors.

Question 2

Why may volatility of alternative investment returns and their correlation with equity returns actually be higher than they appear to be in the reported data?

Answer 2

1. Appraisal-based valuations: smoothing
2. Survivorship Bias and backfill bias - downside risk is understated
3. Indexes of alternative investment returns reflect some degree of diversification because funds in an index may have low correlations of returns with each other. Thus, the volatility of returns on the index is less than the average volatility of returns on index components.

Question 3

What is the long term risk of investing in alternate investments?

Answer 3

Not volatility, but failing to achieve a minimum required rate of return

Question 4

Which has lower correlation with equity returns - bonds or alternate investments?

Answer 4

Bonds

Question 5

Risk Factor Based Approach

Answer 5

Involves statistically estimating their sensitivities to risk factors identified by the manager. examples include economic growth and inflation, interest rates and credit spreads, or currency values. They may also include factors like liquidity, capitalization and value versus growth.

Question 6

Are capital calls regular?

Answer 6

Both capital calls and drawdowns are not on any pre-determined schedule. Capital may be called (or not) at any time during the call-down period

Question 7

What is a side-pocket?

Answer 7

General partners might designate some of the fund’s less liquid holdings as not subject to the fund’s ordinary redemption terms.

A fund’s redemption terms may be misleading if a large portion of its holdings are side pocketed.

Question 8

Is management fee charged on committed capital or capital called down?

Answer 8

Funds with call-down structures charge management fees on the amount of committed capital, regardless of how much of it has been called down. This may generate negative returns in the early years of an investment when much of the committed capital is yet to be called.

Question 9

Are alternative investments transaprent?

Answer 9

No - they have lower levels of transparency than is generally available with traditional investments.

As private partnerships, the funds are not governed by the reporting requirements that apply to publicly traded companies. When they do issue reports to investors, the level of detail varies widely and reports often arrive with a significant time lag. Many hedge funds use independent administrators to calculate their net asse values, but private equity and private real asset funds typically do not, which gives them wider discretion in asset valuations.

Furthermore, private equity and private real assets may be viewed as “blind pools” in that a fund does not begin acquiring assets until investors have already committed capital to the fund.

Question 10

What approaches can be used to decide asset allocation to alternative investments?

Answer 10

1. Monte Carlo Simulation
2. Mean-variance optimization
3. Risk-factor based optimization

Question 11

How does risk factor-based optimization work for alternative investments?

Answer 11

Exposures to risk factors are optimized with respect to an overall risk budget. As with MVO, constraints can be included in the model and in this case, constraints are limits on specific risk factor exposures.

Requires additional step of translating the optimized risk exposures into an asset allocation.

Question 11

How does MVO work for alternate investments?

Answer 11

Results may produce an excessive allocation to this asset class, particularly to illiquid investments such as private equity, especially when the data are not properly adjusted for smoothed returns.

An optimization model may be designed to constrain the allocation to alternative investments (or any asset class) to be within a minimum and maximum percentage or to limit overall volatility or downside risk.

Question 12

What are the limitations of risk factor based optimization?

Answer 12

1. Asset classes’ return sensitivity to some risk factor exposure might not be stable over time.
2. correlations among risk factors may behave like correlations among asset class returns and increase during periods of financial stress.

Question 13

Formula for capital contribution in period t

Answer 13

% to be called in period t x (committed capital - capital previously called)

Question 14

Formula for distributions in period t

Answer 14

% to be distributed in period t x [NAV in period t-1 x (1 + growth rate)]

Question 15

Formula for NAV in period t

Answer 15

NAV in period t-1 x ( 1+growth rate) + contributions in period t - distributions in period t

Question 16

MOIC: Multiple on invested capital

Answer 16

Calculated by dividing the value of the fund’s underlying investments, plus distributions, by total invested capital

Question 17

How do bonds and alternative investments compare in mitigating equity portfolio risk?

Answer 17

Depends on the investor’s time horizon

Over short horizons, return volatility is the pre-dominant risk and bond returns have a lower correlation within equity returns than do alternative investment returns

Over long horizons, the main risk is failing to achieve the target return, so alternative investments may be more suitable than bonds because of their higher expected returns

Question 18

Which alternative asset best mitigates the risks to the portfolio due to unexpected inflation and also has a relatively low correlation with public equities to provide diversification benefits?

Answer 18

Commodity futures

Real assets (including energy, infrastructure, timber, commodities and farmland) are generally believed to mitigate the risks to the portfolio arising from unexpected inflation. Commodities act as a hedge against a core constituent of inflation measures. Rather than investing directly in the actual commodities, commodity futures may be incorporated using a managed futures strategy.

Commodities are also regarded as having much lower correlation coefficients with public equities than with private equities and hedge funds. therefore, commodities will provide the greatest potential to fulfill the indicated role and to diversify public equities.

Question 19

What is a drawback of the traditional approach to define the opportunity set?

Answer 19

A traditional approach used to define the opportunity set is based on the different macroeconomic conditions. The primary limitations of traditional approaches are that they overestimate the portfolio diversification and obscure the primary drivers of risk.

Question 20

Why should a risk-factor based allocation be used over MVO?

Answer 20

1. Risk factor-based approaches to asset allocation produce more robust asset allocation proposals
2. a mean-variance optimization typically over-allocates to the private alternative asset classes due to stale pricing

Question 21

If the current macroeconomic environment could lead to a bear market within a few years, what is the potential impact on liquidity associated with the actions of the fund’s GP?

Answer 21

The current macroeconomic environment could lead to a bear market within a few years. 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 22

What is an absolute return hedge fund?

Answer 22

An absolute return hedge fund has a greater potential to diversify the fund’s dominant public equity risk than private equity or private real estate.

Absolute return hedge funds exhibit an equity beta that is often less than that of private equity or private real estate. Also, absolute return hedge funds tend to exhibit a high potential to diversify public equities, whereas equity long/short hedge funds exhibit a moderate potential to fulfill this role.

Question 23

The reported correlation of investment-grade fixed income with public equity is likely less accurate than the reported correlation of private equity with public equity.

True or false?

Answer 23

False

Private equity returns are based on infrequent reporting and typically use appraisal values, which results in lower return correlations with other asset classes (including public equity) than would be evident from actual transaction prices. In comparison, investment-grade fixed-income returns are based on transaction prices, resulting in a more accurate return series and more accurate return correlation estimates.

Question 24

Unlike the traditional approach, systematic risk factors do equally well at explaining the risk and return patterns of public and private assets, True or false?

Answer 24

False.

Systematic risk-factor approaches typically explain most or all of the risk and return patterns of public assets, but far less of those patterns for private assets. This is due to the widespread use of appraisal-based valuation for private assets and the idiosyncratic risks present in individual funds.