Introduction

Alternative investments include a broad set of asset classes that span the spectrum of risk, return and liquidity. The addition of alternatives has the potential to enhance the performance of a portfolio of traditional assets. Of course, alternative investments are not for everyone-they are speculative investments intended for investors with sufficient knowledge and experience who are willing to bear the high economic risk of the investments. We believe that a multi-asset allocation led approach is the right way to analyze and understand the trade-offs and implications of an allocation to any alternative investment.

Alternative investments often share a few principal characteristics that help identify them as such:


  • Historically low to moderate correlation with traditional asset classes (stocks and bonds).

  • Not listed on an exchange.

  • Private investment funds available only to high net worth and institutional investors.

  • Reduced liquidity.

In general, these are not listed on an exchange and are offered as private investment funds. They aspire to have an absolute performance objective. As such, they do not merely seek to outperform a benchmark but rather aspire to produce positive returns under varying market conditions. Their performance is expected to be derived from investing skill rather than just market exposure. They tend to use leverage to increase returns. They have historically exhibited moderate correlation with traditional financial market indices over long periods of time. They typically also exhibit reduced liquidity relative to traditional investments, with monthly to multi-year lock-ups. Their managers typically charge higher fees, which may include performance fees. A feature that is common across most categories is the large dispersion of performance across managers and a degree of performance persistence; therefore, even more so than for traditional investments, manager selection is of critical importance.

Private Equity

  • Negotiated private investments in mostly non-public companies at different stages of maturity with the objective of reselling at a higher price in the future.

Hedge Funds

  • Private investment funds investing primarily in the global equity and fixed income markets and typically employing sophisticated trading strategies, using leverage and derivative instruments.

Real Estate

  • Negotiated private investments in real estate assets with the objective of generating current income and/or reselling at a higher value in the future.

Managed Futures

  • Investments in global markets including futures, options and forwards on traditional commodities, financial instruments and currencies.

  • Wider choice of investment opportunities than those available in public markets.

  • Skilled managers may enhance portfolio returns.

  • Generally lower correlation of returns to traditional asset classes which may lower portfolio volatility.

  • Longer-term investments subject to lower long-term capital gains tax.

  • Ability to unlock time varying illiquidity premiums.

  • Certain types can serve as inflation hedge.

  • Ability to create variety of directional, semi-directional and non directional exposures.

These characteristics in part explains why universities and other long-term investors have increased exposure to alternative investments. Indeed, the larger the investable assets, the greater the reliance upon alternatives. This approach, being adopted by retail investors, is also known as the “endowment model.”

Despite attractive characteristics, alternative investments bear certain risks, some of which are universal and some of which are unique to the asset class.

Risk Risk Definition

Valuation Risk

  • Alternative investments may trade in esoteric and/or illiquid securities, which make these instruments difficult to price and requiring managers to estimate market values. In stressed markets, market value estimations may leave investors with an imprecise understanding of net asset value.

Specialized Trading

  • Special investment techniques such as leveraging, short-selling and investing in derivatives, including options and futures, may result in significant losses

Manager Risk

  • Fund investing exposes investors to risks particular to that fund manager, including poor decision making, key personnel departures or fraud, among others.

Liquidity Risk

  • Interests in certain alternative investments are generally not readily marketable, not redeemable and not transferable, except in limited circumstances.

Investment Process/Model Risk

  • The manager's investment process may be heavily dependent on the manager's analysis of historical data. No assurance can be given that these analyses will accurately predict future results.

Market Risk

  • The value of securities, commodities, and currencies may fluctuate reflecting a variety of factors, including changes in investor outlook and political and economic environments.

Strategy Risk

  • Strategies may at times be out of market favor for considerable periods, with adverse consequences for the portfolio.

Incentive Compensation

  • In general, managers receive performance compensation, which may give the managers incentives to make investments that carry greater risk than might be the case if no performance compensation were paid.

Default Remedies

  • Some funds may allow for future capital calls. If an investor cannot make the capital call, the investor may forfeit part of its existing interest in the fund.

Traditional approaches fail to address significant concerns about the inclusion of alternatives in a portfolio. Allocating is especially difficult given:


  • Lack of transparency in investing and asymmetric information.

  • Differentiating expensive skills and inexpensive passive market exposure.

  • Properly integrating illiquid and liquid investments together.

  • Stale prices and subjective asset valuation.

  • Constrained access to excellent fund managers.

Gross simplification, rules of thumb and extending MPT just does not work. Prevalent assumptions and widely shared practices are largely flawed. The unique characteristics of alternative investments challenge traditional methods of asset allocation.


Traditional Investments


Alternative Investments

Accurate measurement of returns


Inconsistent measurement of returns

Risk is appropriately measured


Risk is often underestimated

Asset returns are comparable

  • Marked-to-market valuations

  • All assets are fully liquid


Asset returns are not comparable

  • Mixture of stale and current valuations

  • Variable degrees of liquidity

Markets are

  • Open to common set of investors

  • Efficient


Markets are

  • Not open to all investors

  • Not efficient

  • Data measured over same time periods


  • Data measured over different time periods

Source: CAI Research

ActiveAllocator’s model is based on the following key observations:


  • The addition of alternatives to a portfolio can potentially reduce levels of risk for a given return, expanding the Efficient Frontier.

  • Investors without significant liquidity requirements may benefit from taking advantage of above-average returns in illiquid asset classes.

  • The liquid and illiquid parts of the portfolio cannot be separated - liquid asset classes can effectively diversify risk in illiquid assets and in some cases alternative assets can be substituted for traditional investments.

    • Since the illiquid alternative assets may provide above-average returns, they can be balanced by lower-risk, lower-return fixed income assets.

    • Since LBO, and VC are more highly correlated with public equities than other types of alternative investments, they substitute for public equities in a portfolio, thus increasing the fixed income to public equity ratio.

  • Excluding alternatives from a portfolio.

    • Investors forgo the potential benefits of diversification, risk reduction and return enhancement that alternative investments may offer.

  • Optimizing the traditional part of the portfolio and separately allocating a predetermined percentage to alternatives.

    • Liquid alternatives can in some instances replace traditional asset classes and diversify the portfolio.

    • The illiquid part of the portfolio affects the liquid part of the portfolio.

  • Including alternatives in the optimization using the existing data.

    • Inappropriately measuring risk and correlation can lead to unreasonable and inappropriate allocations.

    • Return forecasts must be integrated across all asset classes.

Stale Pricing

In traditional investing returns are accurate, largely marked to market. In Alternative Investments returns for many strategies are not marked to market daily. Our algorithms correct data for stale pricing. Marking to market the returns in illiquid asset classes help us compare alternative assets’ risks and correlations with traditional assets. Our approach takes historical reported data and modifies it with three kinds of information. First, to compensate for illiquids’ stale pricing, we perform a process called “unsmoothing”. This process strips out the previous period’s return from the current one and helps us to arrive at independent and identically distributed returns series. Second, we “mark-to-market” illiquid asset classes to make them comparable to liquid asset classes, including both market risk and liquidity risk. Third, we also incorporate the “cost” of limitations on rebalancing.


Unique Risks

In traditional investing volatility is an appropriate risk measure as returns data is bell shaped/normally distributed. This is not so within alternative investing where volatility may misrepresent true risk. Our algorithms correct data to arrive at better measures of underlying risk. For instance, we incorporate extreme but rare downside events.


Illiquidity

In traditional investing, assets are highly liquid as they are traded continuously in markets. Illiquid investments, by contrast, pose new forms of risk that not easy to measure using standard techniques. They reside in shallower markets and have restricted exit options. Their defining feature is non-tradability which limits ability to rebalance to meet unforeseen cashflow needs or direct capital to new investment opportunities. Different levels of liquidity in Alternative Investments restrict exit options.


Our algorithms make periodic illiquidity premium adjustments. In infrequently valued illiquid investments such as real estate or private equity, serial correlation in returns data understates volatility. This is because returns are inter-dependent as opposed to being independent across time. Also, the true correlation between asset classes is altered. ActiveAllocator algorithms quantitatively adjust returns data using auto-regression techniques to remove serial correlation. Our approach also utilizes a proxy for "mark-to-market" returns. We explicitly incorporate illiquidity risk as we construct multi-dimensional portfolios based on tradeoff around individual requirements for liquidity. Financial Advisors use the ActiveAllocator portal to compare seemingly incomparable assets such as illiquid, non-traded investments in real estate, leveraged buyouts and venture capital, with liquid, publicly traded securities.


Our approach is based on:

  • Accurately measuring the risk in illiquid asset classes.

  • Incorporating the limits to rebalancing one’s portfolio.

  • Accounting for investor-specific liquidity requirements.

  • And perhaps more importantly, forecasting the likely returns in asset classes that trade infrequently.


We believe that the addition of illiquid alternatives can significantly enhance portfolio returns for given levels of risk. Indeed, investors without significant liquidity requirements should seek “excess returns” in illiquid assets. We also believe that the liquid and illiquid parts of the portfolio cannot be separated. One needs to use liquid asset classes to effectively diversify risk in illiquid assets. Our approach reflects what has long been known in the literature that illiquid assets are both a risk-reducer and return-enhancer suggesting larger than typical allocations in retail portfolios


Strategy Heterogeneity

In traditional investing, unlike in Alternative Investments, there is greater homogeneity between sub asset classes. ActiveAllocator algorithms are built to resolve greater heterogeneity in sub-strategies.


Reporting Biases

In traditional investing, one does not have to worry about reporting bias. Within Alternative Investments reporting biases create distortion in performance data. For example, fund managers may cease reporting, typically due to poor performance leading to survivorship bias. Another example is selection bias where a database incorporates the performance of fund managers who choose to report; managers who perform better will typically be more likely to report creating an upward bias. Yet another example is short history bias: shorter history may not accurately reflect longer term returns. ActiveAllocator algorithms address and resolve such biases.


Non-Normal Returns Distributions

When returns are “normally” distributed, loss probabilities are simply a function of volatility. But when they are skewed, loss probabilities could be much higher. In Alternative Investments, Illiquid and difficult to trade securities have unmeasured risk. Securities that are not consistently marked to marked understate risk or volatility. Moreover, extreme event tail risk is difficult to quantify and downside risk capture is difficult to measure. ActiveAllocator algorithms are built to address this and make provisions for left tail skew and kurtosis optimization.


Style Drift

In Alternative Investments, some hedge fund managers do not rigidly limit themselves to one strategy as they pursue market inefficiencies. The flexibility to seek out investment opportunities is an advantage, but such style drift also poses unique risks for investors. ActiveAllocator algorithms group strategies that are correlated as well as have similar statistical return characteristics into baskets to reduce the adverse effect of style drift in portfolios. In addition, we also account for asymmetric information to attenuate style drift in long dated investments.