Until the 2008-2009 crash, leading University endowments and other institutional investors have achieved superior returns over the past decade by shifting a sizeable proportion of their capital to private investments. Over this period, numerous pension trusts have fallen behind, with many funding ratios dropping to the 70–80 percent range.
A potential advantage of alternative investments involves the generation of return patterns that differ from factors that affect equity and bond markets. Stocks and bonds are largely driven by three generic factors: (a) government interest rates, (b) corporate earnings, and (c) a risk premium. An investor is limited because of the dependence on a relatively small number of underlying driving factors.
A second benefit of alternative assets, especially for private markets, is the ability to increase leverage while smoothing price variations over years. Structurally, some private market securities are less subject to the fluctuations of liquid market-based instruments. Owing to a lack of reporting on market returns, there is a barrier in analysing these asset categories within optimal portfolio models. Future research should be aimed at this domain.
Many investors have applied versions of the fixed-mix investment rules with practical successes. For example, the famous 60/40 norm falls under this policy. An example is the Standard & Poor 500 equal-weighted index (S&P EWI) by Rydex Investments. As opposed to the traditional cap-weighted S&P index, stocks have the same weight (1/500) and the index is rebalanced biannually to maintain the target weights over time.
Unfortunately for most individual investors, top opportunities are rarely available without special access privileges. These issues are receding with the introduction of tradable hedge funds and related instruments such as actively managed ETFs, which allow investors to gain a portion of the median hedge-fund returns.
The most comprehensive approach for evaluation of alternative assets is to apply an integrated risk-management system on a set of investment vehicles, which includes alternative asset classes. Rather than conducting a full ALM optimisation, the fixed-mix rule can be applied to the assets and investment tactics.
There are two qualifiers for such an application:
(a) The historical performance of alternative investments may not correspond to future performance owing to, among others, the increase in the number of hedge funds existing today, and (b) it can be difficult to rebalance a portfolio because of restrictions to the entry and exit of capital within many of the private markets. These issues can be partially resolved owing to the emergence of new instruments such as active exchange traded funds. The main message remains – alternative investments can improve portfolio diversification because of the uniqueness of the return patterns. However, the investor should be careful to discover tactics that are truly different from equities and bonds performance.
What are directions for future research? First, we can continue to search for assets with novel sources of returns (as compared with stocks, bonds, and money market securities). A prime example involves weather-related products. Ideally, the emerging securities would develop in liquid markets so that the investor has valid market prices and can achieve rebalancing gains.
Research can be aimed at improving the modeling/pricing of private securities. Current approaches, such as the internal rate of returns for seasoned ventures, are not so helpful for the problem of seeking an optimal asset allocation. Techniques developed for asset allocation (and integrated risk management) under traditional categories will need to be extended for the inclusion of their privately held investments/securities. Also, there are promising methods for “replicating” the return of private investments with publicly traded instruments.
Undoubtedly, long-term, multi-period financial planning models for individual investors will continue to grow in popularity. The aging population of wealthy individuals will require assistance as they approach retirement and also for estate planning purposes. The US government has recently passed legislation that makes it easier for financial organisations to provide probabilistic investment advice. This change in regulation has already led to the implementation of a number of stochastic planning systems. Individual and institutional investors alike can benefit by applying integrated risk-management systems in conjunction with a full set of traditional and alternative asset categories.
This article is an edited version of
an entry in the “Encyclopedia of Quantitative Risk Analysis and
Assessment”, Copyright © 2008 John Wiley & Sons Ltd. Used by
permission.
