Weighing the Alternatives
Posted on by Granite Hall Partners
As the term implies, alternative investments provide exposure to asset classes beyond mainstream equities and fixed income. Less obvious are the tremendous differences among alternative investments. In light of this complexity, how should investors determine the right mix of alternatives to meet their unique needs?
To help answer this question, we present a framework to estimate key asset allocation inputs – expected return, risk, correlation and liquidity – for five alternative investments:
Hedge funds,
private equity,
Real estate,
Commodities, and
Real assets.
We employ a build-up approach to define risk and return from traditional beta, non-traditional beta, and illiquidity premium sources. we also suggest approaches to guard against common pitfalls associated with the historical performance of alternative investments.
Each type of alternative investment offers a risk and return profile that is differentiated from the others and from traditional investments. Hedge funds pursue a diverse set of actively managed strategies, with a return profile that is highly dependent on selecting alpha-generating managers. We consider private equity as a close substitute to public equity, with greater leverage, much greater illiquidity and an accompanying higher level of risk and expected return. Real estate is expected to provide income generation from rent and diversification benefits relative to traditional assets. We estimate that commodities have low expected return and high risk, but still merit consideration for investors seeking inflation protection and increased diversification. Lastly, real assets represent a diverse category of tangible and productive assets that are income-generative and sensitive to inflation.
Along our journey through alternatives, we explore a number of topics related to implementation. Hedge funds and private equity are characterized by significant dispersion among funds, reinforcing the importance that investors should place on manager selection. When choosing between direct investment and funds of funds, investors should consider a range
of factors from fees to risk management. And for real estate, private equity, and real assets, the choice of exposure vehicle – whether privately held or publicly listed securities – often pivots on the trade-off between precise exposure and higher liquidity.
Investors are confronting a range of challenges from low yields to high correlations among traditional investments. By considering the individual merits and limitations of these alternative investments along with their own unique needs, they may be able to improve the structure of their total portfolio.
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