27-1 asset allocation to alternative investments
2 the role of
alternative
investments
in a multi-
asset portfolio
3 diversifying
equity risk
4 perspectives on
the investment
opportunity set
traditional
approaches
to asset
calssification
risk-based
approaches
to asset
classification
comparing
risk-based
and
traditional
approaches
volatility
reduction
over the
short time
horizon
risk of not meeting the
investment goals
over the long time horizon
the role of
private equity
the role of
hedge funds
the role of
real assets
the role of
commercial
real estate
the role of
private credit
driven by
institutions - reduce volatility of the overall
private - reducing downside voliatility / the left tail risk
functional roles
capital growth - long-term / high-return
income generation
risk deversification
safety - government bonds or gold
return enhancer
the illiguidity risk
limited diversification added to publi equity
PE indexes not provide true picture of strategy's risk
span spectrum from risk reducers to return enhancers
most arbitrage involve some degree short volatility risk
→ non-symmetrical
relative high correlation with inflation broadly
or suc-component of inflation
timber - both growth and inflation-hedging
comodity derevatives - hedge against core constituent of inflation / differentiated source of alpha
energy - call-down, private qeuity-style funds /
master limited partnerships MLPs
farmland
infrastructure - illiquid nature / stabel or modestly growing income / high correlation with overall inflation / regulatory risks
range from core to opportunistic
to provide protection against unanticipated inflation
contributes both income and capital gain potential
distressed investment - more equity-like profile - illiquidity risks - take active role throughout restructuring or bankruptcy
low sensitivity to traditional bond risks
direct lending - income-producing -
default or recovery / least liquid
short term horizon - volatility may be the most important risk measure
// long-term - not achieving the long-horizon return objective
reported returns from appraisal-based valuations may result in volatility and correlation estimates too low
→unsmoothing for proper risk estimation
surrvivorship bias and back-fill bias
→ understatement of downside risk
most have positive but less than perfect correlation with equities
government bonds serve as risk haven
during risk-off or fliht to quality episodes
correlation coefficient quantifies linear relationship - diversification
beta measure response of an asset to unit change in reference index
positvie growth surprise good for equities and negative for bonds
inflation becomes a threat - bond's risk mitigation power could erode
shorter horizons - bonds more effective volatility mitigator than alternatives
// over long horizons - heavy allocation to bonds would reduce probability of achieving the investment goal
volatility addresses interim fluctuations in portfolio return → drawdowns nedd to be considered and managed
a liquidity-based approach to
defining the opportunity set
an
approach
1 capital growth assets
2 inflation-heding assets
3 deflation-hedging assets
can extended to macroeconomic
scenario analysis and stress testing
PE and VC hava global equity betas similar to public equities
betas of various hedge fund strategies differ significantly
through a
risk factor
lens to
capture
similarities
equity market return - the best market proxy for growth
size - excess return of small-ca over larege-cap
value - excess return of value versu growth
liquidity - excess return of with large sensitivity to changes in aggregate liquidity versus less sensitivity
duration - sensitivity to 10-year government yield changes
inflation - sensitivity to 10-year inflation-linked bond markets
credit spread - sensitivity to changess in high-yield spread
currency - sensitivity to changes in domestic currency versus basket of foreigh
the extension of the risk factor framework to alternative asset classese enable to more efficiently allocate capital and risk in multi-dimensional framework
/ increasing risk factors improve goodness fo fit - too many difficult to handle and interpret, certain risk factor sensitivities can quite volaitle
illustraton: asset allocation and risk-based approaches
main strengths
of traditonal
approaches
easy to communicate
relevance fro liquidity management
and operational considerations
main limitations of
traditonal approaches
over-estimation of portfolio diversification
→ false sense of diversification
obscured primary drivers of risk
key benefits of
risk-based approaches
common risk factor identification
integrated ris framework
key limitations of
risk-based approaches
sensitivity to historical look-back period
implementation hurdles -
additioanl considerations
based on expected performance
under distinct macroeconomic regimes
expectations of
higher returns / diversification (risk-reduction)