Today’s alternative investment universe should be a fertile environment for portfolio construction. Investors seeking to build or grow an allocation to alternatives can select from an array of strategies offering a wide range of potential benefits such as return enhancement, high current income, better diversification, tail-risk hedging and inflation protection.
Given the wide array of alternative strategies, it should be possible for an investor to build a diverse alternatives portfolio and adjust it dynamically as conditions change to achieve better desired outcomes.
However, in practice, this tends to be quite difficult. Most investors follow an approach that might be described as collecting alternative investments. They budget their capital based on static, generic return and risk assumptions and then allocate by asset class. As a result, the alternative investments sit in silos, with no real unifying framework or effective means to adjust the mix of strategies as markets shift. Further, there is often no consistent or accurate integration of alternatives into the total investment portfolio. As a result, many investors may be failing to realize the full potential of their alternative investments.
An important necessary condition to implement and manage a dynamic, multi-alternative portfolio is to have the right tools to enable investors to identify the underlying risk factors that help explain the behaviour of investments throughout the portfolio, as well as a valuation framework that examines the opportunity set for generating excess returns for each available strategy.
Every investment can be viewed as a group of exposures to distinct risk factors or risk premia. Primary risk factors, such as economic risk, credit risk, inflation risk and interest rate risk are among the primary risks investors are paid to accept. Secondary risk factors represent narrower classes of risk premia and are associated with individual strategies, for example, the small cap risk premium. Generally, a more complete view of factor exposures provides more explanatory power for the behaviour of a given investment and will provide more useful information for building portfolios.
Getting a granular view of the factor exposures for alternative strategies isn’t always easy. Hedge funds employ active trading strategies, which can result in non-stationary, time-varying risk factors. For private market asset classes such as real estate or private equity, industry-wide valuation practices result in return smoothing that can hinder the ability to gauge underlying risk factors through statistical regression techniques. But with advances in statistical and fundamental models of underlying asset behaviour it’s now possible to identify the factors that help drive returns across alternatives.
For alternatives, it’s typical to use three categories of exposures to explain returns: traditional (or primary) risk factors, such as equity beta for private equity or duration risk for illiquid fixed income; alternative (or secondary) risk factors, such as catastrophic weather risk or oil futures; and idiosyncratic risk exposures, such as the price risk associated with a public company’s organizational change, or the risk that an individual real estate tenant does not renew an office lease.
Identifying exposures to traditional betas enables investors to determine how much of their total portfolio risk they want to budget to primary risk factors. However, investors use alternatives to pursue returns in excess of these traditional risk premia so will want to know, for a given investment with a given level of embedded traditional beta exposure, what is the opportunity set for these excess returns at a given time?
It’s therefore important to examine the existing conditions for alternative beta and alpha opportunities, including supply, demand and pricing. The goal is to answer questions such as “At this time, after controlling for liquidity, do we spend our next unit of credit risk on a lending strategy or a debt-for-control investment?” or “is equity risk better compensated in an opportunistic real estate investment in China or a small cap buyout in India?” Clearly, traditional beta matters, but analysis of the opportunity set for excess returns should be an important factor in making investment decisions.
The idea that investors can get more out of alternative strategies if they understand them more deeply seems straightforward. This, after all, is what investors seek to do in every asset class. The challenge with alternatives has been how to gather the necessary critical mass of experience, insight, technology and detailed knowledge of disparate markets.
But the more investors look to alternatives to help them reach their goals, the more important it becomes to integrate alternatives into the total portfolio and gain a complete view of where risks are taken, and where they are desirable, over time. Without this integration, managers of the total portfolio act as spectators rather than participants in alternative investment activity.