Performance Appraisal for Alternative Investments

Performance Appraisal for Alternative Investments

Alternative investments offer investors portfolio diversification opportunities and potentially high returns on a risk-adjusted basis. As such, many investors may neglect the apparent risks, and instead focus only on the expected returns. Alternative investments are associated with the following risks:

  • Low transparency.
  • The strategies and products in alternative investments are complex.
  • Low liquidity on a portfolio basis.
  • Alternative investments often use leverage and sometimes derivatives.
  • Managers are generally faced with difficulties such as differentiation and diversification.
  • Alternative investments are associated with fees that cannot be ignored.
  • Some alternative investment portfolios with specialized niche products may experience mark-to-market issues.
  • The availability of redemption may be limited; also, eventual redemption may mount pressure on the portfolio.

Therefore, analyzing alternative investments before investing is more of a qualitative evaluation than a strictly quantitative evaluation. The evaluation also depends on the objectives of the investor. The analysis should not focus only on the total return but also on risks and portfolio-level correlation benefits.

Common Approaches to Performance Appraisal

Sharpe Ratio

The Sharpe ratio is defined as the portfolio risk premium divided by the portfolio risk. That is,

$$\text{Sharpe ratio}=\frac{R_P-R_f\ }{\sigma}$$

Where:

\(R_p\) = Expected portfolio return.

\(R_f \)= Risk-free rate of return.

\(\sigma_D\) = Standard deviation of the portfolio.

The Sortino ratio modifies the Sharpe ratio by using downside standard deviation (downside risk) rather than the standard deviation (upside + downside risk). Like the Sharpe ratio, the Sortino ratio does not incorporate the correlation of alternative assets with traditional assets.

$$\text{Sortino ratio}=\frac{R_P-R_f\ }{\sigma_D}$$

Where:

\(R_p\) = Expected portfolio return.

\(R_f \)= Risk-free rate of return.

\(\sigma_D\) = Downside standard deviation of the portfolio.

Since the Sortino ratio focuses only on a portfolio’s negative deviation from the mean, it is thought to be a better measure of a portfolio’s risk-adjusted performance since positive volatility is beneficial.

Treynor Ratio and Correlation Behavior

The Treynor ratio is an extension of the Sharpe ratio. Instead of using total risk, Treynor uses beta or systematic risk in the denominator. It is defined as:

$$\text{Treynor ratio}=\frac{R_P-R_f\ }{\beta_p}$$

Where:

\(R_p\) = Expected portfolio return.

\(R_f\) = Risk-free rate of return.

\(\beta_p\) = Measure of systematic risk of the investment.

From the formula above, it is easy to see that the lower the beta of the alternative asset, the higher the Treynor ratio and thus, its suitability for investment.

The disadvantage of the Treynor ratio is that the portfolio beta calculation is based on historical data that might change in the future. Moreover, the Treynor ratio loses the meaning if the beta of the alternative asset to the corresponding benchmark is negative.

Less correlated assets are deemed more suitable for portfolio diversification purposes than more correlated assets. However, the correlation between risky investments increases during periods of market stress.

Proxy for Measuring Return for Alternative Investments

The primary proxy for measuring the risk-return relationships of alternative investments is by evaluating the average return performance record in relation to worst drawdown loss. As such, the following measures is calculated:

  • Maximum drawdown (MDD): refers to the maximum loss recorded from the peak to the trough of a portfolio before another peak is reached.
  • Calmar ratio: is the ratio of the average maximum return of a portfolio to its maximum drawdown risk. The higher the Calmar ratio, the higher, the better (worse) the performance of a risk-adjusted portfolio over a particular period of time.
  • MAR ratio: is a type of Calmar ratio that uses the entire investments history and the average drawdown.

Performance Valuation in Real Estate and Private Equity

Primary valuation techniques in real estate and private equity include the internal rate of return (IRR), the multiple invested capital (MOIC), quartile ranking, the cape rate, and the capital loss ratio.

Internal Rate of Return (IRR)

Both private equity and real estate involve cashflows, whose timing is very crucial in investment decisions. As such, IRR qualifies as a suitable performance valuation tool. 

The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.  For a project with one initial outlay, the IRR is the discount rate that makes the present value of the future after-tax cashflows equal to the investment outlay.

The IRR solves the equation:

$$\sum_{i=1}^{n}{\frac{CF_t}{\left(1+IRR\right)^t}- \text{Initial investment}=0}$$

Where:

\(CF_t\) = Cashflow at time \(t\).

An investment is suitable if its IRR exceeds the required rate of return. The opposite is true.

IRR is a suitable performance valuation tool for long-term investments such as private equity and real estate.

Multiple of Invested Capital (MOIC) or Money Multiple

MOIC is defined as the ratio of the total value of the distributions and assets yet to be sold (residual asset values) to an initial investment. MOIC does not take into account the timing of the cashflows, but it is easy to calculate and understand. A MOIC of 3x implies that an investor earned three times the initial investment. Time is very significan in MOIC. For instance, a MOIC of 3x achieved in 2 years is more beneficial than the same MOIC achieved in 30 years.

Quartile Ranking

This measure is usually used to assess the ability of fund managers. Quartile ranking shows the performance of fund managers relative to a group of peer investment vehicles created with the same investment features and approximately the same timing (same vintage year).

Cap Rate

Cap rate is used to assess the performance of real estate managers. Cap rate is calculated as the ratio of actively earned annual rent less any unoccupied property to the initial price paid for the property.

Capital Loss Ratio

The capital loss ratio is calculated as capital in deals that have been earned but less the costs and recovered capital, divided by the total value of the invested capital. That is,

$$\text{Capital loss ratio} =\frac{\text{Capital in deals that have been earned}-\text{(Costs + Recovered capital)}}{\text{Total investment value}}$$

Question

Which of the following is least likely a risk associated with alternative investments?

  1. Limited transparency.
  2. Low portfolio-level liquidity.
  3. Unlimited redemption availability.

Solution

The correct answer is C.

In alternative investments, the availability of redemption may be limited.

Alternative investments are associated with the following risks:

  • Low transparency. (Option A.)
  • The strategies and products in alternative investments are complex.
  • Low liquidity on a portfolio basis. (Option B.)
  • Alternative investments often use leverage and sometimes derivatives.
  • Managers are generally faced with difficulties such as differentiation and diversification.
  • Alternative investments are associated with fees that cannot be ignored.
  • An alternative investment portfolio with specialized niche products mainly experiences mark-to-market issues.
  • Availability of redemption may be limited; also, eventual redemption may put pressure on a portfolio.

 

 

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