Role of Fixed Income in a Portfolio
Fixed income is also known as debt securities. It is one of the... Read More
Alter alternative investments are notoriously difficult to benchmark. The selection of an appropriate benchmark is made difficult by:
The following sections will discuss these issues as they pertain to specific types of alternative investments.
Hedge funds are not an asset class themselves, but rather an amalgamation of many different asset classes. Hedge fund managers employ a diverse set of strategies in managing the assets under their control, and seek to earn returns in a variety of different ways. This lack of similarity is the first hurdle to creating a meaningful benchmark.
Leverage is another common issue complicating the selection of a benchmark. Hedge funds may lever their capital base many times over, rendering them much less comparable to another fund which employs little or no leverage.
Hedge funds may use derivatives, or short various assets. This again complicates an apples-to-apples comparison among various manager types.
The risk-free rate plus a spread (e.g., 3%–6%) is sometimes used as a hedge fund benchmark for arbitrage-based hedge fund strategies. The argument for using the risk-free rate is that investors desire a positive return and that arbitrage strategies are risk free, with the spread reflecting the active management return and management costs. However, this implies no systematic risk in the fund which is rarely ever the case. Also hedge fund returns are not always highly correlated with the risk-free rate.
Because of the shortcomings of broad market indexes and the risk-free rate, hedge fund manager universes from various third-party providers are often used as hedge fund benchmarks. However, hedge fund peer universes are subject to a number of limitations:
Choosing the appropriate real estate benchmark requires careful consideration and an understanding of the limitations of such benchmarks—and their relevance to the investment strategy under evaluation. The following are some limitations of the available real estate benchmarks:
Further complicating the evaluation of real estate funds is the selection of the appropriate return measure. Time-weighted rates of return are generally used for open-ended funds, where contributions and withdrawals are at the discretion of investors. Closed-end funds, however, generally report using IRR.
Measuring private equity performance is commonly done using an IRR calculation based on cash flows into and out of the fund since it's inception. There are many third-party vendors who create indexes with similar private equity firms based on style and sector. However, these indices, as is the case with most alternative investments are subject to the following biases:
Commodities indexes are put together by third party data vendors. The indexes are typically based on futures contracts in the underlying commodity, which mimics cash returns from physical ownership. These indexes are considered investable. The major indexes contain some common groups of underlying assets. For example, energy, metals, grains, and soft commodities.
However, beyond these basic groupings, they and other commodity indexes vary greatly in their composition and weighting schemes. A market-cap-weighting scheme, which is common for equity and bond market indexes, cannot be carried over to indexes of commodity futures. Because every long futures position has a corresponding short futures position, the market capitalization of a futures contract is always zero. Benchmarking of commodity investments presents similar challenges to other alternatives, including:
Because market indexes do not exist for managed derivatives, the benchmarks are typically specific to a single investment strategy. For example, some indexes take both long and short positions in many futures markets based on a technical trading rule that is specific to an active momentum strategy. Other derivative benchmarks are based on peer groups. These indexes suffer from the known limitations of peer group–based benchmarks, including survivorship bias.
Distressed securities are illiquid and almost non-marketable at the time of purchase, making it very difficult to find suitable benchmarks. If the companies' prospects improve, the values of the distressed securities may go up gradually and liquidity may improve. Typically, it takes a relatively long time for this strategy to play out; thus, valuing the holdings may be a challenge. It is difficult to estimate the true market values of distressed securities, and stale pricing is almost inevitable.
Question
Which of the following alternative investment indexes is least likely to experience stale-pricing issues?
- Real Estate.
- Private Equity.
- Commodities.
Solution
The correct answer is C.
However, consider that REITs are only a portion of the total Real Estate market. Also consider that commodities indexes are valued based on futures contracts. Futures contracts provide pricing discovery, and are typically very liquid, and traded real-time, ensuring that stale-pricing and infrequent valuations are not a specific problem.
A and B are incorrect. Both private real estate and private equity are frequently subject to infrequent valuations, which causes stale-pricing issues. An investment such as a REIT, or other publicly-traded real estate investment could be a possible exception. Candidates who chose Real Estate for this reason are not for off.
Reading 12: Portfolio Performance Evaluation
Los 12 (l) Describe problems that arise in benchmarking alternative investments