Active Share Versus Active Risk
Active Share Active Share represents the degree to which the underlying portfolio mimics... Read More
To effectively analyze a portfolio or potential investment opportunities, investors must establish a comprehensive and mutually exclusive categorization scheme, known as the ‘opportunity set.’ This is crucial to ensure that all investments are considered and prevent double-counting or missed opportunities. Two common approaches are:
The liquidity-based approach typically starts by distinguishing between public and private investments, with private investments being less liquid. This approach further subdivides categories, as illustrated in the table below:
$$ \textbf{Major Asset Class Categories} \\
\small{\begin{array}{c|c|c|c}
& {\textbf{Equity &} } & {\textbf{Fixed Income &} } & \textbf{Real Estate} \\
& \textbf{Equity-Like} & \textbf{Fixed Income-Like} & \\ \hline
\textbf{Marketable/Liquid} & \text{Public Equity} & \text{Fixed Income} & \text{Public Real Estate} \\
& \text{Long/Short Equity} & \text{Cash} & \text{Commodities} \\
& \text{Hedge Funds} & & \\ \hline
\textbf{Private/Illiquid} & \text{Private Equity} & \text{Private Credit} & \text{Private Real Estate} \\
& & & \text{Private Real Estate} \\ \end{array} }$$
Investors can also categorize asset classes based on their expected behavior in different economic conditions:
Easy to communicate
Traditional asset-class-based approaches are widely understood by investors, making communication and comprehension straightforward.
Relevance for liquidity management and operational considerations
These approaches are particularly useful for managing liquidity due to the significant differences in liquidity profiles between public and private asset classes.
Over-estimation of portfolio diversification
Investors might overestimate the level of diversification in their portfolio without a proper analytical framework.
Obscured primary drivers of risk
Different investments may be grouped together under the same asset class, potentially obscuring the primary drivers of risk.
A more precise way to define investment opportunities is through a risk-based approach. This method categorizes investments based on their exposure to specific risk factors, making it less subjective and more quantitative. Risk factors often considered for alternative investments include:
Identify common risk factors
This approach allows investors to identify common risk factors across different types of investments, whether they are public or private, passive or active.
Integrated risk framework
By developing an integrated risk management framework, it becomes easier to accurately quantify portfolio-level risk.
Sensitivity to historical data
The historical data used to determine risk factor exposures can impact the results. For example, an equity portfolio’s beta may remain relatively stable over time, but its sensitivity to inflation could vary significantly. Analysts must be cautious when interpreting risk factor sensitivity measures, such as “inflation beta.”
Implementation challenges
Setting strategic targets for different risk factors is a high-level decision. However, translating these targets into specific investment mandates involves additional considerations, including liquidity planning, manager selection, and rebalancing policies.
Question
Using an approach based on expected returns under various economic regimes, private real estate falls under which of the following categories?
- Capital Growth.
- Inflation-hedging.
- Deflation-hedging.
Solution
The correct answer is B.
Private real estate is primarily known for its inflation-hedging properties. This is because, during periods of higher-than-expected inflation, private real estate can offer two significant advantages:
- Rental rates often increase, leading to higher cash flow for property owners.
- Property prices may also rise, increasing the overall asset value.
A and C are incorrect. Capital growth assets encompass both public and private equities, while deflation-hedging assets typically include nominal government bonds.
Reading 28: Asset Allocation to Alternative Investments
Los 28 (c) Compare traditional and risk-based approaches to defining the investment opportunity set, including alternative investments