Home / Correlations and volatility in alternatives under microscope

by Brendan Swift

Institutional investors may have an overly optimistic view of the value of alternative assets according to new research, which suggests such investments have a stronger correlation to mainstream assets than previously predicted.

The authors of the ‘Asset Allocation: Risk Models for Alternative Investments’ paper argue that alternative investments, such as private equity and venture capital; real assets such as real estate, infrastructure, timberland, farmland, and natural resources; as well as hedge fund and exotic beta strategies, are exposed to many of the same risk factors that drive stock and bond returns. Alternative assets returns depend on factors such as changes in interest rates and how investors value risky cash flows, which are reflected in equity market valuations and credit spreads (while liquidity and other specialized factors also play a role).

“The bottom line is that alternative investments are much more volatile on a mark-to-market basis than their reported index returns would suggest,” the authors wrote in the paper, published in the May-June issue of the Financial Analysts Journal. “This bias tends to be more pronounced for indices that are smoothed.”

The research paper could have implications for the $1.8 trillion Australian superannuation industry. The authors – Niels Pedersen, Sebastien Page and Fei He – are all senior analytics executives at PIMCO in Newport Beach, California.

A $5 billion Asset Recycling Initiative was recently announced by the Federal Government as part of the Budget – a move welcomed by Industry Super Australia,which said that the sector stands to invest an additional $15 billion over the next five years if appropriate deals can be brought to market. Industry funds have generally held significantly higher levels of alternative assets such as infrastructure and direct property compared to retail funds – a factor which has contributed to strong long-term performance. However, the global financial crisis also raised the concerns of the prudential regulator, given funds with significant illiquid investments given rollovers and withdrawals must be completed within 30 days of a member request.

The authors of the investment paper largely relied on US quarterly alternative investment data from December 1991 to December 2012 and made an assessment of the underlying risk factors that drive returns of various alternative assets based on previous academic research. They then attempted to unify their findings by creating various portfolios and compared the apparent (lower) volatility against their adjusted (higher) measures. 

For example, the paper suggests that an unsmoothed, six-asset equal-weighted portfolio (comprised of equities, bonds, private equity, real estate, timberland and farmland) produced a relatively high volatility of 8.8 per cent compared to just 5.3 per cent when the same assessment was made on reported index data. The 8.8 per cent figure was only just lower than the 9 per cent volatility recorded by an equal-weighted portfolio comprised of just stocks and bonds. 

“Nonetheless, our approach should not necessarily lead investors to avoid illiquid assets; investors should simply require a higher rate of return than they would otherwise. Whereas traditional risk models for alternative assets typically lead to corner solutions and a false impression that these assets represent a free lunch, our approach produces a more reasonable representation of the risk-return trade-offs involved in this important asset allocation decision.”