white paper from New York Life looks at the role of alternatives in portfolio
construction and argues that usual risk-return based approaches can
underestimate risk and lead to over-allocation to the alternatives. The paper, by Amit Soni, an NYL
portfolio manager, proposes a new method “to quantify performance dispersion
risk and incorporate it in the portfolio construction process.”
long bull market, especially in equities, has pushed valuations to levels that
make many investors nervous. Also, (and closely related) the long period when
central banks have worked to keep money cheap and carried bloated balance
sheets in order to achieve that, is at or near an end. As Soni observes, these
conditions also have investors worried about diversification. Having both
stocks and bonds may not make one adequately diversified, given “the fear that
a sharp rise in rates might trigger a sell-off in equities as well.”
Underestimation of Risk
means that investors are looking to alternatives, but they should look warily.
Because, Soni writes, an “underestimation of risk” comes about if one uses the
best-known alternative indexes—those “which are derived from aggregating or
pooling returns provided by hedge fund or private equity managers.” There are
two big problems with these indexes. First, they “disguise the significant
dispersion of returns for managers within the index.” Second, they are “subject
to a smoothing effect that comes with illiquidity.”
writes that there has already been a lot of research addressing the second of
those problems, the smoothing issue. This white paper is designed to contribute
to solving the other problem—that which arises from the dispersion of returns.
few words, that problem is this: if one looks at large-cap equities, or for
that matter, intermediate-term fixed-income instruments, one finds that some do
better than others, but that this dispersion is small. On the other hand, the
performance dispersion of PE or of US-domiciled hedge funds is much larger.
Thus, an investor does himself considerable harm from selecting an
underperforming manager in an alternatives space, and this risk is “not
captured by the volatility of the index, but should be taken into
consideration,” Soni says.
Simple Approach is the Right One
simple approach to this is to treat the risk from volatility of the index, ?i,
and the risk of performance dispersion by the underlyings, ?pd, as
uncorrelated. The implies that the total risk is the square root of the sum of
the squares of those two risk components.
argument is that this simple approach is the right one. One problem with application
is that the data may not be available for the entire cross-sectional
distribution for ?pd. Another problem is that of an outlier, a “severely
underperforming fund with minimal assets,” which “likely had no implications
for external investors in general,” but which would lead to a distorted
standard deviation number.
The Real PE Risk
But quintile performance numbers can serve as a surrogate for
performance dispersion. They can be tertile, quartile, or decile. “In most
cases,” Soni says, “this approximation of the variance or standard deviation is
close to the actual variance or standard deviation of the entire distribution,
and, therefore, a reasonable approach to compute ?pd with easily accessible
The performance dispersion for private equity serves as an
example. “For private equity, the dispersion between the 25th and the 75th
percentile … performance is 11.6%.” Soni asks us to assume a normal
distribution of this dispersion. One can argue that this assumption is a
dubious one, in an age where “fat tails” are seen as routine, where
thousand-year floods come along every five years or so—still, given a default
assumption that this dispersion is normally distributed, Soni calculates that
the total risk of an investment in private equity is 12.8%. He also says
that if one ignores the issue of dispersion of results one will erroneously
conclude that the risk of such an investment is only 9.6%.
The difference between a 9.6% risk and a 12.8% risk doesn’t lead
Soni to infer that institutional investors such as New York Life ought to leave
PE and other alternative investment asset classes alone. But it does and should
lead to an emphasis on “robust manager selection process with due diligence on
investment process and risk management.”
here for the original article.