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IN SIDE THIS PAPER
Overview1
Basic Alternative Investment Classifications
2-3
Performance Measurement Challenges with Alternative Investments
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GIPS Guidance for Alternative Investment Performance 5
Investments in alternative investment strategies have grown significantly since the 1990s as investors
seek performance with higher return potential than available from traditional asset classes. There
are over 5,000 alternative investment funds available world-wide with an estimated value in excess of
$1 trillion in U.S. dollars. Recent surveys have shown that alternative investments account for 10%20% of institutional and high net worth portfolios. Today these investment strategies are becoming
more accessible to the general public through Exchange Traded Funds (ETFs). These assets are an
important component of future investment portfolios. However, the strategies are more complex and
difficult to evaluate. This paper provides a high level overview of these strategies and discusses some
of the issues regarding measuring investment risk and performance.
Overview
Alternative investments are ordinarily defined as investment products other than stocks, bonds and
cash–which by contrast are considered traditional investments. The risk-return properties can vary
widely by product depending upon the strategies and financial instruments employed. Alternative
investments are often used to enhance total portfolio returns and reduce total portfolio risk through
diversification. Common characteristics of most alternative investments include:
• Low liquidity
• Diversifier relative to traditional investments
• High due diligence costs due to complex strategies
• Difficulty in performance appraisal due to lack of
transparency, timeliness of information and benchmark
selection.
The alternative investment markets are considered less efficient than the traditional markets with
the potential for higher returns with superior skill and information. These markets can also have
higher risks than the traditional markets with the potential for a wide range of performance. Due
to the complex nature and structure of alternative investments, they are not generally suitable for
the average investor. Many alternative investments are sold as “private placements” to institutions
and qualified investors. However, alternative investments are becoming more available to investors
through Exchange Traded Funds (ETFs). There are ETFs available for commodities, managed futures,
real estate and hedge funds. There are ETFs available to invest in various markets and inverse ETFs
available to take positions against growth in various markets. Access to alternative investment
strategies is growing, as is the need for better communication to investors on the effectiveness of
these strategies.
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Basic Alternative Investment Classifications
There are a wide range of alternative strategies available for participation in the global markets.
However, most of these can be included within six basic classifications.
1. Real Estate: Investors can have direct investments in property or indirect investments in funds
or companies that derive returns from the real estate market. The Global Investment Performance
Standards (GIPS) provide provisions to specific types of real estate investments that exclude
publicly traded securities, commercial mortgage backed securities and certain types of private debt
instruments. These GIPS real estate provisions require the computation of time-weighted returns
and, beginning in 2011, a break out of income returns and capital returns. In addition, moneyweighted returns must be computed for real estate closed-end funds. There are a wide range of
global real estate indices available for comparative analysis.
2. Private Equity/Venture Capital: Private equity investing is where securities are purchased through
a private placement rather than a public offering. Investments are made through private equity
funds which are pooled investment vehicles that are relatively illiquid. These investments include
the venture capital financing of private companies as well as the buyout of public companies. There
is a demand for venture capital in various stages of a company’s growth from early-stage seed funds
through later-stage expansion financing. The fund manager or general partner controls the cash
flows through capital calls from investors. Private equity funds provide opportunities for high returns
but lack some of the diversification benefits of other types of alternative investments. Private equity
funds can be quite risky and are recommended only for qualified investors. There are specific GIPS
performance requirements that require the computation of money-weighted returns. Performance
is measured by vintage year and there are public benchmark sources such as the California Public
Employees’ Retirement System (CalPERS) data base.
3. Commodities: Commodities are tangible assets such as agricultural products and natural resources.
Investments in commodities can be direct or indirect by purchasing claims on commodities through
equity in companies specializing in commodity production. Most direct investing in commodities
is through the futures markets for specific assets. A passive approach to commodities is available
through purchase of a futures contract on a commodities index. Commodities can be used in a
portfolio to manage portfolio risk and serve as an inflation hedge. Investment performance in
commodities is sensitive to unique factors including the supply and demand for the underlying
commodities, storage considerations and the term structure of futures pricing. The approach to
measuring performance for commodities is straightforward when purchasing commodities directly
or through equity companies. Participation in commodities through the equity market requires the
same approach as for the futures market. This includes: recognizing the time value of money through
accruals and discounting, recognizing spot and forward prices and computing marked to market
valuations. Given the risk of volatile price changes in the commodities market it is useful to employ
risk measures such as “value at risk” and “historical worst performance” or “worst-mark evaluation.”
Risk-adjusted return measures focusing on downside risk such as the Sortino ratio or drawdown
measures including the Calmar ratio and the Sterling ratio. There are several commodity benchmarks
available from major sources such as: Reuters Jefferies/Commodity Research Bureau (RJ/CRB), the
Goldman Sachs Commodity Index (GSCI), the Dow Jones-Commodity Index (DJ-AIGCI) and the S&P
Commodity Index (S&PCI).
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Basic Alternative Investment Classifications (Cont.)
4. Hedge Funds: There are several forms of hedge funds available today. Each hedge fund has its
own individual investment strategy that focuses on investments appropriate for that specific strategy.
Hedge funds are generally available to a limited number of qualified investors who pay performance
fees to the fund managers. The five most widely used strategies account for close to 90 percent of
hedge fund assets under management and include three equity-based strategies (equity market
neutral, hedged equity & merger arbitrage), one fixed income strategy (convertible arbitrage) and a
global macro strategy (uses broad range of assets including currencies and commodities). Hedge
funds are distinct from conventional investing since they are structured to avoid legislation which
allows them to be less transparent. Hedge funds employ strategies that include use of derivatives,
leverage and short positions. Many hedge funds have option characteristics with returns that are
distributed with non-symmetric distributions and require appropriate downside volatility measures.
As with private equity funds, hedge fund performance can be measured by vintage and compared
to median managers in the same vintage period. Hedge funds are also available in a fund of funds
(FOF) that invests in a number of hedge funds. Investors receive better diversification with FOF but
pay two levels of fees. There are hedge fund benchmarks available on both a monthly and daily basis
from major providers such as Standard and Poor’s and MSCI.
5. Managed Futures: Managed futures are a segment of the investment industry where professional
managers actively manage client accounts using global futures and other derivatives as the primary
instruments. There are two major categories of managed futures broken out by markets or by trading
strategies. Most of the managed future strategies are based on technical factors such as trends
as opposed to fundamental analysis based on analysis of global supply and demand along with
macroeconomic factors and geopolitical forces. Managed futures are private pooled investment
vehicles that can invest in cash, spot and derivative markets. There are three ways to invest in
managed futures: (1) investment in public futures funds, (2) investment in private commodity funds or
pools and (3) extreme high net worth investors can hire a futures manager directly. Managed futures
funds offer diversification with the potential for downside protection. Managed futures returns have
unique risk-return properties that can vary between strategies. There are peer group benchmarks
available based on managers or commodity trading advisors (CTAs).
6. Distressed Securities: This type of alternative investing is in the securities of companies near
bankruptcy or under financial duress. These investors buy securities that are below investment grade.
Investments in distressed securities are made through a hedge fund or a closed end private equity
fund with a fixed term. Distressed security managers invest in several types of assets including:
distressed company debt and equities, bank debt and trade claims, “lender of last resort notes”
and derivative instruments to hedge market risk of positions. Major hedge fund index providers
provide sub-index benchmarks for distressed securities. Historical performance has been relatively
high in times when the economy is struggling and bankruptcies increase. The return distributions
are non-normal with negative skewness indicating that large negative performance is more likely
than large positive performance. In addition, returns in distressed securities have demonstrated
a large level of kurtosis which indicates these securities are exposed to more outlier events. This
means that performance should be measured with downside risk measures and that risk measured by
the standard deviation would understate true risk. The success of investment strategies is strongly
influenced by event risk which is difficult to predict.
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Performance Measurement Challenges with Alternative Investments
Performance appraisals of alternative investment managers are a challenge for several reasons
including: a wide range of strategies and asset types, lack of transparency, high due diligence costs,
leveraging, risk characteristics and difficulty in selecting benchmarks. It is also difficult to communicate
the results of these more complex investments to clients. The lack of transparency with these strategies
includes obtaining information on pricing, holdings and cash flows. Alternative investments depend
highly on expertise in specific disciplines that are applied in less efficient markets than the traditional
investment markets. Additional performance metrics beyond time-weighted and money-weighted
returns may be required depending on the type of investment. For example, hedge funds are often
considered absolute return vehicles with no direct benchmark. It is difficult to determine positive
selectivity for hedge funds which depend on factors other than the systematic risk of the market. The
risk characteristics of alternative investments differ from the risk of conventional investments and
require measures in addition to the standard deviation.
The development of total portfolio asset allocations and total portfolio performance is also challenging
when one or more alternative investment types are considered. The rules for computing returns vary
depending upon investment type. For example, many private equity funds use a distribution paid-in
ratio (DPI) for comparative analysis to public equity performance. These DPIs and performance are
computed by vintage years. Even if the only alternative performance measures were time-weighted and
money-weighted returns, aggregating these different types of returns is problematic in total portfolios
consisting of both traditional and alternative investments. The same complexities would be involved in
developing the aggregate risk for a total portfolio made up of traditional and alternative investments.
icult to predict.
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GIPS Guidance for Alternative Investment Performance
The underlying principles of the GIPS standards are fair representation and full disclosure. Since
alternative investments are more complex, meeting these standards will require supplemental
information to provide insight into the investment performance. Consider the reporting of risk
and return for example. GIPS would require the computation of either time-weighted or moneyweighted returns depending on the type of alternative investments under consideration. The
required risk measure is the return volatility based on a three-year ex-post standard deviation of
returns. To provide an understanding of performance, alternative investment firms will need to
provide supplemental performance and risk information in addition to the required information.
These additional performance measures include the computation of additional return measures,
explanation of benchmarks and liquidity information. More risk measures should be provided since
alternative investment returns are typically not normally distributed and have the potential for more
downside performance than traditional portfolios. Firms should supply supplemental risk metrics that
help prospective clients understand their compliant presentations.
The consistency of input data is important for compliance with GIPS standards and has been an
issue with alternative investments. GIPS permit the use of “fair value” pricing when the markets are
illiquid and market prices are unavailable. The development of “fair value” must be explained and
represent the firm’s best estimate of the market value. Policies are established for using estimated
“fair value” values versus final values. The disclosure of alternative investment strategies in client
presentations could lead to the development of several composites since such strategies utilize
derivative instruments, leverage and short positions. This leads to performance that differs from
traditional strategies and to performance that can be unique to a particular strategy. Portfolios
within a composite should have a similar level of leveraging. For specific strategies, an alternative
investment composite may include only one or just a few portfolios.
The GIPS Executive Committee established by the CFA Institute has recently drafted a guidance
statement on alternative investment strategies and structures. This statement will provide direction
with regards to compliance issues. The comment period on this draft is open through June 15, 2011
and the expected effective date of the guidance statement is January 1, 2012.
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