A new report from PGIM Institutional Advisory looks at an old question: what role should alternative investments play within the portfolio allocation decisions of institutions?
The question is especially pressing at the beginning of 2017 because US broad equity indexes have done quite well for years, ever since the markets hit their crisis-driven bottom in March 2009. They've done well enough to raise the question: aren't they enough? Shouldn’t lower cost traditional strategies, using equities on the one hand and fixed income on the other, produce results as satisfactory as one can obtain through higher-cost alt investments?
The authors of the report are: Harsh Parikh, Vice President, and Tully Cheng, Director, respectively, of PGIM Institutional Advisory & Solutions. Parikh has a Ph.D. in finance from EDHEC Business School, and an MS in mathematical finance from the University of Southern California. Cheng has a fascinating background at the intersection of finance and medicine. He studied business administration at Boston University School of Management with a concentration in finance, and is the author of a scientific publication of Fourier analysis on medical data for epileptic patients.
Not Necessarily Wrong
Parikh and Cheng don’t offer any very rousing argument in favor of the use of alternatives. Rather, they make the more equivocal case that alternatives aren’t necessarily inappropriate.
They go about this by disaggregating alternatives both by entity (hedge fund, private equity, venture capital, real estate) and by strategy (dividing hedge funds in particular into equity hedge, event driven, macro, and relative value). Further, they employ a data set that goes back a full business cycle before the 2007-09 crises, back to the turn of the millennium. This takes in two full turns of the cycle: bust, recovery, bust again, recovery again, up to 2015.
Parikh and Cheng conscientiously massage the data to free it of biases, but concede that “some common biases such as self-reporting and survivorship remained due to constraints inherent in the data,” so their results could still show more positive hedge fund and private equity results than would correspond to investor experience.
Their conclusion is that most alternatives “produced better risk-adjusted performance than equities over the period studied,” with the exception of venture capital, which was both riskier and produced lower returns than the S&P 500 over these two business cycles. The best risk-adjusted results are those of core and opportunistic real estate, leveraged buyout private equity, macro, event-driven, and relative value private equity.
Diversification
Looking at the results from the point of view of diversification, the authors observe that macro hedge funds are among the studied entity/strategies combos in displaying a positive correlation to fixed income.
Looking within the equity world specifically, they draw the following conclusions from their data:
- Equity hedge and event-driven strategies both “demonstrate consistently elevated correlations to equity,”
- Hedge funds macro provides a distinct potential for diversification, especially yielding non-correlation “during periods of stress such as during the height of the financial crisis.”
Those conclusions, drawn from taking the period 2000-2015 as a whole, are presumably welcome from the point of view of the self-image of the hedge fund industry. But when Parikh and Cheng disaggregate their data along one axis, pre and post GFC, they reach conclusions that will be less welcome:
- The GFC brought about a change in commodity trend factor exposure, reducing the positive relationship between such trends and the results of funds of funds, equity hedge, or macro;
- Most worrisome still, in the years since the crisis none of the hedge fund strategies has demonstrated “statistically significant, positive alpha, raising questions as to the sustainability of alpha going forward.”
To pursue that final point for a moment, a “rolling alpha analysis suggests that many of the hedge fund strategies generated stronger alphas in the earlier, as opposed to the later, years.”
The bottom line is that investors, whether individual or institutional, who want exposure to alternatives entities and strategies must evaluate with care the characteristics associated with the various possibilities, and craft an allocation that meets their particular objectives.
They must also exercise due diligence in manager selection. These authors concur with the prevailing view that PE is very sensitive to managerial skills. They find, though, that much the same is true for hedge funds. “If an institution has access to a manager research program that is able to consistently select managers in the top 25% or even 40% of the peer group, then the appropriate alternatives strategies … are likely to add even more value to a portfolio.”