Evaluating Alternative Investment Performance
Alternative investments, such as hedge funds, private equity, and real estate, possess unique characteristics that must be considered when assessing their performance relative to other investments or more traditional asset classes like stocks and bonds over time. These features, highlighted in previous lessons, must be incorporated into the performance appraisal for alternative investments.
Alternative Investments: Features, Form, and Structure
Alternative investments differ from traditional assets in several key ways:
- Staggered capital commitments over time: Unlike traditional investments, where the entire capital is invested upfront, alternative investments often require capital commitments to be made over some time. For example, a private equity fund may call for capital when identifying investment opportunities.
- Longer required investment horizons: Alternative investments often require a longer investment horizon. For instance, a real estate investment might take several years to yield returns.
- Reduced liquidity: Alternative investments are often less liquid than traditional investments. For example, a hedge fund might have a lock-up period during which investors cannot withdraw funds.
- Less efficient markets: Alternative investments often operate in less efficient markets. For instance, the market for private equity investments is less transparent and less regulated than the stock market.
Alternative Investment Returns and Distributions
Alternative investment returns typically deviate from a normal distribution. This necessitates using different measures of risk and return than those used for more traditional asset classes. For example, the standard deviation, a common measure of risk for traditional investments, might not be appropriate for alternative investments due to their non-normal return distributions. Such distributions might be characterized as J-shaped density models or Weibull distributions.
The following table provides an example of parameters for a non-normal distribution function as mentioned in the technical draft:
| Distribution Parameter | Value |
|---|---|
| Location parameter | 10 |
| Scale parameter | 15 |
| Shape parameter | 0.5 |
Comparability with Traditional Asset Classes
Traditional asset classes, such as public equity and debt securities, are standardized claims that do not require any further capital commitments and provide identical claims to periodic cash flows. If you buy shares of a company like Apple or Microsoft, you are entitled to a share of the company’s profits in the form of dividends. Similarly, if you buy a bond issued by a company or a government, you are entitled to receive periodic interest payments and the return of the principal amount at the end of the bond’s term.
The prices of these publicly traded securities are often continuously quoted on stock exchanges, making it easy to compare their performance over a specific period. Large peer groups of similar investments are available, and common indexes like the S&P 500 or the FTSE 100 are used to benchmark returns. This makes the performance appraisal of publicly traded securities straightforward to implement and evaluate.
On the other hand, alternative investments are customized investments. Their distinctive features complicate the performance appraisal between investments and across asset classes. These features include the timing of cash inflows and outflows for specific investments, the use of borrowed funds, and the valuation of individual portfolio positions over specific phases of the investment life cycle.
