PGIM Institutional Advisory & Solutions Revisiting the Role of Alternatives in Asset Allocation

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From the US stock market’s bottom in March 2009 through December 2015, US broad market equity indices returned more than 200%, far surpassing the gains made in most alternative strategies. As a result, many institutional investors are finding themselves faced with the question: Why invest in alternative assets if they underperformed equities and cost significantly more than traditional strategies?
 


Summary

 

Most alternative strategies have been outperformed by US broad market equity indices in recent years. This, combined with their relatively high cost, has led many institutional investors to question whether they should invest in alternative assets. However, this conclusion is too generalized and one needs to look more deeply before abandoning the asset class completely.

It’s important to remember that alternative assets are not created equal and characteristics vary widely by strategy. They can be separated into categories and sub-categories: hedge funds into equity hedge, event-driven, macro, and relative value; private equity into leveraged buyouts and venture capital; and real estate into core, value-add, and opportunistic.

Analysis over the period January 2000 to March 2015 showed that certain strategies appear to have delivered significant alpha, as well as attractive diversification characteristics. In particular, core and opportunistic real estate, leveraged buyout private equity, and macro, event-driven, and relative value hedge fund strategies appear to perform better on a risk/return basis. While others, such as fund of funds and equity hedge strategies, demonstrated a high level of explainability, relatively stable factor weightings, and lower alpha. As such, they might not, on average, contribute much to one’s overall portfolio.

 

“Core and opportunistic real estate, leveraged buyout private equity, and macro, event-driven, and relative value hedge fund strategies appear to perform better on a risk/return basis.”

 

We can analyze how these strategies might be incorporated into a portfolio and their potential impact on portfolio risk. For example, we may identify a “risk-off” (lower-risk) alternatives bucket with a two-thirds allocation to lower-risk hedge funds (macro and relative value) and a third allocation to core real estate. Conversely, a “risk-on” (higher-risk) alternatives bucket might be allocated with a third in event-driven hedge funds (with stronger ties to equity and credit factors), a third in opportunistic real estate, and a third in leveraged buyout private equity. In short, investors should consider the factors most relevant to their manager universe, as well as their overall investment strategy.

The range of outcomes for alternatives greatly varies in comparison with traditional assets. Investors should therefore consider a range of factors including dispersion, persistence, fees, transparency, and liquidity. Manager selection is critical, and has a significant impact on private equity returns, as well as hedge fund category outcomes.

The fees associated with many alternative investments have come under pressure and several US pension plans have publicly declared that they plan to rethink their fee structure for alternative assets. Investors should ensure that the incentive structure compensates managers for skill, not for leveraging standard market returns.

Alternatives are far from homogenous, and allocation decisions need to be made at a granular level. Investors should carefully evaluate the market exposures and other key characteristics associated with a range of alternatives, in order to craft an allocation that serves their overall investment objectives.

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Authors

Harsh Parikh
Vice President

Tully Cheng
Director

​The PGIM Institutional Advisory & Solutions group advises institutional clients on a variety of asset allocation, portfolio construction, and risk management topics.