Asset Allocation: Risk Models for Alternative Investments

Niels Pedersen, Sébastien Page and Fei He

Financial Analysts Journal, 2014, vol. 70, issue 3, 34-45

Abstract: Often, the lack of mark-to-market data lures investors into the misconception that alternative asset classes and strategies represent somewhat of a “free lunch.” This article proposes solutions to measuring mark-to-market risk in alternative and illiquid investments. The authors describe how to estimate risk factor exposures when the available asset return series may be smoothed (owing to the difficulty of obtaining market-based valuations). They show that alternative investments are exposed to many of the same risk factors that drive stock and bond returns.This article proposes solutions to measuring mark-to-market risk in alternative and illiquid investments. We describe how to estimate risk factor exposures when the available asset return series may be smoothed (owing to the difficulty of obtaining market-based valuations). We show that alternative investments are exposed to many of the same risk factors that drive stock and bond returns.Our approach has profound implications for risk estimation in an asset allocation context. We recognize that there already is a significant body of literature that attempts to estimate risk factor exposures for various individual alternative investments and strategies. However, little research has been done to estimate the risk factor exposures across all alternatives within an internally consistent, unified risk factor framework. Given increased allocations to alternative investments in institutional investors’ portfolios, we see an urgent need to develop a consistent approach that directly integrates the risks of alternative assets with the rest of the investors’ portfolios.Our model uses transformed risk factor returns that account for the lag structure of the index. We have kept the list of factors parsimonious and consistent with those used for stocks and bonds. Reported betas represent the sum of the current and lagged betas, based on a model that addresses liquidity biases, extended to a multifactor framework.We show that returns on alternative assets depend on changes in interest rates, as well as how investors value risky cash flows, as reflected in equity market valuations and credit spreads. Also, liquidity and other specialized factors play a role. The approach based on risk factors typically generates higher correlations between alternative investments and their public market counterparts, especially when their equity betas are high, in addition to higher volatility, expected drawdowns, and tail risk exposures.

Date: 2014
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DOI: 10.2469/faj.v70.n3.4

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