Reports of how leading asset-allocators such as the Yale endowment have increased their returns while lowering risk has generated widespread investor interest in alternative asset classes. This should come as no surprise: the concept of achieving superior risk-reward combinations through diversification into different, uncorrelated asset classes certainly extends to adding private investments to one’s portfolio.
But understanding that alternative investments might benefit your portfolio is very different than actually investing in them. Even on the more macro/portfolio level thinking through exactly what percentage of your portfolio to allocate to alternative investment opportunities is a very complicated endeavor. Why?
Most asset allocation strategies are rooted in Modern Portfolio Theory (MPT) where portfolio allocations are derived from estimated risk and return parameters. But mathematical approximations of risk and return are more complicated in most alternative investments due largely to a lack of unified data. This is caused by three primary factors:
- Private companies and funds, by definition, do not have regularly observed market values. Periodic investment returns therefore have to be estimated from the rare exit values of specific investments.
- Much like hedge fund indexes, private benchmarks tend to suffer from survivorship bias, in which successful companies and funds are more likely to report results than those that fail. This skews estimated returns and distorts us from getting an accurate picture of the true risks associated with these investments.
- It is difficult to obtain precise quantifiable metrics for adjustments for illiquidity, idiosyncratic (business-specific) risk, funding risk, and all the other various nuances that are present in private investments. Over time as the private capital markets evolve we will likely see the entire asset class transition from a skill-based alpha strategy to a more beta exposure/allocation play within portfolios. While this transition is being facilitated by online portals and the growth in secondary trading, this movement is still in its very early days.
The end result of this is that figuring out a specific percentage of your portfolio to allocate to this asset class defies pure quantitative determinations. Instead it greatly depends on individual risk preferences and investing expertise.
Then there is the fact that thinking about private investments as an ‘asset class’ can also obscure the specific business risks investors take on in any given investment. When an investor allocates an investment to a specific company or fund, it is “not a passive investment in a basket of all private companies” but rather “a skill based strategy” representing a very specific investment opportunity.” Basically the risks of each opportunity are extremely unique and should be considered independently as well as within the context of the pure asset allocation decision.
Clearly adding alternative investments to your portfolio can have enormous benefits in enhancing return and reducing risk, but due to the inherent complexity of the asset class investors should take adequate precautions in allocating their portfolios to alternatives and private investments.
I will leave you with some key questions to ask before investing in the asset class:
- What is the correlation of returns between my portfolio and this specific private investment?
- What business specific risk am I taking on? What advantage do I perceive in making this investment?
- What are the risk/reward trade-offs?
- What is the valuation I am buying into and what assumptions does this include?
- Do I understand the potential illiquidity of this investment and what it means for my portfolio?
- Can I accept the risk of total loss of investment?
For another take on allocating to alternative investments, see Jonathan Friedland’s post: Allocating Assets to Alternatives