Institutional investors are increasing their allocations into alternatives and therefore need a more comprehensive understanding of their investment risks and how they can incorporate illiquid or non-transparent investments into risk analysis to best manage their portfolios.
With an increased focus on risks by regulators and industry stakeholders, transparency has become a priority for investors when analyzing investment options and reviewing portfolio allocations. Performance professionals face issues regarding benchmarking, valuations and return calculation methods.
Alternative Investment Benchmarks
Traditional benchmarks are based on assumptions of frequent valuations, where investors control the cash flow. For alternative investments, some of the key assumptions related to traditional investments do not apply. Benchmarks are used to evaluate the effectiveness of asset managers and the overall investment program, and can be used as proxies in making asset allocation decisions. Using publicly-traded benchmarks for alternative investments comes with many challenges, including lagged valuations and returns, different return methodologies, illiquidity, and lack of transparency. These challenges make it difficult to use the traditional indexes for alternative investment evaluation.
In order to accurately calculate the attribution of alternatives to the total fund, investors can use a traditional time-weighted return methodology. However, there are common misconceptions to using a traditional calculation methodology to measure fund performance across all funds. Different performance methodologies are used to answer different questions at various stages of an investment process.
Essentially, to evaluate the effectiveness of a single fund manager, investors should consider an asset-class specific methodology that is appropriate to the fund and investment strategy. This may be different from the methodology that is used consistently to evaluate the contribution of specific funds or strategies to the total fund.
Evaluating Private Equity
Private equity illustrates how some of the assumptions of traditional investing analysis do not always hold true for alternative benchmarking. Publicly-traded index returns have a very low correlation with the monthly return streams for private equity. Traditional benchmarks can still be used for private equity, in certain circumstances.
Different types of performance evaluation approaches will depend on the questions an investor is trying to answer. The timing of private equity valuations poses another challenge to incorporating the returns of alternative investment allocations in total fund returns. More institutional investors are reporting their returns to the market in a bid to increase transparency. Many clients will report a lagged valuation and returns in the current period, and sometimes reopen their books to adjust their valuations at year-end to get the equivalent of what they would have known at that time. It is difficult to make asset allocation decisions based on retrospective data, so clients either use estimates, historical valuations or historical valuations adjusted with current period cash flows.
Transparency on management fees is challenging in private equity because general partners have flexibility to decide how they would define expenses. This lack of transparency can cause a lack of confidence among investors in the fees they are paying for – whether it is for management fee, carried interest or incentive fee.
Evaluating Hedge Funds
Hedge funds are usually valued at least monthly, so publicly-traded indexes may be more appropriate for hedge funds than for less liquid strategies. Hedge funds often provide valuations a few weeks after month end, so depending on the reporting requirements, some investors may need to calculate returns using stale or estimated values, or adjust the prior month values with current period cash flows. Aligning fund returns and benchmark returns in the same time period can present data management challenges. The purpose of investing in a hedge fund is to capture value beyond a passive strategy. Many of our clients use peer group comparisons as a benchmark, based on fund managers reporting their respective returns to research groups that is then aggregated, and published as peer group benchmarks. There are different definitions of risk methods, and many hedge fund performances are based on different ways of looking at return streams.
Many investors define risk as volatility. Investors will often have their own definition of risk. For illiquid strategies, the definition of risk cannot be volatility-based measures because the strategies cannot be valued frequently. For hedge funds, one definition of risk is often around volatility because part of the reason why some hedge fund strategies are structured the way they are is so that the hedge fund managers can invest in opportunities wherever they find them.
Data Strategy is Key
The transparency of the underlying hedge fund investments can also be a challenge. We always encourage clients to think about their data strategy when they talk to fund managers in order to get the level of transparency they need. Having a dedicated management account structure is one of the ways we see large sophisticated investors addressing the challenge of transparency and liquidity, while still getting investments through alpha-seeking strategies.
Credit Strategies Within Alternative Investment Structures
We have seen significant growth in credit strategies. Under this umbrella, there are private debt strategies and high yield strategies, which can be structured as limited partnerships or as liquid funds. There are different approaches to evaluating the measurement and effectiveness of these strategies. A major challenge for credit strategies is the management of the changing data regarding these investments. For example, when a loan restructures, the security identifier can change, complicating security level performance and attribution over time.
Rather than investing in one type of asset with one strategy, alternative funds have the flexibility to invest in different types of strategies which may require different approaches to performance calculations. It is ultimately a question of what methodology best fits that specific strategy and objective.
Managing Director and Head of Global Risk Solutions, BNY Mellon Asset Servicing
Frances Barney, CFA leads the Global Risk Solutions business within BNY Mellon Asset Services, which includes performance and risk analytics, attribution, enterprise risk, and other investment analysis services. Frances has 24 years of investment industry experience, most of it in performance and risk analytics services.View Profile