Volume 2 2025 Level III High Yield Notes

LM03 Asset Allocation to Alternative Investments

The role of alternative investments in a multi-asset portfolio
The major benefit of adding alternative investments to a traditional portfolio consisting of
stocks and bonds is that they can increase the portfolio’s risk-adjusted return.
These investments are typically made to achieve one or more of the following roles: capital
growth, income generation, risk diversification, and/or safety.
Private equity:
 When added to a traditional portfolio, the main role of private equity is to enhance
returns.
 This higher return expectation is based on the illiquidity risk associated with private
equity investments.
Hedge funds:
 Hedge fund strategies span the spectrum from risk reducers to return enhancers.
 Long/short equity strategies provide equity-like returns but with lower exposure to
equity premium.
 Short-biased equity strategies try to generate alpha by going short on overvalued
securities.
 Arbitrage and event-driven strategies deliver equity-like returns with little to no
correlation with traditional asset classes.
Real assets:
 Real assets are generally perceived to provide a hedge against inflation.
 Timber investments provide both growth and inflation-hedging properties.
 Commodities serve as a hedge against inflation and provide a differentiated source
of alpha. Some commodities such as gold, serve as safe havens in times of crisis.
 Farmland investing can have a commodity-like profile or a commercial real estate-
like profile.
 Energy investments are usually considered real assets because the investor owns
the mineral rights to the commodities which are correlated with inflation.
 Infrastructure investments usually generate stable/modestly growing income and
also tend to have a high correlation with overall inflation.
Commercial real estate:
 Commercial real estate provides protection against unanticipated inflation.
 Strategies range from core to opportunistic.
o Core strategies focus on income generation.
o Opportunistic strategies focus on capital appreciation.
Private credit:
 Private credit includes direct lending and distressed investments.

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o Direct lending assets have a bond-like profile.

o Distressed investments have an equity-like profile.
Alternative investments v/s bonds as risk mitigators in relation to a long equity
position

 In the short run (when risk is measured in terms of volatility), government bonds are
better risk mitigators as compared to alternative assets.
 In the long-term (when risk is measured in terms of the probability of meeting the
investment objective), alternative investments are better risk mitigators as compared
to government bonds.

Comparing risk-based and traditional approaches to asset classification

Traditional approaches to asset classification include:
 A liquidity-based approach to defining the opportunity set.
 An approach based on expected performance under distinct macroeconomic
regimes.
Under risk-based approaches, the typical risk factors applied to alternative investments
include equity, size, value, liquidity, duration, inflation, credit spread, and currency.
The following table compares risk-based and traditional approaches to asset classification.
Traditional approaches Risk-based approaches
Strengths: Strengths:
They are easy to communicate and They help identify the common risk factors
implement. across all investments.
They are also relevant for liquidity Investors can build an integrated risk
management and operational framework, leading to more reliable
considerations. portfolio level risk measurement.
Limitations: Limitations:
They tend to over-estimate portfolio Risk factor sensitivities are highly sensitive
diversification and obscure primary to the historical look-back period.
drivers of risk. There are implementation hurdles when
converting risk factor targets to mandates
as they require considerations such as
liquidity planning, rebalancing, etc.

Investment considerations relevant to the decision to invest in alternatives

Important investment considerations for alternative investments include:

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Volume 2 2025 Level III High Yield Notes

 properly defining risk characteristics

 establishing return expectations
 selection of the appropriate investment vehicle
 operational liquidity issues
 expense and fee considerations
 tax considerations
 other considerations such as access to top-tier managers, effective due diligence,
and skills to evaluate and monitor.

Suitability considerations

 In general, alternative investments are suitable for investors with relatively long
investment horizons. The appropriate investment horizon depends on the fund’s
strategy.
 A high level of expertise is required while investing in alternative assets. Investors
should understand the factors which drive the success or failure of different strategies.
 A strong governance program is required to ensure that an alternative investment
program is structured to meet the needs and objectives of investors.
 Investors expecting a high level of transparency should avoid alternative investments.
They tend to have less than 100% transparency.

Asset allocation approaches

Three main approaches used to determine the appropriate allocation to alternative
investments are:
 Monte Carlo simulation
 Optimization techniques
 Risk factor-based approaches
Monte Carlo simulation: The Monte Carlo model construction process includes the
following steps:
1. Identify relevant variables.
2. Establish a quantitative framework to generate ‘realistic’ random scenarios for the
selected variables.
3. If using a risk factor approach, the risk factors should be converted to asset returns
using a factor-based model.
4. Translate realistic asset class return scenarios into meaningful indicators.
Monte Carlo simulation can be used to:
 Generate risk/return scenarios, even if the underlying data is non-normally
distributed.
 Illustrate simulation-based risk and return characteristics over a long investment
horizon.

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Portfolio optimization:
 Mean-variance optimization without and with constraints - Since illiquid alternative
asset classes tend to have high returns and low reported risk, an unconstrained
MVO will tend to over-allocate to these classes. Therefore, high risk portfolios
constructed using unconstrained MVO will be dominated by private equity.
Whereas, low-risk portfolios will be dominated by cash and fixed income.
To overcome this issue, many investors impose minimum and maximum constraints
on different asset classes while performing an MVO.
 Mean–CVaR optimization – Mean-CVaR optimization can be used to determine asset
allocations that minimize downside risk rather than simply minimizing volatility. It
is appropriate for cases where down-side risk is of particular concern.
Risk factor-based optimization:
 Investors can choose to optimize allocations to risk factors rather than asset classes.
However, these allocations must be implemented using asset classes.
 Portfolios with similar risk factor exposures can have very different asset
allocations depending on the constraints imposed on these portfolios.
 There are some caveats associated with the risk factor-driven approach that an
investor should be aware of:
o Investors may have different definitions of risk factors.
o Correlations between risk factors may shift under changing market
conditions.
o Some factor sensitivities are stable, while others are very unstable.

Liquidity planning
There are three primary considerations associated with private investment liquidity
planning:
1. How to achieve and maintain the desired allocation.
2. How to handle capital calls.
3. How to plan for the unexpected.
Cash flow and commitment pacing models enable investors to:
 Manage portfolio liquidity.
 Set realistic annual commitment targets to reach desired asset allocation.

Monitoring the investment program

An alternative investment program should be monitored relative to the goals set up for the
program, and not simply relative to a benchmark. An investor should consider that:
 The goals and objectives can change.
 The market conditions can change.
 The investment manager’s strategy can change.

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Volume 2 2025 Level III High Yield Notes

There are two common benchmarking approaches to evaluate the performance of

alternative investments – custom index proxies and peer group comparisons. However,
both approaches have significant limitations.
Another issue faced during performance evaluation is related to the performance measure
itself. Private equity, credit, and real estate funds typically report IRRs instead of TWR.
IRRs are sensitive to the timing and magnitude of cash inflows and outflows. Two managers
may have similar portfolios but substantially different IRRs depending on their particular
capital call and distribution schedule.
Pricing issues also make it difficult to evaluate the performance of alternative investments.
Most alternative investments are illiquid and have stale pricing, which can distort reported
risk and return measures.
Monitoring the firm and the investment process is particularly important in alternative
investment structures where it is not easy to terminate the manager and transfer assets to
another manager. Some areas to monitor include:
 Key person risk
 Alignment of interests
 Style drift
 Risk management
 Client/asset turnover
 Client profile
 Service providers

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