Thought Leaders
Understanding Alternative Investments

The rising importance of alternative investments — such as hedge funds, real estate, and private equity — has increased the complexity of investment decisions. The options for such investments also have expanded significantly, meaning that some of the conventional wisdom about alternatives may no longer apply.

For example, alternative investments have very diverse risk and return profiles. "Investors need to know that alternative investments are extremely heterogeneous in risks and rewards," said Christopher C. Geczy, Wharton assistant professor of finance. He teaches about alternative investments in the AIMSE/Wharton Investment Institute, a week-long executive education program for investment management sales executives held each January at Wharton. The program was created by Wharton and the Association of Investment Management Sales Executives (AIMSE).

The Devil is in the Details

The complexity of alternative investments means that there are no simple recipes. The devil is in the details. Investors and advisors need to understand the specific characteristics of each investment fund or instrument.

"These days, hedge funds can do almost anything," Geczy said. "Classically, hedge funds have hedged out market risk, which they often accomplished by going short or using derivatives, for example. Now hedge funds span standard asset classes and also present some exposures that are not standard. Investors need to look at the asset class and also at manager selection very carefully."

Investors also have different goals in making alternative investments, he said. "Sometimes folks invest in hedge funds to really hit the cover off the ball. Others invest in a portfolio to balance and mitigate different types of risks."

Smoothing Returns

One of the characteristics that investors should look at is the smoothness of returns. For example, reported returns from private equity or real estate are "notoriously too smooth." Geczy compares it to trying to assess the value of your home on a monthly basis. Since there may be only a small number of sales of similar homes in your neighborhood in that period, the comparables used for valuation will not change much. On the other hand, if you actually sold your home, the value might be quite different.

"What this does is smooth out the price stream and return stream to make the asset look significantly less volatile than if you actually traded your house month to month," he said. "Hedge funds can invest in securities or contracts that are hard to price accurately due to similar effects."

A Growing Part of Portfolios

Alternatives, which once accounted for a relatively small part of most portfolios, are now sometimes taking the lion's share. "If you do unconstrained optimization based on classical modern portfolio theory, you often see that a surprisingly large amount of the portfolio should be in alternatives," Geczy said. After correcting for smoothing effects, alternatives might make up 10 to 15 percent of an average portfolio.

For some large university endowments such as Yale's, however, alternatives have climbed to about 50 percent of the portfolio. Yale and other funds have achieved rapid growth as a result of such investment strategies as well as aggressive fundraising.

Looking Beyond the Fees

Geczy's research also indicates that investors may need to look beyond the fees involved. He recently studied returns from "funds of funds," hedge funds created from groups of other hedge funds (similar to a mutual fund model). Since the larger fund layers it own fees on top of the hedge fund fees, these "funds of funds" are sometimes referred to as "fees on fees." Are they worth it? A study he conducted recently found that even after adjusting for added fees, well-managed funds can add value.

"Funds of funds that don't charge too much in fees and find managers who are able to uncover true arbitrage opportunities can have a positive alpha," he said. Alpha refers to the ability of the fund to add value over and above passive indexes or benchmarks.

Because of fees, picking your own hedge funds will almost always look better initially than using funds of funds, but the fees might be worth it if the funds give investors access to the knowledge of managers and even to investments that may not be available to outsiders.

"Funds of funds can get excellent exposure and have the analysis for effective selection and the capability to hire and fire fund managers effectively," he said. "Investors shouldn't necessarily eschew funds of funds on the basis of fees alone. It is hard to find a situation where the average fund of funds has not added value."

Providing Knowledge for Better Investments

To address emerging opportunities in areas such as alternatives, the Wharton/AIMSE program is revised and updated every year to reflect the latest research and practice. This year's program, for example, will feature an expanded discussion of alternative investments. "Alternative investments require a different approach and new knowledge," said Andrea Bollyky, chair of the AIMSE education committee and managing director of Aetos Capital. "The Wharton program is a good place to gain this knowledge."

"The whole concept of the Wharton program is to promote continuing education," Bollyky said. "The investment horizon is changing dramatically. Institutional investors and individuals need to become more sophisticated in terms of the type of investments they are making and the place those investments should have in their portfolios."

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