Practical analysis for investment professionals
26 August 2015

Understanding Alternative Investments

Posted In: Economics

Alternative investments had a rough year in 2014, leading many investors to shift their strategies away from the asset class.

Over the last quarter of a century, however, alternatives have enjoyed an enviable track record, providing better returns than stocks and bonds and with much less volatility than equities. Yet many investors remain wary.

Bob Rice, the alternative investment expert and commentator, helps clear up some of the misconceptions about the asset class — and discusses his latest book, The Alternative Answer — in a Take 15 interview with Jason Voss, CFA. Rice stresses the importance of alternative investments for portfolio managers, and how best to explain that importance to clients.

The most misunderstood thing about alternative investments? “The idea that they should always outperform the stock market,” Rice says. “Trying to have clients understand why it is that you might have them in strategies that don’t always outperform the Dow is a pretty useful thing.”


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Rice also notes the benefits of outperforming the market on the downside. “The reason that hedge funds have outperformed the market over the last 20 years is pretty simple: They lose less on the downside,” he says. “What I try to emphasize to people is: You don’t need to beat the market on the upside, what you need to do is beat it on the downside.”

One of the other concepts Rice discusses is active alpha. “If you’re looking for alpha, the trick to me is to look for what I call ‘active alpha,‘” he says. “Not somebody who’s sitting back and passively picking this set of stocks versus that set of stocks.” Rather, Rice explains, active alpha is when “people are actually working to create value.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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5 thoughts on “Understanding Alternative Investments”

  1. Brad Case, PhD, CFA, CAIA says:

    Ironically, this interview adds to the most important misconceptions about alternative assets. (I haven’t read the book.) Most alternative assets do NOT actually have “much less volatility than equities.” While it’s possible to manage alternative assets so that they have lower volatility without lower returns (or higher returns without higher volatility), and therefore higher risk-adjusted returns, that’s not what most alternative asset managers do.
    Instead, most “alternative asset” strategies are actually nothing more than “alternative measurement” strategies. When an asset is traded on a liquid exchange, it is a Level 1 asset, meaning that active trading reveals its actual value AND its actual volatility. When a private equity manager takes it out of the public market it becomes a Level 3 asset, meaning that its actual value and actual volatility are no longer revealed by active trading. If nothing has changed except its stock exchange listing, then literally nothing has changed about its actual value or its actual volatility–BUT its value and its volatility will be measured inaccurately (by the manager) rather than accurately (by the market). Not only are the returns of Level 3 assets typically measured much more smoothly than they really are, but they’re also typically measured with significant lag, which makes them look as though they provide a diversification benefit that they really don’t. (I call that “temporal diversification”: a false “diversification” that comes only from a temporal lag in measuring returns.)
    Most private equity and private real estate investment managers appear to do no more, in practice, than “reduce volatility” by taking their targets from Level 1 to Level 3 assets. “Return enhancement” seems to consist primarily of increasing leverage, which of course would make returns more volatile if they were measured properly. And, of course, leverage helps increase investment “management” fees, which subtracts from the investor’s net return. By the way, my statements are supported by substantial empirical evidence.
    It’s the same with hedge funds: while some may reduce actual volatility using long-short strategies, option overlays, and the like, most simply understate the true volatility of their Level 3 (or Level 2) assets and measure their returns with lag that creates “temporal diversification.”
    Of course, clients may well appreciate receiving incorrect information that makes the value of their portfolio appear to be more stable than it really is. It’s kind of a shame that we can’t report the returns of their Level 3 assets with lag and smoothing, just as we can report the returns of their Level 1 assets with lag and smoothing. But understating the true volatility of our clients’ assets is very different from producing good risk-adjusted returns.

  2. Many hedge funds are entirely in level 1 assets, or in a mix of level 1 and level 2 assets in my experience. In liquid strategies such as long short equity, equity market neutral, merger arbitrage, managed futures and CTAs it is very rare to see any level 3 assets.

    1. Brad Case, PhD, CFA, CAIA says:

      Yes, I understand, Hamlin–and in those situations, the reduction in volatility is real. The problem, of course, is that it’s difficult for an investor to distinguish between an actual reduction in volatility (coming from, say, a long/short strategy executed well through liquid markets) and a false reduction in volatility (coming merely from a substitution of Level 3 assets for Level 1 assets). And of course substituting Level 3 for Level 1 is the whole premise of private equity, private real estate, and many other alternative asset management strategies.

      1. Brad-

        Ah, another hater of off-market investment activity. Clearly only an investment observed in the dysfunctional, flash crash, hedge fund driven liquid markets have any real meaning. Level 3, how pejorative. Frankly I’ll take it all day long.

        As a case study, take the NAREIT and NCREIF real estate return indexes. The former represents traded interests and the former represents institutionally held (non-traded) interests. You will not that while your observation of “temporal diversification” is at play here, overall volatility is clearly reduced due to the elimination of behaviorial finance induced volatilty. With reduced vol, the return-risk ratio is much higher for non-traded real estate, and thus clearly preferred for any rational investor.

        1. Brad Case, PhD, CFA, CAIA says:

          I don’t hate off-market investment activity, James: I hate only the fact that people are fooled into thinking that “volatility is clearly reduced” and “the return-risk ratio is much higher.”
          It’s simply not true, and the mistake you’ve made–which is still very, very common–has resulted in the misinvestment of billions or trillions of dollars over the past few decades.
          How frequently an asset trades has absolutely nothing to do with how the actual market value of that asset changes on a day-to-day basis. Liquidity affects only how often and how accurately the actual market value is measured. Take any traded corporation, now buy up all its stock so it stops trading but make no other changes: the factors that now affect the unobserved value of its non-trading stock are exactly the same as the factors that used to affect the observed value of its trading stock. How can you say that its actual volatility has been affected?
          As a case study, take REITs (frequently traded interests in institutional-quality real estate) and NCREIF data (infrequently traded interests in institutional-quality real estate). But instead of using the NCREIF Property Index (NPI), which is based on “values” estimated (poorly) by appraisers, use NCREIF’s Transaction Based Index (NTBI)–same properties, but actual market values rather than appraisals. And, since the NTBI is based on unlevered returns, use unlevered returns for REITs too (the FTSE NAREIT PureProperty Index Series). The volatilities are essentially identical: by property type (apartment, industrial, office, retail), by region (East, Midwest, South, West), and in aggregate. I’ve done it.
          In other words, there is absolutely no ACTUAL difference in volatility between listed equity REITs and unlisted property assets. The only difference is that people like you get fooled by the fact that returns are not measured accurately in the unlisted market.
          Now let’s go two steps further. First, net total returns have been better for listed equity REITs than for unlisted institutional real estate investments, even after adjusting for differences in leverage, property type mix, and geographic location. I can point you to at least 12 independent studies showing better returns for REITs, and I don’t think you can point me to a single study showing better returns for unlisted real estate.
          Second, even the NTBI smooths actual returns, meaning that the volatility of unlisted real estate is not as low as the NTBI says it is. If you adjust the way REIT volatility is measured to make it more comparable to the way NTBI volatility is measured, you find that REITs are actually about two percentage points less volatile. That makes theoretical sense: volatility is a measure of uncertainty regarding asset values, and there is more uncertainty when the market is illiquid and inefficient.
          The conclusion? Risk-adjusted returns are actually higher for listed equity REITs than for unlisted institutional real estate investments.
          I don’t want to be enemies, James. I can support everything I’ve said both theoretically and empirically. And I’m also happy to discuss the reasons why REITs have historically generated better returns, even on a risk-adjusted basis. Please let me know where you would like to take this conversation. Thanks,
          –Brad

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