Benchmarking Alternative Investments

Benchmarking alternative investments is uniquely challenging due to their diverse characteristics, illiquidity, lack of transparency, and inconsistent pricing methodologies. Below, we discuss the problems associated with benchmarking various types of alternative investments:


Hedge Funds

  1. Broad Market Indexes:
    • Issues: Hedge funds employ diverse strategies (e.g., arbitrage, global macro, event-driven), making them fundamentally different from broad market indexes.
    • Characteristics:
      • Use of leverage, short positions, and derivatives.
      • Asset allocation may change dramatically over time.
      • Hedge funds often exhibit low or no correlation with traditional market indexes.
  2. Risk-Free Rate + Spread:
    • Suitability: May be reasonable for arbitrage strategies but not for most hedge funds, which carry systematic risk.
    • Challenges:
      • It requires an appropriate spread to reflect the risk, which varies widely.
      • Hedge funds’ low correlation with risk-free rates undermines their use as benchmarks.
  3. Peer Universes:
    • Drawbacks:
      • Peer funds’ objectives often differ significantly.
      • Subject to survivorship and backfill bias, distorting performance comparisons.
      • Illiquidity and infrequent pricing (e.g., appraisal-based valuations) create a smoothing effect, underreporting volatility and overstating Sharpe ratios.

Real Estate

  1. Common benchmark Issues:
    • Benchmarks often represent only a sample of the real estate market, leading to bias.
    • Heavily influenced by large, expensive properties or specific geographical areas.
    • Self-reported performance data can introduce bias.
    • Use of appraisal data causes valuation smoothing, underestimating risk.
  2. Inconsistencies:
    • Benchmarks may include or exclude leverage, making comparisons difficult.
    • Differing return measures:
      • Time-weighted returns: Used for open-end funds where investors control cash flows.
      • Internal rate of return (IRR): Used for closed-end funds where managers control cash flows.
  3. Assumptions:
    • Benchmarks typically assume no transaction costs, perfect transparency, and normal liquidity—conditions that rarely hold in real estate.

Private Equity

  1. Performance Metrics:
    • IRR: Commonly used but subject to bias:
      • IRR is sensitive to the timing of cash flows, with early gains or losses disproportionately impacting results.
      • Valuation methods differ significantly across managers, reducing comparability.
  2. Challenges:
    • Peer group benchmarks may include funds at different stages of development.
    • Valuations are performed at specific points in time, not reflecting ongoing performance dynamics.

Commodities

  1. Futures-Based Benchmarks:
    • Most commodity benchmarks use futures prices, which may not reflect the actual holdings of commodity investment portfolios.
  2. Key Problems:
    • Leverage differences between portfolios and benchmarks create mismatches.
    • Weighting differences lead to reduced comparability.
    • Portfolios often hold physical commodities, while benchmarks are based on derivatives.

Managed Derivatives

  1. Specific Benchmarks:
    • Often too narrow or broad to accurately reflect the strategy being employed.
    • Peer group benchmarks are subject to stale pricing and survivorship/backfill bias.
  2. Limitations:
    • Benchmarks fail to capture the full complexity of derivatives strategies.

Distressed Securities

  1. Illiquidity Issues:
    • Valuation challenges arise from the lack of a liquid market.
    • Stale pricing is common due to infrequent valuations.
  2. Benchmarks:
    • Market indexes like the Barclay Distressed Securities Index exist but cover a wide array of strategies, limiting their relevance for specific funds.
    • Valuations are often erratic, further compounding benchmarking difficulties.

Conclusion

Benchmarking alternative investments is fraught with challenges due to their unique structures, illiquidity, and diverse strategies. Investors must carefully evaluate the limitations of each benchmark type and may need to rely on customized or hybrid approaches to capture the nuances of alternative investment performance accurately.

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