Portfolio Construction: Alternative investments Video 3

What are the benefits of Alternative Assets to a Traditional Portfolio?

1. Improved risk adjusted expected return due to lower risk (from greater diversification benefits) and higher returns

2. Real Assets can provide inflation protection

3. VC Investments(form of PE) provide substantial return premium over equities to compensate for illiquidity risk and heightened operational complexity

4. HF(the least homogenous of strategies) vehicles span from diversifiers to return enhancers

What are the 4 Main Roles of Alternative Investments in a Multi Asset Portfolio?

1. Capital Growth - top priority for portfolio with a long term time horizon and relatively high return target. Usually, public and private equity

2. Income generation - Certain asset classes, like FI or Real Estate are capable of generating reasonably steady CF streams for investors

3. Risk Diversification - In case of equity oriented portfolio - investors may seek assets that diversify the dominant equity risk. Real assets and several hedge fund strategies may fit here. Similarly, fixed-income investors may be interested in diversifying pure yield curve risk via private credit.

4. Safety - Certain asset classes may play the role of safe haven when most of the risky asset classes suffer. Government bonds or gold may potentially play such roles in a well-diversified portfolio.

What is the role of Private Equity in a multi asset portfolio?

-Private equity investments are generally viewed as a return enhancer in a portfolio of traditional assets - CAPITAL GROWTH + INCOME

-The expectation for a return premium over public equities stems from the illiquidity risk that comes with most forms of private equity investment

-Because of the strong link between the fundamentals of private and public companies, there are limited diversification benefits when added to a portfolio that otherwise contains significant public equity exposure.

-Note: Volatility not observable because holdings not publicly traded - assets valued at lower of cost of value at which company raises capital or when ownership changes

-PE indexes do not provide a true picture of strategy risk and volatility estimated using public equity proxy with an adjustment to reflect provate nature

What is the role of Hedge Funds in a multi asset portfolio?

-Span spectrum of being risk reducers to return enhancers

-long/short equity strategies are believed to deliver equity-like returns with less than full exposure to the equity premium but with an additional source of return that might come from the manager’s shorting of individual stock

-Short-biased equity strategies are expected to lower a portfolio’s overall equity beta while producing some measure of alpha

-Arbitrage and event-driven strategies, executed properly, look to exploit small inefficiencies in the public markets while exhibiting low to no correlation with traditional asset classes

-Opportunistic” strategies (e.g., global macro and managed futures), although very volatile as stand-alone strategies, provide exposures not otherwise readily accessible in traditional stock and bond strategies.

The Role of Commercial Real Estate in Multi-Asset Portfolio

-Capital Growth, Income, Risk Diversification

-the development, acquisition, management, and disposition of commercial properties, including retail, office, industrial, housing (including apartments), and hotels.

-Real estate investments are believed to provide protection against unanticipated increases in inflation: well positioned property can increase rent and value of physical buildings increase (properties often valued as function of replacement cost) - Income + Capital Gain

What are the 2 Types of private Credit in a multi-asset portfolio?

1. Direct lending - provide capital to individuals and small businesses that generally cannot access more traditional lending channels. Some loans are unsecured while others might be backed by an asset, such as a house or car. Direct lending is one of the least liquid debt strategies because there is typically no secondary market for these instruments

2. Distressed funds - typically purchase the securities of an entity that is under stress and where the stress is relieved through legal restructuring or bankruptcy. The investment can take the form of debt or equity, and in many strategies, the manager often takes an active role throughout the restructuring or bankruptcy

Note: Although both strategies involve the ownership of fixed-income assets, their roles are different.

-Direct-lending assets are income-producing, and the asset owner assumes any default or recovery risks. the assets generally behave like their public market counterparts with similar credit profiles (i.e., high-quality, direct-lending assets behave like investment-grade bonds, and low-quality, direct-lending assets behave like high-yield bonds).

-Distressed debt assets have a more equity-like profile. The expected return is derived from the value of a company’s assets relative to its debt. Illiquidity risks are high with both strategies. Direct-lending assets have no secondary market.

What are the 2 Traditional Approaches to defining the AI investment opportunity set?

1. Liquidity Based Approach - liquidity differences among alternative asset classes: Ex. REITS + commodity futures - highly liquid and can be easily traded, PE- highly illiquid and have long term commitment of 10+ years, private credit are more liquid and require shorter time commitment than PE

2. Approach based on expected performance under distinct macroeconomic regimes - may categorize based on how they are expected to behave under different macro environments.

-Capital growth - Priv/public equities - benefit from healthy economy

-Inflation hedging - Expected to outperform other asset classes when inflation expectations rise or actual >expectations. Ex. Real assets - real estate, commodities, natural resources, inflation linked bonds

-Deflation-hedging assets - expected to outperform when economy slows and inflation low or negative

The idea: considering the fundamental economic drivers of asset classes can help investors construct portfolios that are better diversified and more robust

What are the advantages and disadvantages of Traditional approaches?

Advantages: easy to communicate (intuitive and easy to explain),

Limitations - Over estimation of portfolio diversification, obscured primary drivers of risk (investments with very different risk characteristics may be commingled under the same asset class category). Ex. HY and IG bonds are FI but have distinct risk characteristics

What are the advantages + disadvantages of risk based approaches?

• Risk Based is designed to overcome limitations of traditional

• Strengths: common factor identification - investors can indentidy common risk factors across all investments , Integrated risk framework- Investors are able to build an integrated risk management framework, leading to more reliable portfolio-level risk quantification.

• Limitations: sensitive to historical look back period, implementation hurdles (