Stale Pricing Does Not Equal Low Risk or Low Correlation

Alternative asset classes are in something of a sweet spot. Not only do they offer the prospect of a diversifying source of return in an environment when bond yields are at historically low levels, but they also provide a new revenue source for active managers. In the current landscape, strategies where passive replication is problematic or impossible provide a particular allure for margin-pressured asset management firms.  Whilst the attention being lavished upon this area is unsurprising there are certain aspects of discussions about such investments, which are troubling and often misleading.

Alternative assets represent a broad church and can encompass anything that falls outside of the core traditional mix of equities and bonds, from private equity to fine wine.  The nebulous nature of this definition means that it is difficult and unfair to discuss the credibility of the grouping in general terms; however, one common feature tends to be the approach to pricing and valuation.  Whereas the majority of traditional assets are regularly traded and marked to market; alternative assets are typically far less liquid and, in the absence of a regularly traded market price, are valued on some form of model / appraisal basis.  This approach to valuation is not a problem in and of itself – there is often no simple answer to appropriately valuing such assets – however, it does have profound implications for how you might express the risks of such strategies and compare them to traditional asset classes.

The first, seemingly obvious, point is that volatility is a woefully inadequate measure of risk for most alternative assets, particularly if used in comparison with public equity returns, for example.  The pricing of any mark to model asset is smoothed; it is largely immune to the vagaries of human behaviour that drive the vacillations of listed assets – imagine the volatility of the S&P 500 if it was valued on a monthly basis based on projected future cash flows.  Volatility has come to be the primary term for how we express investment risk, even where it is inappropriate for the assets in scope.  This incongruence has been exploited by some to suggest that alternative assets in general terms are inherently lower risk, turning a structural limitation* into a sales message.

Deeply intertwined with the issues surrounding volatility and mark to model pricing in alternative assets is the issue of correlation and diversification.  Whilst some alternative assets will have genuinely distinctive attributes when compared to traditional equity / bond portfolios, these should be driven by the underlying economics / cash flow profile of the assets rather than the valuation methodology or liquidity structure.  The most egregious example often comes in the form of some private equity strategies, where a portfolio of private, medium sized companies can be said to offer material diversification benefits compared to a portfolio of public, medium sized companies.  Clearly, the holdings of the two portfolios are highly economically correlated, even if their differential approaches to valuation provide an optical sheen of differentiation.

The narrative supporting alternative assets is often built around the impact that their addition can have on a traditional portfolio (such as a 60/40); whilst there may be merit to this viewpoint, the primary evidence given is often fatuous. The argument tends to run as follows: ‘look at the beneficial Sharpe ratio and volatility impact of adding XYZ alternative strategy to your portfolio’.  Alternative assets exhibit artificially low volatilities and therefore abnormally high Sharpe ratios, they can also appear to have a low correlation to traditional assets – of course they look wonderful when added to a leaden portfolio of equities and bonds.

The problem is that as an industry we have come to use volatility and Sharpe ratio as default metrics for the analysis of traditional portfolios and are now prone to view everything through these frames even when their usage is entirely inappropriate.  Furthermore, given that many asset allocators are assessed on such metrics the rational course of action for them is to game these measures by utilising alternative assets with depressed volatility and low correlations to ‘enhance’ the overall results of their portfolios.

That is not to say that there is no role for alternative assets but any investment case for them should be driven by an understanding of their economic merit and cash flow profile, we should always ask – do arguments around diversification and low volatility make intuitive sense?  Such assets can appear low risk when viewed through a volatility lens – attractive in risk models and optimisations – but such smooth returns can often cloak an unpleasant tail.  Beware the dangers of mistaking pricing and liquidity characteristics for fundamental ones.

* As I have previously argued, one indirect benefit of illiquid assets is behavioural – if it is difficult / impossible to trade, we are more likely to stay invested for the long-term.