The Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing

Investors in alternative asset classes such as private equity and hedge funds have long had difficulty applying traditional models for making asset allocation decisions. The optimization techniques of modern portfolio theory rely heavily on a trio of descriptive statistics: mean, variance, and covariance. For most traditional asset classes, the abundance of historical data provides a guide for estimating these parameters. However, for some alternative asset classes estimating these characteristics is not always straightforward. Although time series of returns for both private equity and hedge funds are available from reputable sources, reported returns can be misleading. Alternative asset returns can exhibit low volatility and low correlations with publicly traded asset classes. This suggests that they are potentially diversifying assets and incremental allocations to alternative investments may decrease overall portfolio risk. The standard deviations and correlations of reported alternative asset indices, however, cannot be taken at face value. Partnerships holding illiquid securities are valued infrequently and based on appraised values, so positions are not marked-to-market. This “stale pricing” dampens actual volatility. It is possible to empirically estimate the true volatility of alternative assets. We hypothesize that there exists an underlying process of returns that could be measured if positions were continually marked-tomarket as in the public markets. We call this the “economic process” of returns. The reported index returns, based on stale prices, represent a “smoothed process” of returns. The volatility and correlation of the economic process represent actual economic events and are relevant to investors. In this paper we apply a method from the real estate finance literature to estimate the characteristics of the economic process from the smoothed process for several alternative asset classes. Whereas in traditional markets the economic process is observable (and reported), in alternative markets stale pricing can prevent observation of the economic process and the smoothed process is reported. Consequently, we use the standard deviations and correlations of the reported smoothed process data to estimate the standard deviations and correlations of the unobservable economic process of returns. The result is a set of risks and correlations that have been adjusted for the effects of stale pricing. For alternative asset classes, we refer to the statistics of the reported smoothed process as the “reported” risk and correlation. We refer to the estimated statistics of the unobservable economic process as the “adjusted” risk and correlation. This methodology has two distinct advantages over existing methods for estimating risk and correlation in the presence of stale pricing. First, it is computationally simple. Adjusted parameters are calculated directly from historical time series of index returns. This technique is appropriate for individual investments and composites alike; liquidated or ongoing positions. Second, this methodology provides a consistent framework for estimating both risk and correlation. This includes correlation between traditional and alternative asset classes, as well as correlation between multiple alternative asset classes. Using historical data as an example, we have found that adjusting risk and correlation for stale pricing will substantially increase the perceived risk of alternative asset classes and decrease the diversification SEI Investments / Adjusting Alternative Assets for Stale Pricing / ©2002 SEI Investments Development, Inc. 2 benefits of alternative assets with most traditional asset classes, in our example eliminating half of the diversification benefit associated with allocating to alternative assets. Despite this, we find that optimal portfolios based on adjusted risk and correlation do not have a lower overall allocation to alternative assets. Although the overall allocation decision still includes alternatives, the composition of the traditional and alterative portfolios are adjusted to better manage risk. In other words, adjusting for the effects of stale pricing has a meaningful effect on the perception of risk and the asset allocation decision. SEI Investments / Adjusting Alternative Assets for Stale Pricing / ©2002 SEI Investments Developments, Inc. 3