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Secondly, the alternative asset class has often been viewed as in a world of its own, where its risk-return profile has no relation with the two other segments. Obviously, that is not correct. One of the characteristics of these alternative asset classes is illiquidity. Illiquidity can create the illusion that assets are uncorrelated if naively compared with publicly listed equivalents. In reality, there are many fundamental reasons to link alternatives to equities and bonds. Many studies have shown that hedge funds’ strategies have a high component of traditional beta. Private equity returns should closely follow public equity returns. Privately held and managed real estate assets are subject to the same real estate cycles as public real estate assets.
This general misperception of asset characteristics and correlation demonstrates how investors, in general, have lost sight of the fundamental aim of portfolio construction. In response, several leading asset owners are moving away from the traditional asset class categorization to a system that more explicitly accounts for the role of each asset in the portfolio. We will refer to this approach as risk-based asset allocation.
Under this approach, as illustrated in Figure 6, a risk-based asset allocation could be structured along four broad segments: equities, real assets, liability hedging bonds and absolute returns strategies. For investors adopting this approach, the equity segment opportunity set could be represented by global public equities covering the broadest investable universe, such as the one captured by the MSCI All Country World Investable Market Index (ACWI IMI). Allocations to private equity and long/short equity hedge funds could complement this core equity allocation, providing a more diversified return stream along with a strong alpha component. The primary purpose of the equity allocation is to provide the highest long-term real returns possible, matching long-term economic growth.
This core equity allocation could be complemented by real assets. The real assets category could cover real estate, timber and farmland, as well as commodities. Infrastructure investments could also be put in this category, although some may argue it belongs to the equity segment. Real assets would principally be included to provide additional and more effective protection against inflation risk. The third component of this asset allocation framework is liability-hedging. Given the high level of downside risk of risky assets, the closer a retirement plan is to the payout phase, the better the liabilities need to be matched with assets of similar nature and duration. This constraint calls for a mix of low-risk government bonds, including some allocation to TIPS.
A framework that included only these assets would still leave a high number of sources of risky returns unexploited. These sources could be found in the various risk premia associated with the fundamental factors driving traditional asset classes, such as the small-cap or value premium in equities or the credit premium for corporate bonds. For example, an investor holding small-caps receives a market return for investing in equities, plus a risk premium to compensate for the risks of small-cap securities.
Similarly, high-yield bonds yield a return or beta that equals the corresponding yield on a government bond of a comparable maturity, plus a risk premium or spread for assuming the higher risk of holding such a bond. Strategies that aim to capture a specific risk premium through the execution of systematic trading rules also qualify for the risk premium approach. For example, arbitrage strategies such as merger arbitrage or convertible arbitrage qualify under that scheme.
These additional sources of return could be captured in the absolute returns strategies segment of this strategic allocation framework. Briand, Nielsen and Stefek [2009] analyze the risk return characteristics of these risk premia and show that it is possible to create portfolios of risk premia that offer similar returns to a traditional portfolio composed of 60 percent equities and 40 percent bonds with significantly lower volatility. The returns of an equal-weighted one are displayed in Figure 7.
III. Developing An Integrated View Of Risk
Finally, the recent crisis in financial markets has raised awareness of the importance of some types of risk that often receive little attention under normal market conditions. These risks include counterparty risk, operational risk, liquidity risk and concentration risk.
Counterparty risk captures the potential loss from derivative contracts (including swaps, CDS, etc.) should a counterparty default. The bankruptcy of Lehman Brothers left many pension plans and asset managers scrambling to measure their counterparty exposure to Lehman, which is not a good sign of preparedness.
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