Proponents of alternative investments, such as private equity and hedge funds, make a strong pitch for putting some money in the sector: It offers diversification in an asset class whose performance doesn’t correlate with public stock and bond markets.
But how valid is that claim? A new report by Oaks, Pennsylvaniabased money manager SEI Investments suggests that alternative investing offers less diversification than many have thought. When historical data is adjusted to better reflect the value of illiquid securities, the authors say, variations between the performance of stocks and alternatives drop sharply. For example, SEI found that the correlation between stocks (as measured by the Standard & Poor’s 500 index) and the average venture capital fund rises from 0.4 to 0.6 (with 1.0 being complete correlation and 1.0 indicating assets moving in opposition).
The SEI white paper, “The Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing,” grew out of an exercise within the firm’s alternative-investment group to evaluate the distortions of “stale pricing.” The term refers to the inherent biases involved in the appraised pricing (using historical data and other formulas to estimate market value) of illiquid securities. “When you allow managers to price securities based on appraisal rather than market-determined prices, there is a smoothing out, or a fudge factor,” says Daniel Nevins, SEI’s director of investment strategy research. “We knew that stale pricing was at work, so we wanted to see to what extent.”
In some cases, the pricing had quite a lot of impact. With the new data, “you find the correlation between traditional and nontraditional investments becomes a lot higher,” says Andrew Conner, an SEI research analyst. Occasionally, “the diversification benefits can be overstated by as much as 100 percent.”
Alternatives not only appear to be more closely correlated with U.S. stocks and bonds when data is revised, but are more volatile as well. In one of the most extreme examples, SEI looked at historical data for convertible arbitrage hedge funds and found that returns thought to have a 5 percent standard deviation (from the expected return over time) showed a 10 percent standard deviation once the data was revamped. Another alternative asset class that proved more volatile by SEI’s calculation: LBO funds, whose standard deviation moved from 9 percent to 13 percent.
How did the SEI researchers adjust for stale pricing? Using a series of advanced algebraic equations, they developed a methodology for creating synthetic market-determined prices to compensate for the smoothed-out appraisal data. Appraised prices do not reflect real-time changes in value as rapidly as market-determined prices, leading to a smoother pattern of returns. Explains Nevins: “We took imperfect return data and unraveled it. Then we reassigned specific components of the returns that had been smoothed out in the appraisal process to create a more realistic data set.” The mathematical equations allowed SEI analysts to estimate what the correlation statistics would have been in an actual, fast-changing economic environment.
To date, the SEI paper has mostly caught the eye of alternative-investment specialists. “The authors are right to focus on problems in dealing with historical hedge fund performance information,” says Robert Jaeger, CIO of Evaluation Associates Capital Markets, a Norwalk, Connecticutbased consulting firm. “The raw information tends to suggest that hedge funds have low volatility and low correlation with the standard markets. The prudent investor will want to adjust these variables upward.”
SEI isn’t the first to weigh in on this subject. In a widely read white paper, “Do Hedge Funds Hedge?” published in the fall 2001 Journal of Portfolio Management, Clifford Asness, founding principal of hedge fund AQR Capital Management, asserted that several varieties of hedge funds hold illiquid or difficult-to-price derivatives instruments and are prone to take advantage of this leeway when marking positions for month-end reporting.
Concludes SEI’s Conner: “We’re not saying alternatives don’t offer diversification benefits. They just don’t offer as much as people think.”
