Recent events—from eruptions of a volcano in Iceland to environmental disasters in the Gulf of Mexico—have reaffirmed our inability to manage the impact of unexpected short-term events. Perhaps the randomness in short-term events is one of the reasons academics as well practitioners often attempt to focus on decision making over longer-term horizons for which short-term events are just that, short term. In the first section of this issue, George A. Martin, in his article “The Long-Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio,” analyzes the potential role of an expansive set of real asset classes in reducing inflation risk in the portfolios of long-horizon institutional investors. Martin proposes a model that emphasizes the sensitivity of asset returns to expected and unexpected changes in inflation, and to the degree of persistence in inflation. The results provide insight into the viability of various real asset classes as potential hedges for inflation.
Unexpected events, of course, come in many forms. The collapse of the securitized mortgage market may have been forecast by a few, but for most it came as a surprise. Perhaps a closer analysis of the underlying assumptions about the production process would have led more investors to the conclusion that there was a large amount of potential model error and investment risk inherent in the process. In “The Role of the Constant Recovery Assumption in the Subprime Bubble,” Donald R. Chambers, Michael A. Kelly, and Qin Lu analyze the complex models and the parameters used to estimate the risks of the securities. They find that the models themselves, not the inputted parameters, such as expected default rates and correlations, were responsible for inappropriate ratings. In particular, they find that the assumption of a constant recovery rate generated generous ratings for large tranches of securities even with reasonable parameter estimates.
In fact, an understanding the fundamental return process of any alternative investment forms the basis for long-term risk management. The two articles in our section on asset pricing focus on the cash flows to private equity funds and the returns to hedge funds. In “Modeling the Cash Flow Dynamics of Private Equity Funds: Theory and Empirical Evidence,” Axel Buchner, Christoph Kaserer, and Niklas Wagner present a novel continuous-time approach to modeling the typical cash flow dynamics of private equity funds. The model consists of two independent components. First is a mean-reverting square-root process applied to model the rate at which capital is drawn over time. Second is the stream of capital distributions, which is assumed to follow an arithmetic Brownian motion with a time-dependent drift component that incorporates the typical time-pattern of the repayments of private equity funds. The empirical analysis shows that the model can easily be calibrated to real-world fund data by the method of conditional least squares (CLS) and nicely fits historical data. In the second article, “Alternative Asset Pricing: Momentum and the Hedge Fund Puzzle,” Stephen Bond and Lew Johnson question some of the underlying assumptions of financial theory about market efficiency and examine whether a momentum strategy consistently outperformed the market over the past 10 years, including the meltdown of 2008. The results have implications for current regulations on the ability of smaller investors to access these unique return streams.
An examination of the asset markets that underlie various alternative markets is required for a thorough understanding of the current market environment, as well as how various alternative investment strategies must evolve to meet changing market conditions. The last two articles in this issue provide perspectives on alternative investment allocations and on the sources of return in fixed income and foreign exchange in emerging markets.
In “An Early Look at the Deutsche Bank Alternative Investment Survey, 2002–2009,” Erik Benrud presents an analysis of the evolution of hedge fund investor characteristics and expectations based on the Deutsche Bank Alternative Investment Survey (DBAIS): 2002–2009. Some of Benrud’s findings include 1) new hedge fund allocations are primarily determined by a common factor rather than by specific views on particular strategies; 2) allocations to credit-sensitive strategies are negatively correlated with allocations to noncredit strategies; 3) investor strategy allocations tend to chase returns and do a poor job of timing future strategy returns; and 4) the use of managed accounts has dramatically increased.
The importance of understanding the evolution of various hedge fund strategies is illustrated in the last article, “Sources of Return within an Emerging Markets Fixed-Income and Foreign Exchange Portfolio.” In this article, Amer Bisat again reminds investors that much of the research in emerging markets has focused on empirical analyses rather than on highlighting the long-term structural arguments for emerging market investments. Moreover, much of the research has also tended to focus on the equity markets rather than on other forms of emerging market (EM) investment such as fixed income and foreign exchange (FX). In the final practitioner note, Amer introduces the reader to the non-equities EM investment universe, describes a prototypical EM fixed-income/FX portfolio, and quantitatively works out the expected annualized returns on such a portfolio, distinguishing between beta and alpha as the sources of returns.
A review of the articles in this issue indicates that education is not the problem, the problem is re-education. Over years of debate and analysis, walls are built within and across investment areas as to the best way to explain and to manage an investment problem. For many, those walls remain, and moreover, each year they are repaired and, in many cases, they are raised even higher. Constant re-education is required to determine if a wall should come down, and to ensure that if a wall must come down the tools are in place to do it. The Journal of Alternative Investments has as its primary purpose the destruction of walls. Many of us would not agree with some of the material presented in any one issue, but we should remember the following message in Robert Frost’s famous poem “Mending Wall:”
He only says, ‘Good fences make good neighbors.’
Spring is the mischief in me, and I wonder
If I could put a notion in his head:
‘Why do they make good neighbors?…
Before I built a wall I’d ask to know
What I was walling in or walling out
We invite your ideas and your articles.
TOPIC: Real assets/alternative investments/private equity
Thomas Schneeweis
Editor
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