Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing

Abstract

As institutional interest in alternative asset classes such as private equity and hedge funds has grown, plan sponsors are confronted with difficulties applying traditional asset allocation models. Estimating the risk and correlation parameters of these asset classes is often less than straightforward. One culprit is the infrequent and appraisal-based pricing necessitated by investing in illiquid securities. This “stale pricing” can reduce the perception of volatility. In this study we apply a methodology for estimating true volatility and correlation in the presence of stale pricing to alternative investments. We also measure the impact of adjusting for stale pricing on asset allocation and the diversification benefits of private equity and hedge fund investments. We conclude that much of the perceived diversification benefits associated with allocating to private equities and hedge funds is attributable to stale pricing and thus illusory. Nonetheless, we observe that efficient portfolios still contain substantial allocations to alternative investments after adjusting for the effects of stale pricing.