Performance Dispersion Risk Assessment in Alternatives and Active Strategies

Abstract

Alternatives have gained significant investor attention recently. Unfortunately, the lack of a holistic investment framework to incorporate alternatives in a traditional portfolio poses a challenge. Traditional risk–return based approaches, alone, over-allocate to alternatives—a result of underestimation of risks resulting from (a) significant manager dispersion and (b) smoothness in the pooled return indexes used for alternatives. Much research corrects for smoothness of returns; however, the risk from performance dispersion remains mostly unaddressed. In this study, the author discusses a methodology to quantify performance dispersion risk and incorporate it in the portfolio construction process.

TOPICS: Portfolio management/multi-asset allocation, real assets/alternative investments/private equity, private equity, performance measurement

Key Findings

• • Alternative Investments exhibit a much higher degree of performance dispersion among managers than traditional asset classes.

• • Traditional risk measurement approaches on pooled return indices utilized for alternatives underestimate the actual risk of an investment in alternative asset classes.

• • Performance dispersion risk of investing in an alternative strategy can be measured similar to the idiosyncratic risk of a stock and should be included in any risk based portfolio construction process.