stock portfolio allocation / mattes

The proliferation of alternative investment funds and their increasing use by advisors is rewriting the rules of portfolio risk management. Here are three critical ways that thinking about risk has changed, and the implications for your clients’ portfolios.

  1. Volatility is no longer a sufficient measure of risk

Since the inception of modern portfolio theory in the 1950s, volatility as measured by standard deviation has been the dominant measure of risk. In line with this thinking, since 2017 the Canadian Securities Administrators have required that mutual funds and ETFs offered by prospectus use a standardized risk classification methodology. That methodology categorizes a fund into one of five risk classifications ranging from low to high based on its historical standard deviation.

However, standard deviation does not accurately measure risk for certain hedge fund strategies. While standard deviation assumes that returns are normally distributed, returns for some hedge fund strategies exhibit large negative skews. In layman’s language, these strategies can incur much deeper losses during extreme market events than is implied by their standard deviations. The substantial losses incurred by many credit-focused hedge funds when credit spreads exploded during the initial phase of the coronavirus crisis is a recent illustration.

Standard deviation completely overlooks private investment funds’ most important risk: their illiquidity. Traditional private equity, credit and real estate funds invest in illiquid assets and, consequently, cannot offer liquidity to their investors. Even the new breed of open-ended evergreen private funds, which invest a portion of their assets in liquid investments, can offer only limited liquidity.

Further, the illiquid holdings of private investment funds are not valued on the frequent mark-to-market pricing used by funds investing in liquid, publicly traded stocks and bonds. Instead, private investment funds are valued infrequently (typically once a quarter) using a variety of valuation techniques, including discounted cash flow models, private market transactions and public market comparables. Research has found that the private asset valuations smooth out volatility, and this understates their standard deviations. A recent study that de-smoothed private equity returns for the period 1999 to 2020 found their volatility almost doubled, from 9.8% to 17.1%, and private real estate standard deviations went from 11.8% to 17.0%.

Not surprisingly, given the nature of the holdings, these de-smoothed volatilities are like portfolios of publicly traded stocks and REITs, and indicate that these private investments are much riskier than their reported volatilities.

  1. Risk assessment is multidimensional

The range and complexity of alternative fund strategies mean that due diligence must go beyond the return-focused risk assessment methodologies used for long-only equity and bond mutual funds and ETFs, and analyze the portfolio and the manager in detail.

Risk assessment for hedge funds or open-ended private investment funds must review the fund’s current and historical holdings, leverage levels, position liquidity, sector and factor exposures, concentration limits, and valuation methodologies. Effective evaluations of hedge funds require an assessment of their historical and current gross and net exposures and their use of derivatives. Excessive leverage and high concentrations of warrant holdings have been associated with deep losses and closures of several Canadian hedge funds. Private credit funds require a granular analysis of the fund’s holdings, borrowers, payment terms and default status, while open-ended private equity and real estate funds demand a similarly detailed holdings review. The historical financial statements and taxable distributions for the fund as well as fund documentation and legal structure must be analyzed also.

At a firm level, an extensive review of personnel, strategy, process and risk management is critical. Due diligence should encompass a review of the background and experience of the portfolio management team and senior management; the firm’s risk management policy and procedures; its organizational structure; compliance and regulation; back office and fund accounting; administration and cash controls; valuation process; third-party service providers; counterparty risk; cybersecurity and IT; disaster recovery; and business continuity plan.

  1. Alternative investment position sizes must be conservative

An advisor today can diversify their clients’ portfolios across the world’s equity and bond markets with a handful of core funds or ETFs that hold thousands of liquid securities diversified by region and sector. Position sizes in any one fund in a client’s portfolio can be sizable and still appropriately tailored to the client’s objectives and risk profile.

This position sizing is untenable for most hedge funds and all private investment funds. By design, these funds pursue unique strategies that can enhance portfolio performance but in doing so involve more risks. Leverage, shorting and the use of derivatives in hedge funds can lead to unexpected and outsized losses when a strategy or its implementation goes awry. Private investments often have concentrated portfolios, frequently use leverage and at best provide limited liquidity.

The unique risks of alternative investments manifest in the high return dispersion among managers. Research has found that the dispersion of returns among long/short equity funds is much greater than among long-only equity managers. Hedge fund returns overall are more dispersed than returns among traditional asset class managers. In particular, private equity returns have much greater dispersion than public equity funds and also vary tremendously by vintage year.

To manage this active manager risk, many advisors must revisit their thinking on position sizing and use much more conservative weighting in placing any single alternative investment in a client’s portfolio.

Alternative investment funds have increased the potential for advisors to enhance their clients’ portfolio performance, but investing in these funds requires adhering to the new rules of portfolio risk management.

Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.