Portfolio Management with Alternative Investments

Alternative assets such as private equity, hedge funds, real estate, and infrastructure now form a substantial part of the portfolios of institutional investors, with their popularity having increased very substantially over the past two decades. This is principally due to their perceived diversification benefits. However, the application of portfolio theory to portfolios which include alternative assets presents a number of problems, as they differ in some important ways from more traditional assets such as equities and bonds. Alternative assets usually have a highly non-normal returns distribution, and illiquid alternative assets such as real estate and hedge funds have smoothed measured returns, leading to positive autocorrelation and reduced variances and correlations. Therefore, reported returns are a biased measure of true returns and their riskiness. Since the application of portfolio theory requires forecasts of returns, variances, and correlations, the estimation errors for alternative assets are generally larger than for equities and bonds. These issues of non-normality and smoothed reported returns mean that the use of portfolio theory to form portfolios including alternative assets may not lead to an improved performance, and a few studies have found that adding alternative assets to portfolios of equities and bonds can have a negative effect on performance.