Alternative Reality: Return and Risk
Stocks and bonds are the most common investments in portfolios. They are also the investments that we are the most familiar with and that receive the most media coverage. Yet, as I covered in the Portfolio Pie blog, 10% of the investable assets in the world are “alternative” such as commercial real estate and private equity. It is harder for individuals to find information on alternatives as they don’t trade on public markets. To help understand the reality of investing in alternative assets from a portfolio perspective, I look at the main types and how their return and risk has compared to bonds and stocks.
Alternative Alternatives
The main categories for alternative investments are private equity, private debt, and private real assets. Investments are made directly or through funds. Direct investments need substantial resources and expertise. As a result they are only made by large institutional investors and ultra high net worth investors.
Broadly speaking, private equity is capital provided to companies at every stage of their development. Part or all of a company is purchased. Then expertise is provided to increase the value of the company over a period of years before selling it. Private equity is broken down further into early stage (venture capital) and later stage (private equity). There is also a secondary market (secondaries) for purchasing existing private equity investments. Private debt is lending to companies that are not able to borrow or not able to get reasonable rates from traditional lenders such as banks, or where the risk profile of the investment is not suited for private equity. Private real assets are physical assets that have an intrinsic worth. They typically have predictable future cash flows, such as commercial real estate or infrastructure such as toll roads.
There are important considerations when investing in alternatives. They have minimum investment sizes that range from thousand of dollars to millions of dollars. It takes a number of years to fully invest your money. They are also illiquid, as your money is tied up for a long time. For example, typical term sheets for alternative funds say they will have a 10-year lifespan during which your total capital commitment is invested over the first few years, then your capital is returned (hopefully more than you put in) during the last years. Data on funds shows that the actual lifespan of private debt funds has been 4-6 years and private equity funds 4-8 years.[1]
Data Details
There is publicly available data on quarterly alternative return indices, which are reported after fees[2]. I used the North American indices for venture capital, private equity, secondaries, private debt, and real estate from PitchBook[3]. The data starts in 2001. Data on infrastructure is from Preqin and starts in 2008. I measured Canadian stocks using the return on the S&P TSX index, U.S. stocks using the Russell 3000 Index, and Canadian bonds using the return on the FTSE Canada Universe Bond Index[4]. Given the lag in alternatives reporting, I used an end date of December 2020.
Normally it is a straightforward exercise to calculate the returns and risk (defined as the standard deviation of returns) for indices. But there is an issue unique to alternatives. Since they don’t trade on public markets, there is no regular market price that is set by a large number of investors buying and selling the specific assets. Alternatives are typically valued quarterly, using an estimation process, either internally or by a third party.
Historical valuations and return indices for alternatives have a smoother rate of increase or decrease over time, compared to the prices of stocks and bonds. The smoother valuations are due to the techniques and the limited data available for valuing alternatives. That is an issue because smoother alternative valuations and returns result in lower standard deviations, thereby understating the risk compared to stocks and bonds.
Data Desmoothing
There is a solution to smoothed returns, namely desmoothing! Due to smoothing, the alternative quarterly return indices show autocorrelation, meaning the return for one quarter is similar to the return in the previous quarter. If quarterly returns were the same every quarter, then the autocorrelation would be 100%. If they were completely different each quarter, the autocorrelation would be 0%. Publicly traded bonds and stocks have an autocorrelation close to 0%, while the alternatives I looked at range from 36% to 80%. Using the process outlined by PitchBook[5], the autocorrelation was calculated for the returns of each alternative index. The autocorrelation was used in a formula to create a more realistic desmoothed version of each alternative index for comparing returns and risk with bonds and stocks.
To show the effect of desmoothing I created a quarterly Alternatives Index by assuming an equally weighted portfolio of venture capital, private equity, secondaries, real estate, infrastructure, and private debt. Chart 1 below shows the reported (smoothed) returns for the index vs the desmoothed returns, in the base currency of US dollars.
Chart 1
As you can see, the desmoothed returns are more volatile, providing a more realistic picture of the fluctuation in the value of the alternative assets. Over the 13-year period, the reported Alternative Index had an annualized return of 8.8% and a standard deviation (risk) of 6.2%. The desmoothed index had a similar return but a higher risk of 13.2%.
Risky Returns
Now that we have desmoothed returns, Chart 2 compares the return and risk of the alternatives to Canadian bonds and Canadian and U.S. stocks since 2008 (13 years), with all data in Canadian dollars.
Chart 2
In hindsight private equity was the best of the riskier assets in terms of its return versus risk. U.S. stocks were stiff competition, with a slightly higher return and significantly less risk than venture capital. U.S. stocks also had more return, with only slightly more risk, than secondaries and infrastructure. Canadian stocks and real estate had much lower returns and more risk than U.S. stocks. Looking at fixed income, private debt had almost twice the return of Canadian bonds, albeit with more than twice the risk.
As chart 3 below shows, returns and risks can change significantly when we use a different time period. Looking at just the last 10 years, real estate’s return increased and its risk decreased compared to the other investments. Secondaries and infrastructure also had a significant decline in risk, while still providing a robust return.
Chart 3
Dispersed Dispersion
So far, we have looked at the return and risk from an index perspective. Another way to look at return and risk is from a fund perspective. In Chart 4 below we compare the dispersion of returns between the top 25% of funds and the bottom 25% of funds, as well as the median return over the ten years to December 2020, all in Canadian dollars. Canadian bond and stock data is from the RBC Pooled Fund Survey. Alternative data is from PitchBook. Note that the returns between stock, bonds, and alternatives are not directly comparable. Stocks and bonds are time weighted returns and the alternatives are internal rates of return[6] for funds launched in 2010[7]. In addition, the bond and stock fund returns are pre fees, whereas the alternatives are after fees. Despite the difference in methodology the magnitude of the dispersion of returns still stands. The blue diamonds show the median fund returns.
Chart 4
What this chart tells us is that there is a lot more dispersion in the returns for funds invested in alternatives than for publicly traded bonds and stocks. I included U.S. equities again as most of the assets in the alternative indices are U.S. based. You can also see that the median U.S. equity fund return was competitive with alternatives. In addition, the difference between the top and bottom quartile funds in U.S. equities was small compared to the differences for the alternative funds. Given the return and risk numbers from prior charts, it is not surprising that private equity and venture capital had the biggest dispersion between the top and bottom quartile fund performance.
Portfolio Prescription
Based on the desmoothed returns and risk, alternatives such as private debt and private equity can be a good addition to your portfolio. However, alternative investments are not for everyone. You need the right risk tolerance, time horizon, liquidity, and portfolio size to meet minimum investment thresholds.
You now have some understanding of the work involved to create an “Alternative Reality” of desmoothed returns and fund dispersions that enables a fairer comparison of the returns and risks of bonds, stocks, and alternatives. So, it won’t be a surprise when I say it is a more complicated process to add alternatives to a standard bond and stock portfolio. You also saw from the dispersion of the alternative fund returns in Chart 4 that which fund you choose is important. To manage that risk, it is best to invest in more than one fund or fund manager. If you want to make alternatives a reality in your portfolio, I recommend that you utilize someone with the knowledge and experience required for the process.
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.
[1] Demaria, C, Pedergnana, M, He, R, Rissi, R & Debrand, S Asset Allocation and Private Markets: A Guide to Investing with Private Equity, Private Debt and Private Real Assets, John Wiley & Sons Ltd., West Sussex, U.K., 2021.
[2] Given the expertise, experience, and resources required to invest in alternatives the fees are much high than for publicly traded stocks and bonds. Fees usually comprise a management fee of 2% and a performance fee of 15% to 20% of the return over a certain hurdle rate, such as 8%. This results in all-in fees of 2% to 5% or more.
[3] The indices include all reporting funds during each quarter. The return calculations are based on the net asset values and cash flows during the quarter. For clarity, real estate includes core, core plus, distressed, opportunistic and value-added real estate.
[4] Note that the alternative indices are not actually investable. There is no fund or ETF that can replicate having a holding in all the funds in the index. There are ETFs which can replicate the bond and stock indices.
[5] See PitchBook Return Smoothing in Private Markets: Estimating the true volatility of private market returns
[6] The standard for reporting alternative returns is the internal rate of return (IRR). This is due to the time it takes (years) to invest the full capital commitment from the investor. The IRR measures the performance between two dates, including the effects from all cash inflows and outflows. The IRR is subject to potential manipulation by fund managers, as the size and timing of cash contributions and withdrawals affect the IRR. Time weighted returns remove the impact of the timing of cash contributions and withdrawals. They are the standard for public market indices.
[7] Like fine wine, the year that a fund is launched is called the vintage.