Wednesday, May 18, 2016

Simple choices and asset allocation

Simplicity is an important starting point for problem solving.  A simple framework can be applied to asset allocation and the use of alternatives. An increase in alternative is related to the uncertainty of mixing a risky and safe asset. The idea of alternatives as a middle ground between risky and safe assets may shed some light on the reason why some large pension funds have cut their alternative exposure. 

Asset allocation is all about blending risky assets like equity with the safe asset of cash or bonds. If  the investor wants more return, he should allocate more to the risky assets. If the investor wants less volatility, there will be a higher allocation to the safe asset. The safe asset will have a low beta to the market portfolio and may actually have a negative correlation as is the current case with bonds.  

For some, this allocation decision is very strategic. For others, the risk allocation will change tactically. Th core problem is determining what should be the mix between the risky and safe asset, the allocation to assets correlated to "good times" and assets that will do well in "bad times". Unfortunately, this choice is not easy. Allocation to alternatives tries to reduce the problem of uncertainty through finding a "middle" beta with alpha to help with the shortfall of being wrong. 

Alternative beta exposures are somewhere between the risky asset and safe asset. There will be some alternatives that will have a higher beta closer to the risky asset and others may be closer to the safe bond. The expectation is that the alternative investment will have significant alpha to overset the carry from the safe asset.  

So why hold alternatives if can just balance between the risky and safe asset? The reason is simple. The alpha should be enough to offset the drag from the safe asset. The alpha helps offset the risk of getting the choice between risk and safe assets wrong. In the extreme, an investor will want to have all his money in the risky asset when the market is going up and all in the safe assets when the market is falling.  

If a pension fund believes that it can find the right beta through mixing traditional assets, it may not need alternatives. If the alpha from hedge funds falls, then the cushion from holding alternatives is diminished and they are needed less. As pension funds better measure the beta and alpha of hedge funds, they may conclude they can find a better beta mix with traditional assets.

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