Wednesday, April 29, 2020

Alternative investments - Return dispersion is costly

Dispersion can be function of misclassification. When things are wrongly bundled, there will be a greater dispersion. However, dispersion can also be related to differentiation in skill. If there is a wide dispersion in ability, there will be a wide dispersion in results. Of course, in a market economy, those with poor skill should be dropped from the performance set through failure. In the long-run that will be true, but in the shorter-run there may be inertia with firms leading to failure. 

What the CAIA chart for a given year shows is that some \investment sectors will have more return dispersion than others. You get paid for finding winners in alternatives. You don't get paid much for searching for winners in public fixed income. 

Using a benchmark or median firm is not that costly in terms of leaving money on the table by not finding the top quartile firm or by picking the wrong firm who falls in the bottom quartile. The penalty for being wrong or suffering from regret is higher for private equity or venture capital. More due diligence time and effort have to be placed in the alternative investment sectors. Choosing the average firm does not buy you much for performance. Investors have to go big on due diligence or go home.   

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