Alternative Investments ... just scratching the surface

At this week's European Performance Measurement Forum meeting, we touched on the subject of alternative investments. We hear this term bandied about quite a bit; so much so, that it often causes one to grimace when they hear it, because of the fear it can invoke.

While this category can include credit default swaps, as well as other varieties of swaps and swaptions; futures, forwards, and options; along with commodities and fairly esoteric investments, such as guitars, watches, and artwork; it also is where we house [pardon the pun] real estate and private equity.

In the case of real estate and private equity, while we may not know all the answers, many of the rules are fairly well agreed upon. The GIPS(R) standards (Global Investment Performance Standards) after all includes rules specifically for these asset classes.

But there is a broad, make that very broad, collection of instruments for which the rules are less clear. And when we speak about rules, we must consider:

• Valuing the assets
• Deriving returns on the assets
• Measuring risk of the assets
• Determining how to handle them as part of our attribution
• and no doubt a lot more.

This is a topic that we will not attempt to address quickly, as much time is needed for it. Hopefully, we will be able to provide guidance on much of what is faced in the industry today. And so, stay tuned! In the mean time, if you have ideas or questions, please pass them along!

Private equtity attribution

I'll be teaching a class for a client later this month who asked for some specific topics to be included, one of which is private equity attribution. The challenges with private equity are:

1. They typically don't have indexes, so we can't use relative attribution
2. They use IRR, not TWRR, since the manager controls the cash flows.

And so, what is a private equity manager to do if they want attribution? The answer is simple: absolute attribution (aka contribution)! We can utilize IRR at all levels and reconcile to the overall return. We calculate our sector returns, for example, using IRR; calculate their weights, taking cash flows into consideration; and simply multiply the weights by the individual returns. Their sum should tie out to the overall return. For example:

We can see how each sector contributed to the overall return. And just like hedge fund attribution, we can slice up our private equity portfolio in countless ways (e.g., by industry, subsector, country). Does this not make sense? Thoughts?