In investments, nobody wants stale numbers
Jaundre Scheltema, Client Solutions & Research, Sanlam, Investments.
Guy Fletcher, Client Solutions & Research, Sanlam Investments.
How to navigate the potentially murky world of alternative investments by Jaundre Scheltema and Guy Fletcher, Client Solutions & Research, Sanlam Investments.
Alternative asset classes such as private equity, infrastructure, real estate and unlisted credit have become increasingly popular amongst institutional investors and seem to be gaining ever more traction globally. In the US, alternative assets have become the #1 asset class in recent times, with allocations increasing from about 4% to around 20% for institutional investors over a 20-year period (Willis Towers Watson, February 2018). Locally too we’ve seen a similar trend amongst retirement funds.
Why all the hype? It would seem that alternatives have become a particularly attractive asset class primarily for their potential for superior risk-adjusted returns, access to a liquidity premium, and excellent diversification benefits, offsetting the relative complexities.
But, says Guy Fletcher, Head of Client Solutions & Research at Sanlam Investments, all is not as simple as would seem as regards the allocation to alternatives in the context of a balanced portfolio. If you want to build better portfolios, you need to go about it with scientific rigour and an explicit (robust) process. The reason for this, explains Fletcher, is that when you’re trying to build a balanced portfolio that consists of both traditional (listed) asset classes and alternative (unlisted) assets such as alternatives, you have to try and combine one relatively ‘perfect world’ of accurate valuations and market prices, with the slightly more obscure and ‘imperfect world’ of the unlisted market.
Where do the challenges lie?
Some of the common challenges encountered in the unlisted world include the fact that much of the information is not publically verifiable, information is shared selectively, pricing is quarterly and retrospective (so you don’t see the true picture), and because volatility is understated, you only see “smoothed” returns. We could call it a ‘statistical minefield’ that needs to be navigated with care.
But we’re far from deterring investors from going down the road of alternatives! To the contrary, we strongly support allocation to this attractive asset class for all the reasons listed above, but merely suggest you go about it with precision. We try to steer investors and their asset consultants away from naïvely allocating to alternatives by showing them how to use robust statistical techniques to combine the disparate worlds of alternative (unlisted) assets with their traditional (listed) counterparts. We do this specifically by adjusting for stale and infrequent pricing to reveal the unobserved volatilities and relationships, adjusting the estimations and, in so doing, building smarter portfolios.
What is stale pricing?
Stale pricing occurs due to the time lag between the actual valuation of an instrument and its representation or availability in the public domain. Generally, the market value of a listed instrument, such as equities, is available in real-time. However, the market value of an unlisted instrument (be it a private equity fund or a real estate property) is only available after a thorough assessment of relevant (and historic) facts, a review of non-public information, and a validation protocol (often requiring an auditor’s confirmation). Given that these actions are expensive and time-consuming, there is both a natural disconnect between actual value and published value, and a notable reduction in the frequency of appraisals – this is known as stale pricing. Because of this, the published valuations of alternative assets should not be directly compared to listed assets since their performance appears “overly smoothed”, and volatility is understated.
How to combine two disparate worlds
To date, the question of stale pricing in academic literature has been relatively sparse with the majority of the work done on real estate assets. Fletcher and his team interrogated and subsequently developed variations of the statistical techniques published in academic literature. In combining these disparate worlds, they devised an effective method that more accurately represents the true volatility of the fund and its relationship with the market. This also, and more importantly, reflects alternative assets’ significantly higher correlation with traditional assets than naively indicated, whilst adjusting for an implicitly higher actual volatility.
This then provides a rigorous basis for including alternative assets into traditional portfolios for institutional investors and their asset consultants.
