Asset allocation to alternative investments
On this page, we discuss a commonly used approach for determining an appropriate asset allocation to alternative investments. In particular, we follow a simple two-step process:
- We perform the asset allocation using only traditional assets
- We perform asset allocation and also consider the alternative investments.
This process can be assisted by the following set of statistical tools:
- Monte Carlo simulation
- Mean-variance optimization
- Risk factor based optimization
These three statistical tools can be used individually or in combination. Regardless of the statistical approach chosen, an investor must consider the statistical properties of the alternative investment returns that distinguish them from traditional asset classes. Failing to incorporate these properties will tend to lead to an overallocation to alternative assets.
Modelling alternative investments
Let’s discuss the different approaches that can be used to model alternative investment returns and that allow us to subsequently perform asset allocation with the resulting returns:
- Monte Carlo simulation: this first approach consists of determining the set of the set of variables to be simulated, deciding on the statistical distribution of each variable and finally to generate many sample paths. The asset class return scenarios can then be used to develop asset allocations.
- Mean-variance optimization: since illiquid investments tend to exhibit low correlations and lower standard deviations, we should first correct the returns by de-smoothing the returns. Alternatively, we may also need to constrain the allocation to alternative investments or limit the overall volatility or downside risk. When using mean-variance optimization in combination with alternative investments, we should view the results as a guideline rather than a prescription.
- Risk-factor based optimization: this approach is similar to mean-variance optimization. Here we model the risk factors and risk return expectations of alternative investments. Finally, we need to translate the optimal risk factor exposures to an allocation to alternative investments.
We discussed three statistical tools that investors can use to perform a two-step approach to asset allocation to alternative investments.