Alternative Investments: Liquidity, Valuation Issues, and Alternative Benchmarks

Alternative Investments

Alternative investments have been growing in popularity in the last few decades: an increasing number of investors include hedge funds, private equity, or commodities in their portfolios. Compared to traditional investments like stocks and bonds, alternative assets have some different characteristics. Some of the unique features make the decision making and investment management process more complicated with alternative investments.

Most Alternative Assets Have Low Liquidity

Compared to publicly traded stocks, most types of alternative assets have much lower liquidity. It is much easier to sell shares in Microsoft than shares in some privately held firm or a piece of forest in Brazil. Low liquidity goes hand in hand with transaction costs. Besides higher spreads you often need to pay various administrative and legal fees.

From the traditional financial theory point of view, lower liquidity is one of the reasons why alternative assets should provide a higher return on investment (as a premium for illiquidity).

Alternative Assets Are Difficult to Value

Because many real estate and private equity transactions are non-public in nature, it is difficult to collect the data and track the “last” market price. Some assets (e.g. real estate or infrastructure projects) are so unique that it is impossible to find other assets and other transactions which would be similar enough to be used as reference in valuation.

Serial Correlation in Alternative Investment Returns

Under these circumstances valuation is often subject to appraisals, “expert opinions” or theoretical valuation models, which may be far from reality. It has been proved that returns of real estate and private equity investments show serial correlation, which probably results from the imperfect appraisals – price movements are smoothed a bit and the investments appear to have lower volatility (and therefore higher risk adjusted return).

Weaknesses of Alternative Investment Benchmarks

When you invest in liquid publicly traded stocks, it is easy to compare your performance to a stock index, e.g. S&P500 or EuroStoxx50. You have a variety of indices to choose from, based on your geographic or sector focus. With government bonds issued by big countries and more liquid corporate bonds you can also find a suitable benchmark quite easily.

It is much more complicated when you invest in private equity, real estate, or hedge funds. While there have been efforts in the last years to create benchmarks for various types of alternative assets, these benchmarks are far from perfect, as they can’t fix the common issues of valuation and performance measurement of some alternative assets. Besides the above mentioned difficulty of appraisals of private equity and real estate investments, hedge fund indices have weaknesses too – they suffer from various biases, e.g. self-selection bias, backfill bias, or survivorship bias.