Institutional investors are shifting billions of dollars into alternative investment strategies, but figuring how much to allocate to areas such as hedge funds, private equity and real estate is a conundrum for most.
Some institutions such as TIAA-CREF, Morgan Stanley and Citigroup Alternative Investments, all based in New York, are wrestling with ways to make alternatives allocations. But observers believe nobody has come up with the perfect solution.
The problem: Left unconstrained, the traditional mean-variance optimizer — which institutions use to set their asset allocations — spits out high allocations to alternative investments, and none to traditional stock and bond investments.
"If you just follow the optimizer, you'd just have a portfolio combining hedge funds, private equities, timber and a little bit of commodities, for icing," said Stephen Nesbitt, chief executive officer at Cliffwater LLC, Marina del Rey, Calif., a consultant on alternative investments.
The optimizer, which stems from Nobel Laureates Harry Markowitz's and William Sharpe's work on portfolio theory, works well with traditional stocks, bonds and cash. But the tool fails when it comes to alternatives because historical data are scarce on these asset classes. As a result, the optimizer tends to understate risk and overstate diversification benefits.
"The reason is that risk is very hard to measure in these asset classes. It's really just a true bear of a problem," said Richard Michaud, president and chief investment officer of New Frontier Advisors LLC, a Boston-based research and investment advisory firm that specializes in asset allocation issues.
That's why most institutional investors constrain the optimizer. They might cap their allocation to private equities at, say, 10% of total assets, or hedge funds at 5%. While pragmatic, this practice has little intellectual rigor.