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| Risk & Reward: Strategy |
The Holistic Approach
John Ferry
10/01/2005
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“There’s definitely an art to
this,” Wurth adds. “If you let the models run by themselves, then they may come
out with very impractical results, such as 100 percent of the portfolio should
be invested in hedge funds, because from a historical perspective they seem to
have attractive risk and return profiles. Or, because of liquidity issues the
model could come out with a zero allocation to alternatives, depending on how
much of a discount factor you put in for illiquidity.”
Because illiquid assets are now so important to private
investors, leading financial institutions are working hard to devise methods for
integrating assets within a traditional portfolio. Citigroup Private Bank’s
experts worked in conjunction with finance professor Rui de Figueiredo from the
University of California, Berkeley, Haas School of Business to come up with a
framework that they say greatly improves the asset allocation process. Citi’s
analysts attempt to improve the reliability of the data they use by, for
example, “unsmoothing” returns data. They do this by using their own complex
financial models to create an optimized portfolio, but one that is optimal not
just in terms of risk and return (and therefore diversification), but also in
terms of certain idiosyncratic characteristics, or biases, typically displayed
by illiquid assets.
Dealing with non-normally distributed asset behavior is
another challenge. The return probabilities are often biased on the positive or
negative side. Financial analysts refer to these asymmetric distributions as
showing “skewness.” Illiquid assets also often display kurtosis, which means
that the probability of realizing some extreme return (either positive or
negative) is greater than it would be for normally distributed assets. “When we
optimize, we look at the trade off between volatility, returns, skew and
kurtosis,” Tekler says. “So if you have an asset class with a lot of negative
skew, let’s say, then you may want to add an asset class that can help offset
that with positive skew.”
Taking account of these additional factors
associated with illiquid assets can lead to some unconventional recommendations,
as Tekler points out. “Take real estate,” he says. “Many investors would look at
a real estate portfolio and say they want to offset it with bonds, because bonds
are pretty safe and liquid. But actually bonds are susceptible to some of the
same economic factors as real estate interest rates. We would look at that and
say real estate has negative skew, and so a good offset for that would be
something with positive skew, and private equity has positive skew.”
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