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| Risk & Reward: Strategy |
The Holistic Approach
John Ferry
10/01/2005
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Leo Thomas Schrutt has spent decades contemplating investment markets. But in
the past several years, as private investors have embraced hedge funds and
other illiquid assets, the head of group investment research at Julius Baer in
Zurich has had cause to ponder not just the markets themselves, but also on how
investors view them. He is not happy. “I go to these conferences and hear hedge
funds treated as an asset class,” he says. “But this is a major
mistake.”
TOP VIEW
Illiquid assets such as hedge funds, private equity and real estate are
difficult to analyze alongside traditional asset classes such as traded stocks
and bonds, making it hard for an investor to decide how to best allocate capital
to the various investments. In fact, wealth advisors trying to apply the
standard tool of portfolio construction—called modern portfolio theory—to these
unwieldy assets often find that it leads to incorrect and occasionally absurd
outcomes. To address this difficulty, experts are trying to develop academically
sound frameworks to help wealth advisors determine how to allocate their
clients’ capital among liquid and illiquid investments in order to have the best
chance of attaining their goals. Though some claim to have made progress in this
endeavor, the fact remains that for now, these efforts are as much art as
science. |
Schrutt argues that, by definition, constituents of an asset class
should display homogenous characteristics in terms of returns, risk and how
closely they track one another. “But if you look at hedge funds, there are huge
differences,” he explains. “An equity long-short strategy has nothing to do with
a global macro.”
This is one of the major difficulties investment advisors
face when trying to integrate illiquid assets into an investment portfolio.
Products such as hedge funds, private equity holdings and even real estate are
so iconoclastic that it is very difficult, if not impossible, to find measurable
characteristics that can be used to analyze them in the context of a broader
portfolio. Even so, a number of wealth advisors have attempted to tackle this
issue and develop strategies for analyzing these assets in a meaningful way.
“We stepped forward a few years ago to develop a process that would place
these assets in a rational and academically sound framework,” says Larry Tekler,
Los Angeles–based managing director with Citigroup Private Bank. Tekler is
referring to Citi’s Whole Net Worth Asset Allocation program, which uses the
latest quantitative techniques to analyze both liquid and illiquid investments.
Accounting for illiquid assets within a portfolio is crucial to appropriate
portfolio decision making, but it is by no means easy. Despite this, private
investors have pursued illiquid asset classes with gusto, either to boost
returns or to reduce their portfolio risk through diversification. “Typically,
clients will be looking for somewhere between 4 to 6 percent added returns to
compensate for the lack of liquidity,” says Doug Wurth, managing director in
charge of the investment solutions group for clients in Europe, the Middle East
and Africa at JPMorgan Private Bank in London.
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