Kiran Kumar K V
Alternative investments have grown multifold as asset classes for aggressive, high net worth investors, offering a diversification, high-yield alternative in the portfolios. Alternative investments come with different risk parameters unseen in traditional investments. Due to their unique risk-return profiles, non-transparent portfolio and lack of marketability, they need to be understood from a completely unique methodology in terms of their risk analysis. Alternative investments are known to be heavy users of derivative and other risk management tools at times for hedging and also for speculation, the level of risk involved in their delivery of returns. The returns, in case of alternative investments, especially the ones which are managed by experts, like hedge fund managers are relied on individuals than systems.
Major Risks of investing in AI:
1. In case of Private Equity:
a. Investment Horizon
b. Lack of marketability
c. Under or non-performance
d. Leveraged positions
e. Non-recovery of fees
2. In case of Venture Investments
a. Investment Horizon
b. Lack of marketability
c. Early Stage Failure of Venture
d. Leveraged positions
e. Non-recovery of fees
3. In case of Hedge Funds
a. Under or non-performance
b. Lack of marketability
c. Leveraged positions
d. Non-recovery of fees
4. In case of Real Estate Private Equity
a. Investment Horizon
b. Lack of marketability
c. Under or non-performance
d. Leveraged positions
e. Non-recovery of fees
Hedge fund investors are exposed to portfolio level risks at each hedge fund they invest in, as given in below table:
The risks of investing in private equity portfolios have generally longer lock up periods. So investors’ exposure to risk is high. The funds are illiquid and non-transparent in nature. Traditional measures of risk and return like mean, standard deviation and the likes are not sufficient to manage the risks of investing and managing alternative investment portfolios. Moreover, historical returns data are not available in majority of the cases. The reported numbers may not be true to their actuals. And unlike traditional products, in the case of alternative investments, we do not have enough empirical evidences to prove that historical performance can be seen as predictors of future performance of the investment portfolios.
It is advised that investors, follow below precautions while choosing or constructing an alternative investment as a stand-alone portfolio itself or even as part of an existing all-asset class portfolio:
- Diversify across managers, as most alternative investment products’ performances rely on manager’s ability to generate alpha return
- Carefully analyze the reported performance numbers of the past or existing products.
- Know as much details as possible about the use of leverage by the manager.
- Performance fee structures need to be studied. Whether the fee charged is reasonable enough to justify the returns being discussed to be delivered
- The honesty of the company’s staff needs to be carefully reviewed
- The investment policy committee’s composition and experience as well as the impetus given to the involvement such committee in the process of whitelisting of securities need to be studied.
- The exit strategies of investments, including timing and realization price should be understood
- Independent valuation of illiquid underlying assets should be performed on a regular basis.
- Limits on security type, leverage, sector, geography, and individual positions should be well defined in the offering memorandum, and the positions should be carefully monitored by the manager and regularly reported to clients.
- A check in terms of presence of a CRO (Chief Risk Officer) needs to be carried out. Also, the extent to which he is independent of any influence by the business development team should be investigated.
REFERENCES:
An Introduction to Investment Banks, Hedge Funds, And Private Equity – David P Stowell
CFA Material Level -1, CFA, USA