Introduction

Best Practices: Improving Models of Risk and Return

• The research paper, Demystifying Illiquid Assets: Expected Returns for Private Equity, discusses the growing interest in private equity, and the need for asset managers to carefully evaluate its risk and return of investments. Because there is a lack of good, quality data and smoother returns, its is difficult to model a straightforward private equity strategy. This paper works to make clearer the subject of forward-looking analysis by presenting more comparable benchmarks or suitable adjustments for evaluating past performance, and a yield-based framework to estimate future returns.
• For institutional investors trying to calibrate asset allocation, decisions for private equity should use the framework for expected returns that is based on a discounted cash-flow framework, similar to what is used for public stocks and bonds. One big challenge to using this approach is that calibrations are hampered by data restrictions (discussed further in the annual Capital Market Assumptions edition of AQR Alternative Thinking), and highlights how to assess private equity’s realized and estimated expected return. The analysis suggests that private equity does not offer an attractive net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective.
• Additionally, theoretical or risk-based explanations for asset returns follow the premise that higher returns that compensate investors requires taking on additional risk. If private equity has greater exposure than public equity to certain risk factors that have positive expected returns, it is expected to have both higher risk and return. Based on economic intuition and empirical evidence, private equity should have the following factor tilts over public equities: equity risk, (illiquidity premium, size, and value).

• The research Paper, Illiquidity and Investment Decisions: A Survey suggests, illiquid assets provide higher returns and interesting diversification alternatives for asset managers. Portfolio investment decisions when assets differ in degree of liquidity, can be complementary in nature to risk and return. An asset or an asset market is liquid if trades take place, with relatively short notice, and in large quantities without a substantial price change. The article's goal is to provide asset managers with answers to practical questions relevant to investment decisions concerning illiquid securities.
• A coherent and methodological approach to handle the scope of asset illiquidity involves using the existing portfolio framework (Capital Asset Pricing Model- example the Black-Litterman model) with an emphasis on practical implementation. The premise is based on whether assets with different levels of illiquidity will earn different returns. The goal is to assess whether illiquidity is a significant criterium to determine portfolio performance, i.e. is it a priced source of risk distinct from previously identified factor risks.
• One of the strategies mentioned suggests, that if market conditions change considerably to render initial asset allocation less efficient, investors can improve the portfolio risk-return trade off by tilting initial allocation towards the optimal one to account for new market conditions. Due to large swings in illiquidity premia (the additional compensation required by investors to hold illiquid instruments), to substantial mark-to-market losses on fair-valued instruments, as liquidity conditions can deteriorate quickly, it is potentially disadvantageous because investments may require a realigning to offset the effects of different returns on various asset classes. Transactions are not cost-free, and investment managers need a strategy to determine when realigning should be undertaken.

• The research paper, Illiquid Assets and Capital-Driven Investment Strategies suggests, that the risk-based nature of solvency creates an opportunity for asset managers to play a more strategic role in asset management. The strategy uses a simple fixed annuity liability to provide a case study of how asset strategies can be appraised in a risk-based and economical way.
• Two capital-driven metrics were considered — one to calculate expected return on capital employed, and a second economically-sophisticated measure considers access to liquidity premiums as a source of shareholder value in illiquid liability business, and the capital cost required to support the business as a major shareholder cost. Each metrics strategy produced relatively similar behavior across different asset classes highlighted in the paper, implying that more alternative asset classes could be a better fit in the economics of long-term illiquid liability business- as potential sources of risk diversification, and better monetization of the liquidity surplus carried on business balance sheets.
• The challenge with these strategies is that any generic quantitative analysis of unusual, heterogeneous asset types must be carefully watched. Potential problems lie in discovering how the Solvency SII standard formula treats these asset classes, which assets will qualify for a matching adjustment, what the likely liquidity needs of an annuity business will be, and how unavoidable trading costs impact holding period returns.

Research Strategy