Issues in Performance Appraisal | CFA Level I Alternative Investments
Welcome back! In this final lesson, we’ll discuss performance appraisal issues for alternative investments. Let’s dive in!
Characteristic Issues and Manager Issues
Alternative investments can be attractive for their diversification benefits and higher expected returns. However, they come with unique risks:
1. Characteristic Issues:
- Lack of transparency: Hedge funds and private equity funds are less transparent than traditional investments, making it harder for investors to manage diversification and conduct due diligence.
- Illiquidity: Many alternative investments are illiquid, and returns should include a premium to compensate for this liquidity risk.
- Derivatives: Some alternative investments use derivatives, which introduce operational, financial, counterparty, and liquidity risks.
- Leverage: Hedge funds and private equity funds often use leverage, which can amplify both gains and losses.
2. Manager Issues:
- Manager performance: The performance of some alternative investments is highly dependent on management expertise and execution.
- Manager fees: High fee structures can drag down actual returns for investors.
Measuring Risk-Adjusted Return
Measuring risk-adjusted return is crucial in performance appraisal. Some common measures include:
- Sharpe ratio: Excess return per unit of risk, with risk measured as standard deviation of returns. However, standard deviation may not always be the best measure of risk.
- Sortino ratio: Uses downside deviation instead of standard deviation as a measure of risk, focusing on the left side of the return distribution curve where losses occur.
- Treynor ratio: Uses beta as a measure of risk, accounting for diversification benefits from low correlations with returns of traditional investments.
- Calmar ratio: A quick estimation of risk-adjusted return, calculated as average annual compound return divided by maximum drawdown.
These measures have their limitations and may require extensive historical returns data.
Return Calculation for Private Equity and Real Estate
Calculating returns for private equity and real estate investments can be challenging due to their unique cash flow patterns. The internal rate of return (IRR) should be used as an appropriate measure of manager competency in these cases.
EXAMPLE
Project A: initial investment of $3M,
Project B: a year later at $5M,
Project C: another year later at $2M.
At the beginning of year 4, project B sold for $7M, project C sold for $4M a year later, and project A finally sold at the beginning of year 6 for $9M. The IRR of the fund would be 18.06%.
Now you’ve learned about performance appraisal issues for alternative investments. Be sure to understand the unique strategies and fee structures, and know how to calculate them. Good luck!
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