Appropriate Policy Allocation for Alternative Investments

Abstract

One of the greatest problems institutional investors face in evaluating alternative investments such as venture capital, real estate, and hedge funds is determining the normal or policy allocation. The typical approach relies on single-period optimization programs, using historical data as key inputs. This is subject to problems such as enormous allocations to private equity and other non-market-priced investments. Instead, the authors use a factor approach to build a consistent set of return and risk characteristics for conventional and alternative asset classes alike. Simulation techniques rather than optimization provide better insight into the characteristics of the portfolio over time as market swings and liquidity constraints force divergence from the desired policy mix.