Why alternative investment performance is hard to judge

Why can’t you compare an alternative fund with a stock index the usual way?

A stock index is easy to compare against because everything about it is standard. Alternatives are customized, and four features break the usual comparison: when money goes in and out, borrowed funds, how positions are valued, and the fee arrangement.

	Public stocks and bonds	Alternative investments
Claim	standardized, identical claims	customized, one of a kind
Prices	continuous, quoted	infrequent, often estimated
Capital	pay once, no further calls	committed up front, called over time
Peers and index	large peer groups, common benchmarks	few peers, no obvious benchmark
Return shape	close to normal	usually less normally distributed

The performance appraisal of alternatives therefore needs more scrutiny. Because the return distribution is usually less normal, the risk and return measures built for stocks and bonds fit less well.

What four things should you check?

When you appraise an alternative investment, look at four areas in turn: where the investment is in its life cycle, how much borrowed money it uses, how its assets are valued, and how it charges fees. The rest of this module takes each in turn: life cycle and valuation here, leverage in the third lesson, fees in the fourth and fifth.

Alternative investment performance appraisalpublic securities have continuous prices, standard claims and big peer groups; alternatives have none of these by default

• Life cycle phase Memorize cash flows in and out at irregular times
• Use of borrowed funds Memorize leverage magnifies gains and losses
• Valuation of positions Memorize often model-based, not market prices
• Fee structure Memorize complex, and different investors pay differently

Taxes and accounting treatment also differ from ordinary securities. Over long holding periods the tax treatment can change after-tax results by a meaningful amount.

What is the investment life cycle and the J-curve?

The investment life cycle of an alternative investment is longer than that of a stock or bond and runs through three phases with different cash flow patterns. These phases are what make a period-by-period comparison unfair: the same fund looks very different depending on when you measure it.

Memorize

Investment life cyclelonger than for stocks and bonds; returns trace a J

• Capital commitment Memorize manager selects deals and calls capital; fees start; returns negative
• Capital deployment Memorize money is put to work and assets are improved; outflows still exceed inflows, but returns start to climb
• Capital distribution Memorize assets mature and are sold, cash goes back to investors; returns accelerate, then level off

During capital commitment , the manager picks deals and calls capital, either at once or later, and may invest in an early-stage company (venture capital), a mature firm (private equity) or properties (real estate). Fees and expenses start straight away, while the assets earn little or nothing, so returns are negative.

During capital deployment , the manager puts the money to work: building or improving properties, turning a company around, or launching a start-up. Cash outflows still exceed inflows and management fees continue to weigh on returns, but as the investments take shape the return line turns and starts to climb.

During capital distribution , the plan has worked: assets have appreciated or are producing income above their costs, and the fund sells them, perhaps through an initial public offering or a property sale. Returns accelerate, then level off as cash goes back to investors and the fund closes.

The path that results resembles the letter J: negative returns during commitment, a climb that gathers pace as the investments mature, and a leveling off as capital is distributed and the fund closes. That is the J-curve effect .

A fund’s early losses are therefore not evidence that it is a bad fund. To compare funds fairly, compare those with the same vintage year , which is the year of first investment. Then both are in the same phase. Annual returns or returns since inception for the same vintage year give the most accurate comparison. Lockups and illiquidity also mean an investor often cannot sell after seeing weak results.

Exam tip If a question shows negative returns for a young private equity fund, the J-curve is the answer. If it shows a smooth path for an illiquid fund, think valuation.

Go deeper Why IRR is the usual starting point

Because cash goes in and out at different times, and the manager controls when capital is called and returned, the internal rate of return (IRR) is the usual first measure for private equity and real estate. It uses the timing and size of every cash flow, including tax effects. Its assumptions (a financing rate for outflows and a reinvestment rate for inflows) are covered in the next lesson and in the Corporate Issuers topic.

How are alternative assets valued, and why does that smooth returns?

Accounting rules require investments to be recorded at fair value : the price market participants would use to exchange the asset in an orderly transaction at a specific time (the exit price for a seller). The inputs used to get there follow a three-level fair value hierarchy .

Fair value inputshow observable the inputs are

• Level 1 Memorize quoted prices for identical assets, such as listed shares
• Level 2 Memorize other observable inputs, such as an over-the-counter swap priced from market rates
• Level 3 Memorize unobservable inputs and models, such as private equity and private real estate
  • Values stay near cost and move slowly returns look smoothed
  • Reported volatility and correlation are understated needs more due diligence

Public stocks and bonds are mostly Level 1. Private equity and private real estate rely on Level 3 inputs : cash flow projections and other models with assumptions that cannot be observed in the market.

This matters for performance. Once a fund has drawn its capital and no cash is moving in or out, there is little new market information, so accounting values can sit at or near cost and change only on an impairment or a sale. The result is return smoothing : reported returns look steadier than the underlying value really is, and the volatility of returns and their correlation with other assets look lower than they would be if the assets were sold. A more realistic picture can appear if a manager is forced to liquidate early.

A model may reflect a theoretical value rather than what a buyer would actually pay. A manager should therefore have the model independently tested, benchmarked and calibrated to accepted standards, and should document in-house valuation procedures and apply them consistently, because conflicts of interest can affect estimates. As a rule, any vehicle with a lot of Level 3 assets deserves extra scrutiny and due diligence.

Go deeper The fees point in one paragraph

The fourth check is covered in detail later. The key idea for appraisal is that two investors in the same fund can earn different net returns. An investor who commits more capital early, or accepts tighter redemption limits, may pay lower incentive fees. An investor who enters after a sharp drop can owe fees on the recovery, while an earlier investor who suffered the drop may owe none for the same period.