Why should I choose AnalystNotes?

Simply put: AnalystNotes offers the best value and the best product available to help you pass your exams.

Subject 1. Issues in Performance Appraisal PDF Download

Alternative investments are only as good as their performance ratios. Conducting performance appraisal on alternative investments can be challenging because these investments are often characterized by asymmetric risk-return profiles, longer time horizons, unique patterns of cash flows, limited portfolio transparency, illiquidity, product complexity, and complex fee structures.

Achieving portfolio diversification and reaping alpha are the end goals of many investors. However, traditional risk and return measures (such as mean return, standard deviation of returns, and beta) may provide an inadequate picture of alternative investments' risk and return characteristics. Moreover, these measures may be unreliable or not representative of specific investments.

Common Approaches

There are several performance ratios that investors can use to evaluate alternative investment opportunities. These are not included in this year's reading and were widely discussed in previous years'. We include them here for your reference.

Sharpe ratio is the industry standard for measuring the risk-adjusted return of an investment. It is the average return earned in excess of the risk-free rate per unit of volatility, or total risk.

Limitation: The Sharpe ratio uses the standard deviation of returns in its formula as a proxy of total portfolio risk. It assumes that the returns are normally distributed. However, alternative investment returns do not tend to be normally distributed.

The Sortino ratio is a modified version of the Sharpe ratio that measures a risk-adjusted performance that only penalizes returns that fall below a target rate of return. Since the Sortino ratio does not use the standard deviation, it adjusts the performance for risk by only using the downside risk/deviation. It is especially helpful when investors are analyzing asset classes and portfolios that are highly volatile, since the ratio focuses on whether returns are negative or below a certain threshold.

Limitation: it fails to consider the correlation of alternative assets with the traditional assets, and thus fail to include the alternative investments' diversification potential.

The maximum drawdown (MDD) refers to the maximum loss recorded from the peak to the trough of a portfolio before another peak is reached.

  • The Calmar ratio is the ratio of the average maximum return of a portfolio to its maximum drawdown risk. The higher the Calmar ratio, the higher, the better (worse) the performance of a risk-adjusted portfolio over a particular period of time.
  • The MAR ratio is a type of Calmar ratio that uses the entire investments history and the average drawdown.

Private Equity and Real Estate Performance Evaluation

Private equity and real estate investments often have variable cash flows/profits, depending on the investment stage. The term J-curve is used to describe the typical trajectory of investments made by a private equity firm. When a private equity commitment is made, the value of the commitment typically goes down during the early life of the fund. The initial decline in performance is followed, at least theoretically, by a steep improvement in performance. The real estate pathway is similar to the J-curve effect.

Timing of cash flows is an important part of investment decision process. The IRR is often used to evaluate these long-term investments.

MOIC (Multiple of Invested Capital) is a quick indicator of the return on the investment: MOIC = (Realized Value + Unrealized Value) / Total Dollar Invested. For example, if I invested $100 and my total value is $500, the MOIC is 5x. MOIC's simplistic calculation clearly tells investors how much money they're ultimately receiving from an investment.

Time is not factored into the MOIC calculation. Two deals with an MOIC of 5x have the same return regardless of when they achieve it. MOIC is a quick, easy measure that does not involve time-weighted calculations.

The cap rate is often used to evaluate real estate investments.

Many PE funds appear to have low volatility, This is because accounting conventions may simply leave longer-lived investments marked at their initial cost for some time until known impairments begin to transpire. As they are not easily marked to market, their returns can appear somewhat smoothed.

Hedge Funds

Hedge funds:

  • Leverage must be considered when evaluating hedge funds.
  • If the hedge fund has invested in thinly-traded small-capitalization stocks, liquidity can be a concern: which price should be used for valuations?
  • Redemption rules, lockup periods, and timing differences in reporting can bring special challenges to performance appraisal of alternative investments.

User Contributed Comments 0

You need to log in first to add your comment.
You have a wonderful website and definitely should take some credit for your members' outstanding grades.
Colin Sampaleanu

Colin Sampaleanu

My Own Flashcard

No flashcard found. Add a private flashcard for the subject.