Alternatives

Net-of-fees projected 5-year returns and risk for alternative asset classes

Sector

Sector

Equilibrium Return (%)

Equilibrium Return (%)

5-Year Expected Return USD (%)

5-Year Expected Return USD (%)

10-Year Expected Return USD (%)

10-Year Expected Return USD (%)

Standard Deviation (%)

Standard Deviation (%)

Sector

US Real Estate (unlevered)

Equilibrium Return (%)

6.2

5-Year Expected Return USD (%)

4.9

10-Year Expected Return USD (%)

5.6

Standard Deviation (%)

9.0

Sector

Hedge Funds (Low Vol)

Equilibrium Return (%)

5.2

5-Year Expected Return USD (%)

3.9

10-Year Expected Return USD (%)

3.9

Standard Deviation (%)

4.3

Sector

Hedge Funds (High Vol)

Equilibrium Return (%)

5.8

5-Year Expected Return USD (%)

4.5

10-Year Expected Return USD (%)

4.6

Standard Deviation (%)

7.4

Sector

US Private Equity

Equilibrium Return (%)

10.0

5-Year Expected Return USD (%)

7.7

10-Year Expected Return USD (%)

8.0

Standard Deviation (%)

24.0

Sector

Global Private Equity (Unh)

Equilibrium Return (%)

10.0

5-Year Expected Return USD (%)

9.1

10-Year Expected Return USD (%)

9.5

Standard Deviation (%)

24.5

Sector

Infrastructure (Unhedged)

Equilibrium Return (%)

6.6

5-Year Expected Return USD (%)

6.2

10-Year Expected Return USD (%)

6.5

Standard Deviation (%)

17.1

We model alternatives on a case-by-case basis. Some of them—private equity, for example—can be viewed as a straightforward extension of equities. Others, like hedge funds, are very idiosyncratic and are based on cash-plus models. By definition, private markets in real estate, equity and credit have less data to work with than public markets. However, enough history of these investments has accumulated to allow for some understanding of the relationships to public markets from which we can make some crude estimates of return.

The most well understood alternative market is real estate. The long run performance of unlevered property falls between stocks and bonds in both return and risk. Although good data for the US exists going back into the 1980s, it is still based on appraisals and some careful analysis is needed to develop proper risk characteristics2

Thus, for unlevered real estate we expect returns in the 5.0% range and with leverage it is possible to see returns in the 6.5% range. We also see some pressured markets outside the US, after years of steady returns and above-average performance; we temper our expectations and expect mid- to low-single-digit returns. 

For private equity, we assume that the performance of partnerships has an equity beta around 1.8 to 2.03.  This translates to a risk premium around 2.5% over large cap stocks, which we apply in modeling private equity returns. Thus, for US private equity we expect returns in the high single digits, but not on par with some of the touted returns of the past. To illustrate this difference, compare the five- and 10-year expected standard deviation shown in Exhibit 9 above with the reported performance of alternative assets shown in Exhibit 27 (page 38).

Theoretically, hedge funds are pure alpha plays with little to no beta exposures. In practice, we see a significant correlation to the equity markets (the quarterly data for various hedge fund indices are 0.7 to 0.8). We believe that well-constructed, well-diversified hedge fund portfolios can have volatilities in the 4.0% to 5.0% range (this is our Low Vol assumption), while more aggressive portfolios will be around 7.4% (High Vol assumption). We set the returns relative to cash and apply a constant risk premium over time.

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