Alternative Investments in the Institutional Portfolio

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r e s

e a r c h

Alternative Investments in theInstitutional Portfolio

Updated Summer 2000

By

Thomas SchneeweisProfessor of Finance, University of Massachusetts

Richard SpurginAssistant Professor of Finance, Clark University

Vassilios N. KaravasPh.D. Student in Management Science, University of Massachusetts



‘Alternative Investments in the Institutional Portfolio’, Schneeweis, Spurgin, Karavas (AIMA, 2000)2

Over

Overview

In recent years, the flow of funds into alternative investments for pension funds, endowments and

foundations has experienced a dramatic increase. For the largest pension fund and endowments, the GoldmanSachs/Frank Russell survey [2000] reported that strategic allocation to alternative investments (defined primarilyas venture capital, leveraged buyout, and mezzanine financing) increased from 6.3% in 1996 to 7.3% in 1999and is expected to increase to 8% by 2001. However, other alternative investment vehicles, such as hedgefunds and managed futures, have also witnessed an increase in investment. Unfortunately, the very fact thathedge funds and managed futures have only recently come into prominence during the last decade, has meantthat they generally have only recently been considered as substitutes or as additions to other more “traditional”private equity based alternative investment forms.

This study provides an analysis of the risk and return benefits of hedge funds and managed futuresinvestments, along with other principal “traditional” alternative investment assets (e.g., real estate, private

equity, private debt, commodities) when considered as part of an investor’s overall portfolio. Both traditionalMarkowitz efficient frontiers with and without investment restrictions as well as the risk and return performanceof portfolios constructed from adding alternative investments to established U.S. stock and bond portfolios areevaluated. The Markowitz efficient frontier determination is conducted using alternative methods of risk andreturn forecasting, including:

1) historical returns, and2) the construction of ex ante return forecasts in which expected returns are based on their historical

return to risk relationship; that is, ex ante return forecasts are constructed from cross-sectionalOLS regressions of historical return on historical variance are used as inputs into the Markowitzportfolio optimization model.

The latter approach reduces the impact of historically high (low) abnormal returns from influencing the allocationprocess.

The results from this analysis support previous results [Schneeweis and Spurgin, 1998b] which showedfrom historical data, the benefits of managed futures, hedge funds, and traditional alternative investments asadditions to stock and bond portfolios as well as the benefits of adding various managed futures, hedge funds tomixed portfolios already containing investments in stock, bond, commodity, real estate, private equity andprivate debt. Analyses of the Sharpe ratios of various efficient frontier portfolios indicate that depending onvarious assumed constraints, such as required stock and bond investment, that an allocation of at least 10-20%to both traditional alternative investments and managed futures and hedge funds may be deemed appropriate.1

As important, using various methods of ex ante return forecasts consistent with the underlying risk (e.g.,

variance based return premia), results show that alternative investment vehicles must be included withtraditional stock and bond investment to obtain the maximum risk and return benefits. Thus traditional stock andbond investment must be supplemented with managed futures and hedge fund products as well as moretraditional alternative investments such as commodity investment and private debt or equity investment toobtain the maximum risk and return benefits. Lastly, risk and return relationships between traditional andalternative investments in periods of extreme return movement in a traditional stock/bond portfolio are

1 For various means to test for significant differences in Sharpe ratios see FAJ, May/June 1997.



‘Alternative Investments in the Institutional Portfolio’, Schneeweis, Spurgin, Karavas (AIMA, 2000) 3

described. Results show the importance of considering the expected market conditions when deriving assetallocations.

Introduction

Alternative Investment Vehicles in Institutional Money Management

In recent years, considerable theoretical as well as empirical research has been conducted, which hassupported the inclusion of a wide variety of alternative investment classes, in addition to stock and bonds, aspart of investors’ total investment portfolio. Academic research has provided theoretical arguments that due tovarious market imperfections in information, market liquidity, and the like, alternative investments, such asprivate equity, private debt, real estate, may offer unique risk and return opportunities not easily availablethrough traditional asset investment [Schneeweis et al., 1998a]. In addition, recent academic research has also

indicated that market conditions may exist which permit various forms of investing common to hedge funds andmanaged futures to provide unique return scenarios [Silber, 1994; Brush, 1997]. Lastly, even commodityinvestment may offer returns not easily accessible through traditional stock and bond investment [Schneeweisand Spurgin, 2000].

For instance, Schneeweis and Spurgin [1998c] examined various multi-factor models in describing thereturn performance of a wide variety of mutual funds, hedge funds, and commodity trading advisors (CTA). Intheir study, the impact of market factors (index returns, absolute value returns, and intramonth standarddeviation) designed to capture CTA/hedge fund trading opportunities (e.g., arbitrage, overvalued markets) andtrading styles (technical or fundamental) on forecasting of CTA and hedge return performance are assessed.Since various managed futures and hedge fund investment strategies (e.g., market neutral, short selling) areexpected to capture both upside and downside return potential in the underlying asset markets, theperformance of the absolute value as well as the nominal value of existing cash (e.g., government bondposition) and futures-based commodity indices (e.g., GSCI) are used as determinants of managed futures andhedge fund returns. The results of that analysis indicated that hedge funds and managed futures strategies mayprovide unique access to certain return opportunities under various market environments that cannot beobtained from traditional stock and bond investment. Similarly, Schneeweis and Spurgin [1997c] also showedthat various CTA and hedge fund energy based investment provide risk and return opportunities not availablefrom a wide range of traditional commodity investments or real estate investments.

Simply put, institutional investors must consider the wide range of available investments in thealternative investment area and determine the relative degree to which they offer unique return opportunities tothe traditional stock and bond portfolio. While product and security design is constantly changing (e.g., swaps,structured notes, commodity linked bonds), the fundamental sources of return that accrue to investmentremains the essentially the same (Schneeweis and Spurgin, 1998c]. However, because of changes in theinvestment vehicles, the actual return stream to the investor may also change. For example, securitization of residential real estate lending has made investment in such real estate based equity securities (e.g., REITS)reflect more of a traditional investment than an investment in illiquid and credit-sensitive instruments.Assessment of the risk and return impacts for the hedge fund, managed futures as well as illiquid private equitybased alternative vehicles to traditional stock and bond investment is therefore necessary for the manager seeking an optimal allocation of investible capital.




Data and Methodology

In this study, the relative monthly risk/return performance of traditional stock and bond indices,traditional forms of alternative investments such as real estate, commodity, venture capital, buyout funds anddistressed debt and relatively new forms of alternative investment available through hedge fund and CTAinvestment are examined. Among the various forms of traditional alternative investment reported in the recent

Goldman Sachs-Frank Russell survey [2000], the two greatest amounts of institutional capital committed toalternative investments were to leveraged-buyout and venture capital. Descriptions of the equity, fixed income,managed futures and hedge funds sub-indices, private equity, private debt, commodity and other alternativeinvestment classes are presented in an Appendix I and II.2 Returns for all data series are expressed as monthlyholding period returns. The test period 1990-1998 permits analysis of hedge funds, which began trading in theearly 1990s. Statistical tests include presentation of descriptive risk and return characteristics and returncorrelations between each of the asset classes primary and sub-indices.

A wide variety of potential data indices exist for managed futures, hedge funds, as well as privateequity, private debt, or venture capital. For the purposes of this study, Evaluation Associates Capital Markets(EACM) hedge fund indices as well as the Wilshire leveraged buyout, mezzanine and venture indices are used.3

While, for many hedge funds, the returns are based primarily on exchange traded vehicles such that valuation isbased on transaction-based pricing similar to most stock and bond pricing, for some strategies, as well asprivate debt, private equity and distressed securities, transaction based pricing does not readily exist. While it isnot the purpose of this study to offer independently determined return indices for private market debt or equity, itis important to understand that a private market based index may not represent the performance of any oneprivate market partnership. For the purposes of this study, the Wilshire private market indices are used. Thespecifics of their leveraged buyout index are given in Nesbitt and Reynolds [1997]. In brief, Wilshire constructsan index based on publicly traded assets with similar characteristics to the assets in the index. The firm then re-engineers the capital structure of the index to make the index reflect that of the constituent private marketassets. As a result, the correlations of their indices are similar to that of the primary market used to capture thereturn performance. For instance, a “buyout index” is viewed as a “supercharged” equity opportunity where the

focus is on additional return rather than portfolio diversification. For the other Wilshire index (venture capital)used in this study, a similar index construction based on publicly traded assets with similar characteristics to theassets in the index is used.4

This form of index creation differs from that used by other studies [Philips, 1995] which uses an internalrate of return based on vintage year comparisons from data made available from Venture Economics. Since weare primarily concerned with short-term valuation commensurate with viewing assets in an alternative tradeoff structure, we focus on a constructed index approach, which reflects actual market valuations.5

2 For each presentation, we have not included results on the impact of oil/gas or timber partnerships in results. Again, there are numerous alternativeinvestment forms including bank debt, and other alternative asset investments. The purpose of this paper is to focus primarily on the use of managedfutures and hedge funds as alternatives to other alternative investments when considered as part of an overall portfolio.3 For a review of the relative tracking error of alternative CTA and hedge fund indices see Schneeweis and Spurgin, 1996b, 1998.4 Constructed Wilshire benchmarks were regressed against HFR and EACM relevant indices (distressed and event-risk). Results show that while thecorrelation of the benchmark indices are less than .6, when the constructed Wilshire indices are ranked against the relevant HFR and EACM indices,the returns follow similar patterns; that is the lowest return grouping for the relevant Wilshire index is the lowest return group for the relevant HFRindex. It is also important to point out, that the Wilshire index may reflect actual return better than fund based indices, which may include either survivor bias or selection bias.5 The use of a surrogate index for private equity valuation is consistent with research [British Venture Capital Assoc., 1997] which has indicated thatleverage buyout, venture capital and distress debt outside the U.S., (as in the U.S.) are also highly correlated with the underlying primary markets.






EACM Global Asset Allocation (Glob AA)NAREIT (REIT)Wilshire Leveraged BuyoutWilshire Venture CapitalGoldman Sachs Commodity Index (GSCI)

The second analysis of efficient frontier compositions encompasses both traditional and alternativeinvestments general investment indices as follows:

S&P 500Salomon Brothers Government and Corporate Bond IndexEACM 100NAREIT (REIT)Wilshire Leveraged BuyoutWilshire Venture CapitalGoldman Sachs Commodity Index (GSCI)

The Markowitz optimization is conducted using the “solver” routine in Excel. Thus, all results are easilyreproducible by readers. Tests are conducted on an above described alternative asset selection set and theabove described asset set (alternative assets and traditional stock and bond investment) under the assumptionsof no investment constraints and historical variance and covariance parameter estimates. However, theexpected asset returns were also determined after regressing historical returns on historical variance and thenusing the resulting linear model parameters (with ex ante variance equal to historical variance)8.

In the second analysis indices, which capture the overall asset classes are used, a constrainedoptimization is also run with at least 50% investment in the relevant stock indices (S&P 500), and a 30%investment in the Salomon Brothers government/corporate. Efficient frontiers are determined using bothhistorical return, variance, and covariance parameter estimates and with historical variance and covarianceparameter estimates, however, the expected asset returns were also determined after regressing historicalreturns on historical variance and then using the resulting linear model parameters to forecast expected return.

Lastly, risk and return relationships between traditional and alternative investments in periods of extreme return movement in a traditional stock/bond portfolio are described. Returns for an equally weightedS&P 500/Salomon Brothers Government/Corporate Bond portfolio are determined and returns ranked from lowto high. Returns are segmented into three (Worst third, Mid Third, and Best Third) and the average monthlyreturns and correlations in those three segmented ranked returns periods determined. Results show widevariation in the expected return and correlation relationships between traditional stock/bond portfolio returns andalternative investments in extreme stock/bond return periods. Thus, results indicate the importance of considering the expected market conditions when deriving tactical asset allocations between traditional andalternative investments.

8 Some assets such as the Goldman Sachs Commodity Index have an exceptionally low return to historical variance. This is not unexpected sinceassets with low correlation to the traditional stock and bond portfolio may be priced relative to their correlation and not their variance. As a result theGSCI receives an abnormal boost in the return when OLS variance based model was used because of the high historical variance. Therefore, for this particular index the historical return was used instead of the forecasted one. Results for the portfolios with the forecasted return for GSCI arealso available upon request.




Results

Descriptive Characteristics

Traditional investment practice generally equates expected returns with expected risk as proxied by asecurity’s return variance. As shown in Exhibit 1 and 2, hedge funds and traditional alternative investment offer improved risk and return opportunities when considered as stand-alone investments (Exhibit 1) or as anadditions to stock, bond or stock and bond portfolios Exhibit 2). As shown in Exhibit 2, the Sharpe ratios of Portfolios III-V, which include alternative investments (EACM 100) and traditional alternatives, dominate theSharpe ratios of the cited stock and bond portfolio. The graphical representations of the risk and returnrelationships shown in Exhibits 1 and 2 are also given in Exhibits 3a and 3b.

As shown in Exhibit 4, the low correlation between stock, bond markets, and a wide variety of alternative investments makes the results (improved risk and return opportunities) for the inclusion of various

hedge fund strategies and traditional alternative investments consistent across a wide variety of stock and bondportfolios.9 It is important to note the high correlation between the Wilshire indices and that of the S&P 500 andother stock market indices. This is consistent with the construction of the indices as sensitive to underlyingequity markets. In addition, it is important to note the high level of correlation between each of the representedstock indices.

9 At the same time, the differential correlations between certain alternative investment strategies and U.S. stock and bond portfolios under

various market conditions indicate that the importance of various alternative investment strategies are market dependent. See final section.




Exhibit 1

Descriptive Statistics of Index Performance, 1990-1998

Avg annual STDEV Monthly Monthly RTN/ Sharpe Correlation Excess

RTN MIN MAX STDEV Ratio S&P 500 Annual

RTN

Traditional Assets

S&P500 16.5% 13.5% -15.6% 10.8% 1.2 0.85 1.00

Russel 2000 11.8% 17.5% -21.6% 10.6% 0.7 0.39 0.80 7.5%

Sal. Broth. Corp/Gov 8.5% 4.3% -2.5% 4.2% 2.0 0.81 0.40 5.5%

NAREIT 10.2% 12.5% -9.9% 10.4% 0.8 0.42 0.49 8.7%

T-Bill 5.0% 0.4% 0.2% 0.7% 12.8 0.00 11.4%

Traditional Alternative Assets

Leveraged Buyout 12.6% 37.9% -52.5% 23.1% 0.33 0.20 0.85 9.1%

Venture Capital 21.2% 35.8% -32.3% 22.5% 0.59 0.45 0.72 7.1%

Mezzanine Debt Rtn 16.0% 23.7% -31.8% 14.7% 0.68 0.46 0.89 5.9%

Trad. Alt. Portfolio 17.2% 31.1% -38.4% 20.1% 0.55 0.39 0.85 6.9%

Hedge Fund Indices

EACM 100 Index 13.9% 4.1% -4.6% 4.7% 3.41 2.18 0.41 7.5%Relative Value Index 9.7% 3.6% -6.2% 2.8% 2.69 1.30 0.04 4.6%

Long/Short Equity 10.0% 2.8% -1.1% 3.5% 3.58 1.78 -0.19 5.4%

Convertible Bond 9.3% 4.5% -5.1% 4.9% 2.06 0.95 0.09 4.0%

Bond Hedge 7.4% 4.8% -7.4% 2.5% 1.53 0.49 0.04 2.2%

Rotational 11.9% 7.5% -15.1% 4.1% 1.59 0.92 0.08 6.4%

Event Driven Index 12.3% 5.5% -7.8% 4.9% 2.21 1.31 0.57 4.6%

Arbitrage 9.1% 6.8% -11.8% 5.7% 1.34 0.60 0.55 0.9%

Bankruptcy 14.3% 7.0% -8.5% 9.4% 2.04 1.33 0.39 7.0%

Multistrategy 13.2% 5.5% -8.6% 3.8% 2.40 1.49 0.55 5.6%

Equity Hedge Fund Index 16.7% 8.6% -10.6% 6.2% 1.95 1.37 0.72 6.5%

Domestic Long 16.8% 11.5% -16.4% 8.2% 1.45 1.02 0.81 3.8%

Domestic Opportunity 15.2% 8.4% -6.0% 7.1% 1.81 1.21 0.27 8.2%Global International 17.7% 11.1% -9.6% 7.8% 1.60 1.14 0.63 6.8%

Global Assets Allocators 18.9% 10.6% -5.6% 11.3% 1.78 1.31 0.06 13.3%

Commodity Index

GSCI 0.43% 16.7% -13.0% 20.7% 0.026 -0.28 -0.13 10.8%




Exhibit 2

Descriptive Statistics of Portfolio Performance

Avg annual STDEV Monthly Monthly RTN/STDEV Sharpe

RTN MIN MAX Ratio

Portfolio I 12.5% 7.9% -6.9% 7.1% 1.59 0.95

Portfolio II 11.1% 7.0% -7.1% 5.6% 1.58 0.87

PortfolioIII

12.9% 7.9% -8.2% 7.4% 1.64 1.00

PortfolioIV

12.5% 7.2% -7.4% 6.7% 1.74 1.04

Portfolio V 12.8% 6.7% -6.5% 6.6% 1.91 1.16

Where

US Equity Salomon NAREIT GSCI EACM Traditional

Bond 100 Alternative

Portfolio I 50.0% 50.0%

Portfolio II 40.0% 40.0% 10.0% 10.0%

PortfolioIII

40.0% 40.0% 15.0% 5.0%

PortfolioIV

40.0% 40.0% 2.5% 15.0% 2.5%

Portfolio V 40.0% 40.0% 20.0%

Exhibit 3a: Return and Risk Tradeoff (1990-1998)

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%18.0%

20.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%

Standard Deviation




Exhibit 3b: Return and Risk Tradeoff (1990-1998)

11.0%

11.5%

12.0%

12.5%

13.0%

13.5%

6.6% 6.8% 7.0% 7.2% 7.4% 7.6% 7.8% 8.0%

Standard Deviation

A n n u a l i z e d R e t u

r n

Portfolio V

Portfolio I

Portfolio III

Portfolio II

Portfolio



EACM EACM EACM EACM EACM EACM EACM EACM EAC

S&P 500 FR 2000 SBGC NAREIT US TR LBO Ven.CI Mezz Trd. As EACM100 RelVal L/S Eq CnvHdg BndHdg Rot Event Arb Ban

S&P 500 1.00

FR 2000 0.79 1.00

SBGC 0.41 0.16 1.00

NAREIT 0.47 0.64 0.29 1.00

US TR 0.00 -0.09 0.10 -0.23 1.00

LBO 0.85 0.91 0.33 0.65 -0.05 1.00

Ven.CI 0.71 0.88 0.16 0.52 0.04 0.83 1.00

Mezz 0.89 0.96 0.33 0.67 -0.06 0.94 0.88 1.00

Trd. As 0.84 0.95 0.28 0.63 -0.02 0.96 0.94 0.97 1.00

EACM100 0.40 0.41 0.24 0.31 0.06 0.39 0.32 0.45 0.21 1.00

RelVal 0.03 0.13 -0.02 0.09 0.03 0.05 0.01 0.10 0.43 0.56 1.00

L/S Eq -0.19 -0.21 0.14 -0.21 0.32 -0.14 -0.13 -0.14 -0.06 0.33 0.37 1.00

CnvHdg 0.08 0.20 0.09 0.12 -0.17 0.13 0.10 0.18 0.42 0.37 0.70 0.05 1.00

BndHdg 0.02 0.12 -0.04 0.19 0.01 0.02 -0.02 0.07 0.27 0.42 0.77 0.23 0.34 1.00

Rot 0.07 0.13 -0.12 0.05 0.03 0.06 0.02 0.09 0.44 0.48 0.89 0.15 0.52 0.58 1.00

Event 0.55 0.66 0.10 0.57 -0.17 0.56 0.47 0.64 0.37 0.53 0.43 -0.10 0.40 0.36 0.41 1.00

Arb 0.54 0.60 0.14 0.55 -0.15 0.52 0.44 0.58 0.26 0.30 0.15 -0.25 0.17 0.15 0.19 0.84 1.00

Bank 0.37 0.52 0.05 0.44 -0.16 0.39 0.35 0.47 0.38 0.48 0.52 0.00 0.50 0.41 0.46 0.85 0.49

Multi 0.53 0.61 0.07 0.48 -0.13 0.56 0.45 0.62 0.32 0.60 0.45 0.00 0.37 0.37 0.41 0.90 0.69

EQHdg 0.71 0.85 0.19 0.57 -0.03 0.79 0.77 0.85 0.21 0.68 0.29 0.03 0.28 0.23 0.25 0.64 0.52

DomLon 0.80 0.91 0.23 0.61 -0.03 0.84 0.83 0.93 0.16 0.52 0.16 -0.06 0.21 0.12 0.13 0.65 0.54

DomOpp 0.26 0.46 0.04 0.19 0.10 0.44 0.48 0.46 0.06 0.53 0.21 0.25 0.17 0.09 0.16 0.27 0.15

Gl/Int 0.62 0.67 0.18 0.53 -0.12 0.61 0.56 0.66 0.27 0.63 0.35 -0.06 0.30 0.34 0.31 0.60 0.54

GLOB AA 0.06 -0.07 0.24 -0.03 0.15 0.00 -0.05 0.01 -0.08 0.71 0.13 0.31 -0.01 0.06 0.09 -0.01 -0.12

GSCI -0.14 -0.07 0.02 -0.11 0.17 -0.03 -0.12 -0.06 -0.21 0.10 0.02 0.34 0.01 -0.03 -0.09 -0.08 -0.23

Exhibit 4: Correlations (1990-1998)






adjusts historical return to returns, which are consistent with a traditional risk (standard deviation) and returnrelationship.



Variance Monthly Monthly Sharpe Lng/Sht Convert Bond Rotat Bankruptsy Multi- Domest. Domest. Glob

Criteria StDev Return Ratio Equity Hedge Hedge Strategy Long Opport. Int'l

0.80% 8.94% 2.22% 0.25

0.08% 2.83% 1.71% 0.60 6.33%

0.04% 2.00% 1.45% 0.73 7.03% 7.67% 5.46% 31.80%

0.01% 1.00% 1.07% 1.07 58.37% 27.28%



0.80% 8.94% 1.83% 0.20 5.90%

0.08% 2.83% 1.16% 0.41 10.00% 7.70% 10.00% 10.00% 10.00% 10.00% 10.00%

0.04% 2.00% 1.06% 0.53 10.00% 10.00% 5.94% 10.00% 10.00% 10.00% 10.00% 10.00%

0.03% 1.73% 0.98% 0.57 10.00% 10.00% 9.13% 10.00% 10.00% 10.00% 10.00% 10.00%



0.80% 8.94% 1.79% 0.20

0.04% 2.00% 1.24% 0.62 13.04% 38.59%

0.02% 1.41% 1.10% 0.78 30.56% 8.73% 24.08% 5.51%

0.01% 1.00% 0.99% 0.99 59.23% 16.57% 3.89% 3.58%

* For GSCI the historical return was used

Exhibit 5

Panel A: Optimal Weights using historical risk, return, and correlation data

Panel B: Optimal Weights using historical risk, return, and correlation data, and constraints of 1

Panel C: Optimal Weights using historical risk, and correlation data, and with regression-based r



Variance Monthly Monthly Sharpe Venture

Criteria StDev Return Ratio SP500 Bond LBO Capital GSCI REIT

0.50% 7.07% 1.81% 0.21 65.52%

0.08% 2.83% 1.36% 0.36 63.80%

0.04% 2.00% 1.27% 0.45 34.11%

0.02% 1.41% 1.21% 0.57 3.65%


Criteria StDev Return Ratio SP500 Bond LBO Capital GSCI REIT

0.20% 3.61% 1.36% 0.26 50.00% 30.00% 18.58%

0.08% 2.83% 1.22% 0.28 63.33% 30.00%

0.06% 2.45% 1.18% 0.31 50.46% 30.00%

0.05%


Criteria StDev Return Ratio SP500 Bond LBO Capital GSCI* REIT

0.20% 3.61% 1.22% 0.22 50.00% 31.40% 18.60%

0.08% 2.83% 1.08% 0.23 63.36% 30.00%

0.06% 2.45% 1.04% 0.25 50.43% 30.00%

0.05%

* The historical return for GSCI has been used.

Regression-based return forecasts

Exhibit 6: Optimal Allocations for traditional and alternative asset portfolio based on risk tolerance criteria

Panel A: Optimal weights with no allocation constraints: Historical risk, return, and correlation data

Panel B: Optimal weights with constraint of at least 50% SP500, 30% SALOMON Bond

Panel C: Optimal weights with constraint of at least 50% SP500, 30% SALOMON Bond




Traditional and Alternative Asset Investment Return in Periods of ExtremeStock/Bond Return Movement:

Return Performance in Periods of Extreme Stock/Bond Portfolio Return

The results shown in Exhibits 1-6 indicated that various hedge fund strategies may offer unique returnbenefits to “long only” investments and traditional alternative benchmark indices. However, these results reflectthe risk and return benefits of alternative investments over a wide variety of market return environments.Previous research [Schneeweis, 1996; Schneeweis et al., 1996b] has shown that the risk and returncharacteristics of various alternative investment strategies relative to the risk and return pattern of a typicalstock/bond portfolio are conditional on the return environment of the stock/bond portfolio.

Exhibit 7a: Average Monthly Return of Alternative Investmentwith Stock/Bond Portfolio in Worst, Mid, and Best 36 RankedReturn Months: Returns Ranked on Stock/Bond Portfolio (1990-1998)

all bottom mid topS&P 500 1.5% -2.6% 1.7% 5.3%

FRUSL 2000 1.1% -2.8% 1.9% 4.3%

SLMN GVT 0.7% -0.2% 0.8% 1.5%

NAREIT 0.9% -1.0% 1.6% 2.1%

US TREAS 0.4% 0.4% 0.4% 0.4%

LBO Index 1.6% -7.6% 2.8% 9.6%

Venture Capital Index 2.3% -5.0% 3.0% 9.0%

Mezzanine 1.6% -4.6% 2.3% 7.0%

Trad. Asset Port. 1.8% -5.7% 2.7% 8.5%

EACM100 1.2% 0.7% 1.4% 1.4%REL VAL 0.8% 0.8% 1.0% 0.6%

L/S Equity 0.8% 1.0% 1.0% 0.6%

ConvHedge 0.8% 0.6% 1.0% 0.7%

BondHedge 0.6% 0.6% 0.9% 0.4%

Rotational 1.0% 1.0% 1.3% 0.8%

EVENT 1.0% 0.0% 1.7% 1.4%

Arb 0.8% -0.2% 1.3% 1.3%

Bank 1.2% 0.2% 2.1% 1.4%

Multi 1.1% 0.2% 1.6% 1.5%

EQ HEDG 1.4% -0.4% 1.9% 2.8%DomLong 1.5% -1.3% 1.9% 3.8%

DomOpp 1.3% 0.7% 1.4% 1.8%

Gl/Int 1.5% -0.5% 2.2% 2.9%

GLOB AA 1.6% 1.6% 1.7% 1.7%

GSCI 0.2% 0.3% 0.8% -0.6%

Stk/Bnd Port 1.1% -1.4% 1.2% 3.4%




Exhibit 7b: Average Monthly Returns in Worst, Mid, and Best 36 Ranked Return Months:

Returns Ranked on Stock/Bond Portfolio (1990-1998)

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

A v e r a g e M o n t h l y R e t u r n

Worst 1/3 Months 0.7% 0.8% 0.0% -0.4% 1.6% 0.3% -1.4%Mid 1/3 Months 1.4% 1.0% 1.7% 1.9% 1.7% 0.8% 1.2%

Top 1/3 Months 1.4% 0.6% 1.4% 2.8% 1.7% -0.6% 3.4%

EACM100 REL VAL EVENT EQ HEDG GLOB AA GSCI Stk/Bnd Port



Exhibit 7c: Average Monthly Returns in Worst, Mid, and Best 36 Ranked Return Months: Returns Ran

-10.0%

-8.0%

-6.0%-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

A v e r a g e M o n t h l y R e t u r n

Worst 1/3 Months -7.6% -5.0% -4.6% 1.0% 0.6% 0.6% 1.0% -0.2% 0.2% 0.2%

Mid 1/3 Months 2.8% 3.0% 2.3% 1.0% 1.0% 0.9% 1.3% 1.3% 2.1% 1.6%

Best 1/3 Months 9.6% 9.0% 7.0% 0.6% 0.7% 0.4% 0.8% 1.3% 1.4% 1.5%

LBO Index

Venture

Capital

Index

Mezzanine L/S Equity ConvHedg BondHedg Rotat ional Arb Bank Mult i




In exhibits 7a-7c, the average monthly return of alternative investments grouped into three groups (of thirty-six months) determined after ranking on the return of the equal weighted S&P 500/Salomon BrothersGovernment and Corporate bond portfolio for the period 1990-1998 is given. Results, again, confirm previousacademic research [Schneeweis, 1996; Schneeweis et al., 1996b] that during periods of extreme marketmovement (positive or negative) in the S&P 500 and Salomon Brothers Government and Corporate bondportfolio, other international stock and bond markets as well as long only traditional alternative investmentproducts (private equity, etc.) also experienced similar positive or negative returns. Only those assetinvestments (Global Asset Allocators, Relative Value) for which the underlying return process offers thepotential for positive returns in economic conditions which result in negative returns for stock/bond portfolio mayprovide downside risk protection as well as provide positive returns in markets in which a typical stock/bondportfolio performs well.

In order to evaluate the actual performance of the wide variety of alternative asset strategies one mustalso examine sub-strategies within a particular alternative asset classification. For instance, within the Eventcategory of hedge funds, domestic opportunity offers positive returns across all three stock/bond portfolio returnclassifications while, in contrast, more equity sensitive fund strategies (global/international and domestic long)offer higher positive returns in periods of extreme positive stock/bond return and offer negative returns inperiods of extreme negative stock/bond return.

Correlation Performance in Periods of Extreme Stock/BondPortfolio Return

Similar to the results discussed in the previous section, correlation relationships between alternative

investment strategies and a typical stock/bond portfolio are conditional on the return environment of thestock/bond portfolio. For instance, while the correlation between many alternative investments and mosttraditional investments are close to zero (Exhibit 4) when asset returns are segmented according to whether thetraditional asset rose or fell, certain hedge funds (e.g., Long/Short and Global Asset Allocators) have lower correlations in months when traditional asset returns are negative than when traditional asset returns(stock/bond portfolio) are positive. In contrast, during periods of extreme market movement (positive or negative) in the S&P 500 and Salomon Brothers Government and Corporate bond portfolio, equity sensitivelong only traditional alternative investment products (private equity) and equity (domestic long) or creditsensitive hedge fund strategies (e.g., bankruptcy) experienced higher correlation with the stock/bond portfoliowhen it performed poorly than when it performed well. Only those asset investments (Global Asset Allocators,Long/Short) for which the underlying return process offers positive returns in markets which result in extreme

negative returns for stock/bond portfolios may provide downside risk protection. That is, low or negativecorrelation in periods of extreme negative stock and bond portfolio return movement while experiencing positivecorrelation in the periods of positive stock/bond return movement.




Exhibit 8a: Correlation of Alternative Investment withStock/Bond

Portfolio in Worst, Mid, and Best 36 Ranked Return Months:

Returns Ranked on Stock/Bond Portfolio (1990-1998)All Bottom Middle Top

Months Third Third Third

Stk/Bond Port. 1 1 1 1S&P 500 0.97 0.92 0.74 0.89FRUSL 2000 0.72 0.61 0.32 0.44SLMN GVT 0.62 0.30 0.03 0.46NAREIT 0.48 0.44 0.29 0.32US TREAS 0.03 -0.23 -0.22 0.12LBO Index 0.82 0.72 0.30 0.60Venture Capital Index 0.65 0.54 0.25 0.41Mezzanine 0.85 0.75 0.32 0.65Trad. Asset Port. 0.80 0.68 0.29 0.60EACM100 0.41 0.52 0.10 0.37REL VAL 0.02 0.44 0.19 -0.12L/S Equity -0.13 0.05 -0.06 0.13ConvHedge 0.10 0.21 0.26 -0.07BondHedge 0.01 0.48 0.21 -0.18Rotational 0.03 0.41 0.08 -0.10EVENT 0.50 0.62 0.17 -0.10Arb 0.50 0.62 0.11 -0.01Bank 0.33 0.39 0.06 -0.07Multi 0.47 0.61 0.31 -0.14EQ HEDG 0.67 0.63 0.27 0.34DomLong 0.75 0.65 0.21 0.40DomOpp 0.24 0.28 0.18 0.02

Gl/Int 0.58 0.62 0.24 0.32GLOB AA 0.12 0.14 -0.01 0.42GSCI -0.11 -0.17 -0.16 0.02



Exhibit 8b: Correla tion of Alternative Investment with Stock/Bond Portfolio in WoRanked Return Months: Returns Ranked on Stock/Bond Portfolio (199

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

Worst 1/3 Months 0.68 -0.17 0.44 0.44 0.62 0.6

Mid 1/3 Months 0.29 -0.16 0.29 0.19 0.17 0.2

Best 1/3 Months 0.60 0.02 0.32 -0.12 -0.10 0.3

Trad. Asset

PortfolioGSCI NAREIT REL VAL EVENT EQ H



Exhibit 8c: Correlation of Alternative Investment with Stock/Bond Portfolio in Worst,Return Months: Returns Ranked on Stock/Bond Portfolio (1990-1

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

Worst 1/3 Months 0.14 0.05 0.21 0.48 0.41 0.62 0.39

Mid 1/3 Months -0.01 -0.06 0.26 0.21 0.08 0.11 0.06

Best 1/3 Months 0.42 0.13 -0.07 -0.18 -0.10 -0.01 -0.07 -

GLOB AA L/S Equity ConvHedg BondHedg Rotational Arb Bank




As noted when examining relative returns, investors must also examine sub-strategies within aparticular alternative asset classification. For instance, while the long/short equity strategy has low correlationsin all three stock/bond portfolio return environments, for other relative value strategies (e.g., bond hedge,convertible bond hedge) the correlations are positive and higher in periods of low stock/bond return andnegative in periods of extreme positive stock/bond portfolio return movement. Similarly, certain equity sensitive(Domestic Long, Domestic Opportunity, Global/International) or credit spread sensitive hedge fund strategies(Arbitrage, Bankruptcy) offer higher relative positive correlation in periods of extreme negative stock/bondportfolio return movement than they offer in periods of extreme positive stock/bond return movement.

The different performance of hedge fund strategies in various stock/bond portfolios can be the basis for active asset allocation across alternative asset strategies. As shown in the Exhibits 7 and 8, various alternativeinvestment strategies (Global Asset Allocators, long/short equity) have relatively low correlation with stock/bondportfolio return when the portfolio performed poorly. In contrast, in those market environments in which thestock/bond portfolio performed well, alternative investments, which are highly correlated with stock and bondmarket performance (e.g. leverage buyout, venture capital) may deserve greater percentages of recommendedasset allocation. Thus, investors with the ability to adjust portfolio weightings tactically in light of expectedstock/bond portfolio return movements, may wish to consider the conditional expected returns and correlationsexpected to exist in those market environments.



‘Alternative Investments in the Institutional Portfolio’ Schneeweis Spurgin Karavas (AIMA 2000)24

Summary and Conclusion

In this paper, the benefits of adding managed futures and hedge fund products to traditional stock,bond, and traditional alternative investment portfolios is shown. The primary results are as follows:

First, under past (e.g., historical) market environments, a portfolio of hedge funds and managed

futures offers improved risk and return opportunities when considered as additions to a traditional stock and aswell as mixed portfolios (stocks, bond, and traditional alternative investments, private debt, private equity etc.).

Second, under forecasted return relationships consistent with general market conditions, a portfolio

of hedge funds and managed futures offers improved risk and return opportunities when considered asadditions to a traditional stock and as well as mixed asset portfolios (stocks, bond, and traditional alternativeinvestments (private debt, private equity etc.). For instance, to minimize the risk of the full stock, bond, and

traditional alternative asset portfolio, an asset allocation of ten per cent to a portfolio of hedge funds andmanaged futures may be regarded as optimal.

Third, under alternative market conditions (e.g., extreme low/high returns of the stock and bond

portfolio), the benefits of a portfolio of hedge funds and managed futures have a greater impact on riskreduction and return enhancement. More importantly, the portfolio of hedge funds and managed futures offersmanaged portfolio returns not obtainable through other traditional stock and bond investments and/or traditionalalternative investments (e.g., GSCI, REITS).

Fourth, the benefits of a portfolio of hedge funds and managed futures are not sensitive to the

globalization of the stock and bond portfolio. The high correlation between international stock markets as well asthe high correlation between international bond markets, especially in periods of extreme market movements,makes the results (improved risk and return opportunities) for the inclusion of a portfolio of hedge funds andmanaged futures consistent across a wide variety of traditional asset portfolio holdings. Moreover, traditionalalternative investment vehicles must be supplemented with other futures/options based managed futures andhedge fund products to obtain the maximum risk and return benefits of alternative investment products.However, the degree of benefit will depend on the prevailing market environment and the degree to which thatmarket environment is anticipated.

Further research on the degree to which subsets of the managed futures and hedge fund investmentsoffer similar or alternative investments to the overall portfolio results is, of course, required. Analysis of

alternative methods of forecasting return, variance, and correlation relationships between alternativeinvestments and traditional stock and bond investments is also required.

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Alternative Investments in the Institutional Portfolio