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Even Greater Role Seen for Alternatives in Mutual Funds

Mutual fund managers have been increasingly gravitating toward alternative investments as a way to boost returns and compete with hedge funds. By some estimates, alternative investment funds could soon account for as much as 10% of assets in mutual funds.

But according to TIAA-CREF Chief Investment Strategist P. Brett Hammond, that should be even higher, possibly between 20% and 60% of a mutual fund portfolio's composition.

He suggests that professional money managers consider "reverse asset allocation." Instead of building a portfolio around core stock and bond holdings, he advocates placing alternative assets, such as private equity, venture capital, hedge funds and commodities, at the heart.

Alternatives have the ability to boost risk-adjusted rates of return while having a low correlation to traditional core assets, Hammond argues in a recent white paper, "Reverse Asset Allocation: Alternatives at the Core," published in TIAA-CREF's second quarter 2007 report.

Hammond's report targets institutional money managers-including insurance companies, pension funds and mutual funds.

Reverse asset allocation "begins by finding the expected return from a desired allocation to a core group of alternative assets, and then adding bonds and equities as the completion elements to achieve overall portfolio characteristics," Hammond suggested.

Hammond said that alternative assets can deliver an asset-based return alpha with low correlation to traditional asset classes, while limiting risk. Alpha is a measure of the excess return of an investment minus the risk-free rate of return on U.S. Treasury bills. Investments with higher alpha values have better risk-adjusted rates of return.

Hammond analyzed the results of efficient frontier portfolios with different asset allocation mixes based on historical data. The results revealed that a portfolio of alternative assets delivered the best returns with the least amount of risk.

For example, in a portfolio with a mix of 60% U.S. stocks and 40% bonds, the expected rate of return was 5.58%. The beta-based structural alpha was 0.67. The standard deviation was 11.17. The Sharpe ratio was 0.52. The beta value was 0.65.

In a portfolio including 45% U.S. stocks, 18% international stocks and 37% bonds, the expected rate of return was 5.95%. The beta-based structural alpha was 0.88. The standard deviation was 11.17. The Sharpe ratio was 0.53, and the beta value was 0.64.

By comparison, in a portfolio entirely comprised of alternative assets-10% in emerging market stocks, 24% in venture capital, 8% in private equity, 31% in real estate investment trusts, 20% in direct real estate holdings and 7% in commodities-the expected rate of return on the portfolio was a far higher 8.19%. The beta-based structural alpha was 4.30. The standard deviation nonetheless still remained at 11.17. The Sharpe ratio was 0.73. The beta value was 0.44.

Although it may not be practical for mutual funds to put all their assets in alternative assets, for a lot of reasons, Hammond suggested that institutional investors should put between 20% and 60% of assets in alternative investments, with no more than 5% to 10% of assets invested in any one alternative asset.

The study found that keeping 40% in U.S. stocks, 12% in international stocks, 18% in bonds and 30% in alternative assets had an expected rate of return of 6.89% and a standard deviation of 11.7.

Hammond said that the major point of his paper is to illustrate that the addition of alternative assets to a portfolio can improve risk and return levels. However, he said he is not recommending that pension or mutual fund managers specifically use the asset allocation mixes highlighted in his white paper.

"Despite the uncertainty associated with the future behavior of alternatives [assets], the exposure to them can add risk-adjusted values to institutional portfolios," he said.

Still, Hammond hedged that by adding: "The inclusion of alternatives in formal asset allocation models, however, can make these models highly sensitive to small changes in a portfolio's allocations. Moreover, because most alternatives do not have long track records, some may be unsure how to predict the risk/return behavior of these investments."

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.