ASSET ALLOCATION IN ALTERNATIVE INVESTMENTS REISA April 15, Sameer Jain Chief Economist and Managing Director American Realty Capital

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1 ASSET ALLOCATION IN ALTERNATIVE INVESTMENTS REISA April 15, 2013 Sameer Jain Chief Economist and Managing Director American Realty Capital

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3 Alternative Investments Investment Universe Non-Traditional Investments Traditional Investments Real Estate Stocks Private Equity Bonds Hedge Funds Cash

4 Key Characteristics Alternative Investments Defined The name "alternative investments" suggests new and obscure investments, however alternative investments have existed and been established for decades Hedge Funds (1949), Modern Venture Capital (1946), Real Estate (centuries old) Alternative investments often share a few principal characteristics that help identify them as such: Historically low to moderate correlation with traditional asset classes (stocks and bonds). Not listed on an exchange Private investment funds available only to high net worth and institutional investors Reduced liquidity

5 Different from Traditional Investments Alternative Investments Differ From Traditional Investments Traditional Investments Alternative Investments Relative performance objective* Generally no leverage Performance dependent primarily on market returns Historically high correlation with market indices Typically offers daily liquidity Fixed management fee on assets under management Absolute performance objective* May use leverage Performance dependent primarily on advisor skill Historically low to moderate correlation with market indices Typically have reduced liquidity ranging from monthly to 12+ year lock-ups Generally higher fees which may include performance fees *There is no guarantee that these objectives will be met.

6 Wide Range of Liquidity Characteristics And Vary Greatly In Their Liquidity Characteristics Liquid Illiquid Bonds Hedge Funds Private Equity Equities Managed Futures Convertible Arbitrage Fixed Income Arbitrage Statistical Arbitrage Merger Arbitrage Distressed Securities Private Real Estate and Non Traded REITs Equity Market Neutral Long/Short Equity Global Macro

7 Flexibility, albeit at a cost Alternative Investment Managers Generally Have Increased Investment Flexibility Selected Examples: Hedge Funds and Private Equity Real Estate Hedge Fund managers have the flexibility to invest opportunistically in strategies where they see value while traditional money managers may be constrained to invest in certain pre-defined markets Hedge Fund managers can short-sell securities they believe will fall in value and thereby may profit from declining markets if they are correct in their judgment Hedge Fund managers can use derivatives and leverage to hedge or magnify returns (however this also increases risk) Private Equity Real Estate fund managers may have increased access to information regarding private investments Private Equity Real Estate fund managers often invest based on a negotiated price while traditional money managers face limits on shortselling and may be required to be invested even if they believe markets are in a declining trend while traditional money managers are limited in their use of derivatives and leverage while traditional managers investing in listed REITs must rely on publicly-available information, because they only invest in the public markets while traditional listed REIT money managers typically pay market prices However, the added flexibility also increases risks

8 Unique Risks Alternative Investments Can Pose Risks Beyond Those That Exist In Traditional Investments The use of leverage can result in substantial losses if an investment does not behave the way the investment manager predicted Alternative investment managers are often compensated in part through incentive fees (carry) which may create the incentive for the investment manager to take on more risk, particularly if the fund NAV is below par Reduced liquidity in certain alternative investment markets may make it difficult to exit an investment during times of stress Most private investment funds are subject to less regulation than their public counterparts, thereby reducing the level of supervision over an investment manager's activities

9 Despite Attractive Characteristics, Alternative Investments Have Special Risks That Need to be Managed Risk Risk Definition Alternative Investing Investing Risks Valuation Risk Specialized Trading Manager Risk Liquidity Risk Investment Process/Model Risk Certain alternative investment funds often trade in esoteric and/or illiquid securities. In normal markets it is sometimes difficult to price these instruments, causing managers to estimate market values. In stressed markets this problem may be magnified, leaving investors with an imprecise understanding of a portfolio's Net Asset Value. Valuations for investments for which market quotations are not available may at times be estimates, which may affect the amount of the management and incentive fees Special investment techniques such as leveraging, short-selling and investing in derivatives, including options and futures, may result in significant losses Investing in a fund exposes investors to risks particular to that fund manager. These risks can include poor decision making, key personnel departures or fraud, among others. In the case of a fund of funds, although the Investment Manager selects managers it believes are prudent and reliable, managers could perform poorly or reach capacity Interests in certain alternative investment funds are generally not readily marketable and not redeemable. Interests in a fund generally are not transferable except in limited circumstances. Accordingly investors have to bear the risks of investing for the full duration of the lock-up period The Investment Manager's investment process may be heavily dependent on the Investment Manager's analysis of historical data. No assurance can be given that these analyses will accurately predict future results

10 Alternative Asset Classes Challenge Traditional Assumptions That Are Fundamental For Asset Allocation Traditional investments Alternative Investing Allocating to Alternative Investments Alternative investments Accurate measurement of returns Inconsistent measurement of returns Risk is appropriately measured Risk is not captured by data Asset returns are comparable Marked-to-market valuations All assets are fully liquid Asset returns are not comparable Mixture of stale and current valuations Variable degrees of liquidity Markets are Open to common set of investors Efficient Markets are Not open to all investors Not efficient Data measured over same time periods Data measured over different time periods

11 Allocating to Alternative Investments What Do We Believe is Wrong With Other Asset Allocation Approaches When We Consider Alternatives? Excluding alternatives from a portfolio Investors forgo the potential benefits of diversification, risk-reduction and return enhancement that alternative investments may offer. Of course, those benefits cannot be guaranteed and investing in alternatives always carries a degree of risk Optimizing the traditional part of the portfolio and separately allocating a pre-determined percentage to alternatives The different parts of the portfolio cannot be separately allocated Liquid alternatives can in some instances replace traditional asset classes and diversify the portfolio The illiquid part of the portfolio affects the liquid part of the portfolio Including alternatives in the optimization using the existing data Inappropriately measuring risk and correlation can lead to unreasonable and inappropriate allocations Return forecasts must be integrated across all asset classes We believe that the most appropriate approach is to have a unified asset allocation model that integrates forecasts and appropriately measures risk

12 Allocating to Alternative Investments Our Approach To Asset Allocation Attempts To Identify and Address Portfolio Management Issues Specific To the Asset/ Style Class There are 5 major issues related to the inclusion of Alternatives in a traditional portfolio, each of which requires a specific treatment Issue Implication Approach Survivorship bias Serial correlation Strategy "drift" Return forecasting Skew and tail risk Overestimation of returns Underestimation of risk Incorrect classification of strategies and funds, leading to bias & misestimate of risk Forecasts must be fully integrated across asset classes Underestimation of risk & misallocation Choose indices that attempt to filter out bias Unsmooth data to try to correct for serial correlation Aggregate strategies into more stable units Use spreads where more stable over time Theoretically seeks to optimize portfolios against skew and map back to mean variance frontier

13 Allocating to Alternative Investments Follow A Consistent Approach For Private Equity and Real Estate Issue Implication Approach Reported returns are inaccurate and incomplete Not comparable to marked-tomarket returns Do not account for asset liquidity risk Do not account for tail risk Rebalancing costs Misstatement of returns, risks and correlations Not comparable to marked-to-market returns Do not account for asset liquidity risk Do not account for tail risk Limited ability to dynamically rebalance induces "portfolio cost Create "marked-to-market model Add effect for private, illiquid markets to attempt to account for unique forms of risk Explicitly model tails Apply haircut based on estimated cost Option value/liquidity preference Unforeseen liquidity need implies added risk Include as constraint in optimization