How to Evaluate a New Diversifier with 10 Simple Questions

Interest in adding "alternate" asset classes such as hedge funds and commodities to the standard asset class menu has mushroomed subsequent to the early century bear market episode (2000-2002). How should an investor evaluate the addition of an asset class to the portfolio mixture? Harry Kat provides normative guidance for making such decisions in the following paper, which expands the statistical analysis of asset class performance to include skewness and co-skewness measures.

How to Evaluate a New Diversifier with 10 Simple Questions

Kat, Harry M., "How to Evaluate a New Diversifier with 10 Simple Questions" (December 1, 2006). Alternative Investment Research Centre Working Paper No. 39

Abstract:

In this paper we discuss a number of important questions to ask when analysing a new alternative diversifier from either a stand-alone, asset-only or asset-liability point of view. The framework is simple, but highly effective. Apart from the new diversifier's statistical properties, it emphasizes the importance of properly accounting for parameter uncertainty and illiquidity; two elements very often ignored by investors. It also shows the importance of taking the correct perspective when evaluating a new diversifier. What looks good from a stand-alone perspective need not look good in a portfolio context and vice versa. Application of the above framework to funds of hedge funds, commodities and synthetic funds underlines the advantages and disadvantages of these diversifiers and clearly points at synthetic funds as the most and funds of hedge funds as the least attractive of the three.

The Ten Questions To Ask

1. What risk premium is offered?
2. How volatile are the returns?
3. Are returns positively or negatively skewed or explicitly floored or capped?
4. How certain are you of the above?
5. How liquid is the investment?
6. Is the fee charged fair in relation to the above?
7. What is the correlation with the existing portfolio?
8. What is the co-skewness with the existing portfolio?
9. What is the correlation with the liabilities?
10. What is the co-skewness with the liabilities?