Excess returns and diversification benefits from alternative investments : hedge funds, private equity and infrastructure

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NO FULL TEXT AVAILABLE. Access is restricted indefinitely. ----- Following the success of U.S. endowments, institutional investors are allocating more funds to a range of alternative investments even though researchers caution that other institutions may find it hard to match the endowment performance. Our research sheds light on whether an increased allocation to alternative investments is justifiable on the grounds of after fee excess returns, or because of diversification benefits. Our first contribution to literature is in applying a general model that sources alternative investment returns to equity risk, illiquidity risk and various asset class specific factors. Conditioning on these risk factors we find evidence of excess returns for hedge funds. In private equity, we suggest excess returns have been episodic in nature, coinciding with the 1990s technology and the 2000s buyout boom. For infrastructure, we find evidence of excess returns but caution that the result is likely to be sample specific. Second, factor models explain a large part of the return variation across a range of alternative investments and we propose replication strategies capture some of the benefits of alternative investments and can be used for performance evaluation. Third, we expand empirical research into infrastructure investing. We model regulatory risk using options and replicate aspects of defensive and inflation hedging ability. Finally, we investigate the effects on portfolio risk reduction of a larger set of alternative investments. We show factor models more effectively diversify portfolios than alternative investments, but some alternative investments may still offer unique characteristics. We demonstrate an optimal portfolio combines the benefits of both.
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