Beware Alternative Investments

The sophisticated asset-pricing models we have today allow us to determine the underlying sources of returns to investments. Specifically, they permit us to identify the factors to which an investment has exposure.

However, a problem arises when employing current asset-pricing models to consider alternative, illiquid investments. The volatility of such assets is often understated.

This occurs because the data is often “smoothed” due to the lack of available daily pricing information. As a result, we can observe a serial correlation—the correlation of a variable with itself over successive time intervals—of returns that makes prices appear to be less volatile than they really are. The apparently “free lunch” provided through the diversification benefit, plus the lower volatility, tends to lead to an overallocation of such assets.

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