Benchmarking alternatives isn't easy, but it's critical in making sure clients and advisors are clear on the investments' role in the portfolio. Here's how to benchmark private equity, non-traditional bonds and long-short funds.
First, let me fess up that both Wall Street Journal columnist Jason Zweig -- who I spoke with about advisors' use of alternatives for clients -- and I had a very difficult time in coming up with appropriate benchmarks, so the ones that I suggest are subjective. But the more important objective is having advisors identify the benchmark to the client ahead of time to evaluate its performance.
Private equity funds invest in public companies that invest in private businesses. Since private businesses are part of the economy not represented by public markets, it can make sense to have some exposure to this alternative asset.
Benchmarking this alternative asset class is a bit less difficult than others in that the S&P 500 has a listed private equity index of 30 public companies in the private equity space. Another possibility is to benchmark against a mix of small cap index funds such as the iShares S&P Small Cap Index Fund (IJR) and the Vanguard FTSE All-Word Ex U.S. Small Cap Index ETF (VSS), depending on where the private equity is invested.
Non-traditional bonds pursue strategies divergent in one or more ways from conventional practice in the broader bond fund universe. They are often referred to as unconstrained bond funds. Commonly benchmarked against the Barclay’s aggregate bond index, this can miss variations in credit risk and interest rate risk, measured by duration.
Benchmarking this category ahead of time is particularly important as it will help the advisor understand these exposures as well as whether the fund is taking foreign currency risk for non-U.S. holdings. Knowing the fund’s composition is key to determining whether it has a role in the clients’ portfolios.
LONG-SHORT EQUITY FUNDS
Long-short equity funds hold sizable stakes in both long and short positions in equities and related derivatives. As the name implies, the funds can have either a net long position or a full short position.
If, for example, a fund had a net 60% long exposure to U.S. stocks then the appropriate benchmark would be 60% total return of the Wilshire 5000 and 40% cash. It would, of course, beg the question why we would put so much cash in a client’s portfolio.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.