Backcasting Alternative Asset Returns for Risk and Portfolio Analysis
Summary
The document considers whether stock and bond histories can help extend the limited return records available for illiquid assets such as private equity, real estate, and hedge funds. It recommends first addressing serial correlation caused by appraisal smoothing, which can make observed volatility look too low. De-smoothing reported returns may improve risk estimates without inventing a longer history.
For research that needs longer records, the answer describes possible proxies: small-cap equities scaled with an assumed alpha for private equity, house prices for private real estate, and equity benchmarks or a blend of equity and housing data for early REIT history. Hedge fund histories are harder to reconstruct; suggested approaches include cash plus an alpha assumption for market-neutral portfolios, regressions on equity, bond, and credit factors, or blends of replicated strategies. These are modeling choices, not validated universal substitutes. Proxy returns and scaling assumptions can introduce bias, and the document advises checking whether added history changes the analysis meaningfully. It gives no comparative tests or performance evidence for the proposed extensions.
Key ideas
- Serial correlation from appraisal smoothing can suppress measured volatility in alternative asset returns.
- De-smoothing available observations may improve risk estimates before extending the history.
- Small-cap equity returns, scaled with an assumed alpha, are suggested as a private equity proxy.
- House prices and equity benchmarks can help extend real estate and early REIT histories.
- Hedge fund proxies may use factor regressions, strategy replications, or cash with an alpha assumption.
- Backcast series depend on assumptions and can introduce bias, so their effect on results should be assessed.
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# What is the optimal approach to "backcasting" alternative asset classes (i.e. PE, Hedge Funds, Real Estate)? # What is the optimal approach to "backcasting" alternative asset classes (i.e. PE, Hedge Funds, Real Estate)? I am interested in coming up with better risk calculations for alternative asset classes. As these are illiquid, not a lot of historical data is available. My idea is to use performance of stocks and bonds to estimate, say Private Equity returns, back in time and use these estimates, to improve risk estimates. What would be the best approach to this task? ## Answer by Helin (score 2) https://quant.stackexchange.com/a/41185 My recommendation is to focus on improving estimates based on available data. For example, the returns of these assets classes tend to exhibit very strong serial correlations as a result of smoothing, which dampen observed volatilities. You can add a ton of value to the investment process by de-smoothing these returns and estimate risk thereafter. I'm inclined to believe that this is more valuable than extending the returns – it's hard to gauge what kind of biases we might introduce. And if adding the extra returns doesn't change the results meaningfully (likely because we're imposing our will based on observable data), there's no value in adding them anyways. That being said, we do extend these time series in a lot of portfolio construction research, mostly when we're studying diversification benefits (e.g., how these assets interact with others in different economic environments): - For private equity, it's common practice to use something as simple as the returns of Russell 2000 scaled by 1.1 to 1.2, plus an in-house alpha assumption. - Private real estate can be proxied by house prices, which already go back to the late 1800s. - REITs behaved more like equities in the early days and can be proxied by equity benchmarks, or a blend of equities and house prices. - Hedge fund is much more challenging. Insofar that your hedge fund portfolio is truly market neutral, the "replication" can be as simple as cash + an alpha assumption. Otherwise, you can regress either the HFRI or the CS indices against equities, bonds, credit spreads, etc. and go from there. If you're really adventurous, you can replicate some of the popular strategies (trend following, carry, etc.) and create a blend of them. Most banks also offer hedge fund replication products and they provide very detailed documentation on how they do it (mostly just simple regressions), which you can reference for ideas.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.