14 Oct 2011  Working Papers

The Cost of Capital for Alternative Investments

Executive Summary — An accurate assessment of the cost of capital is fundamental to the efficient allocation of capital throughout the economy. Alternative investments are investments made by sophisticated individual and institutional investors in private investment companies like hedge funds and private equity funds. These investments are frequently combined with financial leverage to bear risks that may be unappealing to the typical investor or that require flexibility that public investment funds may not provide. Often there is a real possibility of a complete loss of invested capital. For this paper, Jakub W. Jurek and Erik Stafford study the required rate of return for a risk-averse investor allocating capital to alternative investments. They argue that the risks borne by hedge fund investors are likely to be positive net supply risks that are unappealing to average investors, such that they may earn a premium relative to traditional assets. Key concepts include:

  • Even with direct knowledge of the underlying risks, the commonly used tools for asset allocation and determining required rates of return are inappropriate for these types of risk.
  • A simple put writing strategy closely matches the risks observed in the time series of the aggregate hedge fund universe.
  • Properly evaluating the risks of alternative investments is challenging. At the individual fund level, this will be especially difficult.
  • The calibrations in this paper suggest that despite the seemingly appealing return history of alternative investments, many investors have not covered their cost of capital.

 

Author Abstract

This paper studies the cost of capital for alternative investments. We document that the risk profile of the aggregate hedge fund universe can be accurately matched by a simple index put option writing strategy that offers monthly liquidity and complete transparency over its state-contingent payoffs. The contractual nature of the put options in the benchmark portfolio allows us to evaluate appropriate required rates of return as a function of investor risk preferences and the underlying distribution of market returns. This simple framework produces a number of distinct predictions about the cost of capital for alternatives relative to traditional mean-variance analysis.

Paper Information