Correlation, Alternative Returns, and Performance Measurement
This chapter begins with a discussion of various measures of correlation between assets. The second topic focuses on returns, including the internal rate of return and the distribution of returns through fund waterfalls. The final topic reviews measures of performance.
Understanding and measuring correlation is critical to alternative investment management because the risk of a portfolio relative to the risk of the portfolio's assets is determined by the correlation between those assets. This chapter focuses on four related measures: the covariance, the correlation coefficient, beta, and autocorrelation.
The second major topic focuses on return computation in the context of the complexities introduced by characteristics common to many alternative investments, including illiquidity, unusual cash flow patterns, notional principal, and waterfall distribution. The discussion begins with a section on the internal rate of return (IRR). Chapter 3 discussed issues regarding returns such as compounding and aggregation. But the implicit assumption of most of the discussion of Chapter 3 was that prices or values for the investment were readily and regularly observable. When an asset can be valued at regular intervals, returns are simplified. Some alternative assets, especially private equity and private real estate, are not regularly and publicly valued in a market. This lack of valuation data leads to the use of the ...