Mastering Illiquidity: Risk management for portfolios of limited partnership funds

1

Introduction

Investing in private equity, hedge funds and real assets – such as infrastructure, real estate, forestry and farmland, energy and commodities – has gained considerable momentum in recent years. These assets are often called “alternatives” as their investment history is still relatively short and, unlike traditional asset classes, they are rarely traded in public markets.1 Investors have been attracted by the superior returns that alternative assets may offer. Moreover, as returns are found to be correlated less with traditional asset classes, alternative assets have been regarded as attractive investments helping asset allocators diversify their portfolios. At the same time, it has been argued that the potential returns of traditional asset classes have diminished. Specifically, public stock markets have become increasingly efficient, limiting investors' potential to achieve excess returns by investing in undervalued stocks. In the bond market, yields have declined substantially since the 1980s thanks to successful central bank policies aimed at reducing inflation expectations and restoring confidence in monetary policy.

1.1 ALTERNATIVE INVESTING AND THE NEED TO UPGRADE RISK MANAGEMENT SYSTEMS

At the end of 2011, private equity funds, hedge funds and funds investing in real assets were estimated to be managing around USD 4 trillion. This amount may still seem small compared with the size of the global equity and debt securities markets, whose volume totalled almost ...