Alternatives- Eileen Gension case

The fund’s current portfolio is invested primarily in public equities, with the remainder invested in fixed income. The fund’s investment objective is to support a 6% annual spending rate and to preserve the purchasing power of the asset base over a 10-year time horizon. The fund also wants to invest in assets that provide the highest amount of diversification against its dominant equity risk. Gension considers potential alternative investment options that would best meet the fund’s diversification strategy.

Q. Which asset class would best satisfy the Fund’s diversification strategy?

Private equity
Private real estate
Absolute return hedge fund

My choice would be Real Estate

I second your choice.

C is correct. An absolute return hedge fund has a greater potential to diversify the fund’s dominant public equity risk than either private equity or private real estate. Absolute return hedge funds exhibit an equity beta that is often less than that of private equity or private real estate. Also, absolute return hedge funds tend to exhibit a high potential to diversify public equities, whereas equity long/short hedge funds exhibit a moderate potential to fulfill this role.
A is incorrect because although private equity provides moderate diversification against public equity, an absolute return hedge fund has a greater potential to do so. The primary advantage of private equity is capital growth.
B is incorrect because private real estate provides only moderate diversification against public equity, whereas absolute return hedge funds have a greater potential to do so. The primary advantage of private real estate is income generation.
Asset Allocation to Alternative Investments Learning Outcome

  1. Explain the roles that alternative investments play in multi-asset portfolios

I do not understand why C is the correct choice???

A hedge fund is highly correlated with equity because of the investments in public companies’ equity. So it will not satisfy the second condition. The same goes for Private Equity (private equity mainly invests in private companies’ equity)

Private Real Estates is the right choice because it has both characteristics of debt and equity.

That is why I would think option B is right.

I am also confused on this- why is it C and not B? I mean for C, doesn’t it just mean you are trying to generate a certain amount of return independent of everything? Also absolute return hedge fund- what assets are we using to achieve that? I feel that should also be taken into consideration

I guess the answer is C because, absolute return funds will have a cash benchmark or even an inflation benchmark typically (LIBOR+ or CPI+), that fits well with the objective - particularly over the cycle. Absolute return funds are also typically built to be a diversifying agent within a portfolio and will have lower correlations to equity than PE or PRE - it is not limited to one asset class after all and will make far more extensive use of derivatives for the purpose of risk management.

The fund has equity (and some fixed income).
Think if the “type” of return that real estate offers (you can review in CME readings)
Real estate is though it have a risk premium between equity and corporate debt.
Real estate income is subhect to volatility due to the economy and asset value fluctuations. Fixed term leases though provide stability relative to dividends.
Real esate does provide diversification benefits compared to equity but not as much as an “absolute return hedge fund”.
Equity/real esate returns - related to economy. Absolute returns should not be.