Hedge Funds or Private Equities to achieve long term goals of returns

CFA Level III Alternative Investments
#1

Reading 20, EOC question 2.

This is what they want to achieve.

“If the public equity allocation remains at 60%, is there a single asset class that could be used for the balance of the portfolio
to achieve the greatest probability of maintaining the pension funding status over a long time horizon? Under this hypothetical scenario, the balance of the portfolio can be allocated to either bonds, hedge funds, or private equities.”

They want us to choose between bonds, hedge funds and private equities.

I chose hedge funds, but the answer says private equities. I mean technically even hedge funds would be the right answer too

The answer:

When projecting expected returns, the order of returns from highest to lowest is typically regarded as private equities, hedge funds, bonds. Therefore, the probability of achieving the highest portfolio return while maintaining the funded status of the plan would require the use of private equities in conjunction with public equities. In addition, private equities have a high/ strong potential to fulfill the role of capital growth. Fixed-income investments are expected to have a high/strong potential to fulfill the role of safety.

#2

According to CFA Institute, private equity.

Give them the answer that they want.

#3

And are hedge funds positively correlated to equities and private equities are negatively correlated to equities? Like, let’s say we want to achieve diversification benefits. Which one of the two should we use?

I always thought that private equities were positively correlated to equities and hedge funds were negatively correlated.

#4

It largely depends on the hedge fund strategy.

But in general you can think of it this way. Hedge funds typically invest in publicly traded securities, playing different strategies around them but public securities are their investment universe.

Private equity funds, as their name implies, don’t.

#5

Yes and it depends, respectively.

  • An equity market neutral strategy should have zero correlation of returns with equities (and everything else, for that matter).
  • A dedicated short strategy should, in general, have a negative correlation of returns with equities.
  • A long extension (e.g., 130/30) should, in general, have a positive correlation of returns with equities.
  • Managed futures should, in general, have a positive correlation of returns with equities.
  • Nonequity strategies (convertible bond arbitrage, merger arbitrage, distressed securities, fixed income arbitrage, volatility strategies, reinsurance strategies) could be all over the map: strongly negative, mildly negative, zero, mildly positive, or strongly positive correlations of returns with equities.