Benchmarking Alternative Investments: Beyond Stocks and Bonds

Judging the performance of alternative investments requires a different lens than what you’d use for traditional assets like stocks and bonds. Imagine you’re comparing the speed of different vehicles. For cars, you might use a racetrack or a highway. But what if you’re evaluating a helicopter, a submarine, or a rocket? The racetrack benchmark becomes irrelevant. Similarly, using standard stock market indices like the S&P 500 or bond indices to assess alternative investments can be misleading and inappropriate.

Alternative investments, encompassing asset classes like private equity, hedge funds, real estate, commodities, and infrastructure, operate with unique strategies, risk profiles, and liquidity characteristics. Therefore, you need benchmarks tailored to their specific nature. The goal of benchmarking isn’t just to see if an alternative investment “beat the market,” but rather to assess if it delivered the expected performance relative to its intended strategy and risk level.

For Private Equity, standard stock market indices are largely irrelevant. Private equity investments are illiquid, long-term, and aim to generate returns through operational improvements, financial engineering, or growth in private companies. Appropriate benchmarks include:

• Private Equity Indices: Organizations like Cambridge Associates, Preqin, and PitchBook provide indices that track the aggregate performance of private equity funds. These indices are categorized by strategy (e.g., buyout, venture capital) and geography, allowing for more relevant comparisons. However, these indices are often lagged and based on fund valuations which can be less frequent and potentially smoother than public market valuations.
• Internal Rate of Return (IRR) Hurdles: Many private equity funds aim to achieve a specific IRR, often expressed as a hurdle rate (e.g., 8% or 10% per year). Comparing a fund’s IRR against its stated hurdle rate is crucial.
• Multiples of Invested Capital (MOIC): This metric shows how many times an investment has returned the initial capital. Comparing MOIC to similar deals or historical averages within a specific private equity strategy can be informative.

For Hedge Funds, the challenge is even greater due to the diverse range of strategies employed. A simple stock market index is almost always unsuitable. Instead, consider:

• Hedge Fund Indices: Providers like HFRI, MSCI, and Eurekahedge offer indices that aggregate the performance of hedge funds, often segmented by strategy (e.g., long/short equity, event-driven, macro). These indices provide a broad market benchmark for hedge fund performance but can be influenced by reporting biases and survivorship bias (underperforming funds may cease to be included).
• Strategy-Specific Benchmarks: For a long/short equity hedge fund, a more relevant benchmark might be a combination of long-only equity indices and short-selling benchmarks. For a global macro fund, benchmarks might include global bond and currency indices. The key is to identify benchmarks that reflect the underlying market exposures the hedge fund is taking.
• Peer Group Analysis: Comparing a hedge fund’s performance to its peer group – funds with similar strategies and mandates – can offer valuable context. However, peer groups can be subjective and data may not always be readily available.

For Real Estate, benchmarks should reflect the specific type of real estate and geographic location.

• Real Estate Indices: The NCREIF Property Index (NPI) in the US, or similar indices in other regions, tracks the aggregate performance of institutional-quality real estate. These indices are valuable for benchmarking diversified real estate portfolios.
• Property-Type Specific Indices: Indices exist for different property types (e.g., office, retail, industrial, residential), allowing for more granular comparisons.
• Cap Rates and Yields: Analyzing the capitalization rates and yields of comparable properties in the same geographic market provides a localized benchmark for income-generating real estate investments.

For Commodities, commodity indices are the most direct benchmarks.

• Commodity Indices: Indices like the Bloomberg Commodity Index or the S&P GSCI track the performance of a basket of commodities. These are useful for benchmarking broad commodity exposure.
• Sector-Specific Commodity Indices: Indices focused on specific commodity sectors (e.g., energy, agriculture, precious metals) provide more targeted benchmarks.

Ultimately, benchmarking alternative investments is not about finding a single perfect metric. It’s about using a combination of relevant benchmarks, understanding their limitations, and considering qualitative factors like strategy implementation, risk management, and fees. It’s about asking: “Did this alternative investment deliver the type of performance, adjusted for its unique characteristics, that was expected and justified the allocation?” Choosing the right benchmarks and interpreting them thoughtfully is crucial for making informed decisions about alternative investments.