Phantom Diversification: Performance Reporting Fails When Using Lagged Alternatives By: Gabriel PotterMBA, AIFA® 2015.04.01
This blog often takes a broad view on large issues such as monetary policy, geopolitical conflicts, or new legislation.  Today, we are narrowing our focus to a smaller problem we’ve recently noticed in regards to performance reporting using alternative asset classes.

Performance returns for traditional assets – stocks and bonds – are available instantly.  We can look up results any time to get up-to-date (sometimes to the second) performance information for most investments.  On the other hand, some alternative asset products, like a Hedge Fund of Funds, take several weeks to collate results and determine performance.  Thus, alternative asset performance results are sometimes lagged.  For example, the listed February 2015 monthly performance for a particular hedge fund may actually be January 2015 performance; moreover, the January 2015 listed performance actually represents the results from December 2014, and so on backwards. 

If an investor is comparing lagged performance results to a similarly lagged index, it’s an appropriate solution.  In the very short-term, combined return results are going to be inaccurate, but that problem will diminish significantly over time.  As long as investment consultants keep their focus on long-term results and disclose the potential problem with the lagged alternative performance, this is an excusable concession to make in the name in up-to-date reporting. 

However, most investors are less interested in the individual investments; they want to know about their entire portfolio performance.  So, investment consultants often combine lagged alternative performance results into a portfolio’s return.  It happens all the time and it is a mistake.  Return reporting is not the issue; the much bigger concern regards risk and risk-adjusted return measurements since these results can be terribly skewed using lagged returns.  Essentially, lagged returns creates an illusion of diversification within a portfolio.   

As an example, here are the annual returns of the S&P 500, correlated to the annual returns of the S&P 500 lagged by a year. 

True Correlation:  100%
Lagged Correlation:  -13%

The tendency for an asset class to go down, just after it goes up (and vice versa) is well known:  it is classic mean-reversion.  Comparing the lagged results to actual annual returns generates a negative correlation between asset classes with the identical long term returns:  a godsend to any risk-return optimizer.  Using Modern Portfolio Theory, asset classes with distinct, uncorrelated returns are combined to create optimal portfolios which maximize return for any given level of risk.  However, using lagged returns creates an element of non-correlation that does not reflect the actual behavior of the assets.  In other words, using lagged results will create an element of diversification – thus improving risk and risk-adjusted return metrics, like alpha–which simply isn’t real.  Watch out for this common error in performance reporting.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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