The Cost of Capital for Alternative Investments

Abstract:     
We develop a simple state-contingent framework for evaluating the cost of capital for non-linear risk exposures, and show that properly computed required rates of return are meaningfully higher than indicated by linear factor models. Given the large allocations of typical investors in alternatives, many have not covered their cost of capital, despite earning an annualized excess return of 6.3% between 1996 and 2010. A simple derivative-based strategy, which accurately matches the risk profile of hedge funds, realizes an annualized excess return of 10.2% over this sample period, while providing monthly liquidity and complete transparency over its state-contingent payoffs. Linear clones based on popular factor models deliver annualized risk premia of 0-3% over the same period.

Number of Pages in PDF File: 55

Keywords: hedge funds, downside risk, replication, performance evaluation, risk management, endowment model

JEL Classification: G12, G23, G31

working papers series