Toward Integrated Active Management Based on SBDA

Abstract

Regarding the methodology for separating the investment performance of PE funds into a beta portion (investment performance of traditional assets), which is market performance, and an alpha portion (excess return), we presented it in comparison with the valuation method for interest rate swaps with credit risk in our JMF article dated August 25, 2023, “Spread-Based Direct Alpha (SBDA) as a Performance Measure for PE Funds”. Once we separate the excess return from the benchmark return, we have only to estimate the risk of the excess return, namely tracking error, to evaluate the risk-return efficiency of the PE Fund relative to the benchmark. However, due to the complicated cashflows with capital calls and distributions, it is quite difficult to define and estimate the tracking error of the PE fund being different from the estimation of the tracking errors for the active funds of traditional assets. This study provides the methodology to estimate the tracking error for alternative assets by using the SBDA as a starting point and introducing various new concepts of excess returns. Utilizing the integrated active management, which is available with the estimated tracking error, pension fund managers are able to build the more risk-return (Information Ratio) efficient portfolio incorporating alternative assets in addition to the active funds of traditional assets.