Although most research on private assets asks whether returns are commensurate with risk, we focus on the value of the smoothed volatility profile of private assets that are not marked to market. We find that the smoothing of returns in private equity has a substantial impact on headline volatility: The true economic volatility of private equity is close to 30%, rather than a headline number of 10%. We then quantify the value of the illusion of low volatility with a few thought experiments. Using reasonable assumptions, we find that smoothing results in an almost 0% probability of observing a 30% drawdown, versus a true probability of 15%–16% over a three-year period. We also find the expected observed maximum drawdown is 12% under smoothing, versus a true value of 40%. To be indifferent about the choice between a smoothed private index and a public index with similar risk, a representative investor based on our analysis would require the public index to have 6 percentage points of additional return annually. Smoothing also protects investors from their behavioral demons, such as the tendency to buy high and sell low. For a 10-year horizon, we find a reasonable estimate of the gain from the locking up money in a private equity “straitjacket” is an extra annual return of 1.7%.

This abstract has been provided by the Journal of Portfolio Management. Click here for a link to the full article. © 2022 Pageant Media Ltd. All rights reserved.

The Author

Jamil Baz

Josh Davis

Global Head of Risk Management

Lloyd Han

Quantitative Research Analyst

Christian Stracke

Global Head of Credit Research

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Private equity involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private equity may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in securities of smaller companies tends to be more volatile and less liquid than investing in securities of larger companies. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. Catastrophe (Cat) Bonds are insurance securitizations, structured similarly to traditional bonds, where a specified set of risks is purchased by investors; if a triggering catastrophe occurs prior to maturity investors may lose most or all of their accrued interest and principal. Diversification does not ensure against loss. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy.

This paper includes hypothetical assumptions and scenarios. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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CMR2022-0824-2395228