Introduction
Strategic Asset Allocation (SAA) remains a cornerstone for institutional investors seeking to optimize returns while managing the complex risk profile of private capital investments. As institutional allocations to private assets like private equity and venture capital grow, accurate risk assessments become increasingly important.
However, private capital indices, such as those from Preqin, often show artificially low volatility due to the “smoothing” effect. This dampened volatility results from infrequent appraisals and valuation techniques, which, while stabilizing apparent returns, can lead to an underestimation of actual risks. Addressing this smoothing effect through unsmoothing techniques provides a more realistic view of private capital’s risk, enabling more balanced and informed portfolio optimization.
The importance of private markets in the allocation of investors
At face value, illiquid assets are outperforming the other assets class with a strong performance of Private Equity and Venture Capital since 2007.
Figure 2: Real Estate offers a very good investment with a sound balance between return and volatility
However, there is an uncanny effect in these reporting to present the performance gross of fees, especially in the illiquid markets. Portfolio managers and investment officers may keep in mind the smoothing effect in Private Equity. The Smoothing Effect in Private Capital and Its Challenges Private capital indices frequently display volatility levels significantly lower than those of public market indices, making them appear more attractive in traditional mean-variance optimization (MVO) models. This low volatility is, however, often misleading. Due to lagged valuations and infrequent data updates, private assets tend to show a smoothed return profile that fails to capture true market fluctuations and underlying risk. This phenomenon can skew MVO models toward over-allocating to private assets, as the apparent low volatility and correlation with public assets suggest an outsized role in the “efficient” portfolio.
The smoothing effect arises primarily due to:
- Lagged Reporting and Stale Pricing: Private asset valuations are often based on quarterly data, which does not capture short-term market shifts.
- Valuation Models: Discounted cash flow and internal valuation models used by private firms can mask real-time price changes, leading to valuations anchored to historical values.
- Performance Fees: The asymmetric nature of performance fees dampens perceived volatility, as fees adjust with gains, but losses are less directly penalized.
Together, these factors result in return profiles that may underestimate the real risk, posing challenges for investors who depend on these indices for portfolio decisions.
Unsmoothing Techniques: Revealing the True Volatility of Private Capital
To address the smoothing problem, various unsmoothing methodologies can provide a more representative view of private asset risk. The report highlights autoregressive (AR) models, such as AR(1) and AR(2) filters, as effective tools.
These models recalibrate returns by using lagged values to “unsmooth” data, resulting in a volatility level that aligns more closely with public assets.
For example, unsmoothing venture capital returns with an AR(1) model increases volatility from 10.16% to 22%, a substantial shift that more accurately reflects the asset’s risk profile. Similarly, private equity volatility rises from 8.94% to 15.7%.
These recalibrated risk levels can substantially alter the results of MVO by making private capital appear less uniformly attractive, promoting a more diversified portfolio allocation across public and private assets.
Implications for Portfolio Optimization and Diversification
Introducing unsmoothed returns into SAA models affects portfolio allocation by reshaping the perceived risk-return trade-off. With unsmoothed data, the optimal portfolio often shifts to include more public assets, achieving a more diversified balance.
- Key findings include:
Increased Volatility in Private Capital: Unsmoothing highlights that private assets hold more systematic risk than indicated by raw indices, challenging their overrepresentation in portfolios. - Enhanced Diversification:
When unsmoothed volatility is applied, MVO outputs suggest higher allocations to public assets like stocks and bonds to maintain balanced risk. - Constraints in Allocation:
Even with unsmoothing, the high returns of private assets can still lead MVO to overweight them. Constraints, such as limits on the percentage of illiquid assets, can help achieve more sustainable
allocations.
The report models four distinct MVO scenarios:
- Unconstrained MVO:
Without any restrictions, the model heavily favors private assets, highlighting the potential pitfalls of relying on smoothed data. - Illiquidity-Constrained MVO:
Introducing a 40% illiquidity threshold reduces the allocation to private assets, allowing public equities to occupy a larger share of the portfolio. - Single Asset Class Limitation:
Capping individual private asset classes (e.g., private equity at 30%) further diversifies the portfolio. - Target Return Focus:
By targeting a specific return (e.g., 7%), the optimization emphasizes a mix of public and private assets that balance risk while meeting return objectives.
Risk Management Beyond Volatility: Conditional Value-at-Risk (CVAR)
In addition to standard volatility measures, the report examines Conditional Value-at-Risk (CVAR) as an essential risk metric impacted by unsmoothing. CVAR, which estimates potential losses in the worst 5% of scenarios, provides a more comprehensive view of downside risk. Unsmoothing reveals that private capital’s CVAR is significantly higher than initially perceived, indicating that investors may underestimate worst-case losses if relying solely on smoothed indices. For instance, targeting a 7% return results in an expected shortfall of 6% in the unsmoothed portfolio compared to 4.6% with smoothed data, underscoring the importance of accurately assessing tail risk for robust portfolio management.
Conclusion
Unsmoothing private capital returns provides institutional investors with a clearer understanding of the risks associated with private assets, enabling more balanced portfolio allocations and improved risk management. As private assets continue to play a significant role in institutional portfolios, unsmoothing becomes a valuable tool for achieving realistic asset allocation and managing exposure to illiquid assets. By incorporating unsmoothed data into SAA, investors can avoid over-allocating to private assets, better diversify their portfolios, and enhance overall resilience. For risk-aware investors, this approach offers a more comprehensive foundation for strategic decision-making in today’s complex investment landscape.
This enhanced summary captures the report’s insights into the need for unsmoothing private capital returns to achieve balanced portfolio optimization, emphasizing the implications for institutional investors.