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FRM Part II · FRM Exam Part II · Private Markets Investing

A pension fund is comparing appraisal-based returns on a private core real estate fund with returns on a listed REIT index that holds similar properties. Over the past five years the appraisal-based fund shows a much lower standard deviation of returns. Which is the most appropriate interpretation for risk measurement?

Appraisal smoothing causes reported volatility and correlations of private real estate to be understated, because appraisals lag market prices. Analysts should unsmooth the return series before measuring risk or Sharpe ratios, rather than treating the low reported standard deviation as evidence of genuinely lower economic risk.

  1. AThe private fund has genuinely lower economic risk because it holds the same properties with less leverage
  2. BAppraisal smoothing understates the volatility and correlations of the private fund, so reported risk should be unsmoothed before useCorrect
  3. CThe lower volatility proves the private fund offers a higher Sharpe ratio on an economic basis
  4. DAppraisal-based returns overstate volatility because appraisers update values too frequently

Explanation

Appraisals rely on lagged comparable sales and partial updates, which induces positive serial correlation and damps measured volatility. Reported standard deviation, and correlation with other assets, is therefore biased downward. Analysts typically unsmooth the series before computing risk or Sharpe ratios; taking the figures at face value would overstate risk-adjusted performance.

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