FRM Part II · FRM Exam Part II · Illiquid Assets

A portfolio manager compares a listed equity fund with a private equity fund. Reported private equity returns show much lower volatility and low correlation with public equities. Which conclusion is most appropriate for the risk manager?

Reported private equity volatility and correlation are biased downward because appraisal-based valuations are smoothed and lag markets. The risk manager should unsmooth the returns before using them, since otherwise the diversification benefit is overstated and economic risk understated.

1. AReported volatility and correlation understate true economic risk because appraisal-based valuations smooth returns, so the diversification benefit is likely overstatedCorrect
2. BThe low reported volatility proves private equity has lower economic risk, so its allocation should be increased without adjustment
3. CThe low correlation shows private equity returns are unaffected by market liquidity conditions
4. DThe low volatility indicates the liquidity premium on private equity is negative