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

A risk manager notes that reported private equity fund returns appear much less volatile and less correlated with public equities than their economic risk suggests. What is the most likely cause?

The most likely cause is appraisal-based, smoothed valuation. Private equity NAVs are updated infrequently and lag market prices, so reported returns understate true volatility and correlation with public markets. Analysts often unsmooth the return series to estimate the economic risk more accurately.

  1. AAppraisal-based (smoothed) valuations that lag market prices, which understate volatility and correlationCorrect
  2. BDaily mark-to-market pricing, which adds noise to reported returns
  3. CSurvivorship in public indexes, which lowers the measured private equity volatility
  4. DHigh trading frequency in underlying portfolio companies, which diversifies away risk

Explanation

Private equity NAVs rely on appraisals and manager estimates that update infrequently and partly lag market moves, so reported returns are smoothed. This biases volatility and market correlation downward and the Sharpe ratio upward. Unsmoothing the returns is the usual remedy. Daily pricing and frequent trading are not features of private holdings.

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