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

An analyst notes that reported returns on a private real estate fund are based on periodic appraisals, and the fund's annual return volatility is reported as 6%, while listed REITs holding similar assets show 18%. The true underlying volatility of the private assets is believed to be close to the REIT figure. What is the most likely explanation, and its consequence for risk measurement?

Appraisal smoothing makes private real estate returns lag market values, which understates measured volatility and correlation with other assets. Optimizers using these figures overallocate to real estate and underestimate portfolio risk, so analysts should desmooth the return series before using it.

  1. AAppraisal smoothing understates volatility and understates correlation with other assets, so risk-based allocations will be too high for real estateCorrect
  2. BAppraisal smoothing overstates volatility, causing allocations to real estate to be too low
  3. CLeverage in REITs reduces volatility, so the private figure is accurate
  4. DSurvivorship bias in REIT indexes lowers REIT volatility, so the private figure is accurate

Explanation

Appraisals lag market prices, creating positive autocorrelation and artificially low measured volatility and correlations. Mean-variance or risk-budget models using these figures will overallocate to real estate. Desmoothing the series is the usual remedy.

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