Investors should diversify their portfolios across asset classes that genuinely enhance diversification. Unfortunately, many (professional) investors often fall for illusions. In the realm of private equity, that illusion is akin to “The Emperor’s New Clothes”.
Private equity has surged as a favoured alternative asset class. While it has potential value, the often excessive allocations are largely driven by myths rather than facts.
Misleading allure of Sharpe ratios
Many asset managers have embraced private equity, lured by its purportedly superior Sharpe ratio—a metric suggesting high returns with limited risk. This higher return is often linked to investments in younger, smaller companies, frequently burdened with significant debt and characterised by limited liquidity. However, the so-called limited risk is often the result of a statistical illusion.
The need for desmoothing
Private equity portfolios are typically revalued infrequently and partially, leading to an artificially low volatility measure. This skewed representation of risk can be corrected through “desmoothing” techniques. By adjusting for the relationship between returns of consecutive periods, a clearer picture of volatility emerges.
For example, a well-known private equity fund of funds index shows an unadjusted volatility of 8 percent. After applying a simple regression technique to desmooth the returns, the volatility jumps to 16 percent—double the initially reported figure.
Recognising the real risk
The artificially low volatility of private equity is not a new revelation. Pitchbook data reveals similar patterns in various private assets, with unsmoothed volatilities being twice or more than the reported figures.
Despite this, professional investors continue to heavily invest in private equity. Family offices, on average, allocate nearly a quarter of their portfolios to this asset class. Moreover, private equity returns have been shown to closely mirror those of small-cap stocks. Alarm bells should be ringing: over the past three years, the Russell 2000 Index has fallen nearly 10 percent, while the S&P 500 Index has risen over 30 percent.
Call for reevaluation
It is high time for asset managers to reassess their private equity allocations. If changes begin, we can expect the usual cycle of hiring consultants to determine the “optimal” allocation. However, a dose of common sense and solid mathematical analysis would suffice. They might even discover that gold, which passes statistical scrutiny, is a worthy asset class.
Jeroen Blokland analyses compelling, up-to-date charts on financial markets and macroeconomics in his newsletter, The Market Routine. He also manages his own multi-asset fund, which includes investments in gold. Previously, Blokland was head of multi-asset at Robeco.