The Alternative Truth of Private Equity and What That Means for Asset Allocation

Christopher Carrano at Venn by Two Sigma sets out to answer whether PE truly offers diversification to long equity and bond markets.

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Illustration by II

The investment world loves its labels.

At a recent industry conference, the label “alternatives” became almost synonymous with private assets, particularly private equity. But is this a helpful categorization?

True, PE operates outside the public market. Yet, the real question lies in its ability to diversify a portfolio heavily invested in public equities and bonds. Alternatives, like trend-following or long-short equity, typically offer diversification because they have a low correlation with traditional investments. With that being said, whether talking about PE or trend following, simply labeling something alternative may not guarantee the diversification benefits investors expect.

Let’s be clear. This is not an attack on PE’s alpha-generating potential. However, this analysis takes aim at the alternative label itself. Does PE truly offer diversification to long equity and bond markets — in other words, is PE really an alternative?

Comparing the Risk of Smoothed Private Equity and Listed Stocks

One major hurdle in assessing private equity’s true diversification is the widespread practice of “performance smoothing.” This tactic, prevalent in private asset reporting, allows for valuations to be presented in a way that conceals their true volatility, making them appear less risky than public markets.

Unlike publicly traded securities that are bought and sold every day — marked to market, private assets are valued at various points in time — marked to valuation. This flexibility offers opportunities for smoothing by strategically timing valuations or using specific valuation methodologies. Smoothing can lead to qualities like high autocorrelation, artificially low volatility, and lagged reactions to moves in public markets.

Comparing the characteristics of private equity, represented by the Preqin Private Equity Index, and public equities, represented by the S&P 500 Index, reveals intriguing insights into the potential impact of performance smoothing.

Exhibit 1: Performance Characteristics of Private and Public Equity


Source: Venn by Two Sigma with certain data provided by Preqin Ltd. and S&P Dow Jones Indices LLC. Copyright 2024. All rights reserved. Not for retail use or distribution. Private securities have risks, including the risk of loss. Click here for Important Disclosure and Disclaimer Information.

Comparing the volatility of both the public and (smoothed) private market indexes (Exhibit 1), there is not much basis to believe that the volatility of PE should be close to half that of public equity, especially since one would expect them to have similar exposure to fundamental risk factors such as economic growth. Over a sufficient time-horizon, long-only equity should generally behave like long-only equity, whether private or public.

Further, despite the fact that PE is smoothed, its correlation with public equities is still fairly high at 0.76, but its beta is quite low at 0.41. This suggests the lower beta is being primarily driven by PE’s relatively lower volatility, more so than a lack of positive correlation.

Last, high autocorrelation — the notion that past returns are correlated with future returns — is relatively higher for PE broadly defined. In fact, levels of autocorrelation this high indicate that external forces have acted on the returns of this investment in an unnatural way relative to public markets. This may indicate that asset valuations are being used as a tool to reduce volatility via the smoothing process, and that skepticism of the current returns may be warranted.

Coming back to our original question of PE as a diversifying alternative to public equity — with a beta of just 0.41 and a downside capture of 24 percent — PE has undoubtedly exhibited some diversifying qualities with public equity. While one might hope for zero correlation or beta, these results provide some justifiable confusion about whether PE is differentiated and potentially diversifying. However, to be fair, you can say that some level of diversification can be found in many different asset classes.

However, desmoothing PE returns presents risk in a way that likely aligns closer to public market reality. This results in an intuitive conclusion, that long-only equities, whether private or public, likely exhibit similar behavior.

Desmoothing: A Truer Understanding of Private Equity Risk

Desmoothing leverages regression techniques and a suitable public market proxy to essentially reverse the smoothing process applied to private asset valuations. This allows for the calculation of PE performance with volatility levels and timing that better reflect the realities of public markets. In simpler terms, desmoothing helps answer the question: “How would the performance of my private assets look if they were marked to market instead of relying on valuations?”

Looking at a desmoothed version of the same Preqin PE Index (Exhibit 1), a few things stand out. Notably, volatility increases considerably, to around 17 percent — in line with public equities.

Additionally, correlation increased from 0.75 to 0.89, which, in conjunction with the increase in volatility, caused PE’s beta with public equities to rise from 0.41 to 0.87. This higher beta is intuitive as both are long-only equity exposures and are likely driven by the same fundamental risk factors.

Further, autocorrelation moves considerably closer to public equities, going from 0.54 to 0.17. This indicates that past returns now behave less like future returns. This suggests that some of the marked-to-valuation effects introduced through smoothing may have been mitigated.

Exhibit 2: Smoothed and Desmoothed Private Equity Performance


Source: Venn by Two Sigma with certain data provided by Preqin Ltd. and S&P Dow Jones Indices LLC. Copyright 2024. All rights reserved. Not for retail use or distribution. Private securities have risks, including the risk of loss. Click here for Important Disclosure and Disclaimer Information.

The desmoothed results, which are likely more accurate representations of PE risk, paint a very different picture than using the smoothed version of PE. With public equities as our reference point, it appears that this marked-to-market representation of broad PE has not been a diversifying alternative.

How Does the Definition of Alternative Affect Asset Allocation?

Recent market commentary frequently mentions the demise of the 60/40 portfolio. This traditional asset allocation faced significant challenges in 2022 due to rising correlations between these asset classes, leading to decreased diversification benefits. As a response, interest in alternative investments has grown, with the 50/30/20 allocation (50 percent equities, 30 percent bonds, 20 percent alternatives) gaining traction.

But why introduce a portfolio with 20 percent in alternatives? While alternatives offer unique characteristics, their primary appeal lies in their potential to diversify traditional portfolios, especially when correlations between stocks and bonds increase. However, as we highlighted earlier, reported PE performance could create the illusion of diversification with public equities that may not be true in reality.

By using desmoothing to mark private assets to the market rather than to valuation, allocators may gain greater transparency into the truer risk of a portfolio. By certain measures, a 50/30/20 that uses desmoothed PE in the alternatives sleeve looks and behaves more similarly to a 70 percent equity and 30 percent fixed income portfolio.

Exhibit 3: Performance Characteristics of a 50/30/20 With 20 percent in Desmoothed PE


Source: Venn by Two Sigma with certain data provided by Preqin Ltd. and S&P Dow Jones Indices LLC. Copyright 2024. All rights reserved. Not for retail use or distribution. Private securities have risks, including the risk of loss. Click here for Important Disclosure and Disclaimer Information.

Comparing the performance of a 50/30/20 portfolio (50 percent in the S&P 500, 30 percent in Bloomberg US Aggregate, and 20 percent in the desmoothed Preqin Private Equity index), a 70/30 portfolio (70 percent in the S&P 500 and 30 percent in the Bloomberg US Aggregate index), and a 60/40 as the benchmark (Exhibit 3), we find that the 50/30/20 allocation generates a similar standard deviation as the 70/30. More specifically, it realized a volatility of 11.48 percent vs. 11.83 percent for the 70/30 - both of which are higher than the 60/40 at 10.15 percent.

Our results suggest that introducing PE as a 20 percent allocation into a 50/30/20 realizes more risk relative to a 60/40, not less. Intuitively, realized risk was similar to a 70/30 allocation, though the 50/30/20 portfolio did demonstrate somewhat lower volatility and beta. It is also worth noting that the portfolio with PE did achieve the highest return, and similarly, the highest sharpe ratio as well.

Taking the analysis one step further, using Venn’s Two Sigma Factor Lens (Exhibit 4), we confirm that equity factor exposure was indeed higher for the 50/30/20 portfolio. This included a meaningful increase in exposure to our local equity factor, as well. This is evidence that a 50/30/20 with PE as the alternative actually increases equity exposure, rather than decreases it. While an intuitive conclusion, this defeats the purpose of moving from a 60/40 to a 50/30/20 in the first place, which is to introduce a different and diversifying exposure with equities and bonds.

Exhibit 4: Venn Factor Exposure of a 50/30/20 With 20 percent in Desmoothed PE


Source: Venn by Two Sigma with certain data provided by Preqin Ltd. and S&P Dow Jones Indices LLC. Copyright 2024. All rights reserved. Not for retail use or distribution. Private securities have risks, including the risk of loss. Click here for Important Disclosure and Disclaimer Information.

Another interesting occurrence: remember that the additional allocation to PE also comes at the cost of removing a 10 percent allocation to fixed income. This is a reminder that when one aims to introduce diversification, one must also consider if diversification is part of the funding cost. This dynamic was enough to drown out the statistical relevance of the 50/30/20 portfolio’s exposure to the interest rates factor, as seen in Exhibit 4. Put another way, our factor selection methodology no longer deemed our interest rates factor to be among the most relevant factors to analyze this portfolio. This is an indication of the net negative diversification caused by using PE as the 20 percent alternative allocation in a 50/30/20.

Paper Diversification Versus Real Diversification

As an asset class, private equity may appear to have diversifying properties with public equities, but these properties seem only to exist “on paper.” They are the result of artificially low volatility characteristics that are the product of performance smoothing.

Desmoothing PE returns, which aims to provide a more realistic representation of risk, suggests that broad PE may not offer true diversification against long-only public equities. This finding is particularly relevant for popular approaches like the 50/30/20 allocation. Including PE in this strategy could undermine its original goal of reducing equity exposure via the inclusion of diversifying alternative assets. Instead of offering diversification, it might effectively resemble a 70/30 portfolio with increased equity risk relative to a 60/40.

It’s crucial to remember that this analysis focuses specifically on broad PE. Individual PE funds, particularly those targeting specific sectors like commodities, may still offer diversifying potential. Additionally, other private asset classes, like private credit, exhibit a wider range of risk profiles, with some strategies like direct lending offering more diversification potential compared to others.

Ultimately, quantitative analysis is crucial when assessing diversification potential, not labels. While PE offers unique investment opportunities, its diversification potential within a portfolio should be carefully assessed considering its marked to market risk profile and specific investment strategy. Investors should avoid confusing the alternative label with true diversifiers, as this can lead to unintended portfolio outcomes.

Christopher Carrano is Vice President of Strategic Research at Venn by Two Sigma. Opinions expressed in this commentary are his own and not representative of Venn or Two Sigma. Two Sigma Investor Solutions, LP (“TSIS”) operates Venn. Venn is separate and the services it offers are different from the businesses and services of TSIS’s affiliates. Venn by Two Sigma is for institutional and other qualified clients in certain jurisdictions only.

Opinion pieces represent the views of their authors and do not necessarily reflect the views of Institutional Investor.