The Impact of Amortizing Volatility across Private Investments

While publicly traded stocks, bonds, and real estate have their prices constantly adjusted throughout the day, leading to lots of volatility, private capital managers have significant discretion as to when and how they mark-to-market or mark-to-model their portfolios (typically valued quarterly). Because their valuations are less frequent, private equity returns appear smoother. If the “lagged betas” are not considered, investors will underestimate the risks of private investments, leading to an over allocation.

The Evidence

Nicolas Rabener, author of the 2020 study “Private Equity Is Still Equity, Nothing Special Here,” found that the volatility of private equity returns is understated as a result of smoothing, and the risk-adjusted returns are comparable to those of public equities. An unsmoothing approach results in comparable standard deviations of returns for private equity. He also found that U.S. private equity returns could be replicated systematically through public equities, historically by selecting small, cheap and levered stocks. Since small value stocks are significantly more volatile than the overall stock market, the implication is that advisors including allocations to private equity in client portfolios should increase their volatility assumption to about 20% greater than for public equities.

Underestimating risk by not considering lagged betas is not the only problem. Failure to consider what has been called “volatility laundering” also leads to underestimating the correlation of private investments to public ones, and overestimating the alphas of private assets.

New Evidence

To analyze the impact of lagged betas on private assets, Mark Anson, author of the 2024 study “Amortizing Volatility across Private Capital Investments,” published in The Journal of Portfolio Management (Volume 50, Issue 7), extended the research beyond private equity and venture capital to include secondary private equity, private credit, and private real estate investing. Anson expanded the examination of lagged betas to include not only systematic market risk, but also the full body of Fama–French factors (market beta, size, value, momentum, investment, and profitability). His data sample spanned the period 1998 through 2022.

The following is a summary of his key findings:

• Private valuation methods can lead to a smoothing effect, allowing private capital managers to amortize the volatility of their private investments over time – leading to lower estimates of systematic market risk (beta), lower correlation coefficients with traditional asset classes, and higher estimates of alpha.
• All five private investments exhibited significant serial correlation at the quarterly level—about 0.65 for both real estate and venture capital, about 0.55 for secondaries, about 0.45 for private equity, and about 0.35 for private credit.
• Real estate demonstrated the greatest amount of serial correlation (at four quarters it was still about 0.3), while private credit the least (there was none at two quarters and it was negative at three and four quarters.
• Lagged betas, including stock market risk and the well-known Fama–French factors, account for a significant amount of the returns associated with private capital alpha. For small (large) buyout firms, alphas were reduced from 2.8% (2.2%) to 2.0% (1.8%). For late-stage venture capital, alphas were reduced from 2.8% to 1.9%. For secondaries, alphas were reduced from 2.8% to 1.8%. Real estate alphas were reduced from 1.8% to 0.9%.
• Alphas for early-stage venture capital, which were 4% in the single period model, turned negative (-0.6%).
• Lagged betas and accounting for Fama-French factors had virtually no effect on the returns to private credit—alphas were reduced from 2.0% to 1.9%.
• Using lagged betas to un-smooth the return series associated with private capital leads to a lower allocation to private capital in portfolio construction models.
• Accounting for lagged betas doubled the reported volatility of small buyout funds from 11% to 22%. For large buyout funds the increase was from 12% to 21%. For early-stage (late-stage) VC the increase was from 29% (19%) to 87% (38%). For real estate the increase was from 9% to 25%. For secondaries the increase was from 9% to 27%. However, for private credit there was little impact with volatility increasing from 8% to 9%.
• Adjusting for lagged betas led to dramatic drops in Sharpe ratios (SRs). The SR for small buyout funds fell from 0.97 to 0.44. For large buyout funds the decrease was from 0.77 to 0.42. For early-stage (late-stage) VC the decrease was from 0.19 (0.62) to 0.06 (0.28). For real estate the decrease was from 0.55 to 0.14. For secondaries the decrease was from 0.99 to 0.31. For private credit there was much less of an impact with the SR falling from 0.82 to 0.74.
• In each case, correlations to the S&P 500 increased (though the increase was negligible for private credit) by double digits in all cases except for private credit where the increase was negligible. The increase in correlations was greatest for real estate (increasing from 0.32 to 0.45). 

Using mean variance analysis to allocate between public equity, investment grade debt, high-yield debt, real estate, and late-stage venture capital, Anson found that when using reported results late-stage private equity dominated with an allocation of 50%. When using lagged betas, the allocation fell to 26%. Interestingly, real estate did not receive any allocation regardless of the methodology (it had the lowest SR in either case).  

Investor Takeaways

The amortization of volatility should be of concern for private capital asset classes. In order to properly budget for beta risks, it is critical that investors in private assets understand the amount of systemic (beta) risk that will “wash” into their private portfolios. Depending on the asset, investors should include estimates of lagged betas to properly account for the systematic risk embedded in private assets. Anson showed that for venture capital the lagged betas can extend back three to four quarters, and for real estate—the least liquid asset class—the lagged betas can extend up to five quarters. For private credit, the issue should be relatively minor (assuming one limits investments to higher quality loans such as senior, secured, and backed by private equity).

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future: The Keys to Successful Investing.