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The Value of Smoothing

Although most research on private assets asks whether returns are commensurate with risk, we focus on the value of the smoothed volatility profile of private assets that are not marked to market. We find that the smoothing of returns in private equity has a substantial impact on headline volatility: The true economic volatility of private equity is close to 30%, rather than a headline number of 10%. We then quantify the value of the illusion of low volatility with a few thought experiments. Using reasonable assumptions, we find that smoothing results in an almost 0% probability of observing a 30% drawdown, versus a true probability of 15%–16% over a three-year period. We also find the expected observed maximum drawdown is 12% under smoothing, versus a true value of 40%. To be indifferent about the choice between a smoothed private index and a public index with similar risk, a representative investor based on our analysis would require the public index to have 6 percentage points of additional return annually. Smoothing also protects investors from their behavioral demons, such as the tendency to buy high and sell low. For a 10-year horizon, we find a reasonable estimate of the gain from the locking up money in a private equity “straitjacket” is an extra annual return of 1.7%.