Public Equity May Resemble Private Equity More Than Investors Realize

New research from FTSE Russell and Cboe suggests that the perceived independence of private equity returns is largely due to return smoothing, with correlations to public equity surging as high as 0.92 when adjusted. This challenges the notion that private equity offers reliably low-correlation diversification, as risk-adjusted performance resembles public equities once smoothing is accounted for, impacting portfolio construction and fee justification. Cboe's analysis further indicates that Russell 2000 Index options can effectively hedge private equity drawdowns, suggesting public equity tools can mitigate private equity exposures.

Analysis

New research by FTSE Russell and Cboe challenges the conventional view of private equity as a distinct, low-correlation asset class, arguing that much of its perceived independence from public markets stems from return smoothing rather than genuine detachment. The study demonstrates that when public equity returns are adjusted to mimic the less frequent, non-mark-to-market valuation of private equity (using U.S. private equity data from Cambridge Associates and public equity data from Russell indices with moving averages weighted by private equity's autocorrelation structure), the correlation between the two asset classes surged to as high as 0.92 in the most recent 20-quarter period. This finding significantly impacts portfolio construction, suggesting that private equity's risk-adjusted performance, once accounting for smoothing, more closely resembles that of public equities, thereby questioning the diversification benefits and higher fees often associated with it. For instance, tracking error between smoothed Russell 2000 Index returns and private equity returns fell substantially from 19.5% to 6.2% over the last 20 quarters. The research also highlights that during market stress, such as the 2008 crisis, private equity's lagged and muted recovery, potentially due to asymmetric smoothing (more reactive in downturns than recoveries), distorted its perceived risk and correlation. Building on this, Cboe's analysis indicates that listed options on the Russell 2000 Index, a highly liquid market with approximately 100,000 vega traded daily, can serve as a practical tool for hedging private equity exposures; a simple put spread strategy proved effective in mitigating drawdowns in eight out of ten simulated major drawdown events since 2000. The overarching implication is that while private equity retains unique aspects like access to niche opportunities, its market behavior is more aligned with public equities than standard reporting suggests, necessitating a re-evaluation of its role in diversification and risk budgeting.

Key Decisions for Investors

• Investors should critically reassess the diversification benefits attributed to private equity allocations, given that adjusted correlations with public markets may be substantially higher than reported figures suggest.
• Consider exploring the use of liquid, publicly traded instruments, such as options on the Russell 2000 Index, as a viable means to hedge private equity exposures, particularly in light of research demonstrating their effectiveness during drawdowns.
• Re-evaluate the fee structures and liquidity premiums associated with private equity investments, considering that a portion of perceived outperformance and lower volatility might be an artifact of return smoothing rather than inherent structural advantages.
• Institutional allocators and advisors should re-examine portfolio construction assumptions, particularly regarding risk budgeting and the true contribution of private equity to overall portfolio risk and return, in light of these findings.