Executive Summary

  • 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.
  • The smoothing of returns in private equity has a substantial impact on headline volatility. We find that the true economic volatility of private equity is close to 30%, versus a headline number of 10%.
  • Based on 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.
  • Under the same parameters, 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 locking up money in a private equity “straitjacket” is an extra annual return of 1.7%.

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The Author

Jamil Baz

Josh Davis

Global Head of Risk Management

Lloyd Han

Quantitative Research Analyst

Christian Stracke

Global Head of Credit Research

Disclosures

Sydney
PIMCO Australia Pty Ltd
ABN 54 084 280 508
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Australia
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PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Private equity involves an investment in non-publically traded securities which may be subject to illiquidity risk.  Portfolios that invest in private equity may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in securities of smaller companies tends to be more volatile and less liquid than investing in securities of larger companies. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price.  Catastrophe (Cat) Bonds are insurance securitizations, structured similarly to traditional bonds, where a specified set of risks is purchased by investors; if a triggering catastrophe occurs prior to maturity investors may lose most or all of their accrued interest and principal. Diversification does not ensure against loss. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy.

This paper includes hypothetical assumptions and scenarios. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

The portfolio analysis is based on the indexes shown and no representation is being made that the structure of the average portfolio or any account will remain the same or that similar returns will be achieved. Results shown may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. No fees or expenses were included in the estimated results and distribution. The scenarios assume a set of assumptions that may, individually or collectively, not develop over time. The analysis reflected in this information is based upon data at time of analysis. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Due to the dynamic nature of factors affecting markets, there is no guarantee that simulations will capture all relevant risk factors or that the implementation of any resulting solutions will protect against loss. All investments contain risk and may lose value. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data.

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The Bloomberg High Yield Index is an unmanaged market-weighted index including only SEC registered and 144(a) securities with fixed (non-variable) coupons.  All bonds must have an outstanding principal of $100 million or greater, a remaining maturity of at least one year, a rating of below investment grade and a U.S. Dollar denomination. The High Yield CDX  is an index comprised of 100 credit default swaps on individual high yield credits.  Tranches on this index are structured by order of loss from defaults among the underlying components of the index. The MSCI U.S. REIT Index is a free float-adjusted market capitalization weighted index that is comprised of equity REITs that are included in the MSCI U.S. Investable Market 2500 Index, with the exception of specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The index represents approximately 85% of the US REIT universe. Russell 2000® Index is composed of 2,000 of the smallest companies in the Russell 3000 Index and is considered to be representative of the small cap market in general. S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market.  It is not possible to invest directly in an unmanaged index.

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