Key Takeaways
- • Christopher Carrano, Vice President of Strategic Research at Venn by Two Sigma, argues that broad private equity's apparent diversification versus public equities stems largely from performance smoothing in private asset valuations rather than true economic differentiation.
- • Using the Preqin Private Equity Index, desmoothing raises PE volatility to roughly 17 percent, in line with public equities, and lifts its beta to the S&P 500 from 0.41 to 0.87.
- • Autocorrelation of PE returns falls from 0.54 to 0.17 after desmoothing, moving closer to public equity behavior and suggesting valuation effects were mitigated.
- • In a 50/30/20 portfolio with desmoothed PE as the alternatives sleeve, realized volatility of 11.48 percent is similar to a 70/30 portfolio (11.83 percent) and above a 60/40 (10.15 percent).
- • Venn's factor analysis finds the 50/30/20 increases equity factor exposure, including local equity exposure, which undercuts the purpose of reducing equity risk.
Summary
In an opinion piece published by Institutional Investor, Christopher Carrano of Venn by Two Sigma challenges the common practice of labeling private equity as an alternative asset. He argues that the label alone does not guarantee diversification, and that the question is whether PE actually diversifies a portfolio of public equities and bonds. The author stresses that the critique concerns the alternative label rather than PE's alpha-generating potential.
Carrano identifies performance smoothing as the central obstacle to assessing PE's risk. Private assets are marked to valuation rather than marked to market, which allows managers to time or select valuation methodologies in ways that conceal volatility. Comparing the smoothed Preqin Private Equity Index with the S&P 500, he notes PE's correlation to public equities is 0.76 and its beta is 0.41, with a downside capture of 24 percent. He argues the low volatility is hard to justify given that long-only equity should behave similarly whether private or public, and that the high autocorrelation of PE returns suggests valuations are being used to reduce reported volatility.
Desmoothing, which uses regression techniques and a public market proxy to reverse the smoothing process, produces materially different results according to the analysis. Volatility rises to around 17 percent, correlation increases from 0.75 to 0.89, and beta rises to 0.87. The author concludes that broad PE has not been a diversifying alternative to public equity on a marked-to-market basis.
The piece then examines the 50/30/20 allocation (50 percent equities, 30 percent bonds, 20 percent alternatives), which has gained traction after 60/40 portfolios struggled in 2022 amid rising stock-bond correlations. Venn's analysis finds that a 50/30/20 with desmoothed PE realized 11.48 percent volatility, close to the 11.83 percent of a 70/30 portfolio and above the 10.15 percent of a 60/40 benchmark. Factor analysis using Venn's Two Sigma Factor Lens shows higher equity factor exposure, and the author notes that the reduction in fixed income required to fund the PE allocation adds to the net negative diversification effect.
Carrano cautions that the findings apply to broad PE, and that individual funds, such as those targeting commodities, and private credit strategies like direct lending may offer different diversification profiles. He concludes that allocators should rely on quantitative analysis of marked-to-market risk rather than asset class labels. The commentary represents the author's own views and not those of Venn, Two Sigma, or Institutional Investor.
Carrano identifies performance smoothing as the central obstacle to assessing PE's risk. Private assets are marked to valuation rather than marked to market, which allows managers to time or select valuation methodologies in ways that conceal volatility. Comparing the smoothed Preqin Private Equity Index with the S&P 500, he notes PE's correlation to public equities is 0.76 and its beta is 0.41, with a downside capture of 24 percent. He argues the low volatility is hard to justify given that long-only equity should behave similarly whether private or public, and that the high autocorrelation of PE returns suggests valuations are being used to reduce reported volatility.
Desmoothing, which uses regression techniques and a public market proxy to reverse the smoothing process, produces materially different results according to the analysis. Volatility rises to around 17 percent, correlation increases from 0.75 to 0.89, and beta rises to 0.87. The author concludes that broad PE has not been a diversifying alternative to public equity on a marked-to-market basis.
The piece then examines the 50/30/20 allocation (50 percent equities, 30 percent bonds, 20 percent alternatives), which has gained traction after 60/40 portfolios struggled in 2022 amid rising stock-bond correlations. Venn's analysis finds that a 50/30/20 with desmoothed PE realized 11.48 percent volatility, close to the 11.83 percent of a 70/30 portfolio and above the 10.15 percent of a 60/40 benchmark. Factor analysis using Venn's Two Sigma Factor Lens shows higher equity factor exposure, and the author notes that the reduction in fixed income required to fund the PE allocation adds to the net negative diversification effect.
Carrano cautions that the findings apply to broad PE, and that individual funds, such as those targeting commodities, and private credit strategies like direct lending may offer different diversification profiles. He concludes that allocators should rely on quantitative analysis of marked-to-market risk rather than asset class labels. The commentary represents the author's own views and not those of Venn, Two Sigma, or Institutional Investor.
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