Fitting Private Equity into the Total Portfolio Framework

In this article, the authors propose a risk estimation model that addresses both smoothness and idiosyncratic risk dynamics of narrow private equity portfolio returns. The authors subsequently apply the model to a broad set of private equity return streams with tightly controlled diversification properties. They show that increased model complexity is detrimental to the model's forecasting power and that idiosyncratic risks increase as one goes between hypothetical investment in a broad (albeit noninvestable) private equity index and a real-life, narrowly diversified portfolio of private equity funds. The authors also find that private equity returns have demonstrated a level of exposure to public equity markets that may be considered surprisingly low and offer a possible qualitative justification for this phenomenon. Finally, the authors incorporate the newly obtained private equity risk model into a general portfolio construction framework and demonstrate how to study the inevitable trade-offs between the costs and benefits of increased portfolio diversification.