@article {Rudinjpm.2019.1.106, author = {Alexander Rudin and Jason Mao and Nan R. Zhang and Anne-Marie Fink}, title = {Fitting Private Equity into the Total Portfolio Framework}, elocation-id = {jpm.2019.1.106}, year = {2019}, doi = {10.3905/jpm.2019.1.106}, publisher = {Institutional Investor Journals Umbrella}, abstract = {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{\textquoteright}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.TOPICS: Portfolio theory, portfolio construction, equity portfolio managementKey Findings{\textbullet} By applying a somewhat novel econometric technique to a proprietary dataset, we offer a way to separately estimate systematic and idiosyncratic risks of private equity (PE) programs. Our methodology controls for data overfitting and program concentration.{\textbullet} Observed volatility and equity beta of PE are much lower than that of public equity. We believe this is not an aberration but instead a fundamental consequence of PE being less exposed to the excess volatility of public equity markets.{\textbullet} With the exception of the tumultuous period of the global financial crisis (GFC), risk properties of private equity have been surprisingly persistent; if anything, systematic risks of private equities decreased slightly after the GFC.}, issn = {0095-4918}, URL = {https://jpm.pm-research.com/content/early/2019/09/17/jpm.2019.1.106}, eprint = {https://jpm.pm-research.com/content/early/2019/09/17/jpm.2019.1.106.full.pdf}, journal = {The Journal of Portfolio Management} }