A growing body of evidence suggests the differences between private and public equity may be more a matter of perception than reality. New research published in March by FTSE Russell and Cboe, titled "Managing Risk Exposures to Private Equity through Public Equity," argues that much of the perceived independence of private equity returns stems from return “smoothing” and not genuine detachment from public markets.
The findings, presented during a recent webinar by Mark Barnes, head of Investment Research, Americas, FTSE Russell, and Ed Tom, senior director, Derivatives Market Intelligence, Cboe, challenge one of the most commonly held beliefs among institutional allocators and advisors: that private equity offers a reliably low-correlation alternative to public stocks.
Smoothing Obscures Correlation
Private equity returns, as reported by Cambridge Associates, are not marked to market, and are updated less frequently than public assets. This introduces a smoothing effect that dampens volatility and masks co-movement with public equity benchmarks.
“We know private equity is valued differently,” Barnes noted during the webinar. “But when we actually try to simulate that effect using smoothed public equity returns, the correlation between the two asset classes increases significantly.”
Using U.S. private equity data from Cambridge Associates and public equity data from Russell indices, the FTSE Russell team applied a simple process by using moving averages weighted by the autocorrelation structure of private equity to public equity returns. The result: correlations to private equity surged to as high as 0.92 in the most recent 20-quarter period.
Implications for Portfolio Construction
This finding has important consequences for advisors who use private equity to diversify portfolios or justify higher fees based on differentiated performance.
“Private equity appears to deliver higher returns with lower volatility, but once you adjust for smoothing, the risk-adjusted performance starts to resemble that of public equities,” Barnes said. “And correlations aren’t as low as the raw numbers suggest—especially in recent decades.”
Tracking error analysis reinforced this point. When smoothed public equity returns were compared to private equity returns, tracking error fell dramatically. For the Russell 2000 Index, tracking error dropped from 19.5% to 6.2% over the last 20 quarters.
What Happens in a Crisis?
The relationship between public and private equity appears particularly relevant during market stress. Private equity returns declined in 2008. But the magnitude and timing differed from public markets. The lagged and muted recovery in private equity returns post-crisis reduced measured correlation, despite underlying economic commonalities.
Barnes pointed to evidence of asymmetric smoothing. This is where private equity returns are more reactive in downturns than recoveries as a likely explanation.
“This asymmetry distorts how private equity risk is perceived, especially during rebounds when reported returns are unusually stable,” he said.
Hedging Private Equity With Public Equity Tools
Building on the FTSE Russell findings, Cboe’s Tom investigated whether listed options on the Russell 2000 Index could be used to hedge private equity exposures. The results were surprisingly practical.
Using a combination of tactical and systematic strategies, Tom’s team simulated hedges against the 10 largest drawdowns in private equity since 2000. A simple put spread — long a 15-delta put, short a 5-delta put — proved effective in mitigating drawdowns in eight out of 10 cases.
“Tactical hedging worked best when timed correctly,” Tom explained. “But even systematic strategies running continuously offered meaningful protection.”
Notably, the liquidity of the Russell 2000 options market makes such hedging strategies operationally viable. According to Cboe, Russell 2000 options represent the second-most-liquid index options market in the U.S. Roughly 100,000 vega are traded daily. Vega measures how sensitive an option’s price is to changes in implied volatility, reflecting the market’s exposure to shifts in expected volatility.
Rethinking Private Equity’s Role
The overarching message from the research is clear: Public and private equities share more in common than investors may believe. Private equity retains unique features such as access to niche opportunities and long-term governance advantages. But its behavior may not be as independent of public markets as standard correlations suggest.
For advisors, this challenges some of the assumptions used in portfolio design, especially around diversification, liquidity premiums, and risk budgeting.
“Rather than assuming private equity is inherently uncorrelated, we need to ask whether its differences are structural or statistical,” Barnes said. “When we take a closer look, many of those differences begin to blur.”
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