Chartered Financial Analyst Level 2

Explanation

Appraisal-based real estate indexes tend to lead to overestimation of the diversification benefits from private real estate (Option C). Here's why:

Key Characteristics of Appraisal-Based Indexes:

• Smoothing Effect: Appraisal-based indexes use periodic property valuations rather than actual transaction prices, which creates a smoothing effect on returns
• Lower Volatility: The smoothing effect artificially reduces the measured volatility of real estate returns
• Correlation Distortion: The lower volatility leads to artificially low correlations with other asset classes

Why Option C is Correct:

• The artificially low volatility and correlations make private real estate appear more diversifying than it actually is
• Investors may overestimate the diversification benefits when relying on appraisal-based indexes
• This can lead to suboptimal portfolio construction decisions

Why Other Options are Incorrect:

• Option A: Appraisal-based indexes actually underestimate volatility due to smoothing, not overestimate it
• Option B: Appraisal-based indexes typically lag transaction-based indexes because appraisals reflect past market conditions rather than current transactions

Real-World Implications:

• Investors should be aware of this bias when evaluating private real estate investments
• Transaction-based indexes provide more accurate measures of true market volatility and correlations
• The smoothing effect can mask the true risk characteristics of real estate assets

This understanding is crucial for CFA candidates analyzing alternative investments and portfolio construction.