Answer-first summary for fast verification
Answer: Summary statistics computed using reported returns of PEFs can be biased downward, which compromises the reliability of these risk measures.
**D is correct.** Because private equity funds trade infrequently, their risk measures—such as volatilities, correlations, and betas—can be too low when computed using reported returns. This is due to the smoothing effect of infrequent trading and valuation practices in private equity, which can lead to downward bias in volatility and correlation estimates. **A is incorrect.** Correlations regarding PEF1 are not reliable (See explanation for D). The correlation between the two ETFs is more reliable because ETFs trade frequently and their prices reflect current market conditions. **B is incorrect.** Because the volatility of PEF2 is likely understated, it is not clear that PEF2 truly has the best return to risk profile out of the four investments. Even if it did in fact have the best return/risk profile, it is inappropriate to conclude that the investor should allocate all these funds to that one investment. The investor should consider other factors, such as potential diversification benefits from holding a mixture of the four investments as well as diversification benefits with other investments and asset classes that the investor may own. **C is incorrect.** While PEFs may hold more assets than ETFs, this does not necessarily make them less risky over longer time horizons. Private equity investments typically involve higher illiquidity risk, leverage, and concentration risk, which can actually increase their risk profile compared to more diversified ETFs.
Author: LeetQuiz .
Ultimate access to all questions.
No comments yet.
An individual investor wants to invest USD 8 million in exchange-traded funds (ETFs) or private equity funds (PEFs). The investor obtains the previous year's returns for several ETFs and calculates summary statistics such as volatility and correlation based on these returns. The investor also reviews a database of reported returns and volatilities for several PEFs and then selects two potential investments in each asset class. Using the data from the sources described above, the investor generates the following information for the four potential investments:
| Asset | 1-year return | Annual volatility of returns |
|---|---|---|
| Broad equity market index ETF (ETF1) | 6.5% | 11.4% |
| Growth stock ETF (ETF2) | 8.3% | 13.6% |
| Private equity fund 1 (PEF1) | 7.4% | 12.3% |
| Private equity fund 2 (PEF2) | 10.2% | 11.1% |
| Correlation of returns between ETF1 and ETF2 | 0.67 |
|---|---|
| Correlation of returns between ETF1 and PEF1 | 0.25 |
| Correlation of returns between PEF1 and PEF2 | 0.41 |
The manager evaluates this information while also considering the potential biases and uncertainties in the reported data. Which of the following conclusions is most appropriate for the investor to make?
A
The correlation of returns between PEF1 and ETF1 is more accurate than the correlation of returns between ETF1 and ETF2.
B
The entire USD 8 million should be allocated to PEF2 because it is clearly the superior investment from a return to risk perspective.
C
The number of assets in PEFs are typically higher than the number of assets in ETFs, which makes PEFs much less risky than ETFs over longer time horizons.
D
Summary statistics computed using reported returns of PEFs can be biased downward, which compromises the reliability of these risk measures.