The Volatility Laundering Misconception

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I recently spoke to an investor who made a rare career move in the investing world: They started out as a quant investor working for a public equities-focused hedge fund before moving to an alts-focused investing role for a family office.

Why is that a rare career move? Because most quant-focused investors seem to detest any private assets. While public markets see any market information perfectly and fairly reflected in prices on a daily basis, private markets show just monthly, quarterly, or even less frequent prices, which are (according to quant funds) not set by supply and demand but by the private markets investors themselves. The key term here is volatility laundering, coined by AQR’s Cliff Asness: By having to post as little as four price points a year, which private equity investors or other GPs can (allegedly) partially influence, alts such as private equity undersell their volatility, and thus their risk.

To be clear: I fully understand, and (as you will see below) agree with, the allegations behind volatility laundering. As I outlined in The Quantitative Approach to Private Equity, I detest the private equity “chart crimes” in which GPs show slight outperformance but significantly lower volatility, simply because PE has fewer price points. Anyone thinking that private equity or private debt are less risky than traditional public equities or fixed income should probably stay away from any investment, private or not.

But I think that the volatility laundering debate is overblown: What started out as a rational debate turned into a screaming match in which quant investors cry wolf about topics that alts investors never really disagreed with.

Alternative Investments: Don’t Knock ‘Em Until You’ve Tried ‘Em

My biggest pet peeve by far with any Private Equity opponent is that they often have never invested in the asset class before.

When I launched my business, I talked to a lot of ‘Honorarberater’: Fee-based financial advisors that are by law not allowed to take any commissions from product providers but can only be paid by the client. It’s a great setup, and it should be the norm, but unfortunately, seemed to bring with it a bad case of narrow-mindedness: To those advisors, anything but ETFs and a few semi-indexed quant funds was the devil. But nothing was more evil than Private Equity: Overpriced, illiquid, and (apparently!) easily replicable through factor investing, and of course, just a way for commission-based advisors to enrich themselves.

Interestingly, two things were the case in practice: First, none of the (apparently superior) quant funds that those advisors pitched to their clients did well, often not even outperforming a simple index fund. Second, and more importantly - none of those advisors had ever invested in private equity, or any private asset class, before. They had read countless papers and articles telling them that private equity was apparently bad, but had never seen a capital call or a closed-end fund in a client portfolio. In their quest to be open-minded and client-oriented, they ruled out entire asset classes simply because papers authored by those quant investors had told them that private equity was bad - and when I shared a PE firm’s admittedly well-researched report about their view that investors should have a bigger allocation to alternatives, those same advisors were the first to shout that the PE firm was obviously biased and just looking to sell their products. I once pointed that out to an advisor, but they failed to see the irony.

And unfortunately, the same seems to extend to the highest echelons of quant investing. When I recently spoke to an alumni of AQR about Cliff Asness’ rants about PE, they rolled their eyes: Yes, they agreed on many of his points about PE misstating its volatility and thus its risks, but also didn’t understand why he was so adamant in his views about private equity. (They were pretty sure that Asness has never invested in a PE fund himself.)

But does Asness have a point? Let’s look at a few of his concerns.

Un-Understated Risks

Let’s take Cliff Asness’ recent opinion in Institutional Investor, where he ends with three key points:

1. Private Equity shouldn’t be allowed to make up prices that don’t match the market

2. Investors shouldn’t accept lower expected returns just because private equity returns are “smoothed”

3. Private Equity understates long-term risks to client portfolios in a bear market

Take the point around PE market prices. I remember meeting a large US software buyout firm at a private equity conference two years in a row, once in 2021 and 2022. In between, prices for public tech assets collapsed - but the private equity firm was not deterred: They proudly told me that while they had executed take-privates at 20x EBITDA multiples in 2021, they could now buy assets of similar quality at 10x EBITDA. But when I asked them if they had also repriced those 2021 take-privates to 10x (i.e. a 50% write-down excluding any growth in profits or other KPIs), they dismissed my concerns - those companies were different, of course, and valuations worked differently there, whether because they were going through a significant restructuring, or because the comps had changed, or…

My meeting with that GP (which I did not invest in) could be seen as an example that perfectly demonstrates volatility laundering. Some quant funds might be surprised that I as the private equity investor was even smart enough to realize their pricing shenanigans. Going further, they might think that Cliff’s other points also hold true: That I’m happy to trade fewer price points for lower volatility, and that I am unaware of private equity’s many risk factors.

Of course, that is not the case:

I fully understand the risks of private equity. I know that if I took a proper look at private equity volatility, it would be significantly higher (as I outlined recently). Just seeing fewer data points doesn’t make the asset class less risky.

I know that there is no guarantee that private equity will outperform, especially as rates increase and more capital is chasing fewer good deals. The significant fees within the asset class certainly don’t help with outperformance either.

I’m well aware private equity prices are sometimes made up. But actually, I don’t care about it that much: The performance of any asset between buying and selling it can be incredibly volatile. It could be for company-related reasons, or it could be for market-related reasons. But no matter if it’s a public stock or a private company, all that matters, in the end, is my cash-on-cash return. Any price in between is just nice to have, in the end, I sell when I get an attractive sale price, no matter if public or private.

But interestingly, most quant investors and/or private equity ‘opponents’ do seem to think that investors in the asset class are blissfully unaware of these risks. They think that private equity investors don’t care about performance - they just want an asset without volatility. They think that private equity investors take PE prices for granted, and accept the ‘make-believe’ of prices that players like that software buyout funds show in their reports. They think that investors who dive into private equity don’t think through their decision.

And as a whole, that makes those quant investors seem more narrow-minded than you would expect.

Knowing What You Don’t Know

I might not be the best person to provide a fully balanced view on the quant-alts-debate.

I did well in my finance and econ classes, but they were not my best grades. I was always more of a ‘mental math’ guy than a ‘complex equations’ kind of guy. Hence, understanding the quantitative reasoning behind a momentum trading strategy comes less easy to me than private equity’s simple pitch of buying a business at a good price and turning it around. 

Even from an investing perspective, quant trading (especially any hedge fund-based strategy) seemed like a rough pitch for me: I remember once meeting a US quant fund that proudly told me that they had achieved the S&P 500’s performance over 20 years with half of the volatility. That didn’t really seem appealing to me - why go through the risk of not outperforming, as well as a two-year lock-up, if I could just… buy a S&P 500 ETF? The underperformance of hedge funds over the last decade amid low interest rates certainly didn’t help my mental case for quant funds either (although the performance of Millenium and Citadel are still impressive to me), and even the performance of my own quant or hedge fund investments didn’t spark love for the asset class.

But despite these experiences, in a somewhat Socratian fashion, I know that I know nothing (or at least too little) about those products. I barely scratched the surface investing in those asset classes. Hence, I am careful to have an overly biased opinion. 

But one thing that I do know is that binary thinking - a strong yes OR no for private equity, rather than a humble it depends, is the wrong way of thinking about investing. In my personal experience, it’s the investors that know the pro’s and con’s of every asset class, and construct a holistic portfolio, that have done well: Some of the best-performing family offices that I know have teams dedicated to both hedge funds and private equity, and do well especially because these teams work together.

So I advise you, especially some of the disciples of the volatility laundering discourse: Don’t be narrow-minded. Don’t feel superior. Maybe even discard some of those very-strongly held opinions. As so often in life, we have more to gain by learning from each other, rather than antagonizing each other. And I wish that some of finance’s loudest voices might in the future also be a bit more compromising.

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