Private Equity's Hidden Calculus: Volatility Smoothing and Factor Replication

The Hidden Calculus of Private Equity: Beyond the Hype to Real Investor Value

This conversation with Owen Lamont and Randy Cohen reveals the often-unseen complexities and strategic advantages embedded within private equity, challenging the conventional wisdom that often surrounds it. The core thesis is that while private equity promises superior returns and lower volatility, its true value lies in the disciplined, long-term approach that conventional public market investing often eschews. The hidden consequences of this approach include the potential for "volatility laundering," but also the creation of durable competitive advantages through patience and a focus on fundamental value. Investors seeking to understand how to access private-market-like returns with greater liquidity, or those looking to improve their own long-term investment strategies, will find immense value in dissecting the mechanics and psychological underpinnings of this asset class.

The Illusion of Smooth Returns: Private Equity's Volatility Paradox

The allure of private equity (PE) is undeniable: the promise of outperforming public markets with less volatility. However, as Randy Cohen and Owen Lamont discuss, this perceived smoothness is often a product of how valuations are reported, not necessarily a reflection of underlying stability. PE firms report valuations periodically, and in the absence of forced sales, these marks can lag market realities. This "volatility smoothing," as Cliff Asness famously termed it, can create a misleading picture, especially during market downturns.

"Volatility smoothing is just lying or just making up numbers and you know randy and i are both economists and economists like prices prices are determined by supply and demand except in the private equity where they're just made up numbers that are meaningless so that might be an overstatement but i would just want to caution that an asset that claims to have a price but you can't trade it at that price that's not a price that's something other than a price."

-- Owen Lamont

The consequence of this smoothing is that investors might feel more secure than they actually are. While PE managers argue this allows them to avoid reacting to market panics and maintain a focus on intrinsic value, the reality is that if they had to sell those assets during a downturn, they would likely realize significantly lower prices. This disconnect between reported and actual value is a critical downstream effect that can mask true risk. The advantage for PE, in this context, is the ability to present a more palatable risk profile to investors, which can attract capital that might otherwise flow to more transparent, albeit more volatile, public markets.

Liquid Private Equity: Copying the Smartest Moves

The core of Randy Cohen's research and advocacy for "liquid private equity" lies in a simple yet powerful idea: identify the smart, systematic approaches of PE and replicate them in a liquid format. PE firms, he argues, focus on companies with high profits (to service debt), low multiples (to ensure a reasonable entry point), low risk (to secure leverage), relatively small size, and high payout ratios. These characteristics, he points out, are remarkably similar to the well-documented "factors" that academic research identifies as drivers of outperformance in public markets.

"Oh you tilt towards smaller companies we'll tilt towards smaller companies you tilt towards companies with low risk great we'll find low risk companies and in fact it's a funny thing because if you list the things that make you feasible for an lbo you're going to need high profit as i say in order to pay the interest you're going to need a low multiple because if you pay 30 times earnings that's a 3 3 yield that's not going to cover your interest costs you're also going to need low risk as i say no one's going to lend you two thirds or three quarters of the value of a deal if it's super volatile right you're going to need it to be relatively small and you're going to need a high payout ratio right because if the company plows every dollar back into growth well then there's no money left well guess what high profit high payout low multiple low risk small size those are the five pharma french factors so the exact five things that a quant will tell you leads to outperformance are the same things lbo focuses on."

-- Randy Cohen

The implication here is profound: by systematically identifying and replicating these PE strategies in public markets--tilting towards specific industries, factor loadings, and employing a modest amount of leverage--investors can potentially capture PE-like returns with liquidity. This approach bypasses the illiquidity, high fees, and long lock-up periods of traditional PE, offering a significant advantage to investors who cannot access or do not wish to commit to private funds. The delayed payoff comes from the systematic nature of these factors, which tend to outperform over longer time horizons, and the added liquidity buffer that liquid PE provides for institutional investors. Conventional wisdom, which often dismisses factor investing or emphasizes active stock picking, fails to account for the systematic, data-driven approach that PE has implicitly employed for decades.

The "Best Ideas" Fallacy: Concentration vs. Specialization

The conversation around Owen Lamont's "best ideas" paper highlights a critical distinction: the difference between portfolio concentration and genuine specialization. Lamont's research, using a Black-Litterman model, found that mutual fund managers' "best ideas"--those stocks they most strongly believed in, as inferred from their portfolio weights--outperformed their other holdings by a significant margin. This suggests that managers do have conviction in certain stocks. However, the downstream effect of this finding is often misunderstood.

"My paper your paper is of a guy who holds 120 positions the top three are the best ones and then they make an unwarranted leap of faith that i should hire a guy who only has three because three is better than 120 and it's just not true as an empirical matter that the guy who has very few positions outperforms and it's probably more closely the opposite is true that the guy who only has three positions is just a crazy person and the reason he is successful is that he is lucky not because he is good."

-- Owen Lamont

The danger lies in interpreting this as a mandate for hyper-concentrated portfolios. Lamont and Cohen caution that while managers may have a few high-conviction ideas, running a fund with only three or four stocks is often economically unviable and psychologically difficult due to career risk. The true advantage lies not in picking the fewest stocks, but in identifying and overweighting genuinely superior ideas, whether that's through systematic factor exposure or specialized knowledge. The failure of conventional wisdom here is the conflation of "fewest bets" with "best bets," overlooking the importance of diversification and the practical realities of investment management.

Actionable Insights for Investors

• Embrace Systematic Investing: Understand that many successful private equity strategies can be replicated through liquid, factor-based investing. Over the next quarter, research and consider incorporating low-volatility, quality, and value factors into your portfolio.
• Question Smooth Returns: Be skeptical of reported volatility figures in private markets. Understand the mechanics of valuation smoothing and its potential to mask underlying risk. This insight offers a competitive advantage by leading to more realistic risk assessments.
• Focus on "Best Ideas" with Discipline: If you are an active manager, identify your highest-conviction ideas. However, resist the urge to concentrate your portfolio excessively. This pays off in 12-18 months by avoiding the pitfalls of over-concentration.
• Consider Specialization: Explore managers or strategies that demonstrate deep specialization in specific industries or asset classes, rather than broad mandates. This is a longer-term investment, paying off over several years.
• Diversify Globally: The conversation around the Korean market's performance underscores the importance of global diversification. Over the next year, ensure your portfolio isn't overly concentrated in any single geography.
• Beware of "Volatility Laundering": Recognize that the smoothing of returns in private markets can obscure true risk. This awareness can prevent costly mistakes when market conditions inevitably change.
• Long-Term Perspective: Adopt a mindset that values delayed gratification. The most durable advantages often come from strategies that require patience and withstand short-term market noise. This is an immediate mindset shift that yields long-term benefits.