Managing risk exposures to private equity through public equity

Key takeaways:

• A joint paper by researchers at FTSE Russell and Cboe examining the relationship between private and public equities and addressing the question of whether private equity risk exposures can be hedged by Russell 2000® Index options
• The FTSE Russell authors find that correlations between public and private equity have been higher more recently than during the period before 2000. Also, correlations are unnaturally depressed due to the “smoothing” of private equity returns. Together these suggest that public and private equity returns are more related than overall correlations typically imply
• The Cboe author shows that both tactical and systematic strategies using Russell 2000 Index options can hedge private equity exposures over the recent period, including during the Global Financial Crisis. A battery of efficacy tests is used to generate optimal tactical and systematic hedging strategies to hedge private equity exposures

Points of differentiation:

• This two-part paper combines private and public equity datasets to show that there are more similarities between the asset classes than are apparent or commonly acknowledged
• The FTSE Russell authors take private equity performance as given and perform transparent smoothing transformations of public equity returns to show that the performance streams are more related than commonly assumed
• The Cboe author shows that liquid Russell 2000 index options can be used to hedge private equity risk exposures in both tactical and systematic hedging strategies, with optimal hedging parameters discussed for each strategy

What does our research mean for investors?

Private equity has emerged as an important asset class for asset allocators, but the illiquidity and relative inaccessibility of the asset class presents challenges for investors seeking to integrate it into their portfolios. This research indicates that private equity is more similar to public equities in the form of Russell indices than usually assumed. Specifically, Russell 2000 options are shown to be a good hedge of private equity risk exposures, using both tactical and systematic hedges.