Key takeaways

• Desmoothing and interpolation can reveal truer timing and levels of volatility, improve risk factor explainability, and increase data frequency to daily. However, they do not help bring analysis up to date. 

• Extrapolation, or an educated estimate of missing valuations, can be a powerful tool to conduct portfolio analysis despite out-of-date data.
   
• When used together, de-smoothing, interpolation, and extrapolation may allow investors to better understand levels, timing, and drivers of risk for private assets, while also improving operational logistics.

Earlier this year, we provided readers with two easy steps to view their private asset returns through a public lens. During our discussion, we reviewed the data challenges associated with private asset returns, as well as how de-smoothing and interpolation techniques adjust private assets to account for movements in public markets. By combining these techniques, we showed how investors could reveal truer timing and levels of volatility, improve risk factor explainability, and increase data frequency to daily.¹ 

Using these adjusted private asset returns, one can seamlessly integrate private and public assets together into a holistic multi-asset portfolio analysis. However, private asset managers often report their valuations with a significant lag, such that their up-to-date data virtually never aligns with public markets. To address this, we are introducing extrapolation, or what we believe is the final piece to the puzzle to view private asset returns through a public lens.

Exhibit 1: Introducing extrapolation for private asset returns

Source: Venn by Two Sigma. For illustration purposes only.

A private equity case study
Take, for example, the Preqin Private Equity index, which typically has artificially low volatility, exhibits delayed market reactions, is at a quarterly frequency, and can be out of date for quarters at a time. As we show below, de-smoothing and interpolation helped to solve the first three of these issues by using the S&P 500 as a public proxy.² However, the issue of out-of-date data remains with a current end date for the Preqin index of March 2023 (with this writing as of the end of July).

Exhibit 2: Desmoothed and interpolated Preqin private equity index, trailing five years

Source: Venn by Two Sigma. Public proxy used for de-smoothing and interpolation on the Preqin Private Equity index was the S&P 500.

The early end date is especially problematic when trying to conduct multi-asset portfolio analysis where you are limited by the holdings with the least history. In this example, even if this private equity exposure was only 1% weight in our portfolio, we would be forced to conduct all analysis through March of 2023, a lag of more than four months. This is where extrapolation, or an educated estimate of missing valuations, can be a powerful tool to conduct portfolio analysis despite out-of-date data.

Extrapolation 
Venn’s extrapolation feature provides up-to-date valuations for assets using a public proxy. Similar to de-smoothing and interpolation, the spirit of leveraging a public proxy to estimate missing valuations is based on a belief that private markets are indeed exposed to many of the same systematic risk factors as public markets. Put another way, a private equity investment should react to shocks in risk factors, like economic growth or interest rates, much in the same way a public investment should.

As a result of this belief, we use regression techniques between historical private asset returns and a public market proxy to estimate where that private asset may be valued today. This results in estimated returns that may look and feel like the public proxy, but with an adjustment for the return that is unique to the private asset. Because those returns can first be de-smoothed and interpolated, we believe the end result is an up-to-date public view that can help investors more accurately conduct multi-asset portfolio analysis or individual manager due diligence.

In Exhibit 3, we show the Preqin Private Equity index after de-smoothing, interpolation, and extrapolation. Notice it does not have artificially low volatility or lag the market, is at a daily frequency, and, importantly, is up to date. Extrapolating investment returns may be especially important in today’s market environment due to the stark contrast between negative equity performance in 2022 and the rally we’ve seen thus far in 2023. The chart below illustrates how significantly markets rallied over the period that uses extrapolation, information that was not previously available.

Exhibit 3: Desmoothed, interpolated, and extrapolated Preqin private equity index, trailing five years

Source: Venn by Two Sigma

Three easy steps to take your private asset returns public
Given that our clients continue to leverage Venn for multi-asset portfolio analytics, we are pleased they can use de-smoothing, interpolation, and extrapolation features to view private assets with a familiar public lens.

All three together may allow investors to better understand levels, timing, and drivers of risk, while also improving operational logistics. While these techniques can help provide more transparency into individual private manager performance, perhaps their biggest benefit is providing an easy path to analyzing private and public investments side by side in a multi-asset portfolio. If you are interested in adding de-smoothing, interpolation, and/or extrapolation to your Venn subscription, please contact your account representative.³ 

Extrapolation is for estimation purposes only and has many inherent limitations. Venn’s extrapolation methodology was developed in our professional judgment based on numerous assumptions and may not accurately forecast the value of a security, portfolio or investment.  Extrapolation results are not a recommendation to buy, sell or hold any security, portfolio or investment or a recommendation of any investment strategy.

Read the original article here.

References
¹ The increase of data frequency to daily is a function of interpolation. Interpolation adds a constant daily return to the chosen public proxy returns, such that taking the cumulative return should closely match the private asset’s return. Venn then uses that new daily return stream for the private asset

² You can learn more about de-smoothing and interpolation in the article we mentioned at the beginning of this piece: “Two Easy Steps to Take Your Private Asset Returns Public.”

³Additional fees may apply.