Beware Sharpe Ratios for Private Markets
Private assets can appear less risky because values update less often. Stale pricing can distort volatility and make Sharpe ratios misleading.
Investors often assess risk/return profiles of assets using Sharpe ratios. Some interpret the ratio, which scales an asset’s return over a risk-free rate by its standard deviation, as a measure of how much return you get per unit of risk. But this interpretation rests heavily on whether return volatility captures real-time changes in the underlying asset values.
Public markets allow assets to trade at continuously updated prices. That means changes in the assets’ fair values are instantaneously expressed through price movements. Nontraded assets, on the other hand, don’t have real-time indicators of their value. The returns are based on periodically updated net asset values (NAVs) that could be stale.
We can see this distinction in the volatility of publicly listed versus nonlisted business development companies (BDC) returns. As we have written in the past, indices of traded BDCs are sometimes used as a public proxy for private credit as these companies primarily purchase private credit debt. Prices of listed BDCs change continuously based on the market’s views. Nonlisted BDCs, on the other hand, are not exchange-traded and therefore lack a mechanism to incorporate the market’s views in real time.
The difference in volatility is not subtle. The annualized standard deviation of quarterly returns over the past five years was 13.4% for publicly traded BDCs versus just 2.7% for nontraded BDCs. And this is despite the fact that the underlying investments are often the same between the two classes of BDCs. This demonstrates the challenge in making sense out of Sharpe ratios calculated for private market strategies.
EXHIBIT 1
Annualized Standard Deviation of Quarterly Returns
Glossary
Business development companies: Closed-end funds that primarily purchase private credit debt.
Net asset value: The difference between a company’s assets and its liabilities.
Private credit: Loans made to small and midsize businesses by private investment funds.
Standard deviation: A measure of the variation or dispersion of a set of data points. Standard deviations are often used to quantify the historical return volatility of a security or portfolio.
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