The real question though is whether private equity volatility is artificially low, listed equity volatility too high, or both. There are many studies in this area going back to, for example, Shiller (1981) and French and Roll (1986) which show that public stock price volatility is way higher than is justified by fundamentals. The problem here is, therefore, at least in part, not that private equity understates risk through infrequent valuations, but that listed equity overstates it. And regulators (who, knowingly or unknowingly base their approach on observably wrong Efficient Markets Theory) misguidedly incorporate share price volatility as an input in calculating solvency risk for pension funds. This forces pension funds to reduce their listed equity allocations to well below the level that is justified by underlying economic reality.
This is not just some theoretical observation. It reduces the supply of risk capital to companies, creates a misalignment of time horizons between company management and end investors, and is likely a contributor to lacklustre productivity growth. The logical conclusion is that the existence and easy availability of secondary markets to anyone who wants to trade (speculate) on them has actually become damaging to the financial system. Is there a quick fix for this? Well, one way to do it would be to make it much more difficult to speculate. Of course we’re not advocating that stock markets should only open once every five years (they do actually serve a liquidity function), but as a thought experiment, what if our pension fund clients were able to value their portfolios on that basis? Surely it would be better than the current Alice-in-Wonderland approach of using an artificially created non-fundamental measure of risk to drive damaging real-world behaviour?
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