PRIVATE EQUITY: ITS ROLE IN PORTFOLIO OPTIMIZATION

Alternative investments have increasingly been used to complement a traditional portfolio of stocks and bonds. Among them, Private Equity is found to be able to provide diversification benefits and higher expected returns. This study uses the traditional mean-variance portfolio optimization process with several inputs: “equilibrium” returns for the traditional assets as a neutral starting point generated by the Black-Litterman model; and a range of expected returns of private equity fund types. We find that private equity funds in earlier stages are more suitable for investors seeking higher expected returns and with higher levels of risk appetite, while private equity in later stages are more suitable for investors with lower risk appetite, seeking for more modest levels of returns. In both cases, it is notable that the portfolio gains efficiency after the inclusion of private equity. The diversification benefits from low correlations are also observed.