Lesson 4 of 8 · 11 min

Valuation: fair value levels and smoothed returns

Illiquid alternatives are often valued by models rather than prices, which tends to smooth reported returns and understate their true volatility.

In short

Investments must be reported at fair value: the exit price market participants would agree in an orderly transaction at the measurement date.
Level 1: quoted prices in active markets for identical assets. Level 2: other observable inputs. Level 3: unobservable inputs.
Private equity and real estate are typically Level 3, valued mark-to-model.
With little new information, values stay anchored near cost; returns look smoothed, volatility and correlations look too low.
Level 3 models should be independently tested, benchmarked and calibrated, and valuation procedures disclosed and applied consistently.

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