Private investment funds that invest in illiquid assets such as mortgages, corporate loans, real estate and private companies are growing in popularity. Low interest rates have dulled the appeal of investment-grade bonds, the traditional portfolio stabilizer, while nerve-racking volatility has left many investors disenchanted with stocks, the classic source of higher returns.

Private investment funds often are marketed as a cure-all to these ailments. More stable net asset values (NAVs) mute volatility in comparison with publicly traded securities. Yet, return prospects of private funds are rewardingly equities-like. This is in part due to the “illiquidity premium,” which is the incremental return offered by investments that can’t be converted quickly into cash at fair market value. As icing on the cake, private investment returns appear uncorrelated to those of stocks and bonds.

Unfortunately, undue focus on the benefits of private investments makes short shrift of their risks. Valuation methodologies often overstate the NAV stability of these funds. Private mortgage funds typically do not use proper models to value their holdings to account for changing cash flows, interest rates and debt spreads. Appraisal smoothing due to time lags in comparable transactions and anchoring on prior appraisal values evens out the reported returns of private real estate funds. Private-equity funds face similar problems of return smoothing.

These valuation issues mask the underlying risk of private investment funds relative to their publicly traded counterparts. The systemic risk factors that affect direct real estate, private debt and private companies are the same as those that affect publicly traded real estate investment trusts, high-yield bonds and stocks. A recent study conducted by New York-based BlackRock Inc. found that the economic volatility of private-market assets generally is comparable to public assets and, in some cases, higher.

Concentration risk frequently is high. Smaller private-equity and debt funds often hold a limited number of investments. Many mortgage and real estate funds concentrate their holdings in narrow geographical markets. When reversals occur, the result can be dramatic writedowns in NAV, as well as a sharp reduction in cash-flow distributions.

Management risk is material. Given private funds’ specialized nature and the illiquidity of their holdings, quality of portfolio management – in terms of expertise, operational capability and ethical standards – is crucial. Studies have demonstrated that the dispersion of returns among private debt, real estate and private-equity portfolio managers is greater than that of portfolio managers of publicly traded securities.

There are other factors to consider. Management fees for private investment funds are much higher than those for publicly traded securities. For investors facing taxation on their investments, the income from mortgage and debt funds is taxed as interest income – a major drag compared with capital gains.

Private investment funds can provide portfolios with diverse sources of higher return potential. However, you need to go beyond reported volatility and assess the true underlying risks prior to recommending the inclusion of these funds in clients’ portfolios. Weightings should be appropriate to the risk.

The opportunity set of private investment funds is expanding, as is the added value of thoughtful assessment.

Michael Nairne CFP, RFP, CFA, is president of Tacita Capital Inc. of Toronto, a private family office and investment counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.