Unsmoothing
Adjusting an appraisal-based return series to remove the lag and smoothing appraisals introduce, typically by treating each reported return as a blend of the true one and the last reported one. Volatility and correlations rise.
Where you will meet it
Unsmoothing appears in 5 learning outcomes on the CFA syllabus. A few of them:
- Discuss real estate investment indexes: how they are built and the biases they may contain
“Unsmoothing techniques can remove part of this.”
- Set out the techniques used to forecast volatility and covariance
“Appraisal-based series must be unsmoothed: rₜ = (Rₜ − λ × Rₜ₋₁) ÷ (1 − λ), where λ is the smoothing weight.”
- Explain what alternative investments contribute within a portfolio spanning several asset classes
“Diversification is easily overstated because appraisal-based returns are smoothed, which understates volatility and correlation with equities; unsmoothing reported returns reveals the true co-movement and the smaller diversification benefit.”
- Explain how the liquidity of asset classes affects asset allocation decisions
“Options include excluding such classes from optimisation and setting their weights separately, using public-market proxies such as listed real estate or small-cap equities with adjusted inputs, or unsmoothing returns and adding explicit liquidity constraints.”
See also
Practise it
Practise unsmoothing until it is automatic: questions that explain every wrong option.
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