An investor compares a private real estate fund's reported Sharpe ratio with a listed REIT index's. Why is the comparison misleading?
Show the answer and explanation
Answer: A. Because smoothing understates the private fund's volatility and inflates its ratio
The Sharpe ratio measures reward for each unit of risk. Sharpe ratio = (Return - Risk-free rate) / Volatility, where volatility is how much returns bounce around. Private property is valued by appraisal, which updates slowly, so reported returns look very smooth and volatility looks tiny. A tiny number on the bottom makes the ratio look large. For example, if true volatility is 12% but the smoothed series shows 5%, the ratio looks 2.4 times better with no real improvement. The comparison with the listed REIT index is therefore unfair.
Why the other options are wrong:
B. Because REIT returns include dividends and the private fund's returns exclude income - Both distribute income, and a total return series captures it either way.
C. Because the risk-free rate used must differ between the two asset types - The same risk-free rate applies; the difficulty is that one of the two volatility figures is artificially low.