A separate study by John H. Cochrane, the Myron S. Scholes Professor of Finance at the University of Chicago, concurred with Ms. Woodward that venture capital returns are lower than what is reported.
"We were trying to get behind the smoothing," Mr. Cochrane said in an interview. "On average, venture capital acts very similar to small growth stocks."
His paper, published last January in the Journal of Financial Economics, shows that between January 1987 and December 2001, the average annualized return of the smallest Nasdaq stocks was 62%, about the same as the 59% mean return of venture capital funds during the same period.
"Overall, with all the venture capital projects, I could not find much of an illiquidity premium," he said. In other words, venture capital funds do not appear to provide much extra return over the stock market to compensate investors for locking away their money for 10 years.
"Venture capital is very risky," Ms. Woodward said. She noted half of all venture capital-backed companies fail and some 50% of the money invested in venture capital investments is lost. However, the failure rate is not reflected in existing venture capital benchmarks, she added. The buyout fund failure rate is less than 3%, she added.
Lack of accounting for survivor bias is a big problem with most venture capital benchmarks, Mr. Cochrane said.
"They collect the returns for everybody that is around," he said. "It is like collecting data from everyone still in the casino: They're not asking the people on the bus … who are on their way home."
But survivorship bias is not unique to private equity, Cliffwater's Mr. Nesbitt said. "There are some survivorship biases present in all indexes," he added.
Not only does the smoothing affect private equity returns but the data can alter institutional investors' overall asset allocation modeling, said Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Boston. Using stale prices — even a one- or two-day delay — as the basis of valuing a fund's portfolio affects its correlation with the public markets. Correlations are much more important to investors than overall volatility, Mr. Lerner said. If private equity investments are more correlated to the stock market than institutional investors think, it makes their asset allocation models inaccurate.
"The risk numbers in the asset allocation models are potentially problematic," Mr. Lerner said. "Risk and correlation are very challenging things to handle in private equity."
Mr. Cochrane said the venture capital and buyout numbers would suggest a high level of correlation between those sectors and the stock market.
"They (institutional investors) are kidding themselves that buyout and venture capital are more of an alternative asset class than they really are," he said.