Are public pension funds really delivering the returns they declare? The hole between non-public asset internet asset values (NAVs) and their actual market worth, a phenomenon often known as volatility laundering, reveals important implications for institutional traders. With non-public belongings usually overstated by as a lot as 12%, public pension funds might face higher underperformance than reported. This submit explores how the observe of volatility laundering distorts returns and why transparency in non-public asset valuation is extra essential than ever for public pension funds in the USA.
State of Play
By conference, non-public belongings like unlisted actual property and personal fairness are carried at their NAV within the valuation of institutional funds and within the calculation of their charges of return. NAV is a determine arrived at by the overall companions (GPs) of personal asset funds and reviewed by their accountants.[1]
Lately, a niche opened between private-asset values within the secondary market and their NAVs. The hole persists as we speak.[2] {The marketplace} is telling us that these non-public belongings usually are not value what the GPs and their accountants say they’re value. Cliff Asness coined the time period volatility laundering to explain the observe of not marking non-public belongings to market.
Public Fund Efficiency with Reported Returns
I acquired charges of return for a pattern of fifty massive US public pension funds for the 16 fiscal years ended June 30, 2024. The sources are the Middle for Retirement Analysis at Boston School (CRR) and the funds’ annual stories. I included solely funds reporting returns internet of charges.
I then created an equal-weighted composite of fund returns and developed a Market Index to judge the efficiency of the composite. The Market Index has the identical efficient stock-and-bond market exposures and the identical danger (commonplace deviation of whole return) because the composite. The Market Index blends returns of US- and non-US inventory indexes with these of an investment-grade US bond index to type a single, hybrid index.[3]
The composite has an annualized return of 6.88% for the 16 years, and the Market Index return is 7.84%. The distinction between the 2 collection, or annual extra return (ER), is -0.96%. See Exhibit 1.
Exhibit 1. Historic Returns Fiscal Years 2009 to 2024.
| Fiscal Yr | Public Fund Composite | Market Index | Extra Return |
| 2009 | -19.8 | -17.5% | -2.2% |
| 2010 | 13.7 | 13.0 | 0.7 |
| 2011 | 21.5 | 22.6 | -1.1 |
| 2012 | 1.1 | 1.7 | -0.6 |
| 2013 | 12.0 | 13.9 | -1.9 |
| 2014 | 16.8 | 18.2 | -1.5 |
| 2015 | 3.3 | 4.% | -1.0 |
| 2016 | 0.6 | 0.9 | -0.3 |
| 2017 | 12.7 | 13.6 | -0.9 |
| 2018 | 8.8 | 9.1 | -0.3 |
| 2019 | 6.4 | 7.3 | -0.9 |
| 2020 | 2.2 | 5.2 | -3.0 |
| 2021 | 27.1 | 29.4 | -2.3 |
| 2022 | -3.8 | -13.3 | 9.5 |
| 2023 | 6.7 | 12.2 | -5.5 |
| 2024 | 9.4 | 15.4 | -6.1 |
| Annualized | 6.88% | 7.84% | -0.96% |
Secondary Market Pricing
In fiscal 12 months 2022, an unusually massive hole — 950 foundation factors (bps) — between the general public fund composite return and that of the Market Index appeared. The typical ER within the prior 13 years was simply -1.2%. See Exhibit 1. Inventory and bond markets skilled a pointy decline late in fiscal 12 months 2022.
NAVs reported by GPs of personal asset partnerships, nevertheless, sometimes lag public market reporting by 1 / 4 or extra. The lag in reporting NAVs produced massive optimistic returns for personal belongings in fiscal 12 months 2022, regardless of the sell-off in shares and bonds. This unleashed a collection of NAV changes by fund managers within the years following to convey marks into conformance with market realities. (See fiscal years 2023 and 2024 in Exhibit 1.)
{The marketplace}, nevertheless, believes the GPs and their accountants have extra work to do in marking non-public belongings to market. This remark relies on information from the secondary marketplace for non-public asset transactions. The info in Exhibit 2 have been compiled by Jeffries’s Personal Capital Advisory unit. Exhibit 2 summarizes the reductions from NAV for varied classes of personal belongings in the course of the first half of 2024.
Exhibit 2. NAV Reductions for Personal Property.
| Asset Sort | First Half of 2024 |
| Buyout | 6% |
| Credit score | 15 |
| Actual Property | 26 |
| Enterprise | 30 |
| All | 12% |
Supply: Jeffries Personal Capital Advisory
Within the evaluation that follows, I incorporate the general low cost of 12% for personal asset transactions within the first half of 2024 in estimating pension fund returns that mirror honest market pricing.
The Middle for Retirement Analysis reports that public funds allotted a mean of 24% to personal belongings (non-public fairness and actual property, solely) via fiscal 12 months 2022. I multiply the non-public asset share of 24% by the common NAV low cost of 0.12, which produces a determine of two.9%. Assuming Jeffries’s total low cost applies, this means that the funds, within the mixture, have been over-valued by roughly 3% relative to the market.
I apply this adjustment to the surplus return determine of -0.96%. I do that by dividing 3% by 16 (years), producing a 0.2% (18 bps, to be exact) haircut to extra return. (If we unfold the haircut over the newest 10 years, it quantities to 0.3% per 12 months. The interval chosen for making use of the haircut is bigoted. This leads to an adjusted extra return (AER) of -1.14% per 12 months since fiscal 12 months 2009. See Exhibit 3. The calculations are tough and prepared however ok to get the thought throughout.
Exhibit 3. Recap of Calculation of Adjusted Extra Return.
| Measure | Annualized Returns | |
| Reported Return | 6.88% | |
| Market Index | -7.84 | |
| Extra Return (ER) | -0.96% | -0.96% |
| Personal Property Haircut | -0.18 | |
| Adjusted Extra Return (AER) | -1.14% | |
Key Takeaway
Public pension funds have underperformed a public market index by roughly one share level per 12 months because the International Monetary Disaster. I attribute this to their excessive value of operation and inefficient diversification.
Volatility laundering — the observe of not marking non-public belongings to market — obscures one other dimension of financial underperformance of those funds. Have been public funds to mark non-public belongings to market, it will convey a few two- or three-tenths of a share level per 12 months worsening of their long-term efficiency — a success they’ll in poor health afford.
[1] ASC 820, adopted by FASB in 2008, gives steering on honest market valuation of personal belongings.
[2] Jeffries stories reductions for a basket of personal belongings traded within the secondary market fluctuated between 8% and 19% between 2018 and 2024.
[3] The Market Index contains the Russell 3000 inventory index (52%), MSCI ACWI ex-US shares (19%), and Bloomberg US Combination bond index (29%). The R2 of the general public fund composite with the Market Index is 99.3% for the 13 years ended June 30, 2021, with a wee monitoring error of 1.0%.
