Are public pension funds actually delivering the returns they declare? The hole between non-public asset web asset values (NAVs) and their actual market worth, a phenomenon generally known as volatility laundering, reveals vital implications for institutional buyers. With non-public belongings typically overstated by as a lot as 12%, public pension funds might face higher underperformance than reported. This publish explores how the follow of volatility laundering distorts returns and why transparency in non-public asset valuation is extra important than ever for public pension funds in the US.
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 spot opened between private-asset values within the secondary market and their NAVs. The hole persists in the present day.[2] {The marketplace} is telling us that these non-public belongings should not price what the GPs and their accountants say they’re price. Cliff Asness coined the time period volatility laundering to explain the follow 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 Faculty (CRR) and the funds’ annual reviews. I included solely funds reporting returns web 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 threat (commonplace deviation of complete 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 kind 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 yr 2022, an unusually massive hole — 950 foundation factors (bps) — between the general public fund composite return and that of the Market Index appeared. The common ER within the prior 13 years was simply -1.2%. See Exhibit 1. Inventory and bond markets skilled a pointy decline late in fiscal yr 2022.
NAVs reported by GPs of personal asset partnerships, nonetheless, usually lag public market reporting by 1 / 4 or extra. The lag in reporting NAVs produced massive constructive returns for personal belongings in fiscal yr 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 carry marks into conformance with market realities. (See fiscal years 2023 and 2024 in Exhibit 1.)
{The marketplace}, nonetheless, 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 information in Exhibit 2 have been compiled by Jeffries’s Personal Capital Advisory unit. Exhibit 2 summarizes the reductions from NAV for numerous classes of personal belongings through 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 truthful market pricing.
The Middle for Retirement Analysis reviews that public funds allotted a median of 24% to non-public belongings (non-public fairness and actual property, solely) by fiscal yr 2022. I multiply the non-public asset proportion of 24% by the common NAV low cost of 0.12, which produces a determine of two.9%. Assuming Jeffries’s general 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 yr. The interval chosen for making use of the haircut is unfair. This ends in an adjusted extra return (AER) of -1.14% per yr since fiscal yr 2009. See Exhibit 3. The calculations are tough and prepared however adequate to get the concept 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 proportion level per yr because the World Monetary Disaster. I attribute this to their excessive value of operation and inefficient diversification.
Volatility laundering — the follow of not marking non-public belongings to market — obscures one other dimension of financial underperformance of those funds. Had been public funds to mark non-public belongings to market, it might carry a few two- or three-tenths of a proportion level per yr worsening of their long-term efficiency — successful they’ll sick afford.
[1] ASC 820, adopted by FASB in 2008, supplies steering on truthful market valuation of personal belongings.
[2] Jeffries reviews 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 includes the Russell 3000 inventory index (52%), MSCI ACWI ex-US shares (19%), and Bloomberg US Mixture 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%.
