Are public pension funds actually delivering the returns they declare? The hole between non-public asset internet asset values (NAVs) and their actual market worth, a phenomenon often called volatility laundering, reveals vital implications for institutional buyers. With non-public property typically overstated by as a lot as 12%, public pension funds could face better underperformance than reported. This put up explores how the apply of volatility laundering distorts returns and why transparency in non-public asset valuation is extra essential than ever for public pension funds in america.
State of Play
By conference, non-public property 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 final companions (GPs) of personal asset funds and reviewed by their accountants.[1]
In recent times, a niche opened between private-asset values within the secondary market and their NAVs. The hole persists at present.[2] {The marketplace} is telling us that these non-public property should not price what the GPs and their accountants say they’re price. Cliff Asness coined the time period volatility laundering to explain the apply of not marking non-public property 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 Heart for Retirement Analysis at Boston Faculty (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 guage 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 12 months | 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, nevertheless, usually lag public market reporting by 1 / 4 or extra. The lag in reporting NAVs produced massive constructive returns for personal property 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 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 property to market. This commentary is predicated on information from the secondary marketplace for non-public asset transactions. The info in Exhibit 2 had been compiled by Jeffries’s Personal Capital Advisory unit. Exhibit 2 summarizes the reductions from NAV for numerous classes of personal property in the course of the first half of 2024.
Exhibit 2. NAV Reductions for Personal Belongings.
| Asset Kind | 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 Heart for Retirement Analysis stories that public funds allotted a mean of 24% to non-public property (non-public fairness and actual property, solely) via 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 total low cost applies, this means that the funds, within the combination, had 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 latest 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 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 Belongings 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 for the reason that International Monetary Disaster. I attribute this to their excessive price of operation and inefficient diversification.
Volatility laundering — the apply of not marking non-public property to market — obscures one other dimension of financial underperformance of those funds. Have been public funds to mark non-public property to market, it might convey a couple of two- or three-tenths of a proportion level per yr worsening of their long-term efficiency — successful they will sick afford.
[1] ASC 820, adopted by FASB in 2008, supplies steerage on truthful market valuation of personal property.
[2] Jeffries stories reductions for a basket of personal property traded within the secondary market fluctuated between 8% and 19% between 2018 and 2024.
