The financial landscape of public pension funds is under the microscope these days, particularly when it comes to how their reported returns stack up against actual market performance. Have you ever heard of volatility laundering? This term describes the troubling gap between the net asset values (NAVs) of private assets and their real market valuations. With echoes of the 2008 financial crisis still resonating, this issue raises urgent questions about transparency and accountability in institutional investing.
The Historical Context of Public Pension Funds
In my experience at Deutsche Bank, I saw firsthand how the 2008 financial crisis transformed the investment strategies of institutional funds. Anyone in the industry knows that the lessons from that tumultuous period are incredibly relevant today as we take a closer look at public pension funds. These funds are critical for the financial well-being of millions, yet they often carry hefty operational costs and struggle with diversification.
So, what exactly is volatility laundering? Coined by financial expert Cliff Asness, this term refers to the practice of not accurately marking private assets to their market values. Over recent years, private assets like unlisted real estate and private equity have often been valued based on NAV, which is frequently determined by general partners (GPs) and their accountants. However, the disconnect between these valuations and actual market values raises significant red flags. The secondary market suggests that private assets could be overstated by as much as 12%. This discrepancy highlights a potential systemic issue within the valuation practices of these funds.
Analyzing Returns and Market Performance
To shed some light on the situation, I analyzed the returns of 50 large public pension funds over a 16-year period ending June 30, 2024. The data, sourced from the Center for Retirement Research and annual reports, revealed an annualized return of 6.88% for the composite of these funds. In contrast, a Market Index designed to reflect similar exposures to stock and bond markets yielded a return of 7.84%. The resulting annual excess return (ER) of -0.96% is concerning, especially when we consider the implications for long-term sustainability. Isn’t it alarming to think about how this gap impacts future funding for retirees?
In the fiscal year 2022, a staggering 950 basis points gap emerged between the public fund composite return and the Market Index. This was particularly disconcerting, considering that the long-term average ER had been just -1.2%. The timing of these discrepancies is critical; while public markets faced declines, the NAVs reported by GPs lagged significantly, creating a misleading impression of profitability in private assets.
Further analysis shows that public pension funds have consistently underperformed public market indices since the Global Financial Crisis, averaging a shortfall of one percentage point per year. High operational costs and ineffective diversification strategies are major culprits. Moreover, the ongoing practice of volatility laundering only worsens the situation, obscuring the true performance of these funds.
Regulatory Implications and Future Outlook
With these evolving challenges, the regulatory landscape surrounding public pension funds must adapt. Enhanced transparency in private asset valuations is crucial to protect beneficiaries and ensure the long-term viability of these funds. Recent adjustments to NAVs by fund managers suggest a growing awareness of the need to align reported values with market realities. But is that enough?
Looking ahead, institutional investors should embrace a more rigorous approach to due diligence and compliance, particularly when it comes to valuing private assets. The data from Jefferies’ Private Capital Advisory unit, which consistently indicates a discount of around 12% for private asset transactions, should serve as a wake-up call for both fund managers and regulators.
In conclusion, the implications of volatility laundering are profound for public pension funds. Not only does it cloud the true performance of these funds, but it also hampers their ability to respond to market conditions effectively. As we move forward, it’s vital for these funds to prioritize transparency and rigor in their valuation practices. The lessons learned from the 2008 financial crisis remind us that complacency can have dire consequences. The market will inevitably demand accountability, and those who fail to adapt may face significant challenges in the future.
