Are public pension funds truly delivering the returns they claim? The gap between private asset net asset values (NAVs) and their real market value, a phenomenon known as volatility laundering, reveals significant implications for institutional investors. With private assets often overstated by as much as 12%, public pension funds may face greater underperformance than reported. This post explores how the practice of volatility laundering distorts returns and why transparency in private asset valuation is more critical than ever for public pension funds in the United States.
State of Play
By convention, private assets like unlisted real estate and private equity are carried at their NAV in the valuation of institutional funds and in the calculation of their rates of return. NAV is a figure arrived at by the general partners (GPs) of private asset funds and reviewed by their accountants.[1]
In recent years, a gap opened between private-asset values in the secondary market and their NAVs. The gap persists today.[2] The marketplace is telling us that those private assets are not worth what the GPs and their accountants say they are worth. Cliff Asness coined the term volatility laundering to describe the practice of not marking private assets to market.
Public Fund Performance with Reported Returns
I acquired rates of return for a sample of 50 large US public pension funds for the 16 fiscal years ended June 30, 2024. The sources are the Center for Retirement Research at Boston College (CRR) and the funds’ annual reports. I included only funds reporting returns net of fees.
I then created an equal-weighted composite of fund returns and developed a Market Index to evaluate the performance of the composite. The Market Index has the same effective stock-and-bond market exposures and the same risk (standard deviation of total return) as the composite. The Market Index blends returns of US- and non-US stock indexes with those of an investment-grade US bond index to form 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 difference between the two series, or annual excess return (ER), is -0.96%. See Exhibit 1.
Exhibit 1. Historical Returns Fiscal Years 2009 to 2024.
Secondary Market Pricing
In fiscal year 2022, an unusually large gap — 950 basis points (bps) — between the public fund composite return and that of the Market Index appeared. The average ER in the prior 13 years was just -1.2%. See Exhibit 1. Stock and bond markets experienced a sharp decline late in fiscal year 2022.
NAVs reported by GPs of private asset partnerships, however, typically lag public market reporting by a quarter or more. The lag in reporting NAVs produced large positive returns for private assets in fiscal year 2022, despite the sell-off in stocks and bonds. This unleashed a series of NAV adjustments by fund managers in the years following to bring marks into conformance with marketplace realities. (See fiscal years 2023 and 2024 in Exhibit 1.)
The marketplace, however, believes the GPs and their accountants have more work to do in marking private assets to market. This observation is based on data from the secondary market for private asset transactions. The data in Exhibit 2 were compiled by Jeffries’s Private Capital Advisory unit. Exhibit 2 summarizes the discounts from NAV for various categories of private assets during the first half of 2024.
Exhibit 2. NAV Discounts for Private Assets.
Source: Jeffries Private Capital Advisory
In the analysis that follows, I incorporate the overall discount of 12% for private asset transactions in the first half of 2024 in estimating pension fund returns that reflect fair market pricing.
The Center for Retirement Research reports that public funds allocated an average of 24% to private assets (private equity and real estate, only) through fiscal year 2022. I multiply the private asset percentage of 24% by the average NAV discount of 0.12, which produces a figure of 2.9%. Assuming Jeffries’s overall discount applies, this indicates that the funds, in the aggregate, were over-valued by approximately 3% relative to the market.
I apply this adjustment to the excess return figure of -0.96%. I do this by dividing 3% by 16 (years), producing a 0.2% (18 bps, to be precise) haircut to excess return. (If we spread the haircut over the most recent 10 years, it amounts to 0.3% per year. The period chosen for applying the haircut is arbitrary. This results in an adjusted excess return (AER) of -1.14% per year since fiscal year 2009. See Exhibit 3. The calculations are rough and ready but good enough to get the idea across.
Exhibit 3. Recap of Calculation of Adjusted Excess Return.
Key Takeaway
Public pension funds have underperformed a public market index by approximately one percentage point per year since the Global Financial Crisis. I attribute this to their high cost of operation and inefficient diversification.
Volatility laundering — the practice of not marking private assets to market — obscures another dimension of economic underperformance of these funds. Were public funds to mark private assets to market, it would bring about a two- or three-tenths of a percentage point per year worsening of their long-term performance — a hit they can ill afford.
[1] ASC 820, adopted by FASB in 2008, provides guidance on fair market valuation of private assets.
[2] Jeffries reports discounts for a basket of private assets traded in the secondary market fluctuated between 8% and 19% between 2018 and 2024.
[3] The Market Index comprises the Russell 3000 stock index (52%), MSCI ACWI ex-US stocks (19%), and Bloomberg US Aggregate bond index (29%). The R2 of the public fund composite with the Market Index is 99.3% for the 13 years ended June 30, 2021, with a wee tracking error of 1.0%.
