Mutual fund managers seeking to compete with private equity and interval funds to attract investments, is what is often referred to as “volatility laundering.”
What is volatility laundering?
Volatility laundering is a somewhat disparaging label for funds that invest in private assets. The criticism revolves around the notion that these funds don’t inherently reduce risk but rather hide it from investors. This concealment happens in various ways, such as:
- Less frequent valuation of private holdings
- Locking up investor capital
- Limiting performance visibility between valuation cycles.
While these measures may seem restrictive, they can serve as a useful discipline for investors. Long-term investment success often requires resisting the urge to react to daily market fluctuations, also referred to as “short-term noise.” However, concerns about volatility laundering have three main arguments against them:
- Risk Underestimation: Critics argue that “return smoothing” understates the true level of risk faced by investors, primarily because private markets exhibit lower observable volatility.
- Shielding Losses: There’s a fear that private funds can use return smoothing and optimistic valuations to shield investors from realizing the full extent of their losses until it’s too late, especially if they need to liquidate quickly.
- Portfolio Disruption: Investors flocking to private investments for their return-smoothing qualities may unintentionally overcommit capital, leading to difficulties in maintaining their desired asset allocation.
In response, proponents of return smoothing argue that investors need discipline and emotional regulation, which these measures provide. It’s a trade-off where daily volatility is exchanged for other concerns, aiming to help investors stay the course in their long-term investment strategies.
In conclusion, return smoothing, or “volatility laundering,” is a strategy that aims to manage investor behavior and may have merits in certain contexts, even though it has its critics.