Understanding Volatility Laundering in 2023 Mutual Funds

This is a great summary from a Morningstar Article:

Introduction: Mutual fund managers have recently coined a new term, “volatility laundering,” in an effort to attract investors who are drawn to the massive inflows enjoyed by private equity and interval funds. This article aims to shed light on the concept of volatility laundering, its implications, and the arguments surrounding its use in the financial industry.

Section 1: What is Volatility Laundering? Volatility laundering refers to a practice that involves funds purchasing private investments while downplaying the associated risk and volatility. The contention is that these funds do not inherently possess lower risk compared to funds investing in public markets; instead, they manipulate the perception of volatility by concealing it from investors.

Section 2: Mechanisms of Volatility Laundering Volatility laundering manifests in various ways within private-market investments. Firstly, private-market money managers typically price their holdings on a quarterly basis, resulting in fewer data points and smoother returns compared to daily-traded investments. Secondly, private funds employ measures such as capital calls or gating to restrict investor withdrawals, thereby limiting their ability to assess performance between pricing cycles.

Section 3: The Benefits of Self-Imposed Volatility Laundering While the constraints imposed by volatility laundering might seem restrictive, they can serve as valuable tools for investors. Similar to the concept of burying our heads in the sand, this approach helps mitigate impulsive decision-making based on short-term market fluctuations. By limiting real-time access to performance data, investors are encouraged to adopt a long-term investment perspective, which often yields better results.

Section 4: Addressing Detractors’ Arguments Critics of return smoothing raise three key arguments against volatility laundering. In this section, we will provide counterarguments to address these concerns and highlight why return smoothing is not as problematic as claimed.

  • Argument 1: Understating Risk: Critics argue that volatility laundering masks the true level of risk faced by investors, leading to a potential underestimation of risk. However, private markets introduce other risks, such as cash flow management, leverage, and rebalancing, which must be carefully managed by investors. Accredited investors are subject to rigorous due diligence before entering private markets, ensuring risk factors are not understated.
  • Argument 2: Manipulating Valuations: Critics express concerns that return smoothing allows private funds to shield investors from realizing their true losses until it’s too late. However, similar concerns exist in other investment vehicles, and the ability to manipulate valuations is not exclusive to private funds. Rare events are often overestimated due to availability bias, while the negative impact of mistimed trades and errors of commission in public markets should not be overlooked.
  • Argument 3: Portfolio Disruption: Critics suggest that an influx of investors into private investments for their return-smoothing characteristics may lead to overallocation and a lack of portfolio balance. However, the core issue lies in inadequate risk modeling by investors rather than the frequency of repricing. Proper risk assessment and asset allocation are essential across all asset classes.

Section 5: Embracing Innovation in Investment Practices Investing has evolved over time, and embracing new approaches, including return smoothing, is a natural progression. Technology advancements have made it easier for investors to access information and hold fund managers accountable. Volatility laundering in private equity offers a trade-off between daily volatility and other risks, providing a valuable service to investors seeking investment discipline and emotional regulation.

Conclusion: Volatility laundering, although often criticized, can provide benefits when employed effectively. Understanding the mechanisms and arguments surrounding return smoothing is essential for investors to make informed decisions. By embracing innovative investment practices, investors can navigate the ever-changing landscape of the financial markets more effectively.

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