Regulators recently approved a change that allows 401(k) plans to offer private equity and other private funds. Many people see this change as a big step forward because it gives retirement savers access to investments that were only available to institutional and high net worth investors in the past.
This change raises an important question: Will the addition of private funds improve outcomes for the average 401(k) participant, or will it just make things more complicated without offering any real benefits?
Why do investors like private funds?
Private equity, venture capital, and private real estate opportunities were once only offered to a select few that could meet the requirements of being “accredited investors” or “qualified purchasers”[i]. The appeal is straightforward.
The primary attraction lies in the potential for higher returns. Some private funds, especially those in the top tier, have generated returns that significantly exceed those of public markets.
Also, diversification is very important. Private investments usually include businesses or real estate projects that aren't traded on the stock market, which gives investors access to different parts of the economy.
Investors might also like the fact that these investments offer diversification from publicly traded stocks and bonds. Private investments may seem less volatile than stocks because their prices don't get updated as often as public securities. This can help some investors stay calm when the market changes.
Also, private funds often put money into new businesses and technologies before they go public, giving them early access to growth opportunities.
The Other Side of the Story
However, studies such as Dimensional Fund Advisors’ recent paper, Understanding Private Fund Performance by Kaitlin Hendrix, CFA, and Mamdouh Medhat, PhD, show that private funds have pros and cons to consider.
Performance varies a lot. Some private funds do very well, but the median fund often does worse than public market benchmarks after fees are taken into account. Choosing the right manager is very important, and even experienced professionals frequently fail to outperform.
Also, performance isn’t consistent. In the past, top managers were able to keep their success going, but more recently, past performance has not been a good predictor of future returns.
Another worry is illiquidity. Most private funds require investors to lock up their money for long periods, which can conflict with the liquidity needs individual investors may expect.
Finally, fees and lack of transparency can create serious challenges. Compared to index funds or ETFs, private funds are usually pricier and less clear. These costs and limits can lower the returns that investors end up receiving.
What This Means for People Who Save in 401(k) Plans
For some participants, particularly those with a long investment horizon and a tolerance for illiquidity, private funds may offer added value. Evergreen structures, such as the Cascade Private Capital Fund (CPEFX), aim to tackle some traditional issues by providing the daily access of a mutual fund (albeit with limited liquidity) and minimizing the risks associated with single fund investments.
For many others, though, the drawbacks may outweigh the potential advantages. Without access to the same level of institutional research and manager selection, most savers will likely struggle to realize the benefits that private funds promise.
A Balanced Approach
I believe that private funds can be a useful complimentary addition to a portfolio, but they shouldn't take the place of core investments. A good retirement plan should still start with a broad, low-cost investment in public markets, which are open, liquid, and offer reliable long-term returns.
Adding private funds to 401(k) plans is intriguing, but it shouldn't make you completely change how you invest for retirement. When making an investment decision, you should always keep your goals, risk tolerance, and time frame in mind. If you would like to discuss how or if private funds make sense in your portfolio, get in touch.
[i] Investing in private funds is limited by U.S. securities law to individuals or entities that meet certain financial or professional thresholds. An accredited investor generally has a net worth of at least $1 million (excluding a primary residence) or an annual income of $200,000 individually ($300,000 with a spouse/partner) for the past two years. A qualified purchaser is a higher standard, usually requiring at least $5 million in investments for individuals or families. These rules are intended to ensure that only investors with sufficient resources and sophistication take on the unique risks associated with private funds.