“It is the holy grail,” the man said to me in a solemn tone. He worked in private equity, and he was referring to the 401(k) market. We were just making small talk at a reception, but as it turns out, his view is not uncommon in the industry: Private equity wants access to Americans’ retirement accounts, and is lobbying President-elect Donald Trump’s administration to get it.
I was skeptical about my newfound acquaintance’s metaphor. But I am even more dubious about his assertion that small retail investors should invest their scarce retirement funds in such an opaque and lightly regulated asset class. And almost one-quarter of economists in a recent poll agree with me: Privately owned assets do not belong in 401(k) accounts.
That’s not to say proponents of investing in private markets don’t have their reasons. One has to do with the time horizon. Retirement funds are in it for the long term, and private assets are supposed to offer a higher expected return in exchange for being illiquid. Why shouldn’t long-term individual investors benefit in the same way as long-term institutional investors, such as pension funds or insurance companies? Another has to do with diversification. Private assets are a distinct asset class, and including them in retirement funds would allow them to reduce risk by offering access to a wider variety of assets.
In theory, both of these arguments have merit. But in practice, there are a few problems. First, the risk involved in private assets is not just lack of liquidity. It is lack of transparency.
Market pricing offers valuable information that keeps security prices somewhat honest. Private funds offer estimates on their returns each year, but since their investments don’t have a market price, it is impossible to know if they are accurate. Some pension funds are now finding that the returns they’ve been promised all these years didn’t pan out, if they can get their money back at all.
There is also less regulation in private markets. After the stock market crash of 1929, there was a consensus that retail investments should be transparent and well-regulated. Over the decades, securities sold on public exchanges became subject to lots of scrutiny. But an exception was carved out for “accredited investors” — wealthy or sophisticated people who supposedly knew what they were doing. They are free to invest in less regulated securities, including private equity and credit.
Perhaps this exception is unfair, because it means only rich people have access to certain investments. But even if that’s the case, it doesn’t follow that ownership of exotic assets should be made available to the least sophisticated investors in the market.
At any rate, it is not clear how much diversification private assets offer. In some ways it depends on what the underlying investments are — they could be debt, shopping malls, retirement homes or just a leveraged position in a privately owned company. A lot of private equity or credit is not that different from what’s traded in public markets, which is why buyout funds are highly correlated with public markets, and their strategies could be replicated with publicly traded assets. The big difference is that private markets are less transparent, less regulated, highly leveraged, and charge higher fees.
The other concern is that not all private equity and credit funds are equal: Some pay off more than others. It is unlikely retail investors would have access to these better funds, especially if their inclusion invites more regulatory scrutiny. And while private assets did provide better returns for a few decades, there is evidence that the returns started to be less great as the asset class grew to meet the demand of yield-seeking pension funds. The economic case to expand this market still further is not great.
The timing is also terrible. Private funds thrived in a low-interest-rate environment where leverage was cheap and many institutional investors were chasing yield. Those days are over, and the industry may be more likely to shrink than to grow.
The bottom line is that the illiquidity premium or the supposed diversification benefits are not reason enough for retail savers to invest in private funds. There is a guiding principle behind everything that happens in financial markets: Greater returns are not possible without greater risk. This applies to private as well as public markets.
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