The discussion regarding the inclusion of private investment in 401(k) plans is a hot topic in the investment community. With assets of over $8 trillion and a growing asset base, the US Definition Contribution (DC) market is a significantly undeveloped market for private use.
Research paper: Why is private investment necessary for defined contribution plans?[i]” – a collaboration between the 2019 Definition Contribution Alternative Association (DCALTA) and the Private Capital Institute (IPC) – provides an analysis of the potential benefits of including private equity and venture capital in DC plans.
A balanced view should consider the purpose of the research sponsor. Specifically, DCALTA's mission statement calls for “advocacy regarding the benefits of including hedge funds, private equity, and other alternative investments in defined contribution frameworks.”
In line with the organization's mission, the bold conclusions of the 2019 survey include:
- Investing in private funds “always increases the average portfolio return” when publicly traded stocks are replaced by private equity (called “buying” in research) and venture capital investments.
- The study states, “… Despite the broad return rate of private funds, the ability to diversify by investing in multiple funds is sufficient to guarantee historically superior returns.”
Message: When you play the game correctly, your personal investment will always win.
If you read the research carefully, you will need to ring the alarm bell for a careful investor or trustee.
1. That means that Any Private investment and outperformance in the public market justifies investment.
2. Research will be used The mean return improves the outcome of the scenario when the median result is more appropriate.
3. We assume that the small VC market in the 1990s could accommodate incredibly large investments in the early days of simulations.
4. In fact, assume that the overall size of the venture capital market is equal to the acquisition market, but in reality it is much smaller.
5. The cost assumption for creating traditional stock and bond indexes is relatively high. There are low-cost options on the market.
6. Although the findings of the paper are based on hypothetical returns, recent real-world studies have shown that the median funds drag the S&P 500.
Devil of Details
This paper compares the historical returns (1987-2017) of traditional 60/40 shares/bond portfolios with simulated portfolios in which chunks of stock allocation traded public-privately traded stocks are replaced by randomly selected venture capital and/or buy-out funds.
To compare the results with the open market, this paper uses Public Market Equivalents (PME), a methodology for assessing the performance of private equity against public equity benchmarks, as an important measure. For example, a median PME of 1.06 for private equity means that typical buy-out fund returns are 6% better (not more than lifetimes) than returns from similar investment patterns on the S&P 500.
Is that okay? I think the late Yale University respected David Swensen would have said no. He writes: “The high leverage inherent in buy-out transactions and the inherent in venture investments will lead investors to experience greater fundamental risks and expect a substantially higher investment return.”[ii]
The author's conclusions seem to suggest that even a 1.01x PME is worthy of problem. The wise investors disagree.
| Average Public Market Equivalent (PME) Return | Median open market (PME) return | |
| Private Equity (aka Buyout) | 1.12 | 1.06 |
| Venture Capital (VC) | 1.18 | 0.86 |
Source: “Why is private investment necessary for defined contribution plans?”
In fact, you're not invited to the party
Despite median VC performance, it took over the open market[iii]the average return was juiced by a few killer VC funds that ACME 401(k) plans were inaccessible (and unable to). Everyone was invited to the simulation. In fact, there was a velvet rope. Even for large institutional investors. This is no secret. The research acknowledges that:
“It's difficult for most investors to access because there is an excessive demand for these funds and the general partners of VCs tend to limit the size of the funds.”
Temporal anomalies and retrospective reemphasis
In 1987, the US DC market was worth $525 billion.[iv] Therefore, the target allocation for venture capital assumptions for the simulation would require an investment of $52.5 billion. To the point that it was useless, the venture capital that was raised for five years from 1987 to 1991 was $31 billion.[v] Marty McFly's 401(k) plan may have reaped the loot of the year of Halcyon. Not all of us have a time travel DeLorean.
This simulation relies on each equal allocation made to both VC and buy-out funds despite the capitalization of VC funds that are much smaller (higher return) than the buy-out market. This simulation places a significant emphasis on smaller, better performance (based on average results) VC funds. Does this mean when they say VC investments lead to great innovation?
Finally, the 60/40 Vanguard index funds used for most of the paper (VTSMX and VBMFX) have an annual expense ratio of 14 and 15 basis points, respectively.
It's cheap if you ignore the cost
The key scenario in this study calls for planning to invest 10 funds a year. Most institutional investors in the private market invest less than three times a year. To get more than 10 funds for your purpose, the plan will likely need to invest in the funds. In a world that is not imitated, it costs more money. This paper is compared to the actual funds cost versus ~2%, assuming an additional cost of up to 0.5% per year for private use.[vi] Furthermore, the paper's claim that returns are effectively guaranteed to perform better than the 60/40 portfolio does not appear to reflect the additional costs associated with private investments.
A more constructive approach is to analyse the actual performance of funds. It's useful, scholars already have it. One study[vii] It shows that more than half of the fund's funds are below S&P's performance based on PME. The author of the paper stated, “Our results also have policy implications as to whether and how the 401(k) plan should invest in PE funds.”
Beware of the journey of investors and trustees on alternative/private market journeys: Your alternative journey is not real life and is not simulated. Always consider real-world evidence and the motivations of those who are selling to you.
[i] “Why is private investment necessary for defined contribution plans?” DCALTA/IPC research paper
[ii] Pioneering portfolio management, an unconventional approach to institutional investment. 2009. Swensen, David. Page 221
[iii] 25% Percentile Results: Acquisition: 0.87x Venture Capital 0.62x. There is a shortage of open markets where many funds are not publicly available
[iv] US DOL website page 13
[v] https://www.nytimes.com/1989/10/08/business/venture-capital-loses-its-vigor.html
[vi] “Diversification of private equity” by Gredil, Liu and Sensoy
[vii] “Divider Private Equity” by Gredil, Liu and Sensoy Page 32
