Do private markets offer better returns than public markets? Good question

Adam

Summary:

Private markets can outperform, but results are mixed and depend on benchmarks and methods. High fees and liquidity limits pose challenges, though they may still offer diversification benefits over public markets.

An executive order signed last month by President Donald Trump aims to make it easier for workplace retirement plans like 401(k)s to offer investments in alternative assets, like private equity and private credit.

Supporters of the idea believe it would “democratize” access to investments that largely have been available only to institutions and very wealthy individuals. They say it would provide retail investors better exposure to the whole economy since so many companies choose to remain private.

It’s also touted as a chance for ordinary investors to potentially get better long-term returns on their money. But is that true?

The question of how private markets have performed relative to public markets is the subject of debate. So the answer you get depends on who you ask, what studies they’re referring to and the metrics they choose to compare.

Different metrics lead to different outcomes

While some studies say private markets have outperformed, others say that they haven’t.

This discrepancy is driven in part by which public benchmarks researchers use for comparison, what type of private funds they analyze, how they calculate the private funds’ returns and what timeframes they choose for measuring performance.

For starters, there is no index for private assets that is comparable to public market indexes like the S&P 500 or Russell 2000. So you can’t make a true apples-to-apples comparison, said Zane Carmean, director of quantitative research at market data firm PitchBook.

And there is no uniform way that researchers measure private funds’ performance.

They may calculate what are called “public market equivalent” (PME) returns — but there are different ways to measure those, each with their pros and cons, Carmean said.

Another metric used is the “internal rate of return” (IRR). But in a recent article, Jack Shannon, Morningstar’s principal of equity strategies, warned these are “not the compounded, annualized returns everyday investors are used to, so they should be skeptical of any marketing materials that compare IRRs with the annualized return of a public benchmark.”

So, when asked if private markets have outperformed public ones, you often may get a yes from those who favor giving retail investors access to alternative investments.

“Our updated analysis finds that private equity and credit funds continue to generate high returns and offer significant portfolio diversification opportunities,” the Committee for Capital Markets Regulation, a financial policy research group, said in a report last month.

The committee’s report cites many studies suggesting outperformance relative to public equity indexes over time. One found that if private equity buyout funds had accounted for 20% of the equity portion of a traditional balanced 60-40 portfolio between 1995 and 2017, it would have reduced the portfolio’s risk — and it would have increased average annual returns by about three-quarters of a percentage point, after accounting for the higher fees normally charged by private investments.

But other researchers and retirement experts may say private markets have not outperformed public ones.

For instance, a recent study by Ludovic Phalippou — professor of financial economics at Oxford University’s Said Business School and author of the book “Private Equity Laid Bare” — concluded that private equity funds returned “about the same as” public equity indexes since at least 2006.

“There is no clear outperformance in the US. There is in Europe, but it seems driven by (a) different industry mix,” Phalippou said in an email to CNN.

Meanwhile, a 2022 study by the Center for Retirement Research at Boston University focused on returns for public pension plans that invest in a mix of public and alternative private assets, like private equity and real estate. It concluded that “from 2001-2022, alternatives have not helped overall returns although they may have reduced volatility.”

Another critical comparison will need to be made for 401(k) plans

Beyond the public benchmark comparisons, 401(k) plan sponsors should consider whether the private options that will be pitched to them are likely to perform as well as traditional private funds.

To better fit the needs of 401(k) participants, the new products will have to be structured differently than a traditional private investment fund. Traditional funds typically have very high fees, very little transparency and only call for investors to put their money in when the managers have secured a deal to invest in; and traditional funds often require investors to keep their money in the fund until it offloads given assets after a number of years.

By contrast, an investment product with private asset exposure designed for workplace retirement plans may have somewhat lower costs and let investors put money in regularly as well as make periodic withdrawals during the year. But the product may limit how many redemptions investors can make to ensure liquidity demands can be met.

What’s more, the money invested on a regular basis by a 401(k) participant might not be put to work until the fund manager finds the next deal to invest in. That means they could see a somewhat lower return over time if their money spends a lot of time held in cash or cash-equivalent assets before being deployed.

“The returns are based off the timing of the inflows and outflows of cash into the fund,” Shannon, the Morningstar analyst, said in an interview about private assets.

Even if a new product charges investors less than what they would have to pay in a traditional private fund, they still will pay more than what they’d be charged in index funds, some of which can cost as little as $3 to $10 a year for every $10,000 invested.

“The new products being designed for 401(k)s and wealth platforms add yet another layer of costs (distribution fees, liquidity management fees, platform charges) on top of the already high fee structure of traditional PE funds,” Phalippou said.

Bottom line: “It is certainly possible that some of these new products may beat a traditional, public-market equity fund. But they’re going to need to clear significant fee hurdles to do so, as these funds are much costlier than the average (exchange-traded fund) investors are used to,” Shannon said.

Then again, he also expects a number of new products will offer “hybrid portfolios that mix both public and private assets.”

“We are seeing a lot of development in this space, particularly with collective investment trusts, which is a good thing, as CITs often require daily liquidity, and having too much private exposure in a daily liquid vehicle would be a recipe for disaster,” Shannon said.

Source: cnn

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