The Department of Labor’s proposal to add private equity funds to 401(k) plans made headlines and raised concerns in June. But it will take a lot of time for these funds to work their way through the regulatory system and be made available to accredited investors, let alone retail clients, according to a panel of experts who spoke recently at this year’s virtual Morningstar Investment Conference.
In February, when Vanguard broke the news that it would be introducing private equity funds to investors, the fund giant startled those who feel this type of fund should be limited to high-net-worth investors.
A panel of experts explored this and other issues in detail during a discussion led by Bethany McLean, the journalist who broke news of the Enron escapades. She began by asking Vanguard’s global head of portfolio construction and principal, Fran Kinniry, why the fund giant is making this move.
His response: “Vanguard’s entire history has been to take institutional asset classes that we believe and research shows improve investor outcomes.”
Kinniry pointed out that index funds were originally institutional products, but Vanguard was able to bring them to retail investors. “We ‘retailized,’ or democratized, indexing,” he explained.
“We believe there’s a strong investment case for private equity. It’s been limited to the largest asset pools, and … with our brand, our scale, our size, we can deliver a world-class private equity offering,” he added.
Chadd Evans, managing director and chief investment officer of Altera Investments, who used to work in private equity, thought Vanguard’s move “made sense.”
However, Morningstar’s John Rekenthaler, vice president of research, has been “puzzled” by Vanguard’s move, especially as it services retail clients at a low expense ratio. Private equity is neither retail nor low cost, he said during Thursday’s session.
He also wondered how Vanguard will price private equity funds daily. “Computing total returns on private equity is a whole different matter” from index funds, he said.
Kinniry argued that Vanguard has managed “tax-exempt bond funds on the active side [where there’s] not a lot of transparency, not a lot of trading, not a lot of liquidity, so there are … other [similar] areas where we’ve entered the market, including high-yield corporate bonds … . This is going to be a broadly diversified offering [made] through HarbourVest.”
The fund giant’s institutional advisor services unit will allow investors to invest directly into the PE fund, while HarbourVest itself will invest in private equity funds that are geographically and strategically diversified. Kinniry called it a “turnkey” solution for the private equity market, which will have between 600 to 800 holding companies.
McLean wondered about the fee structure, especially with another layer added to the direct investments.
The Vanguard executive explained that he couldn’t give fee details due to the fact that the planned product is a private investment, but it will not have another layer of fees. He added that, although the PE product’s fees aren’t as low as those of an index fund, “they aren’t as high as some people believe” — as most fees will be based on performance, or “carry,” which is the terminology in private equity.
Rekenthaler said Vanguard also should focus on standardizing measurement of performance.
There has to be a database that “when customers see performance of a private equity fund, they know what their getting,” the Morningstar executive and columnist explained, adding that now funds are calculated in multiple and complex ways.
“How do I know when I see 12% vs. 9% managers that the 9% money manager didn’t perform better? It’s not something we run into with our Morningstar database,” Rekenthaler said.
With Altera Investments’ business based almost entirely in alternatives, “fees matter a lot,” said Evans. With Vanguard and others coming in, “fee compression is already starting to happen,” he said.
However, one issue with PE is that “it’s not obvious what you’re paying for to the retail investor or even the institutional investor, but it all comes back to how you track performance” Evans explained.
Who’s Allowed to Buy Them?
Vanguard has started work on PE products within its own outsourced chief investment officer (or OCIO) business, which acts as a manager, and allocates and rebalances investments. Next, it will move to develop PE products for other groups, such as its ultra-high net worth investors, who are qualified with investments of $5 million and above.
Although it is now “in market” in the OCIO space, Vanguard is working on getting the “backend” prepared for the high-end retail investors, Kinniry said.
Evans said he didn’t see this type of investment making its way “fully” down to the retail space for 10-plus years, adding that this development depends a lot on the regulatory environment.
“The accredited investor will have some kind of exposure but will get it through a fund of funds or some other more sterilized vehicle that will be managed by a Vanguard-type firm,” Evans said, noting that PE-access is available now to these investors but with little variety.
He added that “true direct investment, even through some of these platforms, will still be the domain of $25-million-plus type of client.”
Also, as there are just a handful of companies that dominate the 401(k)s marketplace in the United States, Rekenthaler said “they will be slow to put these [PE products] into their funds and cautious, because they have a lot to lose. So I don’t see the practical implications [of using PE in 401(k)s] for a long time.”
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