In June, the SEC and the Department of Labor (DOL) released new guidance allowing participants of 401(k) plans to invest in private equity through qualified designated investment alternatives. This guidance comes on the heels of the December 2019 passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which requires plan sponsors to provide income projections to participants and outlines safe harbor rules for sponsors offering lifetime income via annuities, among other changes. Due to these regulatory actions, retail investors now have access to a broader menu of investment options — some of them riskier, more complex, and less liquid than public equities or traditional fixed income securities.
Brown Brothers Harriman took a very constructive timeout to speak with Bill Kelly, CEO of the Chartered Alternative Investment Analyst (CAIA) Association, about these recent developments to the defined contribution arena. What follows are highlights from that conversation.
BBH: Does the loosening of restrictions on private equity investments for 401(k) participants present a meaningful growth opportunity for asset managers in the coming years?
Bill Kelly: In short, yes. U.S. defined contribution AUM totaled $7.3 trillion as of December 31.1 If we estimate that target date funds (TDFs) make up about $2 trillion of that pie,2 we are now able to potentially invest up to 15 percent in the illiquid bucket of that $2 trillion into private equity — that means hundreds of billions of dollars of potential opportunity. What's more, the TDF is likely the private equity access point with the least point of friction for retail investors. We have seen many cases—such as the COVID-shaken markets in March, for TDFs further away from retirement—when allocations to TDFs were stickier than the taxable parts of most retail portfolios. Likely, individuals own their TDFs and forget about them, so by hewing to the long-term nature of compounding and not trying to time the market, TDFs may be a sensible home for private equity.
That said, there is still a lot of work to be done, and expectations for private equity performance are wildly out of line. U.S. investors project 15.4 percent in average annual returns from investment portfolios over the next five years, according to a post-COVID survey from Schroders.3 U.S. investors' return predictions outpaced those of all other investors across the globe. If 401(k) participants believe that regulators will open these private markets — which, by the way, already have $1 trillion of institutional dry powder sitting on the sidelines trying to make its way in — and they will be able to generate high double-digit returns, then they may be in for a rude awakening because a 15 percent return assumption is simply not realistic.
BBH: In the past, alternative investments have been open to only a small subset of investors that has comprised institutional, high net-worth, and other investors defined as accredited. Now, with 401(k) investors able to place their capital into private equity, what could this mean for general partners?
BK: Globally, about $89 trillion in assets are currently under management, and just over 40 percent of this pie is retail, per Boston Consulting Group (BCG).4 In 2019, retail AUM grew at a rate of 19 percent, while institutional AUM increased 13 percent, per BCG. This means that we are one to two clicks away from retail investors dominating the global asset pool. Meanwhile, alternatives make up only 16 percent of the total AUM but have a nearly 50 percent share of global revenues. This is likely because the space for traditional assets has become much more commoditized and fees and expense ratios on index funds have been drastically compressed. If an investment manager is seeking high operating leverage, it will be increasingly more difficult in the traditional space, so some of them may turn to alternative product offerings to protect or grow their investor base. This shift could benefit general partners, but such benefits will only accrue to the investors if these are high quality and truly differentiated offerings.
However, we need to consider the behavioral differences among different types of investors. We are taking a very sophisticated strategy offered in a private fund with very few constraints, then moving it into a 40-Act Fund with daily liquidity, strict limits on the use of leverage, and tremendous disclosure and regulation requirements. Providing retail investors the option to trade in and out on t+1 has the potential to minimize the importance of long-term conviction when investing, particularly in the private market space.
BBH: Could you discuss how alternatives have fared through the recent COVID-related market volatility?
BK: The view on alternatives performance is largely a function of expectations. Given the risk-on mindset among investors post the financial crisis, we have seen many individuals want to have 100 percent of the alternatives upside but 0 percent of its downside, and wrongly focus on excess returns over the S&P 500 Index. It is more important to think of alternatives in the context of diversification, and in that sense, alternatives have held up well. Year-to-date through April, all tradeable alternatives strategies, including managed futures and commodity trading advisors (CTAs), had higher returns than the S&P on a relative basis, based on the Preqin All-Strategies Hedge Fund Benchmark. This is a narrow window into the importance of diversification and the mitigation of the drawdown risk that can occur with any single asset class.
In April, equities came roaring back and outpaced the Preqin All Hedge Funds Strategies benchmark return by almost 700 basis points. Still, in April, the All-Strategies posted its highest monthly return since May 2009. Furthermore, CTAs, which have been out of favor for quite some time, is the only asset class —including the S&P and all alternatives strategies — that is positive (April) year-to-date, with a gain of 1.6 percent. So, again, evaluations of performance are a function of expectations, but if you are seeing alternatives as a true diversifier, then they delivered on that purpose.
BBH: Then, based on this information, would you view alternatives as a “slow and steady” safe haven in times of turbulence?
BK: While alternatives are often solely viewed as the high-octane part of a portfolio, diversification is one of the key components of the value proposition of private equity. Benefits such as the uncorrelated risk premium, lower volatility, lower drawdowns, and better risk-adjusted returns are important considerations for private equity. It is more nuanced than this, though. When we view underlying returns on private equity, private debt, and hedge funds, the median returns are similar to the public market proxies for these asset classes. But the dispersion of those returns among fund managers is extremely wide. So, when allocating to a private equity strategy, that decision must be wrapped in a tremendous amount of due diligence and discovery.
It really comes down to manager selection, to a large degree. Rather than focusing on, “What percent of my portfolio should be in alternatives?”, investors should be asking, “Am I getting true diversification by investing with this manager?”
BBH: It seems inevitable that retailers will try to get into alternatives either through their retirement plans or through direct access. What can service providers like BBH do to prepare for this?
BK: I have to believe that extensive data collection and data mining will enable service providers to better serve clients. A little-known fact is that the endowment model, which includes alternatives, was started by a Ford Foundation grant of $2.5 million to The Commonfund approximately 50 years ago, and at that point, the endowment fund was born. Fast forward to 1982, only 24 private equity general partners existed in the world. When you think about information asymmetry and the inefficiencies that could be exploited for investment opportunities, it would have been great to be a general partner back then — or a limited partner investing with them. Since then, it has become much more difficult and challenging to find value and juicier returns, even in the alternatives space. In my view, the next bastion of alpha is going to come from the owners of data.
William (Bill) J. Kelly is the CEO of the CAIA Association. Bill has been a frequent industry speaker, writer, and commentator on alternative investment topics around the world since taking the leadership role at the CAIA Association in January, 2014.
In addition to his current role, Bill is a tireless advocate for shareholder protection and investor education and is currently the Chairman and lead independent director for the Boston Partners Trust Company. He has previously served as an independent director and audit committee chair for ’40 Act Mutual Funds and other financial services firms. He is also currently an Advisory Board Member of the Certified Investment Fund Director Institute which strives to bring the highest levels of professionalism and governance to independent fund directors around the world. A member of the board of the CAIA Association, Bill also represents CAIA in similar capacities via their global partnerships with other associations and global regulators.