Why Your 401(k) Will Thrive Without Private Investments!

The buzz around integrating private investments into 401(k) plans continues to captivate the investment sphere. As the US defined contribution (DC) market sits on a staggering $8 trillion in assets and continues to expand, private investments are carving out a niche in this market. The 2019 research paper, "Why Defined Contribution Plans Need Private Investments," presents a thought-provoking analysis on the advantages of incorporating private equity and venture capital into DC plans, effectively advocating for this paradigm shift.

An Insider’s Perspective

1. Changing the Game: The study boldly asserts that substituting publicly traded stocks with private equity and venture capital investments consistently elevates the average portfolio returns.
2. Diversification Drives Performance: The paper emphasizes that despite the volatility in private funds’ returns, diversification by investing in multiple funds historically leads to superior returns.
3. Private Investments Reign Supreme: A clear message emerges from the study – when played strategically, private investments always come out on top. It’s a game of calculated risk and reward.

Unveiling the Realities

Upon a closer examination of the research, it becomes evident that there are underlying concerns that should give investors and fiduciaries pause:

1. Performance vs. Justification: Merely outperforming public markets does not automatically justify investment in private markets.
2. Real-World Evidence: While the research relies on hypothetical returns, real-life studies have shown that the median fund of funds’ performance has lagged behind major benchmarks.
3. Market Inefficiencies: The assumption that the VC market could have supported impossibly large investments poses challenges in reality.
4. Venture Capital vs. Buyouts: The paper’s assumptions regarding the equality of the venture capital and buyout markets are in stark contrast to reality, where VC remains a smaller player.
5. Cost Concerns: The study uses relatively high cost assumptions for traditional investments while overlooking more cost-effective options available in the market.
6. Missing the Mark: By focusing on mean returns, the study bypasses a more relevant analysis based on median results.

The Fine Print

Delving into a historical analysis spanning three decades, the paper compares a traditional 60/40 portfolio with simulated portfolios integrating private investments. Public Market Equivalents (PME) forms the basis for evaluation, with a median PME of 1.06 for private equity representing a 6% lead over the S&P 500.

Reality Check

In reality, median VC performance falls short of public markets, with a select number of top-performing VC funds dictating the mean returns beyond the reach of many investors. A closer examination reveals the exclusivity of these high-performing VC funds, making them inaccessible to the average investor.

Navigating the Realities

1. Temporal Realities: The analysis overlooks historical market limitations, such as the VC market’s capacity to accommodate massive investments.
2. Capitalization Discrepancies: The over-reliance on VC funds in the simulation creates a skewed representation of market dynamics, favoring innovation over practicality.
3. Cost Considerations: The study’s premise of guaranteed outperformance overshadows the additional costs and complexities associated with private investments.

In conclusion, the investment landscape is rapidly evolving, with private investments poised on the cusp of revolutionizing the DC market. Investors and fiduciaries must approach this paradigm shift with caution, considering real-world evidence over theoretical simulations. A transparent evaluation of motivations and market dynamics is imperative to navigate the complexities of alternative investments successfully.