Should individual investors join the private-equity party?

By Mark Hulbert

Private equity isn't all it's cracked up to be, a review of Wall Street research shows

Think twice-better yet, three times-before jumping at the increasing opportunities that individual investors now have to get into private equity.

That's because the average private-equity (PE) fund lags behind some publicly available index funds, according to new research from Dimensional Fund Advisors. PE funds may still provide valuable diversification, but that is a secondary virtue compared with the outsize returns that are motivating many individuals to seek out PE funds.

Private equity is just that: private. It refers to equity investments in companies that are not publicly traded. Historically these investments have been available only to large institutions and high net worth individuals, but increasingly in recent years they have been made available to individuals.

Several exchange-traded funds now exist that invest in private equity, for example, as you can see from the accompanying chart. Vanguard in 2020 announced its intention to create a private-equity fund that would be available to individuals, and earlier this year Schwab announced it was creating an alternative investments platform (including PE funds) for individuals.

I think it's fair to say that private-equity firms aren't opening their doors out of altruism. At the same time that these investments are being opened up to individual investors, institutional investors are souring on all alternative assets, including private equity. Richard Ennis, a former editor of the Financial Analysts Journal, was quoted last year in Institutional Investor as saying that "alpha appears to respond to the presence of alts [alternative investments] as if the latter were kryptonite - the greater the exposure, the harsher the effect on alpha."

The Dimensional Fund Advisors study that sheds new light on private equity was published in July. The study, "Understanding Private Fund Performance," was conducted by Kaitlin Hendrix, DFA's Asset Allocation Research Director and Vice President, and Mamdouh Medhat, DFA's Senior Research and Vice President.

The researchers analyzed a comprehensive database covering more than 6,000 North American private funds between 1980 and 2022. They found that while the average fund outperformed the S&P 500 SPX, it lagged behind the small-cap value asset class. That is especially revealing since private-equity funds typically invest in companies that fit the small-cap value profile.

This sobering conclusion is based on averages, however, and not all PE funds have lagged behind small-cap value benchmarks. Some have produced spectacular returns, in fact, outperforming small-cap-value indexes by large margins. But this is of limited value, since there is little correlation between PE funds that have performed well over one period and those that do well in the subsequent period as well.

That was the conclusion of a study published a year ago in the Journal of Corporate Finance, "Has persistence persisted in private equity?," the study was conducted by Robert Harris of the University of Virginia, Tim Jenkinson of Oxford University, Steven Kaplan of the University of Chicago, and Ruediger Stucke of Warburg Pincus in London.

For buyout firms, the researchers found "little evidence of persistence," and though they found that some performance persistence exists among venture-capital firms, it has been declining.

As mentioned above, however, it's possible that some PE funds can still help diversify your equity portfolio. Because of that, a portfolio diversified with both public and private equity may perform nearly as well as a portfolio of public equity alone while nevertheless incurring less volatility and risk. If so, the public-plus-private equity portfolio would come out ahead on a risk-adjusted basis.

If increasing your risk-adjusted performance is your goal, therefore, this new study contains reason to consider allocating a portion of your equity portfolio to private equity. But the study provides a reality check if you were hoping that investing in private equity would produce the huge returns that you imagine (mistakenly) the rich and famous have been earning in these heretofore exclusive investments.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

-Mark Hulbert

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09-16-24 1207ET

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