The regular working Joe Schmo has always gotten the short end of the investing stick. Before the industrial revolution, no working people had enough capital to buy property. Land was the source of wealth and was handed down from generation to generation creating a permanent ruling class. The first company to let the public own it and trade its shares was the Dutch East India Company formed in 1602. For 94 years the company paid a dividend that paid between 12% and 63%, probably one of the greatest long term investments of all time.

Returns like this invite imitation and soon enough many countries were creating legal structures that allowed the public to own shares. The rules we have in the market now are the result of spectacular bubbles and crashes we have experienced in the past as well as heartless theft by those with a little knowledge trying to make a buck. This includes brokers, executives and unscrupulous entrepreneurs. Even with more robust rules in place to protect investors, it wasn’t until the mid 20th century and academia taking a serious interest in how securities markets performed and behaved that theories on investing started to develop that influence much of what your suburban strip mall Fidelity advisor pushes today.

Slowly but surely government has tried to balance both protecting investors as well as open up new opportunities to them that at one time were only available to the wealthy. Financial innovation and bold risk takers have also made huge strides in democratizing investing and harnessing the tools once only available to a few knowledgeable people.

In modern times the high cost of mutual funds gave way to index funds and ETF’s. Junk bonds opened up the space of high yield investments to the average investor who could tap these bonds through bond funds. More recently, expensive broker assisted trades have now given way to free trades available on Robinhood. As I discussed in my last post, retail investors have even warmed to options, so much so that they now dominate some portions of the US call market.

There have been a few stubborn pockets however where the wealthy have been able to keep out the unwashed masses. Hedge funds were the rock stars of the 90’s and early 2000’s and were closed to those that were not accredited investors and didn’t have the capital. However, returns have since been lackluster for much of the hedge fund industry, getting blown out by the S&P 500 since the financial crisis. One study found that funds took on average two thirds of the gains from investors.

The other area which until recently remained for the domain of the rich was private equity. Venture capital that was able to invest in tech startups first. M&A that was able to take while companies private, streamline them, make them more efficient and return them to the market more valuable than before. Or just plain old investing in companies that the public did not have ready access to.

That may have started to change recently with guidance issued by the Department of Labor (DOL) on what 401k plans were allowed to offer to their participants. Despite the drab sounding title, the changes could drastically change the way that target date funds are constructed and in my view, add value for retail investors. It helps to first understand what a target date fund is and how it would change under the new guidance.

Target Date Funds

In simple terms, a target date fund is a fund which puts all your long term investing decisions in automatic. The fund adjusts between more aggressive and more conservative investments based on how close or far away you are from retirement.

Stocks tend to be volatile but also offer much higher growth over time. By contrast bonds offer lower volatility but also lower return over time. The riskiest stocks tend to be those found in emerging markets and there is additional currency risk when investing in overseas companies in general. So the target date fund starts with aggressive, stock heavy investments early in your career and then automatically adjusts towards a more conservative portfolio to protect your accumulated returns as you age. The rate at which this happens is called the slope and can be seen in the graphic provided by Vanguard below.

You can see above that before 25 years from retirement, the portfolio is aggressively tilted towards stocks in order to benefit from the many years the worker has to see long term gains. At 25 years out from retirement, the bond portion of the portfolio starts to increase and reach about 40% of the portfolio upon the retirement date. For simplistic purposes it is assumed that people will retire after about 45 years of work.

The target date portfolio is usually the default portfolio for 401k plans and it’s not a bad one. It protects gains as workers age and offers diversification across investing classes. Despite the hype now that tech stocks are driving everything, this phenomenon is far from guaranteed to continue in the long term. Same for international stocks which have underperformed in the last 10 years. There is no reason to think we could not see a reversal of fortune. This is the rationale behind international diversification, there is no telling which market will be hot next so it’s easiest to hold them all and benefit from it in some form.

The drawback to this is that it consists of only publicly available securities. Those investments that are illiquid, leveraged or private are not represented in these portfolios and this is where the wealthy have an advantage.

The Billionaire Portfolio

In contrast the billionaire portfolio looks quite different. Forbes did an article a number of years ago that is likely still relevant today. It shows the typical portfolio of a portfolio for someone worth over $200 million which can be seen below.

Although this chart is about 7 years old, it’s still relevant to contrast how a typical 401k investor’s portfolio may look compared to a billionaire or someone with hundreds of millions. Notice that only 32% of the portfolio is dedicated to public equities in contrast to the retail portfolio which can have as much as 90% of the portfolio allocated to this asset class.

Equity like products account for another portion: private equity, venture capital, hedge funds, direct investments and direct real estate account for another third of the portfolio. The only major change we may see in a wealthy investor’s portfolio today would be a smaller allocation to hedge funds given the weak performance of the past ten years and likely a larger allocation to private equity and venture capital.

It’s also worth noting that there is a bit more of a conservative tilt in a wealthy investor’s portfolio. This is because the big money has been made, there is more of a focus on preserving the wealth accumulated rather than being aggressive to see more gains. Despite this, the diversification of opportunity can offer an important lesson on how the wealthy get to invest different and how the DOL guidelines may change the game.

How Things Could Change Now

The DOL’s new guidelines are specific in the sense that they leave the option for target date funds to diversify into private equity. Many news outlets have been sounding the alarm about this and saying retail investors could be at risk investing in something where they have little understanding of the risks involved. However this doesn’t take into account that these target date funds are run by professional firms that can easily diversify and also the fact that most people investing in these funds are more the “set it and forget it” types. Professional diversification could greatly benefit these passive investors, as long as the fund managers invest prudently.

Why would they want to diversify into private equity? Well the first reason is that, as is no surprise, it tends to offer higher returns than public equities. This is what I mean by the democratization of opportunities, it should be just the wealthy that have access to higher returns that the rest of us are locked out of achieving.

The other is that, although the data on this is sparse and somewhat controversial, it seems that there is less volatility in PE returns. This has to be qualified by the fact that there is no PE index to compare returns to, reporting may be voluntary and subject to “smoothed” data because it may rely on estimates provided by fund managers who have a conflict of interest.

You will see that even in low growth Europe, buy out PE funds were able to beat returns for their public market equivalents (PME) and didn’t experience the same heavy losses in down years. This is the type of opportunity that could add to return and reduce volatility for those same retail investors. This is captured by the Sharpe ratio in investing terms. Those wealthy investors tend to have portfolios with higher Sharpe ratios compared to retail investors due to the access they have to asset classes the rest of us don’t.

This has only caught scant media attention to date but could represent a big change for both private equity as well as retail investor returns. We will see in the coming years if the big fund providers like Vanguard, Fidelity and State Street take the plunge and dive into this market.

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