Does Private Equity Deserve A Spot In Retirees' Portfolio?

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Includes: MDY, PEX, PSP, SLY, SPY
by: Dave Dierking

Summary

On the surface, private equity with its potential diversification benefits and high yields could appeal to retirees.

In practice, private equity and publicly traded equities are quite highly correlated.

Private equity ETFs are also hampered with high costs making them less appealing.

Should retirement investors at least consider adding a small allocation to private equity in their portfolios?

In general, retirees should maintain a diversified portfolio largely comprised of income producing investments. Securities like dividend growth stocks, high quality bonds and CDs should be the main focus in order to deliver a steady income that retirees can live off of for the rest of their lives. Small allocations to riskier asset classes like small caps and junk bonds for a little extra boost are OK too.

One asset class that is overlooked by many retirees is private equity. While investment in privately held companies is usually reserved for the wealthy or well-connected, individuals can indirectly invest in private equity through investment in publicly traded companies that engage in private equity investment. Some of these companies pay significant dividends to shareholders but do they fit in a retirement portfolio?

I like to use the PowerShares Global Listed Private Equity ETF (NYSEARCA:PSP) as a proxy for this segment of the market since it's the largest private equity focused ETF in the marketplace and holds about 60 different providing instant diversification.

Retirees might like the surface view of the Private Equity ETF for a few reasons. First, those dividends. The Private Equity ETF currently sports a trailing 12 month annualized yield of 7% which at times has spiked above 10% depending on the economic environment at the time. Second, an inherently riskier investment like private equity should provide important risk-reducing diversification benefits to an overall portfolio in a way that other equity investments may not.

However, those two points aren't, in reality, quite as appealing as they appear. Also, there are a few other issues that need to be addressed with regard to the Private Equity ETF and private equity investment in general.

The Inconsistent Quarterly Dividend

The main problem with the ETF's quarterly dividend is that while the overall annualized yield looks good, it's terribly inconsistent on a quarter to quarter basis.

Retirees looking for a steady dividend sure won't find it here. Quarterly payments have been as high as $0.62 per share and as little as $0.01 per share. Retirees need a predictable monthly (or quarterly) income stream in order to manage their budget and a dividend as unpredictable as the one that comes with this ETF won't help. Granted, any allocation to private equity should be small and should not have a huge impact on the portfolio's overall income level, it adds a level of unpredictability that retirees probably don't need.

No Significant Diversification Benefits

It's often assumed that more investments in a portfolio means better diversification but that's not the case if the investments are highly correlated to each other. One might think that adding a specialized asset class like private equity to a retirement portfolio is a good idea from a risk management perspective. In reality, publicly traded stocks and private equity investments are actually quite highly correlated.

Consider the correlation of the Private Equity ETF to the S&P 500 (NYSEARCA:SPY).

In the past five years, the correlation between the two has rarely dropped below 0.75. Most of the time, it hovers around the 0.85 area and even got as high as 0.97 back at the end of 2011.

The correlations with the S&P 400 MidCap Index (NYSEARCA:MDY) and the S&P 600 SmallCap Index (NYSEARCA:SLY) show similar results.

These two indices do a bit better providing diversification than the S&P 500 but not much. Correlations between the Private Equity ETF and each of the three indices currently sit at 0.82 or above.

In short, private equity is going to move in a substantially similar manner to other equity investments. That won't provide retirees much comfort when the markets continue moving down.

The High Expense Ratio

Let's not forget that investing in ETFs comes with a cost. S&P 500 Index ETFs can be had for just a few basis points making the cost negligible but the Private Equity ETF falls on the other end of the spectrum. The expense ratio for this ETF currently sits at a staggering 2.09%.

This expense ratio combined with private equity underperformance relative to the S&P 500 and the ETF's benchmark, the Red Rocks Global Listed Private Equity Index, has made it very difficult for investors to keep up. A $10,000 invested in the Private Equity ETF at inception on October 24, 2006 through the end of 2015 would have returned investors just $7,308. An investment in the underlying index would have returned a modestly better $9,169.

The difference in performance between the ETF and the underlying index demonstrates how the fund's high costs have cut significantly into shareholder returns. Any fund with an expense ratio of 2% should be avoided.

Conclusion

Historical underperformance aside, it's difficult to recommend adding a private equity investment to a retiree's portfolio given its high cost, high correlation to the broader market and inconsistent income stream.

Unfortunately for those interested in investing in private equity, there's not much alternative in the ETF marketplace. The ProShares Global Listed Private Equity ETF (BATS:PEX) is a much newer, much smaller and much more thinly traded ETF that runs into many of the same issues that the PowerShares ETF does.

Given the issues already mentioned, private equity doesn't warrant inclusion in most retirees' portfolios.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.