Those who earn less than $200,000 a year -- that’s most people -- face a barrier when it comes to the kinds of investments they can make. Acting Securities and Exchange Commission (SEC) Chair Michael Piwowar wants to tear it down.
Piwowar is targeting the SEC’s Regulation D, which divides investors into two categories: those who can invest in the realm of private equity and partnerships, hedge funds and other esoteric products, and those who can’t.
The dividing line is $200,000 in salary -- or $1 million dollars in assets -- which allows an “accredited” investor into the rarified world of charismatic hedge fund managers who experience gains and losses that the rest of us only dream of or hear about on cable TV. According to Piwowar, this is an unfair advantage.
Only one of two remaining SEC commissioners, Piwowar is due to be replaced as chair by President Donald Trump. But in the interim, he’s making good use of his time. In his remarks at the February “SEC Speaks” Conference, the Republican economist framed his eloquent appeal for giving the little guy a bigger seat at the investment table with phrases like “the forgotten investor” and “Les Miserables,” the title of Victor Hugo’s novel about the revolt of the French underclass.
“[It’s] like something out of the ancien regime,” he said. “I question whether nonaccredited investors are truly protected by regulations that prevent them from investing in high-risk, high-return securities available only to the Davos jet-set.”
Piwowar made several valid points. While inflation and salaries have risen steadily since 1982 -- when the $200,000 rule was enacted -- that litmus test hasn’t been updated in 35 years. Even worse, the million-dollar threshold to play in the hedge fund-private equity game was squeezed further by the Dodd-Frank Act, which disallowed equity in personal homes from being included. So if you have $1.4 million in assets, but $500,000 is tucked inside your home, you’ve missed the cut.
Should investors with only $100,000 gain access to the private equity domain? According to Piwowar, the key word is “correlation.” Average investors should be allowed to find investments that don’t correlate to the basic stock and bond markets, where most of their assets now reside, to obtain diversification.
For example, if stocks take a tumble, holdings in a longer-term private equity fund would minimize the loss because that part of their portfolio wouldn’t correlate to the flips in the stock market. If the correlation between stocks, bonds and private equity is low enough, a private equity holding may even decrease an investor’s overall risk, even though it’s riskier alone.
“By holding a diversified portfolio of assets, investors reap the benefits of diversification,” asserted Piwowar.
Another factor to consider: While most investors don’t want a big loss late in life when they may actually need the money, it’s a well-known axiom that people at the start of their careers should take more risk because it could result in bigger rewards over time. They shouldn’t face “a blanket prohibition on their earning the very highest expected returns,” the SEC chair said.
Piwowar’s proposal has received mixed reviews. Wharton professor of business ethics David Zaring agreed that “anyone has the right to invest. And it’s unfair that accredited investors get breaks that nonaccredited investors don’t. There may be good reasons to change that $200,000 gate into the pasture.”
Zaring disputed the idea that simply having a higher salary or more assets makes you “smarter.” He does, however, recognize the argument that having more money allows you the freedom to lose more money (as well as earn more) without going into bankruptcy. “Riskier investments should be reserved for those who can survive them,” he said.
At the other end of the financial spectrum, and in the negative column regarding hedge funds, is Christopher Phillips, Vanguard’s head of Institutional Advisory Services. Known for its low-cost mutual funds, Vanguard is the opposite of hedge funds and private equity funds, which normally charge a high entry fee. Vanguard doesn’t offer any private equity vehicles.
“The SEC’s Regulation D was put in place for a reason,” said Phillips. “The level of complexity in these privately registered funds is more than most investors have the time, desire or technology to dig into. The leverage they offer amplifies their ups and downs. Not only do you have that risk, but you also have liquidity risk. [Since] your money may be tied up for three to five years, what happens if you need it in the meantime?”
Phillips said a comparison of Vanguard’s index of a 60 percent stock and 40 percent bond fund matched up well against the fund of $515 billion in college and university endowments, which includes investments in private equity, over a 10- or even 30-year horizon. “They are remarkably similar,” said Phillips.
Nonetheless, large institutions and insurers -- particularly life insurers with long time horizons prior to payouts -- definitely put a portion of their investments into private equity, usually about the 3 percent limit allowed by regulators. These institutional investors like the diversification, and the sometime bump in earnings makes their investors happy.
But therein lies the rub, said Phillips. “If you’re a top performer in the hedge fund market, you’ll want that $5 million from the institution, not the $5,000 from an investor. He or she will be relegated to the poor performer who needs the petty cash. So the odds will always favor the big money.” He added: “You may not want to hear it, but that’s the way it’s always been.”
As for Wharton’s Zaring, he said his school, the University of Pennsylvania, invests in private equity, “but as for me, I’m an indexer.”