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IN APRIL 2005, art dealers Robert Simon and Alex Parish traveled to New Orleans to attend an auction. They were particularly interested in a work titled Salvator Mundi. The painting was in bad shape, having been neglected for years. But Simon and Parish ended up bidding on it and taking it home for $10,000.
After some restoration work, the pair succeeded in having it authenticated as a work of Leonardo da Vinci. Since then, the painting has changed hands a number of times, most recently for $450 million. In that last sale, it became the highest-dollar art transaction ever.
Prior to its sale back in 2005, the painting had been hanging in the Baton Rouge home of a fellow named Basil Hendry. His family put it up for sale when he died, having no idea that the dilapidated work was a da Vinci. If they’ve been following the news since, I imagine they aren’t too pleased.
For most people, these kinds of things aren’t everyday concerns. But it does highlight an issue which is worth our attention, and that’s the challenge posed by appearances. In the case of the Salvator Mundi, the painting ended up being worth much more than it initially appeared. But when it comes to our personal finances, there’s the opposite risk: that things often appear more valuable than they are.
That’s for a few reasons. For starters, there’s the marketing concept known as value-based pricing. The idea is that consumers generally associate value with price. In other words, if a product carries a higher price, we tend to interpret that as a signal of quality. Price serves as a shortcut of sorts in making consumer choices.
There’s a well-known story, in fact, about the eyeglass chain Warby Parker. The group that founded the company met while they were students at the Wharton School. The founders had determined that they could sell glasses profitably for just $45, but they figured they’d ask their marketing professor, Jagmohan Raju, for advice. After looking at the numbers, Raju didn’t disagree that they could make a profit at $49 but nonetheless suggested they price them at $99.
Why? Raju felt that consumers might worry about the quality of Warby Parker’s product if the price were too low. “There are many companies selling cheap eyeglasses. Anyone can go on the Internet and buy two pairs for $99. But there is a perception among customers that the quality is not as good.” So Warby Parker went with $99 and has been very successful.
In many cases, it’s a useful mental shortcut for consumers to associate price with value. But when it comes to investing, it can work against us. The late Jack Bogle, founder of the Vanguard Group, summed it up best: “In investing, you get what you don’t pay for.” Price, in other words, is not a good signal of value. According to the data, it’s the opposite. Higher-priced investments have delivered worse performance, not better.
Investors know this, but still, it’s a challenge to sidestep high-priced funds. Why is that?
Author William Bernstein quotes the economist John Kenneth Galbraith, who wryly commented, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”
Wall Street, in other words, is very good at marketing. As consumers, we know what to expect from high-priced investments, but the industry is always finding new ways to convince us it can somehow defy the odds.
Which of Wall Street’s “innovations” should concern us most today? In my view, it’s a category known as private equity.
Private equity refers to investments in businesses that aren’t publicly traded. The pitch here is simple: Due to the growth of big tech companies such as Apple, Google and Nvidia, public markets have become very top-heavy. Today, more than 40% of the S&P 500 is riding on just 10 stocks. Historically, this has been much lower—between 20% and 30%. To detractors, this concentration means that public markets carry significant risk. For that reason, they see private equity, which is less top-heavy, as a good alternative.
Promoters of private equity also point to the fact that the number of public companies has fallen in recent years. For a variety of reasons, more companies are choosing to stay private. As a result, public markets are narrower than they were in the past.
I don’t deny either of these points. The question, though, is whether private equity is necessarily the right answer. In my view, there are quite a few other, simpler and better alternatives. There are mid- and small-cap funds, value funds and international funds—all of which allow investors to diversify beyond the big-tech exposure in the S&P 500 without venturing into private equity.
Why don’t I recommend private equity? I see five potential issues.
First, the government requires far less regulatory oversight of private funds. In contrast, especially with big mutual funds and exchange-traded funds, there is daily visibility into their holdings. That leaves much less room for mischief.
Private funds are almost universally more expensive than simple, publicly-traded index funds. Worse yet, because of the labyrinthine nature of some funds, it can be difficult to even know what the fees are.
Private funds also tend to be less diversified. That’s because the process of investing in private companies is complicated, requiring due diligence, negotiations and extensive documentation. All of this is time-consuming and expensive, so private fund managers don’t have time to make a large number of investments. Thus, these funds end up not being very diversified.
Private funds like to hold themselves out as being lower risk because the share prices of private companies don’t bounce around as much as the stock prices of public companies. That’s a clever argument but a little disingenuous. Unlike publicly-traded mutual funds, which are priced every day—and exchange-traded funds, which are priced throughout the day—private funds are often priced only on a quarterly basis. So their prices only appear less volatile. But that doesn’t mean they’re actually less risky.
The final concern with private funds stems from a combination of illiquidity and complexity. This year, a number of universities have had budgetary issues, and as a result, they’ve been scrambling to raise cash. Schools are big holders of private funds, but selling them hasn’t been easy. Because these funds aren’t tradeable on stock exchanges, the only offramp is through what’s known as the “secondary” market, where transparency is more limited. This added complexity doesn’t necessarily make these funds more risky—but it does make it much harder for investors to distinguish between a da Vinci and something that might just look like one.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Thanks Adam for another great article. The more we know the better we can navigate the more than many ways to invest. Always Beware.
I have a checklist I use for investments.
This excellent article was a good reminder to stay with my “checklist” and hopefully avoid some of those problems.
And then there are the PE Zombie funds which I am sure they will be eager to offload onto unsuspecting 401k account holders. I wonder if protections will be put in place (I suspect not)?
Per AI:
“Private equity “zombie funds” are investment vehicles that have exceeded their typical 10-year lifespan because they cannot profitably sell their remaining assets. These funds, which continue to collect management fees, are stuck with poorly performing “zombie companies” that are unable to be sold, even at a discount. This situation can trap capital, drain returns for investors like pension funds, and create regulatory risk for fund managers.”
I assume large institutions/endowments etc. get to see behind the curtains before investing in PE. Average Joe in his/her 401k not so much. Buyer beware!
I agree Private Equity and Private Funds are a true “buyer beware” investment choice. Like many, I “dipped my toe” a few years ago to earn some extra yield in some well known REITs and am still waiting for my withdrawal request to be fulfilled. Worse yet, the yield has declined and the investment is underwater. It will be 3+ years to extract my initial investment. My fear is that these funds will get tucked into balanced and target date funds that end investors will never know about.
A good cautionary tale, Adam, thank you.
I remember “closed end” mutual funds which had less opaqueness than private equity but shared restrictions on withdrawals. Are those still around?
Reinventing the wheel indeed.
David, your question brought to mind this article from Sanjib Saha.
https://humbledollar.com/2020/12/behind-closed-doors/
what percentage of future 401k customers will ever consider even 1 or 2 of your 5 points before putting some amount, or even a large amount, of their money into PE after a slick, glossy and positively slanted brochure or pitch is made to them? I’m betting those PE funds will explode and look good for a few years too, just like subprime MBS looked great in 2005. So can you short these in the future?
We previously held a small stake in the Prism ETF as part of a diversification strategy. I missed the prospectus comment that you could not withdraw all of your investment at once. Short version: it took several years to withdraw a less than $7500 initial stake in this fund. Never again.
There is no logical consistency here. The discussion of pricing does not lead to the one on private equity.
They are both interesting topics, but they haven’t really been related in this article.
Stock index funds are at an all time high. I guess we should avoid them because a lower price is correlated with higher future returns?
A lot of people have rated my comment unfavorably, but I think the missed the point.
I agree that people mistake price for quality. That’s an important point of the article. But it does not lead to the following justified attack on private equity. There are plenty of reasons to avoid private equity, but they lead to the conclusion that they are too expensive at any price point, not that their price point is an attraction.
Hi Michael – I think I understand your argument. My view, and maybe I could have expanded on the thought, is that private equity is perceived as a sophisticated and exclusive investment. It’s what Harvard invests in, etc. So it’s the whole picture — which includes the high price — that takes advantage of consumer perception.
FWIW, I wasn’t one of them.
Human psychology ironically leads us to use price as a signal of value. With investments, a lower price is correlated with higher future returns. Price matters. Private equity can be mistakenly viewed as having more consistent value because such holdings are priced quarterly, not daily like public funds or ETFs.