Private equity ETFs: Are they worth it?

Are those ETFs really private equity, though?

Right off the bat, we need to distinguish between investing in a private equity firm's fund directly, versus investing in the shares of a publicly traded private equity firm. Think of this as the difference between buying gold directly, versus buying a share of a gold miner. The latter is a proxy approach that gives some exposure but introduces different sources of risk and returns. 

That's the main issue with private equity ETFs. Consider the Invesco Global Listed Private Equity ETF (PSP). This ETF tracks the Red Rocks Global Listed Private Equity Index, which holds 76 publicly traded private equity firms from around the world. The fund is heavily concentrated in the financial sector, with the top 10 holdings currently comprising:

1. III LN - 3i Group PLC (5.17%)
2. PGHN SW - Partners Group Holding AG (5.02%)
3. KKR - KKR & Co Inc (4.93%)
4. MRO LN - Melrose Industries PLC (4.59%)
5. OWL - Blue Owl Capital Inc (4.56%)
6. EQT SS - EQT AB (4.31%)
7. CG - Carlyle Group Inc/The (4.18%)
8. BX - Blackstone Inc (4.17%)
9. SOF - Sofina SA (3.95%)
10. TPG - TPG Inc (3.49%)

As I noted earlier, investors who buy a fund like PSP are still one step removed from the real deal. Instead of directly investing your money in a private equity fund (and thus privately held companies), the ETF invests it in an index of publicly traded private equity companies. 

Essentially, your investment thesis changes from "investing directly in private equity to generate better/non-correlated returns" to "investing in private equity companies and hoping that they do more deals and are more profitable over time." 

Why this isn't ideal

This extra step fundamentally changes the reason to invest in private equity – the ability to deliver better risk-adjusted returns that are uncorrelated to the stock market. By investing in the shares of publicly traded private equity companies, you are once again taking on excessive market risk. Take a look at this chart which compares the correlation of PSP to the S&P 500, for example. 

PSP is too correlated to equities to have much of a diversification benefit, and it's understandable why: the ETF is still comprised of stocks, not actual private equity. What you're actually getting is sector concentration – your investment returns now hinge on the private equity industry outperforming. On an annual return basis, we see this occurring. 

As seen above, when times are good (low-interest rates, bull markets), PSP outperforms the market as more deal activity occurs. The opposite occurs during bad times when PSP draws down severely. The problem with this is that investing in private equity ETFs like PSP becomes a timing exercise. 

For example, if you invested right when the fund debuted, you would have to overcome a -64% loss in 2008, which would have resulted in years of under-performance.

The final word on private equity ETFs

I think these ETFs still have a use as a thematic tilt. That is, if you think the private equity industry will outperform (and that's a reasonable thesis during low-interest rate bull markets), then an ETF like PSP might be suitable for your investment objectives. 

PSP might not be the best option if you're looking for an alternative investment with positive expected returns and a low correlation to stocks and bonds. In that case, managed futures or commodities might be a better pick for attaining diversification. 

Finally, it's worth noting that most private equity ETFs are expensive. PSP charges a management fee of 0.50% but has incurred an overall expense ratio of 1.34%. This is very costly compared to an index ETF (which can go as low as 0.03%) and is even pricier than leveraged ETFs that usually run around 0.90% - 1.00%. 

Please note this article is for information purposes only and does not constitute investment advice.