SEC Investor Advisory Committee on Mainstreaming of Alternative Assets to Retail Investors

I was recently given the chance to join an SEC advisory committee on the mainstreaming of private assets for retail investors, including the efforts of asset managers (including Armada) to increase the allowance for PE and other private assets into ETFs and mutual funds.

As part of the committee hearing I presented the following to the SEC, and I wanted to share it here.

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Good morning. I am very glad to be here.

I want to express my gratitude to the Securities and Exchange Commission for the opportunity to speak as part of this committee on the mainstreaming of alternative assets to retail investors. The effort made by the SEC to solicit feedback and diverse perspectives from market participants through opportunities for public comments, advisory committees, and transparency of speeches and rulemaking orders is noticed and appreciated throughout the market.

It was the most regulated of times, it was the least regulated of times.

I was recently told by our medallion distributor, representing Finra rules, that in a letter to our investors I could not refer to one of our funds as “unique”. After much back and forth, it was decided that I’d be allowed to use the word “distinct”. For a regulated asset manager, the precise line between compliance and fraud was being drawn in between those words: unique and distinct.

Around the same time, a cryptocurrency called Fartcoin launched, and has since accumulated over $200 million in investor assets.

While I wouldn’t dare challenge the intrinsic value or economic utility of a Fartcoin, I bring it up to contrast against the reality of a heavily regulated securities market.

Investment professionals are not allowed to give public investment advice unless they add a disclaimer that their investment advice is not, while bad actors outside the industry promoting questionable ideas are left unchallenged.

This is the result of the letter of the law taking priority over the spirit of the law.

The fact is that we are living in an age of Financial Nihilism, where the zeitgeist promotes gambling and recklessness, where risk-taking is being rewarded by markets, and prudence punished.

With this backdrop we are here to talk about private assets being mainstreamed to retail investors. With this backdrop, the topic is sure to be met with skepticism. I’ve been writing about this topic for a couple years now, and I constantly receive feedback from people concerned that this is another scheme to stick retail with dubious assets. However, my comments were prepared as a way to address the very issues that concern those same people in a positive and proactive way.

The goal here is not to throw hard-to-value assets at an unprepared public, but to bring sunlight into corners of the market that currently get no light at all.

It is critical to establish this fact up front: valuations of private assets are not reliable. I recently published a detailed analysis of the leading private REIT fund. Using publicly traded comparables we found the performance divergence from the public markets to be as high as 30%.

How could such a large divergence in valuations occur? Well, the fund’s prospectus told us how.

“NAV calculations are not governed by governmental or independent securities, financial or accounting rules or standards. The methods used… to calculate our NAV are not prescribed by rules of the SEC or any other regulatory agency. Further, there are no accounting rules or standards that prescribe which components should be used in calculating NAV, and our NAV is not audited by our independent registered public accounting firm. We calculate and publish NAV solely for purposes of establishing the price at which we sell and repurchase shares of our common stock, and you should not view our NAV as a measure of our historical or future financial condition or performance.”

This NAV, it should be noted, has been the basis of more than $5 Billion in fees charged by that fund at that NAV. So is it any surprise that we found it to be inflated?

That NAV has also been repeatedly used as evidence of performance, and outperformance of the fund versus public market competitors.

The issue of how the performance of private assets is represented extends beyond returns. Volatility of private assets is perhaps the greater distortion.

Private equity marketers have long used the infrequent marks (relative to public markets) to calculate standard deviation, volatility, sharpe ratios and related calculations, and either assert or imply less risk than their public market counterparts. This is both dangerous and deceptive. The leverage embedded in many private equity investments makes them more - not less - risky than the public markets. Yet we often see them marketed to risk-averse investors with those risk metrics cited.

The liquidity premium that would historically be associated with more liquid assets has turned into an illiquidity premium, selling the perception of exclusivity. As Cliff Asness wrote, “the illiquidity [was] once implicitly acknowledged, appropriately, as a bug, but are now clearly sold as a feature.”

Still, I come here today not to complain about the state of markets, but to praise them. And to provide a solution.

The public markets are a modern miracle. US stock exchanges now trade more than 10 billion shares per day, and they trade with low latency and stunning connectivity. The NYSE processes over 1.5 million quotes per second at trading peaks. On June 28, 2024, during the Russell index reconstitution, Nasdaq executed 2,899,191,109 shares (over $95 billion) in 0.878 seconds.

The miracle is not just the volume and speed of trades. Those trades happen at the best prices anywhere on the planet, because the fundamental mechanics of the market won’t allow you to buy above the lowest offer or sell below the highest bid.

And the miracle extends to the regulation of the public markets overseen by the SEC.

One of the few issues we have in the public markets is too few securities listed. The Wilshire 5000 is down to just 3400 companies. There are fewer public companies today than 30 years ago.

Why is this the case? One reason might be the regulatory burden of maintaining a public security. Bank of America estimates the cost of regulatory compliance and governance of a public stock at $8-10 million per year.

If the regulatory burden can be eased to allow private assets to be brought onto public markets, I believe that will lead to price discovery of those private assets where liquidity is best: the public market stock exchanges.

Exchange Traded Funds are currently unable to hold private assets, outside of a small illiquid bucket allowance. If that restriction was lifted ETFs would be one way that price discovery could happen on exchanges, and out in the open.

There is concern that public markets would be unable to price the securities, but precedent says otherwise. In March, 2011, the Egyptian Exchange was closed during a period of political instability in Egypt. Despite the closure, ETFs such as the VanEck Egypt Index ETF (EGPT) continued to trade. Global price discovery moved to the US stock markets, where investors could access that investment exposure, and vote on valuation in real time with real dollars.

Similarly, In June, 2015, the Athens Stock Exchange was shut down for more than a month as part of Greece's financial crisis. Despite this, the Global X MSCI Greece ETF (GREK) continued to trade on the US stock market.

In fact, ETFs tracking foreign exposure in different time zones trade every single day during US market hours, providing price discovery and liquidity for the entire global market.

If we allowed private assets to benefit from the same opportunity for price discovery and liquidity, valuations would be determined by the point at which buyers and sellers meet. Buyers are naturally incentivized to pay the lowest possible price, sellers naturally incentivized to get the highest price, and liquidity providers incentivized to connect them and to close any arbitrage gap. It is a beautiful system that works in real-time every day.

Issues of trust and transparency of the data reported by private assets must be addressed ahead of any public market solution. I would submit that there are new technologies being built now that will address those issues. Those solutions include innovations such as third party real-time data validation utilizing AI and blockchain reporting, which can introduce efficiencies in addition to increasing trust. In other words, innovation is the answer.

Hester Peirce wrote in February, 2020, “Investors are well served when innovation flourishes. I recognize that innovation involves risks, but it is investors who should get to choose the winners and the losers of the market. Regulators should not impede investor choice; rather, they should ensure that investors have access to accurate disclosures about the range of available products, including their risks.”

Bringing private assets onto public markets brings their valuations into the open, determined not from inside a closed office but determined by the public on open exchanges. It would lead to a wave of innovation in the asset management industry, and likely, lower fees and better liquidity for investors.