By Dr. Jim Dahle, WCI Founder

Josh Katzowitz, our content director, reads financial pornography. I've been trying to break him of that habit, but instead, he seems more successful in getting me to read it and, worse, write about it. The latest edition comes from an article on CBS News titled “Trump wants your 401(k) to access crypto and private equity. Here's what to know.” The article talks about an executive order President Trump signed on August 12 that makes it easier for your 401(k) and other employer-provided retirement plans to include options allowing employees to invest in cryptoassets and private equity funds. The executive order, titled Democratizing Access to Alternative Assets for 401(k) Investors, says:

“It is the policy of the United States that every American preparing for retirement should have access to funds that include investments in alternative assets when the relevant plan fiduciary determines that such access provides an appropriate opportunity for plan participants and beneficiaries to enhance the net risk-adjusted returns on their retirement assets.”

The order defines alternatives as:

  • Direct and indirect private equity and debt
  • Private real estate equity and debt
  • Digital asset funds
  • Commodities
  • Infrastructure development projects
  • Annuities

What could go wrong, right? Well, the main problem is that the majority of the investments in the assets above should probably be avoided by most Americans, whether or not they are available in their 401(k). Most Americans should be mostly investing in boring old index and index-like stock, bond, and real estate funds. Lots of investments in the categories listed above are investments designed to be sold, not bought.

How will the executive order provide access? It's going to loosen up regulations on fiduciaries that own companies and practices that offer 401(k)s. I'm not necessarily against that. I'm not even necessarily against allowing employees access to alternative investments. I mean, we put the WCI 401(k) in place. Not only does it allow Mega Backdoor Roth contributions, but it basically allows all employees to invest in just about anything they can buy at Fidelity, including the private real estate debt funds Katie and I invest in, within the 401(k). But loosening fiduciary duties might not be the best thing for every company and every employee in the country.

 

The 3 Questions

Assuming your 401(k) takes advantage of this new executive order and offers more private investments, there are three issues at hand.

  • The first is whether you should invest in the asset class at all. Maybe that's where we should spend most of our time, but unfortunately, each of these asset classes under discussion is worthy of not just a single blog post, but a series of blog posts.
  • The second question is whether the investment vehicle chosen by the 401(k) investment committee is the right way to invest in this asset class.
  • The final question is a question of asset location, i.e., is your 401(k) the right place to put this particular investment as opposed to another account like a Roth IRA or a taxable account, assuming you also have access to those.
 

Should You Invest?

The fun part about investing is that there are no “called strikes.” You don't have to invest in everything to be successful. Katie and I have chosen to invest in three types of producing assets: stocks, bonds, and real estate. We find them relatively easy to understand, see long-term profitable track records, and find it so simple to manage a portfolio with these assets that we don't need to hire professional help to do it. Of that long list of what is now going to be allowed in 401(k)s, the only one we're already doing is private real estate. We don't invest in cryptoassets, commodities, private equity (well, outside of the businesses we control), or annuities. And I have no idea how to invest in “infrastructure.” We don't have to invest in that stuff (including private real estate), and you don't either. It's perfectly acceptable to just avoid it all completely.

We find speculative assets particularly odious. For us, speculative means the return is completely dependent on getting someone else to pay you more for the asset than you paid for it. It is a non-producing asset. It doesn't produce earnings, interest, or rents. You might even have to pay taxes on it or to insure it and protect it. Examples include empty land, currencies (including cryptocurrencies), precious metals, collectibles, and commodities. That doesn't mean you can't get a good return out of a speculative asset. Just imagine buying Bitcoin in 2011, the first time I warned you about it. If you had held that investment from 2011 until today, you would have made a killing. But the same caution I gave out then, I give again today: limit the amount of your portfolio invested in speculative assets to a single-digit percentage of your portfolio.

A particularly important issue to understand about private investments is that they tend to be illiquid. They're not publicly traded. That means there is no market for them anywhere comparable to the public stock and bond markets. You can't just go to cash tomorrow because you want to or because you're quitting a job and rolling over your 401(k). You might not have the ability to get your money back for months or even years. Now, I'm perfectly fine giving up some of my liquidity so long as I am paid to do so. But if you're not, you'd better avoid private investments in your 401(k). I'm sure a lot of these funds will do what they can to give you some liquidity so they can get access to the $13 trillion in defined contribution assets, but that will surely come with some additional fees to whoever is providing that liquidity. In short, you're giving up at least some of that illiquidity premium.

“Private equity” is the latest hot investing topic. The argument is that you get higher returns and lower volatility than you would with publicly traded investments. A neighbor of mine runs a private equity fund. He does think higher returns are available (although far from automatic), but he readily admits the lower volatility is mostly just hiding the volatility. The wonderful thing about public equity is that we've already figured out the best way to invest in it, and that way is super cheap and super simple. It's called “index funds.”

Basically, investing is free, so long as you invest in publicly traded stocks. It's no surprise then that those trying to make money by selling investments must now go into some other asset class to make it. Voila—private equity! Now, investing is complicated again, and you need a pro to show you the right way to do it. And that pro must be paid. There are no private equity index funds. That doesn't mean you shouldn't invest in them, but you're basically going back to the pre-1975 investing world where you have to spend forever figuring out who to invest with; monitor them carefully; and then pay them most, or all, of the excess return they get for you in the form of fees.

Tread carefully in private investments. Every one of them is unique and must be evaluated on its own merits. It's perfectly OK to ignore all of them.

More information here:

Why I Am Winning with Crypto

The Emotions Behind Short-Term Trading: The Other 5% of Your Money

 

Investment Committee Considerations

I serve on two 401(k) investment committees, one for my physician partnership and one for the WCI 401(k). Our primary consideration in those meetings is our fiduciary duty to the other employees. But I'm really not impressed with the abilities of most 401(k) committees to select winning actively managed investments for their plans. They never really figured out how to do it with publicly traded stocks, so I have little faith they'll pull it off with digital assets and private equity.

Just because it's “private equity” and it's in your 401(k) doesn't mean you should buy it. You can't just rely on the investment committee's due diligence. You have to do your own. Maybe you get lucky and you get a really good PE investment in your 401(k), but don't count on it.

One alternative that investment committees have is to let the employees invest in mostly anything they want and have them sign a waiver releasing the committee from being liable for their stupidity. That's pretty much the approach we took at WCI. But we're also running a financial literacy business where most of our employees have advanced degrees and know more about investing than most of those who call themselves financial advisors. We might be a little bit of an exception. But even my physician partnership 401(k) at Schwab offers the “PCRA” option, which is basically just a brokerage window. Don't like the mutual funds the committee chose? Fine, go put it all in Nvidia and Tesla. But don't try to sue the company for your risky decisions.

 

The Asset Location Decision

Once you've decided to invest in an alternative asset class and found the investment vehicle for it, you're still left with the asset location decision. Is your 401(k) really the place for this asset class and this investment in particular? With crypto, the answer is almost surely not if you have any taxable money anywhere. Crypto may be the most tax-efficient asset class out there. Bitcoin does not pay any dividends, it gets capital gains tax treatment, and you don't even have to worry about a wash sale rule when tax-loss harvesting. You can buy it back 10 seconds later and harvest any loss you get. If I owned any, it would be the first asset class I put in my taxable account, not the last.

Other alternative asset classes may not be as tax-efficient, but private equity real estate is more tax-efficient than most of my asset classes since the income tends to be shielded by depreciation. My point is that your 401(k) may not be the best place for this investment anyway. If all of your investment money is in tax-deferred accounts and you want to invest in alternatives, this executive order might matter more to you than it does to me. But that's not the case for most white coat investors.

More information here:

A Moderate-Income Physician’s Approach to Alternative Investments

Should Doctors Be Angel Investing?

 

The Bottom Line

Don't expect to see any change in your 401(k) for a year or two. It will take time for the SEC, investing companies, and your 401(k) investment committee to act on it. Even if you do see a change, you can probably ignore it. If you want to invest in alternatives, tread carefully and limit them to a reasonable percentage of your portfolio. A portfolio composed entirely of boring publicly traded investments is completely reasonable and, if funded adequately, it should allow you to reach all of your financial goals.

What do you think? Does your 401(k) offer any alternative investments? Would you use them even if it did? Why or why not? If you're investing in private equity, how are you doing so?