Private Equity ETFs Enter Mainstream Investment Arena

In Brief: Bryan Armour, director of ETF and passive strategies research for North America at Morningstar Research Services, discussed the emerging frontier of private equity and private credit ETFs in a recent podcast interview. Armour identified a fundamental challenge facing everyday investors: traditional ETF benefits like transparency, tax efficiency, and low fees directly conflict with the opaque, illiquid nature of private assets. He warns that while these hybrid products are "coming no matter what," current offerings reveal significant pricing inconsistencies and transparency gaps that require investor caution, predicting the landscape will look "very different" within a decade as the industry works to solve these structural problems.

Big Picture Drivers:

• Market Evolution: Fewer small companies are going public and staying private longer, creating demand for private market access

• Regulatory Changes: Post-2007 banking restrictions and Dodd-Frank have shifted lending from traditional banks to private credit firms

• Democratization Push: Asset managers and advisors are working to expand private market access beyond institutional investors

• Product Innovation: Financial firms are experimenting with new structures to combine private assets with ETF wrapper benefits

Key Topics Covered:

• Definition Challenges: Private equity encompasses everything from garage startups to half-trillion-dollar companies like SpaceX

• Structural Conflicts: ETFs' core benefits of transparency and liquidity clash with private assets' opaque, illiquid nature

• Current Products: State Street's PRIV and ERShares' XOVR represent two different approaches to private asset ETFs

• Pricing Methods: Firms use varied strategies from daily liquidity arrangements to static pricing models

Key Insights:

• Transparency Issues: Current private asset ETFs fail to provide adequate disclosure about underlying holdings, with State Street refusing to reveal specific private credit deals and ERShares providing minimal information about their SpaceX access structure.

• Pricing Inconsistencies: XOVR hasn't updated its SpaceX valuation since December despite it being the fund's largest holding, while State Street created a complex daily pricing mechanism through partnership agreements with Apollo.

• Regulatory Workarounds: State Street circumvents the SEC's 15% illiquid asset limit by establishing liquidity arrangements with Apollo, while ERShares stays under the threshold but uses static pricing.

• Performance Variations: State Street's PRIV performs similarly to intermediate core-plus bond categories due to its focus on liquid investment-grade private credit, while XOVR has underperformed since adding private companies.

• Diversification Questions: While private assets may offer diversification benefits, they remain subject to the same economic risks as public markets, with pricing that may not reflect true correlation due to infrequent mark-to-market updates.

• Industry Trajectory: Despite current challenges, private asset ETFs are inevitable and will evolve significantly over the next decade as firms work to solve transparency and liquidity issues.

Memorable Quotes:

• "Some people probably would envision it like buying Apple when it's still in Steve Jobs garage, but in reality it could also mean buying SpaceX which would be a large cap public company worth something like half a trillion dollars" - Bryan Armour, explaining the broad scope of private equity investments

• "It's still sort of like the wild west, they're still challenges being figured out" - Bryan Armour, describing the current state of private asset ETF pricing and operations

• "We don't know what costs go into buying the SPV, if there's ongoing costs" - Bryan Armour, highlighting transparency issues with ERShares' SpaceX investment structure

• "At this point transparency is an issue and something that every investor needs to be aware of and do their own due diligence" - Bryan Armour, warning about current product limitations

• "I think they're coming no matter what, so it's happening" - Bryan Armour, predicting the inevitable growth of private asset ETFs despite current challenges

The Wrap:

The emergence of private asset ETFs represents a significant shift in how everyday investors can access previously exclusive investment opportunities, but current products reveal fundamental tensions between ETF structures and private market characteristics. While firms like State Street and ERShares are pioneering different approaches to solve liquidity and pricing challenges, investors face unprecedented transparency gaps and pricing inconsistencies that require careful evaluation. The industry's acknowledgment that these products will evolve dramatically over the next decade suggests we're witnessing the early stages of a new investment category that could reshape portfolio construction for retail investors.