Commentary: An open letter to SEC Chairman Jay Clayton

Dear Chairman Clayton,

We applaud the recent dialogue and your proposal to update the outdated accredited investor rule that determines eligibility for persons to participate in the private capital markets. As the professional body for alternative investments, CAIA Association works with our 12,000 global membership base to represent savers, beneficiaries and the general public, intent on ensuring that financial markets serve the greater good by allocating capital efficiently to the most socially and economically beneficial activities. In that vein, CAIA Association sees a number of benefits to expanded investor access to private markets, but only with appropriate conditions and safeguards.

As you well know, changes in capital formation over the last two decades have resulted in large portions of the economy utilizing private markets for longer periods of time. It is well documented that exchange-listed firms in the U.S. have more than halved since 1996. This trend is magnified in both small cap and service-oriented industries, leaving the remaining publicly traded firms disproportionately consisting of dated and slow-growth business models. Further, the ability to avoid onerous and costly regulation, disruptive activist behavior, and to align themselves more with long-term value creation vs. short-term and emotionally driven price gyrations, is causing many companies to even consider remaining private indefinitely.

These structural shifts coupled with increasing pressure to meet retirement outcomes places undue and unsustainable pressure on public equities. Public equities have outperformed nearly every asset class since the global financial crisis of 2008, and a precipitous, steady decline of interest rates has led to strong fixed-income performance as well. Along with unprecedented global central bank support, these phenomena have rendered anything other than a traditional 60/40 portfolio unnecessary. Advisers and their investors who have entered into a relationship in the last 10 years haven't experienced a significant correction or recession and may undervalue the importance of a diversified portfolio among weak public markets and stagnant growth. A careful study of financial history and investment performance will showcase that the last decade is far from representative; the "easy money" is likely behind us and advisers will need to work harder to meet investor expectations going forward.

We believe the merits of diversification will roar back to life in this return to "normal" environment when stocks and bonds may offer lower, more volatile and even negative returns. The careful addition and use of alternative investments can mitigate downside risk, lower volatility and enhance risk-adjusted returns over the long term. But alternatives should not be viewed as a panacea or desperation move to improve alpha or close underfunded retirement gaps. This reductionist view typically includes arbitrary performance comparisons to public indexes and endless debates about the extinction of the illiquidity premium vs. publicly traded securities.

While we believe that investors can produce superior returns in private capital, it is far from universal given the wide dispersion of manager performance, natural trajectory of market cycles and the recent flaws in the price discovery process brought home by the WeWork debacle. Given we are likely late cycle with record setting levels of dry powder, the narrative supporting the benefits of alternatives must be centered on the uncorrelated cash flows, drawdown mitigation, inflation protection and diversified income streams, not an alpha beauty contest. We contend that all educated long-term investors should be given the opportunity to create a more sophisticated and balanced portfolio that extends across the full risk premiums.

While higher levels of wealth are likely correlated with more disposable income, it certainly doesn't approximate by itself to investment sophistication.

To qualify investors to participate in private markets, we therefore support a dual path toward eligibility as a proxy for sophistication:

In addition to meeting the binary wealth and income levels, a prospective accredited investor must pass a financial literacy test focused on alternative investments from a set of providers approved by the Securities and Exchange Commission.

Professional designations such as CAIA, CFA and CFP should also clearly qualify and allow the investor to waive the wealth and income requirements.

Investors must employ investment advice professionals who are properly trained, held to a fiduciary standard of care, and bound by an ethical code of conduct (e.g., CAIA, CFA, CFP). General business education such as an MBA, a FINRA licensing exam typically given to entry level sales representatives and/or a certification that excludes a fiduciary standard should not qualify.

In this context, we must also address the elephant in the room in regards to investment advice regulated by FINRA and only bound to a "suitability" standard. Respectfully, the SEC failed the public last year by missing the opportunity in Regulation Best Interest to finally clarify the difference between investment professional and salesperson by simply reserving the title "adviser" to those bound by a fiduciary standard of care to investors. Unfortunately, this has left most investors naively subject to agents with significant conflicts of interest, trade-churning incentives, preferential treatment of in-house products and revenue sharing with partners.

While we don't want to alienate investors that prefer to rely on a brokerage relationship to access the private markets, the threshold must be higher due to these inherent conflicts and standard of care shortcomings. Brokers must be willing to serve as gatekeepers to determine whether investors should qualify as accredited investors based on financial resources and sophistication. They also must be willing to be held accountable through a formal commitment that the proper education and disclosures about the risks are fully understood.

Regardless of path chosen, we also recommend that the SEC establish a clearinghouse that approves simply packaged, easy to understand, retail "liquid alternative" vehicles with standard disclosures and leverage limits that allow access to inexpensive and diversified beta rather than the more expensive and often elusive promise of alpha.

The generational shift to defined contribution plan from defined benefit plan over the past 50 years has placed significant pressure on individuals in stewarding a dignified retirement when that responsibility largely fell to employers in the previous generation. That burden on the nest egg has been further exacerbated as retirees continue to live longer. Underlying beneficiaries of both public and private pension funds have long been able to benefit from the full array of asset classes available to institutional investors. And yet, defined contribution plans such as 401(K)s are limited to largely listed equity and fixed-income wrappers when, as described, these domains are increasingly dominated by large and tired organizations representing a shrinking portion of the global economy. We believe this trend will continue for the reasons outlined in the coming years and call upon the SEC to thoughtfully liberalize the rule that balances the two core tenants of its existence: fairness to and protection of the public.

John L. Bowman is senior managing director at the Chartered Alternative Investment Analyst Association, based in Charlottesville, Va. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.