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Four professional investorsPrivate equity is a popular asset class for those seeking alternatives to traditional stocks and bonds. But for the typical investor, it’s often out of reach. It’s possible, however, to find an entry point through private equity ETFs. A private equity ETF is an exchange-traded fund that utilizes private equity strategies to invest. These funds can be attractive for individuals who may be shut out of traditional private equity investments, though there are some advantages and disadvantages to keep in mind.

Before jumping into alternative investments, consider working with a financial advisor to ensure your portfolio aligns with your risk tolerance.

Private Equity, Explained

Private equity is a type of ownership or investment interest in a company that isn’t publicly traded. Private equity funds pool funds from individual and institutional investors to purchase ownership stakes in companies that are either not listed on a public stock exchange at all or are but will soon be delisted. The popular perception of private equity firms is of entities that take a struggling corporation private, sell or close down one or more weak divisions, lay off employees, restructure what’s left so it becomes profitable and then book a huge profit when the company is sold.

One hallmark of private equity investments is the fact that there’s typically a high barrier to entry. Accredited investors can access private equity but they may be required to put up hundreds of thousands of dollars as a minimum initial investment. Some private equity investments may require minimum investments of $1 million or more. An accredited investor is someone who meets SEC guidelines for income or net worth, typically high-net-worth or ultra-high-net-worth individuals.

The upside of private equity investments is that there’s significant return potential. Investors make money by eventually selling their ownership stake for more than what they paid for it. In that sense, private equity is similar to venture capital or angel investments, though the way these investments are structured works differently.

What Is a Private Equity ETF?

Before diving into a private equity ETF definition, let’s start with ETFs in general. An ETF, or exchange-traded fund, is a security that can be traded like an individual stock but which typically consists of a diverse array of securities within it — often tracking a particular sector (like tech) or an index (like the S&P 500). A private equity ETF is an exchange-traded fund that concentrates investments on private companies. In that sense, it seeks to mirror traditional private equity strategies.

Private equity ETFs can be bought and sold on an exchange like any other stock or ETF. In terms of how a private equity ETF invests, this can depend entirely on the fund and the fund manager’s overall strategy for generating returns. For example, some private equity ETFs invest globally, holding private companies in markets all around the world. Other private equity ETFs may apply indexing strategies to drive performance.

With indexing, the goal is to match the performance of an underlying benchmark. So a private equity fund that seeks to invest in companies in the energy or tech sectors, for example, might choose investments based on a specific energy or tech stock benchmark. This is the same way other index mutual funds or ETFs work. Depending on the fund, private equity ETFs can hold many investments or just a few.

Pros of Investing in Private Equity ETFs

Private Equity signpostPrivate equity can yield attractive returns for investors if they’re able to sell their ownership shares later for much more than what they initially invested. This is based on the premise that the companies they’ve invested in will increase in value. But again, the high minimum investments are often a roadblock for the everyday investor. Investing in a private equity ETF affords a wider base of investors access to this asset class.

Rather than needing $250,000 or more to invest, for example, you may be able to gain entry to a private equity ETF with just a few thousand dollars through an online brokerage. That’s an advantage if you’re hoping to diversify your portfolio with more than just stocks, bonds or other more traditional types of ETFs.

Private equity ETFs can offer high return potential, depending on how well the underlying investments perform. If the companies included in the fund grow and appreciate significantly in value then investors benefit when they sell their shares of the ETF or the company goes public through an initial public offering. A private equity ETF can also pay out dividends, providing an ongoing passive income stream for investors.

Cons of Investing in Private Equity ETFs

Similar to hedge fund ETFs, which are another type of alternative ETF, private equity ETFs can carry more risk. That’s because you’re assuming that the underlying holdings will grow in value over time. If the company doesn’t see its value increase as anticipated, then you may break-even when it’s time to sell or worse, realize a loss on your investment.

This leads to a secondary challenge of private equity ETFs: liquidity. While you can trade private equity ETFs just like a stock, they are often considered more of a buy-and-hold investment. That’s because it can take years for a company to appreciate in value. If you’re considering private equity investment, you may be looking at a holding period of five to 10 years, during which time the ETF will be subject to market volatility as economic conditions change.

Cost is another concern with private equity ETFs. Generally speaking, ETFs are often low-cost investments, more so than traditional mutual funds. That’s because many of them follow passive investing strategies. But private equity ETFs may have significantly higher expense ratios or management fees. This is where you have to consider whether a higher cost is justified by the returns you could earn and how long you’re willing to hold onto a private equity ETF.

How to Invest in Private Equity ETFs

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If you’re interested in adding private equity to your portfolio through an exchange-traded fund, you can do so with an online brokerage account. Many online brokers now offer commission-free trading of exchange-traded funds and stocks, which is a boon for investors. When comparing online brokerages, first consider whether they offer access to private equity ETFs. Then consider things like commission or trading fees as well as the minimum investment required to add a particular private equity fund to your portfolio.

Also, take time to compare individual private equity ETFs. Specifically, look at how they invest and what they invest in, the typical holding period for those investments and the fund expense ratio. Performance is also an important consideration, though you should remember that past performance doesn’t necessarily guarantee future returns.

The Bottom Line

Private equity is something you might be interested in if you’re ready to invest in more than just stocks or bonds. A private equity ETF is a simplified way to invest in this asset class with a lower barrier to entry, though it’s helpful to understand exactly what you’re investing in before purchasing shares.

Tips for Investing

  • Whether you’re new invetor or a seasoned expert, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
  • Consider talking to a financial advisor about private equity ETFs and whether they make sense for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect quickly with professional advisors in your local area. If you’re ready, get started now.

Photo credit: ©iStock.com/Estradaanton, ©iStock.com/mindscanner, ©iStock.com/metamorworks

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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