The dream of many investors is to build enough net worth to be able to invest in a private equity fund as a limited partner. However, private equity frequently underperforms index funds. These mystical funds can invest in private businesses and various other securities. Such great flexibility and sophistication should ensure excellent results, but this is only sometimes the case.

There are six reasons to stick to index funds:

1. Private equity has very high fees. The only people that consistently make money from private equity are the fund managers. While fees vary, a standard fee structure is 2% plus 20% of the profits. If the fund loses money, the managers are still paid. They also take a big chunk of any profits.

• If you’ve ever wondered why private equity managers are often billionaires, now you know why.
• These fees are tough to overcome. A 2% fee means you’re already 2% behind. Losing 20% of your profits creates an additional burden.
• Many index funds have fees under 0.2%, and they keep their hands off your profits.

2. Private equity has become too big. While index funds are substantial, this isn’t an issue because of the size of the public markets. Many private equity funds have become too big to take advantage of lucrative financial opportunities – especially in small and mid-market companies. In short, there’s too much money chasing too few deals. When a great opportunity presents itself, private equity cannot put enough money to work on it to obtain the best return.

• Private equity must invest a significant portion of the fund in lower-quality investments. The size of a fund can be very challenging. Warren Buffett has often said he could earn 100% per year on a million dollars. Investing several billion dollars is very limiting.

3. The market is very efficient. This means that all the information available to investors has already been incorporated into the price of stocks. In theory, it isn’t possible to beat the market.

• The market isn’t 100% efficient since investors regularly outperform the market. However, beating the market consistently is very challenging. To make up for that extra 2% fee, private equity must beat the market by more than 2%. That doesn’t even take into account the 20% profit scrape.
• Private equity must beat the market by a considerable amount to provide a competitive return to an investor.

4. When private equity loses money, it can lose a lot. Private equity take on a high level of risk. Private equity managers love risk. They’re already guaranteed 2%. Any profits significantly increase their income. A high level of risk is also necessary to overcome the fee structure and provide high returns to investors.

• The ratio of risk to returns is relatively high.
• Private equity has much exposure with leveraged buyouts and often “skinny asset” company portfolios.

5. Low liquidity makes it difficult for investors to get out quickly. If the future isn’t bright, getting your investment out of the fund can take time. You might watch your investment shrink daily before you can cash out. Depending on the fund, you may also have a capital call requiring you to pay into the fund when you can least afford it. Index funds are incredibly liquid – you can trade out or in within a few seconds and at a meager cost.
6. Index funds have too many advantages. Index funds can provide comparable market returns with little of the risk found in private equity. The ability to guarantee market-matching returns with low fees cannot be consistently matched by private equity.

Index funds have many advantages over private equity. You don’t need a million dollars in net worth to invest in an index fund. Private equity cannot consistently beat the market and overcome the oppressive fee structure. With all things considered, the lowly index fund is an excellent investment for most investors. If you can move beyond index funds, direct investment in private companies through a family office of your own, or your fund, may make far more sense. If looking at private equity, you may want to consider smaller, well-established funds where investments in small and mid-sized private businesses in the $10 to $50 million range are the norm for their portfolio.

There are many good books on investing generally and index investing specifically. One of the better books on index fund investing is All About Index Funds by Richard Ferri. You will get information on structure, ETFs, market dynamics, and more. This is an excellent book for getting baseline information on the topic.