Unaccredited retail investors — individuals who earn less than $200,000 per year and have a net worth of less than $1 million, or a couple that earns less than $300,000 per year with a net worth of less than $1 million — have been significantly marginalized by the financial services industry. The reason: Financial service providers have been increasingly strangled by escalating compliance costs stemming from a seemingly never-ending stream of retail-hostile securities regulations.
Though well intentioned, many of these antiquated securities laws have done more economic harm than good — such as furthering a monstrous national wealth gap by ensuring the institutional monopolization of U.S. capital markets at the expense of the country’s small, unaccredited retail investors.
Fortunately, two monumental dynamics occurring in confluence will set new precedents and level the playing field for retail investors:
- Legislation to grant unaccredited investors greater access to alternative products, such as private equity or private debt, continues to garner bipartisan support.
- Advancements in technology have made it possible for retail investors to not only purchase alternative investment products in tiny increments, but also to hold them in retirement accounts.
These two forces are respectively known as regtech and fintech. Whereas fintech makes it affordable to distribute alternative assets, regtech makes it legal. Working in tandem, fintech and regtech are bringing an entirely new generation of alternative investment products to the retail market and will utterly transform current asset-allocation paradigms.
THE NEW REGULATORY FRAMEWORK
In late 2011, in an effort to give U.S. job creators greater access to capital, legislators introduced a bill called the Jumpstart Our Business Startups Act (JOBS Act). Although the bipartisan legislation was primarily intended to facilitate small-business capital formation during a challenging economic climate, one of the most significant aftereffects of the JOBS Act appears to be its impact on smaller retail investors.
While aiming to foster small-business growth, lawmakers ended up enacting a law that would not only grant retail investors access to certain private equity offerings, but would also help engineer a new breed of alternative fixed-income products for retail consumption.
Two key components of the JOBS Act — Title III (Regulation Crowdfunding) and Title IV (Regulation A+) — permit small issuers to raise capital from any investor, regardless of income level, without having to adhere to rigorous and costly reporting requirements. Although these issuers must abide by offering thresholds, they are able to sidestep the “accredited investor” rule, which would otherwise limit their offerings to a diminutive number of wealthy investors. As a result, unaccredited investors are gaining access to a new pool of alternative assets. The investment opportunities now open to unaccredited investors include venture investing, as well as a new breed of higher-yielding fixed-income alternative products being created via Reg A+.
Some of the innovative businesses concurrently leveraging both regtech and fintech to produce new alternative debt products for retail investors include Groundfloor Inc., StreetShares Inc., American Homeowner Preservation, and Worthy Financial’s Worthy Peer Capital. Their novel fixed-income products, created through the Reg A+ exemption, return anywhere from 5 percent to 14 percent per annum. Some accept minimum investments as low as $10 and even offer immediate liquidity, making them both attractive to as well as attainable for small retail investors.
Other online marketplaces have opted to open their platforms to retail investors by registering nontraded REITs with the SEC. Realty Mogul Co., Fundrise and Impact Housing REIT are prime examples of real estate investment funds using Reg A+ to bring a diversified pool of real estate investment opportunities to retail investors.
Because these new retail alternative products are emanating out of peer-to-peer lending and crowdfunding platforms, and are being engineered through employment of JOBS Act legislation, some are referring to them as “crowd-centric retail alternatives.” While that space is promising, it is currently a tiny universe of products. In fact, this asset class is presently more of a solar system than a universe.
Should crowd-centric retail alternatives marry a modernized self-directed IRA industry that provides a suitable retirement vehicle with which to hold this novel asset class, however, the crowd-centric alternatives ecosphere could experience stratospheric growth, similar to how the mutual fund and IRA/401(k) industries were each able to balloon into multitrillion-dollar industries after unifying in the 1980s.
The parallels between what is transpiring today in the U.S. legislature, financial markets and technology labs and a series of disruptive events that occurred in the 1980s — commencing with the signing of the Economic Recovery Tax Act of 1981 — are remarkable.
By giving mainstream appeal to the IRA and rise to the 401(k), the Economic Recovery Tax Act — combined with significant strides in financial technology and investment product ingenuity — dislocated the entire U.S. retirement infrastructure and simultaneously created the most remarkable asset distribution channel in the history of finance.
That is, until now.
REDEFINING PRODUCT DISTRIBUTION
The automation of “micro-alternative investing,” coupled with a more inclusionary regulatory regime, has the potential to serve a limitless number of investors. This formidable combination also has the power to attract first-time investors, create new and grander distribution channels, and expand the retail retirement market to historic levels.
In addition to powering micro-alternative investing, fintech is presently being used to draw fresh retail investors to the markets. Game-changing digital investing apps have increasingly been garnering attention, and robo-advisers have experienced an upsurge in both subscribers and assets under management. Juniper Research projects total assets under management by robo-advisers will jump to $4.1 trillion in 2022, from about $330 billion in 2017.
Millennials, in particular, have been charmed by these digital investing platforms, and it will not be long until this new generation of young, tech-savvy retail investors begins allocating portions of its capital to crowd-centric alternatives and holding it in modern self-directed retirement vehicles.
With as much as $30 trillion in wealth estimated to transfer from baby boomers to millennials over the next few decades, the growth potential is staggering.
Until such time as crowd-centric alternatives garner widespread acceptance, however, other methods of bringing alternative products to retail investors need to be pursued. One avenue currently being explored is to legislatively amend the definition of “accredited investor.”
In the spring of 2015, small-investor advocate David Schweikert, an Arizona congressman, introduced a bill that would broaden the definition of “accredited investor” and allow many more retail investors access to alternatives.
If passed, H.R. 2187 — the Fair Investment Opportunities for Professional Experts Act — would expand the definition of accredited investor to include certain natural persons, regardless of whether they meet the income and net-worth requirements under Rule 501(a) of the Securities Act of 1933. Although the bill still upholds certain financial criteria, it enables individuals to be qualified based on nonfinancial credentials, such as professional sophistication.
While shifting the barometer from financial stature to knowledge and expertise can have sweeping and lasting economic benefits, broadening the accredited investor rule is only the first step in narrowing the wealth gap, democratizing investment product diversification and preventing a retirement crisis.
Although it is encouraging to see Congress addressing the inherent flaws in the accredited investor rule, at some point legislators will need to consider abolishing the rule altogether.
THE CASTE SYSTEM
U.S. political leaders need to question the constitutionality of a rule that favors one class of citizens over another. The most coveted growth stocks currently are staying private for much longer — in many cases even suspending their IPOs indefinitely — making them off-limits to retail investors. As a result, today’s most promising growth companies are legally only able to appreciate in the hands of the wealthy. The postponement of IPOs, until long after critical company growth spurts have passed, has forced small investors to serve more as an “exit strategy” to the financially privileged than as an issuer’s once-coveted “longer-term growth investor.”
The same restrictive laws that prohibit small investors from participating in private equity also preclude them from bolstering their fixed-income portfolios with private debt investments. As interest rates remained at historic lows, retail investors weighted in treasury, municipal and even many corporate bonds were barely able to outpace inflation. All the while, institutional capital was freely able to seek refuge in alternative credit products that delivered stronger risk-adjusted returns.
Given the fractured small-cap IPO market, the volatility of the stock market, diminished Treasury yields, and today’s rising inflationary fears, investors can no longer rely solely on traditional stocks, bonds and mutual funds for growth and yield. It is for this very reason, in recent years, alternative assets have become an increasingly critical component of institutional investor portfolios. Unaccredited retail investors have not been afforded the same opportunities to properly diversify.
While qualified investors such as hedge fund managers, wealthy individuals, endowments, foundations and financial institutions have been free to choose from an array of alternative products, it has been nearly impossible for unaccredited retail investors to access most of these types of investments — especially in their retirement accounts, where alternatives are most needed. Thus, the nation’s financially privileged have unfettered opportunity to diversify risk and enhance returns with alternative investment products, but those of lesser means remain encumbered.
According to present U.S. securities law, unaccredited investors are legally prohibited from participating in most private equity, private debt, venture capital, hedge fund and private placement opportunities. Because income and net-worth levels presently serve as the only barometers for accreditation, citizens of lesser means, no matter how financially astute, are not deemed sophisticated enough to freely allocate their money outside of traditional stocks, bonds and mutual funds.
With the vast majority of the U.S. population legally prohibited from partaking in the upside of some of the nation’s most exciting private businesses and banned from diversifying portfolio risk with higher-yielding private-debt instruments, the country continues to experience an ever-widening wealth gap shadowed by a looming retirement crisis of enormous proportions.
The wealth divide in the United States has been called the defining issue of our time. The resolution, assert many financial industry observers, is to democratize the investment industry, starting with broadening access to a wider and more diversified pool of asset classes.
Fortunately, through a few legislative tweaks, some investment product ingenuity and the mass deployment of financial technologies, the once-disenfranchised retail investor is about to rise and assume a more active and influential role in the investment industry.
It is likely to change everything we know about financial services.
Dara Albright (firstname.lastname@example.org) is founder and CEO of Dara Albright Media, which specializes in the creation of fintech content and conferences.