Can venture capital and hedge funds be a force for good?

The rise of the alternative investment industry, which includes asset classes such as private equity buyouts, venture capital and hedge funds, has led to many concerns. Some say that hedge funds are unsafe, too risky and not worth the fees they charge. Others charge that private equity buyout firms are harmful to companies and jobs and that venture capital primarily benefits the rich.

While there are indeed examples of this, short-hand indictments do not do the industry as a whole justice. Taken together, alternative investments affect the economy in a positive way, without denying controversial individual examples. Here are five things we believe everyone should be aware of when it comes to the industry:

1. Alternative investments are a gigantic industry

The alternative investments industry has grown seven times bigger since 2000, from $1 trillion to $7 trillion in assets under management, and doubled in size just since the financial crisis. As a point of comparison, that is more than the total value of all stocks listed on the London Stock Exchange or NASDAQ. Yet despite their size, alternative investments have not been found to play a systemically destabilizing role in the financial crisis.

2. Alternative investors are highly diverse, and impact the financial system in many different ways

Alternative investors are highly diverse and range from long-term oriented funds that provide debt and equity to new and high-risk companies (venture capital), mature and growing companies (private equity buyouts and private debt), or physical assets (real estate or infrastructure) to funds that buy and sell securities in the same year (hedge funds).

The industry provides the financial system with:

• liquidity, which lowers the costs to all investors who trade stocks, bonds or other instruments;
• a rigorous screening process for start-ups, which helps to channel capital to high potential companies such as Google and Facebook; and
• sophisticated analysis, which lowers the cost of trading complex instruments and helps improve the performance of companies.

As such, they are a key part of the engine that keeps capital moving within the financial system and in the real world.

3. Alternative investments provide pension savers and other investors with a range of benefits, including higher returns and greater diversification

The primary beneficiaries of alternative investments are institutional investors, with 4,800 such investors providing the vast majority of capital to the industry. These include pension funds, foundations and endowments, and sovereign wealth funds, all of which are focused on serving the public good.

Pension funds like the Washington State Investment Board and the Canada Pension Plan Investment Board and universities such as Stanford and Harvard rely on alternative investments to support retirees, students and research, while sovereign wealth funds representing countries such as Singapore and the United Arab Emirates invest on behalf of the public in order to stabilize the economy and provide future benefits.

Over time, these investors have come to trust and rely on alternative investments to support their objectives, with allocations by countries with the largest pension systems soaring from 5% in 1995 to 25% in 2014 and endowments and foundations typically allocating more than 30%.

4. The impact of alternative investments on the real economy is largely positive, but there are some real concerns

Alternative investors have an effect on the economy in numerous ways – and not all are unambiguously positive. At the highest level, they seek to allocate capital towards its most productive use and enforce discipline on its deployment. Often this means funding innovative new products, increasing firm productivity, or creating corporate governance structures that better align the interests of executives and investors.

All of these changes have the potential to improve the economy and society, but the process of doing so may also result in adverse effects such as layoffs. Moreover, the industry cannot thrive or survive by itself, as it relies on the broader financial system to provide much of the capital (e.g. debt capital) and services that it needs to operate.

5. Policy-makers have an important responsibility in ensuring the positive effect of alternative investments

The potential unintended consequences of new financial regulations should be of significant concern to policy-makers. A review and analysis of this topic can be found in the Forum’s report, Alternative Investments 2020: Regulatory Reform and Alternative Investments.

At the societal level, capturing the benefits of alternative investments, while managing their risks appropriately, requires a subtle understanding of the complex machinery at work.

Our aim is to contribute to this understanding and provide a primer and reference guide that can inform policy-makers and the public, and serve as a starting point for an ongoing dialogue on the role of alternative investments.

To learn more about the Forum’s work on alternative investments, read the full report on the industry here.

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Authors: Michael Drexler, Senior Director, Head of Investors Industries, World Economic Forum. Jason Rico Saavedra, Senior Project Manager, Investors Industries, World Economic Forum. 

Image: Office buildings of housing banks and wealth management funds are pictured in Singapore’s financial district March 17, 2009. REUTERS/Vivek Prakash