Alternative investments and the economy

Published: 01 November 2016


1. The hedge fund industry employs hundreds of thousands of highly-skilled people across the world, who in turn make a significant economic impact themselves. 

According to AIMA estimates, the global hedge fund industry employs around 300,000 people. This figure includes both those employed directly within the hedge fund sector and those jobs generated by the industry among service providers including legal services, administrators, prime brokers and accountants. The ratio of direct to indirect jobs was found by AIMA to be 1:2 on average globally (regional variations exist).  

2. Many hedge funds are lending directly to SMEs and other businesses.  

Many hedge funds invest in and lend directly to companies, filling a gap in the market caused by a reduction in traditional bank lending since the global financial crisis. Some of the main beneficiaries have been small and medium-sized enterprises (SMEs) and businesses in difficulty. Typically, such businesses are too small to raise financing through the corporate bond market and have also been negatively affected by the ongoing stresses in the banking sector.  In a report in 2015, AIMA found that private debt financing accounted for approximately 6% of the total estimated funding for SMEs in the European Union. Given bank lending to SMEs is likely to continue to decline, funding from the private debt industry as an overall percentage of total SME funding in the European Union could reach levels of between 15%-20% by 2020, the AIMA report said.   

3. Hedge fund activities support the real economy in other ways, such as enabling the creation of common financial products and helping to reduce the cost of capital. 

Hedge funds are key participants in the bond and equity markets – also known as the capital markets. Academic research has shown that the larger the capital markets, the greater the economic growth. The balance between capital markets based finance and bank lending matters, with over-reliance on banks coming at a cost in terms of reduced economic growth. Deep capital markets are also good for firms which carry out significant research and development expenditure, since R&D intensity is positively correlated with the level of equity financing. 

Hedge funds are typically active investors and use their expertise to engage with and create positive governance changes in the firms in which they invest - changes which provide long-term benefits for firms, ultimately protecting and enhancing the value of people’s savings and pensions and improving the allocation of resources in the economy. 

Finally, and at a technical level, hedge funds aid efficient price discovery and add liquidity to markets, which reduces the cost of capital and helps to prevent the misallocation of resources in the economy. 

4. Activist hedge funds use their expertise to engage with and create positive governance changes in the firms in which they invest, which creates jobs and grows economies. 

By taking stakes in companies, and holding those positions often for years at a time, activist hedge funds support improvements in the performance of thousands of firms around the world. Struggling businesses are turned around, well-run businesses improved, capital more efficiently allocated and the interests of managers, shareholders and other stakeholders better aligned. 

Influence on company boards and management is often exerted in a spirit of collaboration and constructive engagement. Adversarial interventions are by no means the norm.  

The success of these efforts can be measured in a number of ways. One is simply in the growth of the activist hedge fund sector, which enjoyed a six-fold increase in assets under management from 2005-2014. This growth was driven largely by demand from institutional investors including public and corporate pensions, sovereign wealth funds and endowments. Another measure relates to the positive impact of activist campaigns on the share price of the targeted companies themselves, both during the holding period and following an exit by the activist via a sale of that stake. There is much academic research in this area; an analysis conducted on the Activist Insight database of companies exited by alternative activist managers in 2012 revealed that on average, the share prices of the target companies increased 25% in the subsequent two-year period regardless of the success of engagement. Little wonder that activist hedge funds were called “capitalism’s unlikely heroes” by The Economist.

5. As hedge funds are not too big to fail, closures are contained and do not harm the wider economy. 

Even in 2008, the hedge fund industry’s worst ever year, when the sector declined by 20% in terms of assets managed and investment losses amounted to around $300 billion, not a single hedge fund was bailed out by a government. Indeed, no hedge fund has ever in the history of the industry been bailed out by taxpayers’ money. Hedge fund failures, while potentially harmful to investors in those funds, do not create systemic issues which would require tax-payer intervention.   

Even the most serious failure in the industry’s 70-year history, which occurred in 1998 and involved a US business called Long-Term Capital Management (LTCM), did not cause a systemic crisis or require the injection of public money. In this case, the New York Fed oversaw a rescue of LTCM orchestrated by a number of Wall Street banks that had lent it large sums. Regulatory reforms since 1998 – and particularly since the financial crisis – mean that a repeat of a collapse on the scale of LTCM, which had been allowed to borrow extraordinarily large sums, is virtually inconceivable today.  

A number of regulatory agencies, including the Financial Stability Board and the UK's Financial Conduct Authority, have said in separate studies that no individual hedge fund is systemically important to the extent that its failure would endanger financial stability. 

6. Hedge funds do not pose systemic risks themselves. Hedge funds contribute to financial stability by often acting in a counter-cyclical, contrarian manner, helping to restrict the expansion of potentially dangerous asset-price bubbles.  

Hedge fund managers were among those who publicly took a sceptical view about the over-valuation of the US housing market, well before the 2008 crisis. A decade earlier, it was hedge funds that first began to wonder if dotcom stocks were overvalued. A specialist short seller also was one of the first people to identify potential mismanagement or fraud at Enron. By acting in a counter-cyclical and contrarian manner, hedge funds and other sceptics can help to restrict or deflate speculative bubbles – the kind that can destroy value in financial markets and even, in the worst cases, spill over into the real economy, as happened in 2008. Policymakers recognise the implications of this in tackling systemic risk and preventing dangerous speculative bubbles. That is why large hedge fund managers are contributing to supervisors’ financial stability analysis. This information, it is hoped, could help regulators prevent another global crisis.

Further reading

Financing the Economy 2016

 

Unlocking Value: The positive role of activist alternative investment managers (executive summary)