Highlights
American Compass, an organization that promotes populist policy views, has positioned itself as a periodic critic of the financial services industry. In 2021, the organization launched an initiative to promote heavier regulation and taxes on the industry, decrying investment in “excessively risky and illiquid assets that deliver subpar returns while collecting excessive fees.” The group applied this sweeping generalization to not one form of investment, but three: private equity, venture capital and hedge funds. Note that between and within these investment approaches are highly diverse strategies, but such nuance is often overlooked in populist critiques. The organization tracked investment returns of these industries on a quarterly basis. And then gave up for three years.
Perhaps one reason for abandoning the effort was being wrong. As has been well documented elsewhere, American Compass research is often wrong. With respect to alternative investments, which encompasses private equity, venture capital and hedge funds, American Compass began tracking the return performance from Q2 2019 and then stopped in Q2 of 2021. In 2021, Compass warned that the economy-wide downturn due to the pandemic could lead to an “Armageddon” for private equity buyout firms. The organization soon thereafter abandoned tracking fund performance until recently, when it released an update for Q2 of 2024. The update is perhaps most useful for pointing out that Armageddon never came.
Indeed, the Compass report acknowledges that “private equity experienced one of its best years in 2021.” Nevertheless, with apparent glee, the report goes on to say that PE activity has “stalled” in the last two years since. Nevertheless, the report grudgingly acknowledges PE’s outperformance of the S&P 500 as of Q2 2024. Indeed, over the past 5, 10,15, and 20 year periods, PE has outperformed the S&P 500.
It is also important to note that it is far from clear that the S&P 500 is an appropriate reference point for alternative investment. These vehicles are generally only available to accredited investors and large institutions. Central to that is risk and regulatory requirements. Average retail investors are generally barred from investing in these funds because they are not subject to the same regulations that govern public equities and other retail investment products. These prohibitions are put forward in the name of consumer protection. Accordingly, for large investors, alternative investment is part of a diversified portfolio that typically includes public equities as well.
The goal of a diversified portfolio is to balance risks for a given investment goal. As one research report noted, the S&P 500 is dominated by 7 stocks that account for about a third of its weight and about nearly two-thirds of its returns. A diversified portfolio would do well to broaden its scope. Alternative investment approaches provide that opportunity – with more than 85 percent of U.S. and international companies inaccessible to investors in public markets.
Importantly, alternative investment serves an important role in fostering risk-taking and innovation. Companies are not born on public stock exchanges. They spring from the combination of ingenuity and capital – and often fail. Alternative investment is critical to supplying capital to nascent firms – it is inherently risky. Indeed, 75 percent of VC-backed firms fail. It is facile to compare early-stage investing to the performance of mature, public firms on the S&P 500. Further, it’s a good thing that in the U.S. there are firms willing to take these risks.
Alternative investment has an important role to play in U.S. capital markets. They serve different investors for different purposes at different times. Like any industry, some serve those purposes well, and some will not. But blind criticism of investment approaches, as exemplified by Compass, is more in keeping with the viewpoints of Elizabeth Warren or Bernie Sanders, rather than conservative thought.