Suppose that a hedge fund promises to return, say 20 percent annually, regardless of whether the market goes up or down. There are lots of such funds that promise big returns without too much risk. Now consider the situation of the managers of General Electric. As of October 29, 2005, finance.yahoo.com shows that GE has a return on equity of 17.62 percent annually. If the managers of GE believe the claims of the hedge fund managers, wouldn’t the best thing that they could do for GE shareholders be to sell all of GE’s businesses and put the money into the hedge fund returning a risk-free 20 percent? Even Microsoft only shows a 12.6 percent return on assets and 19.93 percent return on equity. Only Google, the world’s fastest company to reach $1 billion in revenue, beats the hedge fund geniuses, with a return on equity of 22.8 percent.
What am I missing? Why don’t most big companies sell all of their business units and put the $$ into hedge funds?
It’s because hedge funds don’t really make that big return.
What you’re missing is that the 20% the hedge fund is offering is very far from risk-free, whatever they may promise.
Four words: Long Term Capital Management.
Yeah, hedge funds can offer 20% right up until the year they crash and lose everything by making a bet that didn’t pan out. Another issue is that all investment opportunities are limited in scope – the bigger a fund gets, the harder it is for it to make decent returns. I’m curious what fund you have in mind that you think could absorb the capital from all of GE’s business units and still return 20%. (Actually, I’m also curious what fund you think returns 20% risk-free.)
In any gold rush, the people who make money are the ones selling picks and shovels.
Two words: “survivorship bias”. Here’s a good article: http://www.fpanet.org/journal/articles/2004_Issues/jfp0104-art6.cfm
Quote: “in 2003, Gotham Partners Management Co., Beacon Hill Asset Management LLC and the Eifuki Master Fund have earned the honor of high profile failures, remarkable for the speed and size of their collapse. The Eifuki Master Fund lost its entire $300 million market value in seven trading days. Investors in this fund included the legendary George Soros. There are about 6,000–7,000 active hedge funds, and it has been estimated that about 20 percent cease their operations every year due to poor returns (Brown, Goetzmann and Ibbotson 1999).”
More importantly, GE makes something. Michael Dell was asked, before Steve Jobs return, what he would do if he were given the reigns of Apple. He said he would sell the assets and return the money to the investors.
I think that would have been a fine return on the money. I think it also would have been a poor deal as far as advancing competition, technology and culture is concerned.
Others above have brought the 20% figure into question, with good reason.
But taking the 20% estimate on face value, there’s still a reason to invest in GE: risk diversification. GE and MS and the hedge fund all have different kinds of risk, i.e. when you factor out the general market trend, their returns have a relatively low correlation. Even if we can confidently estimate that a hedge fund returns 20% and GE 17% with comparable risk profiles, a diversified strategy is still preferable for the average investor. (These companies aren’t the best examples since they’re already somewhat diverse.)
Others mentioned good stuff, but I think you are also missing the employment factor.. if all big companies sell their assets, shut down their business, and invest in hedge funds, there will be a whole lot of people out of work. Which would cause less money to be put into the market, which would cause basically a general downward spiral of everything.
It’s not all about making “the most profit” – or at least it shouldn’t be.
“Suppose that a hedge fund promises to return, say 20 percent annually” … “hedge fund returning a risk-free 20 percent”
This is a joke, right?
How would you react to a programmer who told you he produces product faster than than any of the established, experienced programmers you know? And further this programer claims that his code was free of the risks of bugs? Would you base an investing decision on a claim like that?
The closest thing out there to “risk free” investing is a U.S. Goverment inflation protected instrument, which return 1 or 2 percent plus the rate of inflation.
Anyone promising to do better than with no risk is crazy or a criminal.
Bank Of America actually tried exactly what you’re advising GE to do. (a friend of mine was writing trading software for D.E. Shaw at the time of their big crash – their trading algorithm worked GREAT right up until the Hong Kong real estate bubble popped.) Let’s see what happened!
http://www.siebertnet.com/html/body_newsletter.asp?Idx=69
Quote:
“The most widely publicized new hedge fund to fail is D.E. Shaw & Co. Bank America Corp. loaned Shaw $1.4 billion as part of a joint trading venture. The loan terms were unusual because instead of a fixed rate, the interest included half the Fund’s profits. The bank was also obligated to pay for half of any losses. D. E. Shaw then used this loan and substantial leverage to purchase over $20 billion in securities.
Reflecting the $372 million loss related to their D.E. Shaw investment, Bank America’s operating earnings fell 50% in the third quarter . Bank America took over the fund’s portfolio reported to be $20 billion, to effect an orderally liquidation of the fund’s holdings. The chairman has resigned – possibly due to this loss. When a large hedge fund fails and is forced to unwind its positions it can effect financial markets around the world. It can also have a strong impact on currencies. For example, the dollar lost 13.7% vs. the yen in one day. Hedge funds had borrowed yen in Japan where interest rates were below 1%. They then sold yen for dollars and invested those dollars in U.S. Treasuries at 5% or higher yielding bonds, making a huge profit. When banks started asking for more collateral, hedge funds were forced to unwind positions since interest rates in the U.S. were going down and the yen was getting stronger.”
Any financial enterprise which isn’t built on creating new value can only survive as a parasite on value created by others but which is underexploited due to a market inefficiency. As market inefficiencies tend to be temporary anyway, and are particularly sensitive to large infusions of savvy money, a 20% return on a hedge fund will only become less sustaintable as more money pours into the fund. This is even before factoring in the law of diminishing returns.
So in other words, the proposed solution would be pushing in toward failure from both sides…both diminishing the productivity growth from which genuine value gains come, and reducing the ability to do what successful hedge funds do well…exploit market inefficiencies.
Besides…in order to sell off business units, someone has to be prepared to _buy_ them. Where would that money come from, in your proposition? The most you’d likely accomplish would be to reorganize those businesses.
Big companies are the darlings of hedge funds. If they all cash in, there’ll be no hedge fund to put their money into.
Maybe it’s a Darwinian thing. Consider the percentage ROA or ROE the equivalent of an ecological niche. Eight years ago you would have been stupid to invest your money in durable commodities. One Republican president and two wars later, you’ve got CEOs before Congress having to apologize for windfall profits. My wife works in the book division at Time Warner. The bean counters look at her division’s CD-like return rate and shake their heads in frustration. Still, when it comes time to chop up the company for parts, they need that slow-and-steady stability to drive a harder bargain in the sale of AOL.
Careful Philip, Some business school educator might skim through your posting and think its a grand idea. Next thing you know it will be taught to hundreds of graduating mba’s, actually turn a profit for one or two then followed as gospel by droves of business-lemmings.Eventually, wise bloggers are chiding american business people for ever thinking such a gambit might work.But really, Matt and other posters have already covered most of the points.
Hedge funds are a tick on the ass of global business. Hedge funds invest tens of Billions on companies that generate Trillions of revenue.
These business revenues are diluted down to income by such things as wages, utilities, property,plant and equipment.
These trillions of dollars spent on wages, etc. support the real economy by way of consumer purchases, loans, investment, etc…
Hedge fund’s gross revenue is only diluted by the manager’s wages and disbursments to investors. This in no way supports the larger economy unless you subscribe to some dated notion of ‘trickle-down’ economics.
So what economy do you want to be a part of? A growing economy where businesses produce goods, invest in innovation, support and rely on a large base of workers, or a stagnant economy where a small group of money-managers pick the bones of business clean for their own profit, leaving the bulk of the working class to fend for themselves while fighting of the leftovers of the larger scavengers?
Sam, if you’re talking about the oil industry, those “windfall profits” the CEOs are apologizing for were only 9.9% ROI for the year. Sure, they made >10 billion, but they had over 100 billion invested. The average return is of course even lower since they had so many down years prior to that one. Your wife’s book division might well be doing better over the long haul.
I tend to agree with the assertions thus far about hedge funds. They can be a nice thing for some folks to toss a few percent of money in to speculate, and some provide a modicum of safety, but they are not particularly risk-free.
One thing to keep in mind is that GE is the gold standard of corporates. Even if a hedge fund was a “relatively low-risk” investment vehicle (I would argue it is not), it is an order of magnitude more risk than GE share and bondholders want to see. GE’s corporate debt is considered one of the (if not the outright) safest debt out there; it’s about the closest thing to sovereign debt out there while still being corporate. For GE to dump its funds into a hedge fund would undermine the trust built up in its corporate debt.
Yeah, what those guys said in the posts above, but let’s give a tongue in cheek question its due…
The irrationality of a company (or most profitable companies) selling assets and putting the cash into hedgefunds could easily be overcome: reward corporate Board members and executives for that kind of transaction and voila, you’d see it happening.
How else to explain so much of the M&A activity that seems so irrational? When analyzing corporate transactions, look first at the executive employment agreements and their bonus, option and buyout provisions.
Rather than GE and a hedge funds, why not ask the same question on long-run investment in airlines vs. a bank account? You would have been wise to go for the bank account.
Investment decisions are not always very rational, even in companies which employ hardened professionals who try to be rational about it. For example, a project normally has to clear a hurdle rate of return. In practice, it appears that, once the project has been greenlighted, this requirement is often swept under the carpet. The consequences are predictable.
To the folks who thought that I was proposing a complete sell-off of corporate American assets: You might not want to read this Weblog so literally. I was trying to point out that the idea that hedge funds can, in the long run, consistently return more than the average S&P 500 company’s ROI, would have the natural consequence that all of those S&P 500 companies would sell their businesses in order to best serve their shareholders. So obviously something has to be wrong with the hedge fund claims or the calculation of ROI in our public companies.
Philip: Maybe next time you’re making fun of a claim you should provide a link to somebody making that claim, rather than have it appear that /you/ are the one making the silly claim. I still don’t know where you are getting this idea /from/. I’ve never heard anyone claim that hedge funds can, generally and in the long run, consistently return 20% in all markets. You seem to be assuming it’s a general knowledge fact. All your responders are pointing out that the claim can’t possibly be taken seriously so there’s no point in taking the logic any further.
Your post resembled this argument: “The moon is supposedly made of green cheese. Given that premise it seems like it would be worthwhile for somebody to send a rocket up there and collect all the cheese to feed the starving people in Africa. But nobody has done this. So why not? What am I missing?”
Philip … one point : assume that GE’s VPs all sign off on the deal, and the 20% return is in fact earned. How can they justify their big salaries and options grants if they are basically just depositing money in a bank account?
If most of the big companies (presumably a sizable chunk of the economy enough to rattle the FED) unload their business units, to better serve their shareholders (logical enough), who is going to work the economy?
Isn’t hedge funds a game of betting on futures?
There are different profiles of investors. Not all are foot-loose, young and fancy-free like Philip! One of the biggest set of players, for example, is the pension fund and annuity industry. They need to be invested in stuff that will retain value and pay a regular dividend, with which to send the monthly cheques out to those fine old ladies and guys who built America. A hedge fund cannot come close to guaranteeing that level of regularity.
ROE isn’t everything either. GE (like most major companies) presumably also has debt funding, and its return has to be considered. However, the level of ‘gearing’ in GE is much lower than in a hedge fund, and there is at least some correlation between gearing and risk.
Gearing and risk is only one part of the downside for hedge funds, and hedge fund managers will tell you that over time they can manage the risk. However there is also unquantified uncertainty, specifically the risk of illiquidity to consider. The hedge fund manager can say what he likes, but he basically cannot quantify the danger from illiquidity, and he cannot manage it to any great degree. You have read ‘When Genius Failed – The Rise and Fall of Long Term Capital Management’ (Lowenstein), which has the subtitled ‘How one small bank created a trillion-dollar hole’, haven’t you? 😉