24/08/18

HEDGE FUNDS: Apple is a Hedge Fund That Makes Phones.

(Wall street Journal) -- When you buy a share of Apple stock, you do not simply buy into a $1 trillion technology company. You also buy a share of one of the world’s largest investment companies: Braeburn Capital, a wholly owned subsidiary of Apple. Braeburn manages a $244 billion financial portfolio—70% of Apple’s total book assets. Apple acts like a hedge fund by supporting this portfolio with $115 billion of debt.

Like a hedge fund, Apple provides minimal disclosures on Braeburn Capital’s holdings. But unlike a hedge fund, Apple does not restrict itself to accepting funds from sophisticated investors. Apple invests the money of everyday investors, like a mutual fund—but without telling investors what they own, the most basic protection mutual funds offer.

Equity and debt holders beware. Similar shadow hedge funds abound within S&P 500 industrial companies. Most disclose less information than Apple about their activities. Our research, published in the Journal of Finance, shows that in 2012 these corporations managed a combined portfolio of $1.6 trillion of nonoperating financial assets. Of this amount, almost 40% is held in risky financial assets, such as corporate bonds, mortgage-backed securities, auction-rate securities and equities. Current accounting standards require companies only to report aggregate valuations on a quarterly basis.

Like Apple, these companies lever up. The debt may appear safe at first when it is backed by financial assets. But these assets are not the safe and liquid ones that typically facilitate day-to-day operations. By shifting into riskier and more illiquid financial assets, corporations hurt their debt holders, ostensibly to help equity holders.

Equity holders don’t seem to gain any benefit, though. Our research shows that large holdings of risky financial assets are associated with the destruction of value. The market values a dollar of risky financial assets at substantially less than a dollar. Large risky asset holdings are also associated with poorer corporate governance, CEO overconfidence and risk-incentivizing executive compensation such as stock- and option-based pay.

Through these shadow hedge funds, industrial companies chase after alpha. But beating the market is hard, and the attempt destroys value through fees and the ensuing management distraction from the core business. Only the most select hedge-fund and mutual-fund managers outperform the market. It seems unlikely that the financial industry’s best money managers would choose to work for industrial companies at lower pay. Moreover, if corporate treasurers truly create value, companies should be happy to trumpet their success. Instead they hide their results from investors by taking advantage of weak disclosure requirements.

Harmonizing the disclosure standards of these shadow hedge funds with those required of mutual funds and other financial intermediaries—including quarterly reporting of every asset held and daily marking-to-market of the portfolio value—is critical for an informed investor base. This could be accomplished. Any company holding more than 1% of book assets in non-cash-equivalent financial securities should be required to hold these assets in a subsidiary that reports its net asset value daily. Investors should be able to evaluate the performance of these shadow hedge funds for themselves and decide how they want to invest their money.

Messrs. Gilbert and Hrdlicka are assistant professors of finance at the Michael G. Foster School of Business at the University of Washington.