By Ari J. Officer Monday, Jan. 05, 2009
Bernard Madoff’s $50 billion Ponzi scheme continues to rock the financial world.
But most hedge funds actually engage in similar — albeit legal — practices in the short run. These practices helped inflate their gains, as well as hedge fund managers’ salaries and bonuses, in the past, but subsequently helped bring about the recent failure of many major hedge funds.
At the heart of this is the distinction between realized gains and unrealized gains. Gains are realized when assets are liquidated into cash. For instance, if you buy a stock for $100 and it is currently trading at $200, you have made $100 in unrealized gains. If you sell it at $200, you have made $100 in realized gains. Most hedge funds do not regularly liquidate their entire portfolio, so they always report unrealized gains to their investors and to the public. (See the top 10 scandals of 2008.)
Now comes the murkier part: Many assets — particularly those that unregulated hedge funds can trade — are not as liquid as stocks, and so they do not always have a definite price on the market. Since a fund reports unrealized gains, it could easily get away with inflating profits. More specifically, the fund could use the most optimistic models to price its illiquid assets, which include mortgage-backed securities and other swaps. After all, economists disagree about how to value these assets, so the fund is not necessarily dishonest in its assessment…
Even in the most vanilla of trading, liquidation can impact the market price. With lightly traded securities, this can be magnified. For example, a fund might corner some asset by buying and buying and buying, and then report a huge unrealized gain. But the moment the fund tries to sell and realize the gain (perhaps to pay off its last few investors), demand disappears, and the asset crashes. Again, investors withdrawing early get better returns over that time period than those who wait until later.
