The Ponzi Scheme in every hedge fund

Discussion in 'Wall St. News' started by patchie, Jan 5, 2009.

  1. patchie


    Monday, Jan. 05, 2009

    The Ponzi Scheme in Every Hedge Fund
    By Ari J. Officer

    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. In the past, these practices helped inflate their gains as well as hedge-fund managers' salaries and bonuses, but recently they helped bring about the failure of many major hedge funds.

    At the heart of the difference is the distinction between realized and unrealized gains. Gains are realized when assets are liquidated to 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 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, 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 being dishonest in its assessment.

    Madoff never even came close to realizing the gains he reported and paid out to some investors. Yet even funds with fairly accurate estimates of unrealized gains are guilty of engaging in similar Ponzi practices in the short term. Here's why:

    Suppose some investors decide to withdraw their money from a hedge fund. The fund must liquidate the appropriate amount of its assets to pay these investors. Say the fund holds large positions in illiquid assets. The fund cannot immediately sell these assets, except at a fatal loss, so it would sell its more liquid assets. Given that the fund is more likely to inflate its estimation of the illiquid assets, it would seem that investors who withdraw early get the better returns over that time period. Sounds a bit like a Ponzi scheme, right?

    Even in the most vanilla of trades, 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 reporting 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 got better returns over that time period than those who waited until later. (See the top 10 financial collapses of 2008.)

    Every year hedge funds do have to liquidate part of their profits in order to pay their managers, traders and other support staff. Fund managers typically keep 20% of (unrealized) trading profits. But first they must realize that 20% by selling the liquid assets. If a fund is overestimating the value of the illiquid assets, then its manager's profit is grossly overestimated. In most cases, the profit is at least slightly overestimated because of slippage in the liquid assets. In other words, if a fund liquidated all profits, the supposed 20% taken out first would actually be larger than 20% of the total realized profit.

    If hedge funds had to regularly liquidate assets, we would not see the spectacular returns reported in the past. One factor of the supposed success of hedge funds is their ability to report unrealized gains and to be flexible in liquidation, since investors who believe they are getting high returns are unlikely to withdraw their money. That was how Madoff was able to maintain his charade for so long.

    Wonder why Chicago-based hedge fund Citadel is not allowing investors to withdraw their money until at least March? Citadel has already reported about 50% losses for its two largest funds. Remember: these are unrealized losses. If Citadel liquidated assets to pay out to investors, losses would be even greater. Barring a miracle, the first investors out would lose less than those going out later. But even in good times, the withdrawal of money from a hedge fund impinges its performance.

    Hedge funds are designed to take in more and more investors' money. Then inefficiencies and performance distortions of withdrawing money for investors and profit-taking for managers are smoothed out. The recent failures in hedge funds, while rooted in the financial meltdown, have been further fueled by the lack of new investment as well as pressure from current investors to take their money and run. Regardless of a fund's investment strategy, liquidation tends to make unrealized gains smaller — and unrealized losses larger — when they are finally realized.

    By design, hedge funds benefit managers more than investors. Since the liquidation of assets always results in slippage — the more that is sold, the worse the price — managers for every hedge fund always get the "best" 20% of the profit.

    So you see, there could be a little Ponzi scheme in every hedge fund. It is inherent to the model of the modern hedge fund. The only way to avoid these schemes is to regularly liquidate all assets and allow all investors to decide what to do with their cash returns. In the past, this would have meant seemingly diminished returns. With returns seemingly high, investors did not complain about the status quo. Now, given that regular liquidation would mean more transparency and diminished losses, in recent days investors' opinions would likely differ.

    See pictures of the stock market crash of 1929.

    See pictures of the recession of 1958.

    Click to Print

    Find this article at:,8599,1869196,00.html
  2. He doesn't even mention a possible conspiracy to 'keep the ball in the air' among various funds.

    Just a hunch, I have a good imagination.

  3. Exactly.

    Insurance is the same way. The only way for it to work is for it to remain in the air.
  4. mokwit


    In addition to inflation for outright padding of returns and thus performance fees, they probably used illiquid asset prices to smooth the returns and give that nice smooth ~1% a month that institutions like to see.
  5. talknet


    According to above statement Microsoft, Walmart and all other giant companies should be Ponzi because Microsoft's market cap is $252 billion and Wal-Mart is $245 billion. But these are unrealized gains.

    To earn $252 billion, Microsoft must sell the company
  6. Liberally speaking a Ponzi scheme is a revolving line of credit run amok. Businesses sometimes expect to be in the red for years before they can actually get ahead of their debt sometimes never.
  7. What isn't a ponzi scheme in finance? Why is this article so sensationalist?
  8. I'm much more concerned with the very many overpaid idiots running around.

    Too many to list , you know who you are and they are.
  9. talknet


    Example-: "Ambani Brothers (Mukesh & Anil)" were collectively valued at $91 billion by Forbes some 4 months back. One of their companies "Reliance Power" received $200 Billion IPO subscription where the IPO was for $2 Billion only (not sure). Later on the stock market crashed, if not then investors (hedge funds & mutual funds) would have invested $200 billion in a "worthless company"which was original valued at $2 billion through the stock market . That is 100 times over-valued or unrealized gains.

    Ambani's are the owner's of most over-valued, over-hyped, over-invested & basically worthless "Reliance Industries". No Company or Investment Firm in the world will ever pay the current market capitalization for acquisition of Reliance because the profits are not worth it. There is no future.

    Basically there is "blind investments or unrealized gains" into Indian companies from local and international investors (hedge funds & mutual funds). There is no sales future.

    That's the reason I always write "China & India will crash to rock bottom now.
  10. bidask


    this analogy is wrong.

    #10     Jan 6, 2009