Hedge Fund Funny Money Tricks

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A new academic study shows that hedge funds often mark illiquid financial instruments up a bit more than they should. Since these are securities that rarely trade, it is hard to get a handle on their values. Sort of.

One of the authors of a new study of fund practices took a very harsh view of the practice, according to The Wall Street Journal. "Hedge-fund managers purposefully avoid reporting losses by marking up the value of their portfolios."

The work was based on a look at industry reporting activity using a database from the University of Massachusetts to analyze monthly returns from 4,268 hedge funds with varying investment styles from 1994 to 2005. In some cases, funds seem to be using these techniques to change small monthly losses into small monthly gains.

Hedge funds have been largely left to police themselves. If investors do not like the returns, they can sell out. Unless, of course, a fund gets into trouble and cuts off redemptions. But, regulation has been based on demand. Good returns equal good money flow.

Much of that may change now. The federal government won’t like the smell of the new study, nor should it. It could ask hedge funds to report their performances with lists of underlying securities. It could force outside auditors to sign-off on quarterly performance.

Either way, running a hedge fund could become a much more cumbersome job.

Douglas A. McIntyre