Food for thought: Inflated numbers

[tireg]

Wasn't sure where this fit.. mods move at your own discretion

Another thing that's come to my attention is the alarming and increasing use of reporting
AUM or net assets. Inflated numbers are funny like that.
For example, say I'm an investor with 400 million and I invest all of it into a Fund of Funds
(we'll call it FOF 1). FOF 1 then has 400 AUM, right? Then let's say they invest ALL of
it into another fund (we'll call this one Fund 2). Doesn't Fund 2 now also have 400 AUM?

So if we were to look at both funds, FOF 1 has 400 AUM, and Fund 2 has 400 AUM.
In this two-fund universe, there is 800 AUM total. Funny isn't it?

Of course this is because we're only looking at ASSETS, and not LIABILITIES.
From a pure accounting perspective, we would see on the balance sheet that
FOF 1 has assets of 400MM and liability of 400MM (to the original investor)
and Fund 2 has assets of 400MM cash and a liability of 400MM (to FOF 1)
so if the balance sheets were to be simplified, everything would be deflated.
But nobody ever reports liabilities...

Which makes me wonder just a little about this $1.5 TRILLION dollar HF industry.
While there are legitimate big players and a bunch of smaller ones and even more
tiny players, how much of this number is inflated due to true asset growth or due
to inflated numbers?

Here's the fun part.
Now let's take this example to an extreme case.. and say Fund 2 invests all of their money
in FUND 3, who invests all of it into Fund 4, etc... to.. say a universe of 50 funds total.

Now in this 50-fund universe, there is 20 Billion AUM! (400MM * 50 funds). And each of them
charge.. let's say.. 2%. Management fees, of course.. etc. to pay for all the new houses
in CT.

400million * .02 = 8 million. Per fund. In fees.
8million * 50 funds... = 400 million. In fees the first year. Riight?

Where did our investor's money go???

Let's take a closer look.

Say fund #50 ended up with the actual cash, and sat on it.

Fund #50's assets at the end of year 1 = 400(AUM) - 8(in fees) = 392 million.
Fund #50's liabilities at the end of year 1 = 400 (owed to Fund #49). Or does it??
In actuality, they took home a loss of 2%. So they report a net loss for the year of 2%.
Then, *due to accounting magic and the structure of funds* Fund #50's liabilities = 392 million!
What a coincidence.

Fund #49's assets at the end of year 1 = 400(AUM) - 8(in losses) - 8(in fees) = 384 million.
Fund #49 was down 4%, due to losses of Fund #50, and their own fees.
Fund #49's liabilities at the end of year 1 = 384 million (= assets), down from 400MM.

Fund #48's assets at the end of year 1 = 400(AUM) - 16(in losses) - 8(in fees) = 376 million.
Fund #48 was down 6%, due to losses of Fund #49, and their own fees.
Fund #48's liabilities at the end of year 1 = 376 million (= assets), down from 400MM.

etc etc etc..

Fund #1's assets at the end of year 1 = 400(AUM) - 392(in losses) - 8(in fees) = 0.
Fund #1 was down 98% (hey, they had a bad year) due to losses of Fund #2 and their own fees.
Fund #1's liabilities at the end of year 1 = 0 (= assets), down from 400MM.

Scary, isn't it.

I think something similar to this scenario could possibly be what happens when the hedge fund bubble busts.

What happens also if our investor wants to pull out?

Just some food for thought

 

[tireg]

PS I know that many funds take 2%/12, meaning they take their cut every month instead of all at once.. but for simplicity's sake, the example still applies.

 

[2cents]

u can also inflate your B/S no end just by making money go round, e.g.:

. A withdraws from 'cash' and lends $100K to B -> no change to A's A&L figures, but B's A&L figures show a $100K increase

. B withdraws from 'cash' and lends $100K to C -> no change to B's A&L figures, but C's A&L figures show a $100K increase

. C withdraws from 'cash' and lends $100K back to A -> no change to C's A&L figures, but A's A&L figures NOW show a $100K increase! and unless one analyses A, B & C together it all looks like legit commercial transactions, i.e. reflecting REAL activity...

make this same $100K go round again and you've increased A, B & C's A&L figures by yet another $100K

the beauty of this is money needn't even change hands at all, all you need is A, B & C's authorized officers (preferably all different persons...) to sign 3 sets of loan docs simultaneously and the appointed accountants can take care of the rest... and you just do it as many times as required...

if your worried the auditors may smell a rat, you just set up companies D, E, F etc and arrange as many 3-4-5-etc loops as required to make things harder to track... of course companies B, C etc are all domiciled in the BVIs, Caymans etc where set-up and running costs are petty cash, and disclosure requirements are nil... and if your auditor's really smart, well, as long as you and i can agree that the scheme is or can be made opaque enough so nobody can blame him / her for not seeing thru it, u guys can be friends

make him a director of any one of your A B C etc now $10mio+ asset-size companies and everybody's happy!

{yawn}

anyway... bottom line is nobody serious gives a rat's arse about asset size / AUM size etc and for good reason... what matters is yr ROA... better be above average!

 

[tireg]

I think you've missed the point.

Your $100k A->B->C etc example is a loan, and thus would be a liability for the borrower and an asset to the lender, thus balancing eachother out on the B/S. If B lost the $100k LOAN, they would no longer have the $100k ASSET, but the LIABILITY would still be there, making them net -$100k.

BUT.. in my example above, due to the structure of funds and accounting for losses (non-responsibility, essentially), when Fund #X loses ASSETS, their LIABILITIES also go down.... by the same amount.

 

[2cents]

the point is:
. as the $100K go round, they inflate A, B & C's B/S... for instance on each round A's B/S shows more lending to B on its assets section, and more borrowing from C on its liabilities...

iow, there are loads one can do with accting, with little effort... thats why what really matters is ROA, not asset size... if A's ROA is good enough, everybody's happy to invest there...