Hedge funds are partnerships set up to trade financial securities for profit. Clients can include a variety of types of entities, such as wealthy individuals, companies and pension plans. When a client invests money in a hedge fund, trading managers pool it with money from other clients and use it to buy and sell securities and commodities. Each client periodically gets a share of the profits from realized gains, which are the profits made from conducting successful trades. Realized losses also occur.
When a hedge fund trader buys some shares in a company and later sells the shares for a higher price, the result is a realized gain on a trading position. The trading position is the number of shares that were purchased. Positions in all sorts of assets, like stocks, bonds, and currencies and in commodities such as oil or cattle, are frequently traded at hedge funds. Sometimes a position can grow if, for example, a trader buys more shares after an initial purchase. Positions can be partially closed, as when a trader sells half the shares he previously bought.
Gains and Losses
Each time a position is partially or completely closed, the hedge fund records the gain or loss. For example, if the trader had purchased 200 shares of XYZ Corp for $50 a share and a week later sold 100 shares at $52 each, the gain would be $2 for each share sold, or $200. There is a realized gain on the sold shares because that portion of the total position no longer exists. The remaining 100 shares in the position are also showing a profit of $200, but this is an unrealized gain because the position still exists. Losses work the same way.
When a realized gain is recorded on a fully or partially closed position, the hedge fund updates its bookkeeping and uses the information in several ways. First, the profit or loss updates the income accounts for the fund. The results are tracked for each trader to evaluate performance. The realized gain is classified as long-term if the position was open for over a year; otherwise it is short-term. Gains are distributed to the hedge fund clients after the fund deducts its fees. Each client is liable for any tax liabilities resulting from his portion of the gains. Clients benefit from long-term gains because they are taxed at a lower rate than short-term gains.
Unrealized gains and losses represent the current profit or loss on an open position. Because the position is still open, the gain is not real yet, so it doesn’t trigger the same activities as those resulting from realized gains. The hedge fund reports unrealized gains on its balance sheet using the current position value, based on the current price of the traded asset to calculate the unrealized gain and loss. When the position is eventually closed, the gain or loss is reclassified as realized.
- The Complete Idiot's Guide to Finance and Accounting; Michael Muckian
- Taxation of U.S. Investment Partnerships and Hedge Funds: Accounting Policies, Tax Allocations, and Performance Presentation; Navendu P. Vasavada
- Accounting For Dummies; John A. Tracy
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.