Hedge funds: Are the huge profits real or an illusion?
Whether you own a hedge fund or are contemplating
investing in one, we would advise that you fully understand the
benefits as well as the pitfalls of this type of investing.
Hedge funds became popular when their returns shined
during the market collapse at the beginning of the millennium.
Unlike stock and bond investments, which will typically follow
the direction of their respective markets, hedge funds attempt
to provide an absolute return. This means that hedge funds attempt
to make a profit in up or down stock and bond markets.
Take-aways
• Hedge fund K-1s may be misleading.
• Taxes, management and incentive fees can erode 60
percent of your hedge fund income.
• Accredited and affluent investors must know the
solutions to the pitfalls of hedge funds. |
We will not bore you with historical returns, Beta,
Alpha and such things as standard deviation or Sharpe ratios.
Instead, we will attempt to use plain English to lay out some
of what you should consider. Studies have shown that adding an
absolute return investment to your portfolio can be very beneficial
to reducing volatility. But, just as you wouldn't cash out $1
million from your $3 million portfolio to bet on a race horse
that has won 20 races straight, we would argue that even if a
hedge fund has a tremendous track record, it doesn't mean that
we put all of our eggs in one or even two or three baskets of
hedge funds.
Although the portfolio diversification benefits
of adding hedge funds to a traditional investment portfolio can
be significant, perhaps the most serious challenge facing investors
who invest in hedge funds either directly or through a hedge fund
of funds approach is the inherent tax inefficiency.
For instance, many hedge funds utilize short selling.
In a short sale, the interest the investor earns on the short
sale proceeds is treated as interest income. Any gain on a short
position, no matter how long the short position is held open,
is treated as short-term capital gain and therefore taxed at your
highest ordinary income tax bracket.
Unlike mutual funds, which make cash distributions
of their gains, hedge funds send no money. Instead, they deliver
a K-1 statement detailing the taxable income on which an investor
must pay taxes. Even worse, many investors in funds of funds (as
well as some hedge funds) often wind up paying taxes on more profit
than their investment actually earned. How does that happen?
Before flowing through on a K-1, hedge fund expenses
are not netted against income. Rather, the gross return is taxable
to the investor with the management and performance fees shown
separately as miscellaneous deductions to the investor. Many accredited/affluent
taxpayers cannot deduct miscellaneous itemized deductions because
that type of deduction must exceed two percent of adjusted gross
income to indeed be a deduction. Investors subject to the alternative
minimum tax also can be disadvantaged by this outcome.
As an example, an investor who owns a hedge fund
with a $110,000 gross return and $20,000 in total management fees
is left with a K-1 showing a $110,000 taxable income flowing through
on their 1040 when all the investor realized was $90,000.
There is a good reason hedge funds are typically
offered to accredited investors (typically those with a net worth
exceeding $1 million). As an accredited investor you are expected
to understand the full extent of the risks being taken as well
as the consequences of taxes, management and incentive fees to
your pocketed returns.
It is ultimately up to each of us to fully understand
our financial picture before we can discern if an investment is
a good one or not. The responsibility of ensuring that the IRS
and your hedge fund don't end up with the lion's share of the
profits is up to you, the investor.
Management fees are another potential pitfall. Let
us assume a distressed debt fund charges a 2 percent management
fee and then charges another 20 percent performance fee on the
remaining profits. If this fund had a gross return of 15 percent,
the net return to the investor would be 10.4 percent. Many hedge
funds take the position that they are traders and that these management
and performance fees are incurred in their business and deductible
under Section 162. Thus the entity's form K-1 reflects only taxable
income of 10.4 percent.
But, if the IRS took the position that the fund
was an "investor" and not a "trader," then
the K-1 would reflect an investment income of 15 percent and 4.6
percent in miscellaneous itemized deductions. If investors were
not able to use those deductions, they would pay tax on 15 percent
even though they only earned 10.4 percent. So what was thought
to be a 10.4 percent pre-tax return, and thus a 6.76 percent after-tax
return, is actually only 5.15 percent after-taxes. These calculations
use a 35 percent federal tax rate and don't include state taxes.
Christopher G. Snyder and Haitham "Hutch"
E. Ashoo are principals of Pillar Financial Services in Walnut
Creek. Contact them at 925-356-6780.
DOWNLOAD
A PDF VERSION »
|
