What Every Tax Advisor
This presentation is the property of its rightful owner.
Sponsored Links
1 / 37

What Every Tax Advisor Needs to Know About Hedge Funds PowerPoint PPT Presentation


  • 125 Views
  • Uploaded on
  • Presentation posted in: General

What Every Tax Advisor Needs to Know About Hedge Funds. Paul S. Lee, J.D., LL.M. National Managing Director. Hedge Funds: Staggering Popularity and Growth. Over 9,000 Funds. Over $1.4 Trillion. Source: HFR Industry Report , Fourth Quarter, 2006. Fund Strategies & Categories.

Download Presentation

What Every Tax Advisor Needs to Know About Hedge Funds

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


What every tax advisor needs to know about hedge funds

What Every Tax Advisor Needs to KnowAbout Hedge Funds

Paul S. Lee, J.D., LL.M.

National Managing Director


Hedge funds staggering popularity and growth

Hedge Funds: Staggering Popularity and Growth

  • Over 9,000 Funds

  • Over $1.4 Trillion

Source: HFR Industry Report , Fourth Quarter, 2006


What do you need to know as an advisor

Fund Strategies & Categories

Financial Instruments

Fund Structure

Non-U.S. Funds

U.S. Funds

U.S. Trade or Business

FDAP

PFIC

UBTI

CRTs

Tax Classification

Subchapter K

Valuation Issues

Taxation of Investments

Investor Level Issues

pgs.

39-44

Choosing a Fund

What Do You Need to Know as an Advisor?


Hedge fund no standard legal definition

Hedge Fund: No Standard Legal Definition

  • Lightly regulated investment vehicle

    • Not registered under the Investment Company Act of 1940

    • Securities not registered with SEC

    • Limited to high net worth individuals and institutions

  • Limited liquidity

  • Flexible investment mandate

    • Not just “long,” but also “short”

    • Employ “leverage”

  • Two layers of fees

    • Investment management fee (1% to 3%)

    • Incentive fee based on profits (10% to 30%)

      • With a “watermark”

      • Above “benchmark”


Categories of hedge fund strategies

“Categories” of Hedge Fund Strategies

“Market Neutral” (~1/3)

  • Event Driven

    • Merger Arbitrage

    • Distressed Securities

  • Equity Market Neutral

  • Arbitrage Strategies

    • Fixed Income Arbitrage

    • Convertible Arbitrage

Directional Strategies (~2/3)

  • Long-Short Equity Strategies

  • Global Asset Allocators (Macro)

  • Emerging Markets

Source: HFR Industry Report 2006.


Going long and short

Going “Long” and “Short”

  • Financial tools and strategies

    • Short sales

    • Futures and forwards

    • Options

    • Notional principal contracts (pg. 5, fn. 4)


Mechanics of a short sale

Mechanics of a Short Sale

Loan

100 shares XYZ

“Short Sale”

100 shares XYZ @ $10 per share

Short Seller

(Borrower)

(Hedge Fund)

Owner

(Lender)

Market

Borrow Fee

+

In Lieu Dividends

Proceeds ($1,000)

+

Interest

@$15 per share

($500) Loss

Short Seller

Closing Transaction

Short Seller

(Borrower)

(Hedge Fund)

Owner

(Lender)

Market

Return

100 shares of XYZ

“Closing” Purchase

100 shares XYZ

@$5 per share

$500 Profit

Short Seller


Mechanics of a futures forward contract

Mechanics of a Futures/Forward Contract

Contract to Buy/Sell

(No Premium or Up-Front Payment)

Purchaser

(Long Position)

Seller

(Short Position)

Obligation:

Buy

Obligation:

Sell + Deliver

Future Date

+

Futures Price

Gain to

Long Position

Loss to

Short Position

Commodities

Currencies

Securities

“Cash-Settled”

Futures Contracts

and

Mark to Market System

Market

vs.

Futures Price

Loss to

Long Position

Profit to

Short Position


Options

Options


Structure of onshore hedge funds

Investment

Manager

General Partner

Hedge Fund L.P. or LLC

Structure of “Onshore” Hedge Funds

Limited Partners (Investors)

  • Levels of Inquiry

  • Tax classification of fund

  • Subchapter K implications

  • Valuation Issues

  • Taxation of investments

  • Investor-level issues

Hedge Fund Investments


Tax classification of fund

Limited Partner (Investor)

Hedge Fund L.P.

Hedge Fund Investments

Tax Classification of Fund

  • Onshore hedge funds are partnerships

    • “Publicly traded partnership” exceptions (pg. 7)

  • Hedge fund status

Trader or Investor

vs.

Dealer


Subchapter k allocation of profit and loss

General Partner

Hedge Fund L.P.

Subchapter K: Allocation of Profit and Loss

Limited Partners (Investors)

General AllocationsNet capital appreciation(depreciation) to capital accountsTax items allocated under§ 704(b) and § 704(c)based on net capital

Special AllocationIncentive FeeBased on benchmark?Index: -9Return: -1Incentive Fee: 20% of +8%

Hedge Fund Investments

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Subchapter k contribution of assets in kind

Hedge Fund L.P.

Subchapter K: Contribution of Assets In-Kind

Limited Partner (Investor)

Assets-in-kindNon-taxable eventUnless hedge fund is“Investment Company”§§ 721(b) and 351(e)Exception for“Diversified portfolio”“Insignificant amount”

Special AllocationsDifferences inbook value& tax basis

Hedge Fund Investments

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Subchapter k disguised sale rules

Hedge Fund L.P.

Subchapter K: Disguised Sale Rules

Limited Partner (Investor)

Presumed Disguised Sale§ 707(a)(2)(B)Contribution of appreciated propertyDistribution of other property or cash to contributing partnerWithin 2 years

Triggering EventsPartial redemption or withdrawalTax Distributions?Distributions with corresponding allocation?

Hedge Fund Investments

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Subchapter k mixing bowl transactions

Hedge Fund L.P.

Subchapter K: “Mixing Bowl” Transactions

Other Partner

Contributing Partner

Recognition of Gain/LossContributed propertyDistributed to any other partnerorReceive other propertyWithin 7 years

Capital accounts unaffectedOutside basis of contributing partner and inside basisof property automatically adjusted (no § 754 election)

Hedge Fund Investments

Character of gain/lossdetermined at fund level

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Valuation issues

Donor/Decedent (Investor)

Hedge Fund L.P.

§ 754

Hedge Fund Investments

Valuation Issues

Valuation forWealth TransferTax Purposes

Withdraw

Cure Book/Tax

Lose “Watermark”

  • Date of Transfer

  • Value Received (Future)

  • Previous Valuation

Restrictions

  • Transferability

  • Withdrawal

  • No Chapter 14

Book/TaxDisparity

Valuation of theInvestments

  • Accounting/Valuation Periods

  • Actively traded

  • Hard to value assets


Taxation of investments the rules and exceptions

X

Limited Partner

Hedge Fund L.P.

X

Hedge Fund Investments

Taxation of Investments: The Rules . . . And Exceptions

CAPITAL GAIN/LOSS

Contracts under § 1256

Currency Transactions (§ 988) [pgs. 15-16]

Conversion Transactions (§ 1258) [pgs. 25-26]

Constructive Ownership (§ 1260) [pg. 35-37]

CLOSE OF TRANSACTION

Contracts under § 1256

Constructive Sales (§ 1259)

Straddle Rules (§ 1092)

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Taxation of short sales borrower s standpoint

Taxation of Short Sales (Borrower’s Standpoint)

  • Gain or loss is on the closing transaction

    • Short-sale proceeds less basis in replacement stock

  • Short-term

    • Unless replacement stock has a long-term holding period

    • Special rule for converting short- to long-term gain

    • Special rule for converting long- to short-term loss

  • Section 1259 Constructive Sale

    • Appreciated financial position (contributed or acquired)

    • Deemed to have been sold upon the short sale

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Taxation of futures and forward contracts

Taxation of Futures and Forward Contracts

  • Realization events

    • Sale or exchange of the contract

    • Physical settlement at maturity

    • Offsetting contract

    • Cash settlement at maturity

  • Capital gain or loss

  • Short term

  • Options are essentially the same (pgs. 21 - 25)


Section 1256 contracts mark to market taxation

Section 1256 Contracts: Mark to Market Taxation

  • Includes:

    • Regulated Futures Contracts

      • Traded on an established exchange

    • Foreign Currency Contracts

      • Forward contracts traded in interbank market

    • Nonequity Options

      • Traded on an exchange

      • Broad-based equity index options (not narrow)

      • Options on commodities, currencies and financial instruments

  • Annual mark to market realization

  • Tax treatment

    • 60% long-term capital gain/loss

    • 40% short-term capital gain/loss

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Straddle rules section 1092

Straddle Rules (Section 1092)

  • Defer loss realized from disposition of a straddle position

  • Straddle

    • Positions that are valued on an established market,

    • That can be sold, exchanged or otherwise liquidated, and

    • The value change in one position will result in an inverse change in value in the offsetting position.

  • Included

    • Short sales while holding a long position in the stock

    • Any short position in “substantially similar” property

All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Summary of investor level issues

Summary of Investor Level issues

  • Straddle rules apply to investors’ outside holdings (pg. 28)

  • Deductibility of Interest and Short Sale Expenses (pgs. 30 - 31)

  • Deductibility of Hedge Fund Investment Expenses (pgs. 31 - 32)

  • Passive Activity Rules (pg. 33)

  • At-Risk Limitations (pgs. 33 - 34)

  • Tax Shelter Reporting Requirements (pgs. 37 - 38)


The hedge fund claim

The Hedge Fund Claim

  • Produce equity-like returns

  • Maintain lower volatility

  • Exploit low correlation to rest of portfolio


Hedging market exposures tends to lower volatility

Hedging Market Exposures Tends to Lower Volatility

Market-Neutral*

Directional Strategies*

  • Fully hedge market exposure

  • Examples: Arbitrage; Event-Driven

  • Retain some market exposure

  • Examples: Long/Short Equity; Global Macro

Annualized Volatility: 1996–2005

*We group Convertible Arbitrage, Event-Driven, Equity Market-Neutral, and Fixed-Income Arbitrage hedge funds (as defined by the TASS database) into our index of Market-Neutral Hedge Funds. We group Long/Short Equity, Emerging Markets, CTAs, and Global Macro hedge funds (as defined by the TASS Database) into our index of Directional Hedge Funds. See “TASS Database” in the Appendix for a description of these indexes. Bonds are represented by the Lehman Brothers U.S. Aggregate Index, stocks by the S&P 500.

Source: Lehman Brothers, Standard & Poor’s, TASS, and Bernstein


Hedge funds don t move in tandem with the markets

Hedge Funds Don’t Move in Tandem with the Markets

Correlations to S&P 500*

1996–2005

High Correlation

US Growth Stocks

US Value Stocks

International Stocks

Directional Hedge Funds

Market-Neutral Hedge Funds

Real Estate

Low Correlation

Bonds

*Correlation between the S&P 500 and other investment alternatives, which are represented by the following—US Growth Stocks: Russell 1000 Growth Index; US Value Stocks: Russell 1000 Value Index; International Stocks: Morgan Stanley Capital International (MSCI) All Country World Index–Ex-USA; REITs: National Association of Real Estate Investment Trusts (NAREIT) Index; Hedge Funds: TASS and Bernstein; Bonds: Lehman Brothers U.S. Aggregate Index. Past correlations are not necessarily indicative of future results.


Analysis of hedge fund database

Analysis of Hedge Fund Database

Market-Neutral Funds

Directional Funds

12.4%

(1.2)

(3.1)

8.1%

16.6%

(2.2)

(5.0)

9.4%

  • Full history of funds currently reporting

  • Remove returns that were “backfilled” (Backfill Bias)*

  • Include returns of funds no longer reporting (Survivorship Bias)*

  • Adjusted Hedge Fund Returns

*“Backfill bias” is the tendency of reported database returns to be higher as a result of hedge funds beginning to report returns after they have achieved strong performance and then retroactively filling in their history. To adjust for this, fund returns were included only if they appeared after the date that the fund first reported to the database. “Survivorship bias” is the tendency of reported database returns to be higher as a result of capturing only the returns of funds that continue to report to the database. To adjust for this, returns of funds that dropped out of the database were added back. All funds with less than $10 million in assets under management were removed from the sample. Given the data in the TASS database, the impact of “look-ahead bias” (unreported returns of funds leaving the database) cannot be determined. See “TASS Database” in the Appendix.

Source: TASS and Bernstein


Hedge funds superior trade offs

Hedge Funds: Superior Trade-Offs

1996–2005 Annualized*

Directional Hedge Funds

Return (%)

Market-Neutral Hedge Funds

Stocks

Bonds

T-Bills

*Past performance does not guarantee future results. Stocks are represented by the S&P 500, bonds by the Lehman Brothers U.S. Aggregate Index; maturity of Treasury bills is three months. See “TASS Database” in the Appendix for details on our hedge fund indexes. Hedge fund performance is given after fees (1% on asset management and 20% of profits, with a highwater mark).

Source: Federal Reserve, Lehman Brothers, Standard & Poor’s, TASS, and Bernstein


Traditional allocation models a new paradigm

Traditional Allocation Models: A New Paradigm?

Percentage of Total Assets

Traditional Assets Only

With Hedge Funds

40% Bonds

60% Stocks

100% Hedge Funds?


Market vs manager the traditional approach

Market vs. Manager: The Traditional Approach

Sources of Returns: 1996–2005*

Manager Decisions (Alpha)

17%

  • Objectives

  • Capture market return

  • Add a premium (alpha) through long-only security selection

Market Movements

*We measured the variation in monthly returns attributable to the Russell 3000 Index for each fund in our sample universes. We then took the average result to represent the market return driver. Though funds may have had exposures to other market factors, we attributed all returns not explained by the Russell 3000 movements to active manager decisions. See “Mercer Database” in the Appendix for details.

Source: Mercer, Russell Investment Group, and Bernstein


Hedge funds focus on alpha not the market

Hedge Funds Focus on Alpha, Not the Market

  • Sources of Alpha

  • Long security selection

  • Short-selling

  • Various markets and instruments

  • Leverage

  • Specialized strategies(arbitrage, etc.)

Sources of Returns: 1996–2005*

Manager Decisions (Alpha)

Market Movements

*We measured the variation in monthly returns attributable to the Russell 3000 Index for each fund in our sample universes and took the average result to represent the market return driver. Though funds may have had exposures to other market factors, we attributed all returns not explained by the Russell 3000 movements to active manager decisions. See “TASS Database” in the Appendix for details on how we analyzed hedge fund returns and “Mercer Database” for a description of how we analyzed traditionally managed stock returns.

Source: Mercer, Russell Investment Group, TASS, and Bernstein


Alpha dispersion among hedge funds is wide

Alpha Dispersion Among Hedge Funds Is Wide…

Alpha +/- Median Manager: 1996–2005 Annualized*

DirectionalHedge Funds

Market-Neutral Hedge Funds

Top-Decile Manager

Median

Bottom- Decile Manager

*“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s estimated sensitivity to Russell 3000 Index returns (in excess of the rate on cash). See the

Appendix for details on how we used and adjusted the TASS database of hedge funds and the Mercer database of traditionally managed portfolios.

Source: Federal Reserve, Mercer, Russell Investment Group, TASS, and Bernstein


But much narrower for traditional managers

…But Much Narrower for Traditional Managers

Alpha +/- Median Manager: 1996–2005 Annualized*

DirectionalHedge Funds

Market-Neutral Hedge Funds

Long-Only Stocks

Long-Only Bonds

Top-Decile Manager

1.3%

0.4%

Median

(0.4)%

(1.2)%

Bottom- Decile Manager

*“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s estimated sensitivity to Russell 3000 Index returns (in excess of the rate on cash). See the

Appendix for details on how we used and adjusted the TASS database of hedge funds and the Mercer database of traditionally managed portfolios.

Source: Federal Reserve, Mercer, Russell Investment Group, TASS, and Bernstein


Low volatility masks full downside risk

Low Volatility Masks Full Downside Risk

Worst Peak-to-Trough Loss*

1996–2005

*Bonds are represented by the Lehman Brothers U.S. Aggregate Index. See “TASS Database” in the Appendix for details on our Market-Neutral Hedge Fund Index.

Source: Lehman Brothers, TASS, and Bernstein


More like stocks at just the wrong times

More Like Stocks at Just the Wrong Times

Correlations to S&P 500*

1996–2005

Up S&P Months

Down S&P Months

Bonds

Market-Neutral

Hedge Funds

Bonds

Market-Neutral

Hedge Funds

*See “TASS Database” in the Appendix for details on our Market-Neutral Hedge Fund Index. Bonds are represented by the Lehman Brothers U.S. Aggregate Index. Past correlations are not necessarily indicative of future results.

Source: Lehman Brothers, Standard & Poor’s, TASS, and Bernstein


Choosing the right hedge fund manager

Choosing the Right Hedge Fund Manager

  • Core competence

  • History of positive alpha

  • Experienced management team

Competitive Advantage

  • Diversified sources of return

  • Market/economic exposure quantified

  • Prudent use of leverage

Risk Management

  • Efficient trading and operations

  • Legal compliance/independent accounting

  • Detailed reporting

Infrastructure and Oversight

Superior Performance After Fees and Taxes


Appendix

Appendix

TASS Database

The TASS database includes the net-of-fee performance of individual hedge funds whose managers have elected to report to the database. As of December 2005, there were a total of more than 6,000 funds included in the database. In constructing our Market-Neutral Hedge Fund, Directional Hedge Fund, Hedge Fund, and Fund of Fund indexes, we included the performance of funds only after their managers decided to report to the database, and only for those funds that had at least $10 million in AUM. We also included the performance of all funds in the database that are no longer currently reporting. The indexes are equal-weighted. We calculated after-tax returns using ordinary-income and capital-gains tax rates at the highest marginal brackets in effect each month over the 1995-2005 period. In the case of directional hedge funds, we assumed that 75% of the return was characterized as ordinary income and 25% as long-term capital gain; for market-neutral funds, we assumed 90% ordinary income and 10% capital gain. In the calculations for funds of funds, we assumed a weighted average of the two fund categories.

Mercer Database of Equity and Fixed Income Managers

In analyzing traditional active long-only equity manager and fixed income manager returns, we used the Mercer database of large-cap equity and fixed income managers. The database includes the net-of-fee performance of individual managers. As of December 2005, more than 1,400 funds were included in the large-cap equity manager database and more than 500 funds in the fixed income database. In both cases, we included the performance of all funds in the database that were no longer currently reporting.

Hedge Fund Allocation Recommendations

The recommendations regarding the allocations to hedge funds are based on an analysis and consideration of the financial circumstances and risk profile of one specific client. The allocations to hedge funds in total recognize that there is unusual uncertainty regarding the ability of any hedge fund to achieve its premium goals, and therefore long-term risk is higher than it might appear. This leads us to limit the client’s overall hedge fund exposure in a way that varies with the risk profile of the client. These recommendations are intended to provide general guidance only and may not be suitable for all clients with that type of stock and bond allocation. The characteristics of hedge funds vary widely and may contain aggressive investment strategies designed for investors who understand and are willing to accept the risks associated with investing in funds that may utilize various investment strategies to enhance returns, including the use of leverage, investment in futures and options, and the technique of short-selling securities. There are substantial risks associated with investment in hedge funds, including the loss of all capital invested. Sales of hedge funds are restricted to investors who meet certain qualification standards.

This presentation is neither an offer to sell nor a solicitation of an offer to buy shares or interests in any AllianceBernstein hedge fund. The offering of any AllianceBernstein hedge fund is made only pursuant to the fund’s Confidential Memorandum, Subscription Agreement, and if available, current financial statements, all of which must be read in their entirety. No offer to purchase shares or interests will be accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation.


  • Login