HEDGE FUNDS: MORE RICHES

FOR THE RICH OR TAXES FOR

THE GOVERNMENT?
Arthur C. Gudikunst, Ph.D.
Associate Professor of Finance
Christopher Newport University

Presentation to CNU Faculty at Teaching,

Scholarship, Research and Learning
Seminar, August 21, 2007
 Outline of Presentation
1. Description of Mutual Funds, Hedge Funds
and Private Equity
2. Hedge Fund Investment Strategies- Overview
3. Investor Qualifications for Hedge Fund
Investing
4. Compensation for Managers of Hedge Funds
5. Taxation of HF/PE Profits
6. Politics and Taxation of Hedge Funds
 Mutual Funds, Hedge Funds and Private
Equity Funds
• Mutual Funds- registered pools of funds under
Investment Company Act (40), regulated by SEC for
retail investor protection.

• Hedge Funds- unregistered pools of managed funds

open only to “qualified” investors based on wealth and/or
income.

• Private Equity Funds- unregistered pools of capital

for direct investment in purchase of entire companies
and business units, “qualified” investors only.
 Why investor interest in Hedge and
Private Equity Funds?
Advantages Presumed for HF/PE:
1. Higher rates of returns can be earned.

2. Riskiness of returns is lower in HF/PE.

3. Improved diversification of portfolios by

including new assets with lower
correlations with existing assets.
 CREDIT SUISSE / TREMONT HEDGE FUND INDEX
 
Ten sub strategies track every major style of hedge fund manager:
 

•Convertible Arbitrage: Exploiting price inefficiencies

between convertible securities and stock.
 

•Dedicated Short Bias: Equity and derivatives portfolios

with net short, “bearish” focus.
•Emerging Markets: Equity and fixed-income investments
in emerging markets worldwide.
 

•Equity Market-Neutral: Offsetting long and short equity

positions that are beta-neutral, currency-neutral, or both.
 
  CREDIT SUISSE/TREMONT HEDGE FUND INDEX
Hedge Fund Manager Style (continued)
 
 
 Event-Driven: Corporate strategies focused on distressed securities,
     

high-yield debt, Regulation D, and risk arbitrage.

 
 Fixed-Income Arbitrage: Exploiting price inefficiencies between related
     

debt securities.
 
 Global Macro: Directional macroeconomic strategies.
     

 
 Long-Short Equity: Directional equity and equity derivative strategies.
     

 
 Managed Futures: Listed futures strategies often driven by technical
     

or market analysis.
 
 Multi Strategy: Multiple strategies from styles above.
     
Hedge Fund “Accredited” Investors
• Exemption from Securities Acts of ’33 ’34
and ICA and IAA of ’40 requires that
investors meet the following:
1. Single investor- two years of income over
$200,000 per year
2. Married investor- two years of joint
income over $300,000
OR Net worth of invested assets over $1
million, excluding personal real estate
 Mutual Fund ICA’40
Regulations
• Custodial requirements
• Liquidity and portfolio diversification
• Restrictions on use of debt leverage
• Short selling restrictions
• Management fee arrangements
• Redemption requirements
• Disclosure and reporting requirements
 Exempt Hedge Funds Operations
• Trade any security or financial instrument
• Operate in any security market in world
• Unlimited use of derivative securities
• Unrestricted use of short selling
• Unlimited use of debt leverage
• Hold concentrated positions
• Set own investor redemption policies
• No extensive disclosure requirements
 Hedge Fund Fee Structures
• Exemption under ICA ‘40 allows:
Any fee structure desired.

This means that fund managers are allowed

to set fees based on assets under
management, and performance fees that
may be “asymmetric” (i.e., heads I win if
returns are positive, tails I do not lose if
returns are negative). (see next table)
Distribution of Management Fees and
Incentive Fees in Hedge Funds
TASS NFR CISDM
(percent) (percent) (percent)

A. Management fees
0 percent - 0.99 percent 5 3 4
1 percent - 1.99 percent 73 72 78
2 percent - 2.99 percent 20 22 17
3 percent and up 3 2 1

B. Incentive fees
0 percent - 19.99 percent 10 10 18
20 percent 85 86 78
20.01 percent and up 5 4 4

Source: TASS, HFR, CISDM

 Three Regulatory Concerns
About Hedge Funds
• Investor Protection due to growth of HF
industry, instances of increasing fraud and
broadening exposure of institutional
investors in HF investments.
• Systemic risk to other regulated financial
institutions caused by HF failures.
• Market Integrity risk caused by HF
activities in the financial markets.
 Taxation of HF/PE: Basic
Structure
• 1. HF/PE in USA is typically structured as a
limited partnership, the general partner being the
HF management company.
• 2. Partnerships are not taxed directly as an
economic entity (i.e. not a legal corporation)
• 3. Profits earned in partnership are reported to
individual partners as income subject to their
Personal Income Tax filings (the good ole Form
1040)
United States Personal and Corporate Taxation

2007 Personal Tax Rates: Married Filing Jointly

If Taxable but not Tax is: of the amount

Income over: over: over:

$0 $15,650 10% $0
$15,650 $63,711 $1565 + 15% $15,650
$63,700 $128,500 $8772 + 25% $63,700
$128,500 $195,850 $24972 + 28% $128,500
$195,850 $349,700 $43830 + 33% $195,850
$349,700 no limit $94601 + 35% $349,700

Interest income taxed as earned income.

Dividend income taxed at flat 15% tax rate.
Long term Capital Gains taxed at 15% tax rate.
Short term Capital Gains taxed as earned income.
 2007 Corporate Tax Rates

If Taxable but not Tax is: of the amount

Income over: over: over:

$0 $50,000 15% $0
$50,000 $75,000 $7500 + 25% $50,000
$75,000 $100,000 $13,750 + 34% $75,000
$100,000 $335,000 $22,250 + 39% $100,000
$335,000 $10,000,000 $113,900 + 34% $335,000
$10,000,000 $15,000,000 $3,400,000 + 35% $10,000,000
$15,000,000 $18,333,333 $5,150,000 + 38% $15,000,000
$18,333,333 no limit 35% $18,333,333

Dividends received from other corporations: 70% exclusion from taxes

Capital Gains taxed as any other corporate income.
 Tax Issue under Debate
1. General Partner earns “carried profits” from
managing funds, as major source of income for
their services.
2. Carried profits are not taxed as income for
services rendered (i.e. wages and salary), but
rather as investment income subject to Long and
Short Term Capital Gains.
3. Partners do not pay highest personal marginal
tax rate (35%) but only 15% rate on Long Term
Capital Gains. (STCG taxed at 35% marginal)
 Illustration of Taxation Issue
Case Study: assume HF earns $5 million of
profits in year 2007. The profits are $3
million in LTCG, and $2 million in short
term gains.
How will this profit be taxed under both the
Corporate Taxation model or as a Limited
Partnership?
How will an individual investor with 10%
ownership of the HF profit after taxes?
 Case Study Taxes
Corporation: Partnership:
Pre-tax Profit $ 5.0 mil Pre-tax profit $ 5.0 mil
Fed Corp Tax $ 1.7 mil Tax LTCG(.15) $ 0.450 mil
After-tax Profit $3.3 mil Tax STCG(.35) $ 0.700 mil
Effective Tax Rate= 34% Total Taxes $1.150 mil
Dividends paid $3.3 mil Effective Tax rate= 23%
Personal Taxes $ 0.495 mil (higher LTCG, lower
Total Tax $2.195 mil (43.9%) effective tax rate)
 Case Study: 10% Investor
Under Partnership taxation, 10% equity
owner pays $115,000 in personal taxes,
with net gains of $385,000 after taxes.

Under Corporate taxation, 10% equity owner

receives $330,000 in dividends and pays
additional $49,500 in personal taxes. Net
gains to investor is $ 280,500 after tax.
 Political Taxation Response
• Congressman Levin (H.R. 2834) bill
proposes that HF/PE managers income be
taxed at 35% rate, eliminating 15% LTCG
treatment.
• Sen. Baucus and Grassley (S. 1624) bill
would remove ability of publicly-traded
partnerships (only for HF/PE) income to be
taxed under partnership rules, hence
taxed as Corporations.
 Politics of Taxation
• Philosophy 1: The federal (and state)
governments should increases taxes on
the rich, especially those earning money
just from investments in paper assets.
• Philosophy 2: Lowering taxation on
invested assets spurs increased economic
performance, and actually increases tax
collections in the future.
• WHICH IS CORRECT? You debate!
 Investor Protection and Regulation
Basic attitude of SEC regarding HF investors is “let them
fend for themselves”.
SEC, in Dec., 2006, adopted rule 203(b)(3)-2 that requires
most HF advisors to be ‘registered’ under IAA ’40. This
will allow SEC oversight regarding 1) conflicts of interest,
2) anti-fraud provisions, 3) more disclosure of financial
records, 4)limits on advisor fees based on performance
(i.e., no “asymmetric” performance fees).
Only HF with “qualified” clients (net worth over $1.5 mil or
min $750,000 invested with advisor) can maintain the
“asymmetric” performance fee structure.
Other HF limits and restrictions not set by SEC, but rather by
contractural relationships with INVESTORS and the
market discipline of CREDITORS and
COUNTERPARTIES.
 Systemic Risk of Hedge Funds
The possibility of a series of Hedge Fund failures and
defaults that are highly correlated with resulting
defaults inflicted on lenders (banks) and other
securities brokerage firms, that occurs over a short
period of time. This may also be caused by a single
major event in the markets or economy.
Causes by be:
1. Illiquidity of assets held by HF due to being non-market
traded, long time to find opposite trade, and asset
being too large to sell to single buyer.
2. Hedge funds may have high serial correlations with
performance in past time periods. This raises potential
that loss in one month may be continued for many
subsequent months.
 Retailization of the Hedge Funds
Methods by which retail investors, below the “accredited” standards,
can invest in the Hedge Funds:
1. More households are meeting “accredited” standards (i.e., in
2002 5.2 million households qualified, and in 2006, 8.9 million
households did).
2. Fund of Funds allow lower investments by retail customers
because the FOF is the “qualified” investor in the individual HF.
However, the FOF advisers charge their advisory fees on top of
fees paid to the individual HF advisors.
3. Buy shares in a Hedge Fund Management Advisory company
when it goes “public” in IPO. (see Fortress Investment Group IPO
in Feb 9, 2007, at price of $18.50 per share, ending after first day
at $31 per share on NYSE)
4. Pension plans (private and public) are investing in HF on behalf of
the many retail customers that are in the pension plan.
 Credit Suisse/Tremont Hedge Fund Index
(year 2006)
 

YTD
Index / Sub Strategies Return

 
Credit Suisse / Tremont Hedge Fund Index 13.86%
 
Convertible Arbitrage 14.30%
Dedicated Short Bias -6.61%
Emerging Markets 20.49%
Equity Market Neutral 11.15%
Event Driven 16.73%
Distressed 15.58%
Multi-Strategy 16.38%
Risk Arbitrage 8.15%
Fixed Income Arbitrage 8.66%
Global Macro 13.53%
Long / Short Equity 14.38%
Managed Futures 8.05%
Multi-Strategy 14.54%
 
 
S&P 500 15.79%
Merrill Lynch All US Convertibles Index 12.83%
Goldman Sachs Commodities Index -15.09%
Credit Suisse High Yield Index 11.82%
Citigroup World Government Bond Index 5.99%
Dow Jones World Index 18.52%
Dow Jones World Emerging Index 26.15%
 
 RETURN STATISTICS (December 2006)

Inception-to-date Cumulative Annualized Annualized Annualized Sharpe

Statistics Return (%) Tot. Net. (%) Ex. Ret. (%) Volatility (%) Ratio (USD)

Credit Suisse / Tremont

Hedge Fund Index 285.41% 10.94% 7.04% 7.66% 0.92

Convertible Arbitrage 208.06% 9.04% 5.15% 4.62% 1.11

Dedicated Short Bias -26.58% -2.38% -6.28% 16.97% -0.37
Emerging Markets 216.03% 9.25% 5.36% 15.99% 0.34
Equity Market Neutral 245.74% 10.01% 6.12% 2.88% 2.12
Event Driven 324.74% 11.77% 7.88% 5.54% 1.42
Fixed Income Arbitrage 125.67% 6.46% 2.57% 3.66% 0.70
Global Macro 420.55% 13.53% 9.64% 10.76% 0.90
Long / Short Equity 340.78% 12.09% 8.20% 10.05% 0.82
Managed Futures 126.53% 6.49% 2.60% 11.84% 0.22
Multi Strategy 227.96% 9.76% 5.79% 4.28% 1.35
S & P 500 283.38% 10.89% 7.00% 14.27% 0.49
MSCI World 212.30% 9.16% 5.26% 13.46% 0.30
CORRELATION STATISTICS ( Inception thru Dec., 2006)

Credit
Suisse / Tremont S & P 500 MSCI World
Hedge Fund Index

Convertible Arbitrage 0.41 0.14 0.13

Dedicated Short Bias -0.49 -0.76 -0.75
Emerging Markets 0.65 0.48 0.54
Equity Market Neutral 0.33 0.36 0.35
Event Driven 0.67 0.56 0.60
Fixed Income Arbitrage 0.45 0.03 0.04
Global Macro 0.85 0.24 0.19
Long / Short Equity 0.79 0.59 0.63
Managed Futures 0.15 -0.14 -0.07
Multi Strategy 0.22 0.10 0.17

Credit Suisse/Tremont
Hedge Fund Index 1.00
S & P 500 0.49 1.00
MSCI World 0.49 0.94 1.00
Summary Statistics for Monthly CSFB / Tremont Hedge Fund Index
Returns and Various Risk Factors, January 1994 - August 2004

Sample Annualized Annualized Corr. With

size mean SD S&P 500

CSFB / Tremont indexes

Hedge funds 128 10.51 8.25 45.9
Convertible arbitrage 128 9.55 4.72 11.0
Convertible short-seller 128 -0.69 17.71 -75.6
Emerging markets 128 8.25 17.28 47.2
Equity market neutral 128 10.01 3.05 39.6
Event driven 128 10.86 5.87 54.3
Distressed 128 12.73 6.78 53.5
Event-driven multistrategy 128 9.87 6.19 46.6
Risk arbitrage 128 7.78 4.39 44.7
Fixed-income arbitrage 128 6.69 3.86 -1.3
Global macro 128 13.85 11.75 20.9
Long/short equity 128 11.51 10.72 57.2
Managed futures 128 6.48 12.21 -22.6
Multistrategy 125 9.10 4.43 5.6

S & P 500 128 11.50 15.84 100.0

Banks 128 21.19 13.03 55.8
LIBOR 128 -0.14 0.78 3.5
USD 128 -0.52 7.51 7.3
Oil 128 15.17 31.69 -1.6
Gold 128 1.21 12.51 -7.2
Lehman Bond 128 6.64 4.11 0.8
Summary Statistics for Monthly Total Returns of
Mutual Funds and Hedge Funds

Mutual funds
Ser Cor.
Sample Mean Std Dev lag 1
Fund Start Size (%) (%) (%)

Vanguard 500 index 76.10 286 1.30 4.27 -4.0

Fidelity Magellan 67.01 402 1.73 6.23 12.4
Investment Company of America 63.01 450 1.17 4.01 1.8
Janus 70.03 364 1.52 4.75 10.5
Fidelity Contrafund 67.05 397 1.29 4.97 7.4
Washington Mutual Investors 63.01 450 1.13 4.09 -0.1
Janus Worldwide 92.01 102 1.81 4.36 11.4
Fidelity Growth and Income 86.01 174 1.54 4.13 5.1
American Century Ultra 81.12 223 1.72 7.11 2.3
Growth Fund of America 64.07 431 1.18 5.35 8.5
Summary Statistics for Monthly Total Returns of
Mutual Funds and Hedge Funds (cont'd)

Hedge funds
Ser Cor.
Sample Mean Std Dev lag 1
Start Size (%) (%) (%)

Convertible / option arbitrage 92.05 104 1.63 0.97 42.6

Relative value 92.12 97 0.66 0.21 25.9
Mortgage-backed securities 93.01 96 1.33 0.79 42.0
High-yield debt 94.06 79 1.30 0.87 33.7
Risk arbitrage A 93.07 90 1.06 0.69 -4.9
Long/short equities 89.07 138 1.18 0.83 -20.2
Multistrategy A 95.01 72 1.08 0.75 48.9
Risk arbitrage B 94.11 74 0.90 0.77 -4.9
Convertible arbitrage A 92.09 100 1.38 1.60 33.8
Convertible arbitrage B 94.07 78 0.78 0.62 32.4
Multistrageby B 89.06 139 1.34 1.63 49.0
Fund of funds 94.10 75 1.68 2.29 29.7

Source: FRB of Atlanta