HEDGE FUNDS: MORE RICHES FOR THE RICH OR TAXES FOR

THE GOVERNMENT?Arthur C. Gudikunst, Ph.D.

Associate Professor of FinanceChristopher 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 Funds5. Taxation of HF/PE Profits6. 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 fees0 percent - 0.99 percent 5 3 41 percent - 1.99 percent 73 72 782 percent - 2.99 percent 20 22 173 percent and up 3 2 1

B. Incentive fees0 percent - 19.99 percent 10 10 1820 percent 85 86 7820.01 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 taxesCapital 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

Total Tax $2.195 mil (43.9%)(higher LTCG, lower 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 FundsMethods 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 SharpeStatistics Return (%) Tot. Net. (%) Ex. Ret. (%) Volatility (%) Ratio (USD)

Credit Suisse / TremontHedge Fund Index 285.41% 10.94% 7.04% 7.66% 0.92

Convertible Arbitrage 208.06% 9.04% 5.15% 4.62% 1.11Dedicated Short Bias -26.58% -2.38% -6.28% 16.97% -0.37Emerging Markets 216.03% 9.25% 5.36% 15.99% 0.34Equity Market Neutral 245.74% 10.01% 6.12% 2.88% 2.12Event Driven 324.74% 11.77% 7.88% 5.54% 1.42Fixed Income Arbitrage 125.67% 6.46% 2.57% 3.66% 0.70Global Macro 420.55% 13.53% 9.64% 10.76% 0.90Long / Short Equity 340.78% 12.09% 8.20% 10.05% 0.82Managed Futures 126.53% 6.49% 2.60% 11.84% 0.22Multi Strategy 227.96% 9.76% 5.79% 4.28% 1.35S & P 500 283.38% 10.89% 7.00% 14.27% 0.49MSCI World 212.30% 9.16% 5.26% 13.46% 0.30

CORRELATION STATISTICS ( Inception thru Dec., 2006)

CreditSuisse / Tremont S & P 500 MSCI World

Hedge Fund Index

Convertible Arbitrage 0.41 0.14 0.13Dedicated Short Bias -0.49 -0.76 -0.75Emerging Markets 0.65 0.48 0.54Equity Market Neutral 0.33 0.36 0.35Event Driven 0.67 0.56 0.60Fixed Income Arbitrage 0.45 0.03 0.04Global Macro 0.85 0.24 0.19Long / Short Equity 0.79 0.59 0.63Managed Futures 0.15 -0.14 -0.07Multi Strategy 0.22 0.10 0.17

Credit Suisse/TremontHedge Fund Index 1.00S & P 500 0.49 1.00MSCI World 0.49 0.94 1.00

Summary Statistics for Monthly CSFB / Tremont Hedge Fund IndexReturns and Various Risk Factors, January 1994 - August 2004

Sample Annualized Annualized Corr. Withsize mean SD S&P 500

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

S & P 500 128 11.50 15.84 100.0Banks 128 21.19 13.03 55.8LIBOR 128 -0.14 0.78 3.5USD 128 -0.52 7.51 7.3Oil 128 15.17 31.69 -1.6Gold 128 1.21 12.51 -7.2Lehman Bond 128 6.64 4.11 0.8

Summary Statistics for Monthly Total Returns of Mutual Funds and Hedge Funds

Mutual fundsSer Cor.

Sample Mean Std Dev lag 1Fund Start Size (%) (%) (%)

Vanguard 500 index 76.10 286 1.30 4.27 -4.0Fidelity Magellan 67.01 402 1.73 6.23 12.4Investment Company of America 63.01 450 1.17 4.01 1.8Janus 70.03 364 1.52 4.75 10.5Fidelity Contrafund 67.05 397 1.29 4.97 7.4Washington Mutual Investors 63.01 450 1.13 4.09 -0.1Janus Worldwide 92.01 102 1.81 4.36 11.4Fidelity Growth and Income 86.01 174 1.54 4.13 5.1American Century Ultra 81.12 223 1.72 7.11 2.3Growth 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 fundsSer Cor.

Sample Mean Std Dev lag 1Start Size (%) (%) (%)

Convertible / option arbitrage 92.05 104 1.63 0.97 42.6Relative value 92.12 97 0.66 0.21 25.9Mortgage-backed securities 93.01 96 1.33 0.79 42.0High-yield debt 94.06 79 1.30 0.87 33.7Risk arbitrage A 93.07 90 1.06 0.69 -4.9Long/short equities 89.07 138 1.18 0.83 -20.2Multistrategy A 95.01 72 1.08 0.75 48.9Risk arbitrage B 94.11 74 0.90 0.77 -4.9Convertible arbitrage A 92.09 100 1.38 1.60 33.8Convertible arbitrage B 94.07 78 0.78 0.62 32.4Multistrageby B 89.06 139 1.34 1.63 49.0Fund of funds 94.10 75 1.68 2.29 29.7

Source: FRB of Atlanta