Have Hedge Funds Lived Up to The Hype?
Cory Lyon, TFG Financial Advisors
Recent studies show that investors continue to pour money into hedge funds, which have now hit a record $3+ trillion. Despite ample evidence of their underperformance, hedge funds continue to attract great attention from investors. But one has to wonder why, in light of the hype and hope that investors so often hear from hedge fund managers, many hedge funds haven’t become the universal remedy for negative share market returns. Hedge funds are not for the meek – they require a level of sophistication and investors must have both the knowledge and experience necessary to evaluate and understand the risks and merits of such an investment. Then there’s the tax implications…..
Here’s what you need to know in a nutshell:
1. A hedge fund isn’t a specific type of investment. It is a pooled investment structure setup as limited partnership or a limited liability company by a money manager or registered investment advisor. Whereas a mutual fund issues shares to its investors, a hedge fund will set up as a partnership and issue ownership. So instead of being paid in dividends and growth, you experience the profits (and losses) of the hedge fund.
2. The hedge fund manager raises money from outside investors and then invests it according to a particular strategy. You buy into it with large amounts of cash, and receive ownership. As the hedge fund grows you share in the profit (minus a fee for the management). There are hedge funds that trade everything from junk bonds to real estate, even hedge funds that put money to work in assets like patents and music rights. There are hedge funds that engage in private equity purchasing privately held businesses, improving operations, and later sponsoring an initial public offering. Basically hedge funds can specialize in just about anything, even “long-only” equities where they only buy common stock and never sell short.
3. Hedge funds are taxed as pass-through entities and issue a K-1 to each investor.
4. Hedge funds are essentially high end investment vehicles for accredited and sophisticated investors who meet one of the following standards:
• An executive, partner, director, or other qualified person tied to the hedge fund itself.
• An employee benefit plan or trust fund with a minimum net worth of $5,000,000, not specifically formed for the purposes of making the investment, and
• Any entity in which all of the equity investors are accredited investors on their own merit.
Hedge funds might be tempting due to their ability to create high returns, but the risk of this type of investment is also extremely high. Many hedge funds will require your money be locked in, withdrawals may take several weeks to over a year. Fees tend to be higher than in traditional managed funds as well. A hedge fund can be a great investment, but can also present complications when tax time rolls around. Expense deduction depends on the type of fund — trader or investor — rapid portfolio turnover or holding securities for a longer duration. Both types can deduct all ordinary and necessary expenses, but for an investor in an investor fund they will be classified as miscellaneous itemized deductions and subject to the 2% of adjusted gross income (AGI) limitation.
Hedge funds often have investment interest expense, since they make use of leveraging. To the extent the interest expense exceeds investment income, the excess is carried forward indefinitely.
Hedge funds that qualify as trader funds are generally not subject to passive activity loss limitations, which means investors can use their share of hedge fund ordinary losses to offset unrelated active ordinary income (such as salary), and capital losses from the fund may offset unrelated capital gains.
Hedge funds are often a mix of trader and investor activities and include both non-passive and passive income. This adds complexity for tax returns. Hedge funds often do not issue their Form K-1 to the investor in a timely fashion, requiring an extension of the investor’s tax return.
If you’re curious about how “hedge” funds got their name, the original hedge funds were structured to hold stocks both long and short (positions were “hedged”) so that investors made money regardless of whether the market increased or decreased. For example, you would buy Coca Cola shares at $5, believing the price will go up in the long run. But just in case of market volatility, you sell (or short) Pepsi. So if the soda industry falls off, you at least made the money you lost in Coke by selling Pepsi. This strategy reduces your risk. Hedge funds were initially set up to emulate strategies like this on a very large scale, and after a time the name stuck!
Contact Us: Basically a hedge fund is a company with a strategy to create growth of capital. Curious about the performance of your hedge fund investment? The fees you are paying? We can do an analysis of your investments and provide a breakdown on the tax implications of your hedge fund. Feel free to contact me, Cory Lyon, directly at 561-209-1120, with any questions regarding financial investment strategies. At TFG, we believe in customized investment portfolio design and personalized asset management. I act as a fiduciary for all my clients.