1st Place Winner, 2005 Stephen L. Kessler Writing Award

Making Hedge Fund Investing More Tax-Efficient

By Thomas J. Boczar, Esq., CFA, and Mark Fichtenbaum, Esq., CPA
Twenty-First Securities Corporation
Originally published by The Monitor, Investment Management Consultants Association, July/August 2004.

Since the mid-1990s, the hedge fund industry has exhibited explosive growth, whether measured by the number of funds available to investors or by total assets under management.

Advisers to high-net-worth (HNW) investors have been increasing their allocations to hedge funds and apparently for good reason. Hedge funds appear to exhibit risk somewhat below that of the S&P 500, with returns slightly below the index as well. However, hedge funds do not appear to be highly correlated with most other asset classes, including the S&P 500. In particular, hedge funds appear to significantly outperform the broader market during periods of poor market returns.¹ Also, hedge funds had a Sharpe ratio that is significantly higher than the S&P 500, implying a superior risk-return tradeoff.² Thus, hedge funds constitute an asset class with the volatility and return expectations similar to the S&P 500, but one that is not highly correlated with the S&P 500 or any other asset class. This powerful combination has attracted the attention of the investment community, as it should enable investors to construct portfolios with lower risk while not significantly affecting returns.

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 their inherent tax inefficiency. Because of the nature of the various investment processes and styles that hedge fund managers typically employ, a very high percentage of the profits that are generated will be in the form of investment income taxed at the ordinary rate.

For instance, many hedge funds utilize short selling. In a short sale, the interest the investor earns on the short sale proceeds (i.e., short interest rebate) 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. In a similar vein, if a long position is hedged, most, if not all of the time, the dividends received will not be "qualified" dividend income subject to the 15% long-term capital gain rate. Rather, such dividends will be taxed at ordinary rates.  

However, numerous investment tools, structures, and strategies are being devised to increase the tax efficiency of hedge fund investing.³ This article will focus on how investors can utilize synthetic ownership to enhance the tax efficiency of hedge fund investing and compare and contrast the traditional way of investing in hedge funds (e.g., through a fund of funds) with synthetic ownership.

U.S. Tax System Relating to the Taxation of Financial Instruments

There are numerous methods that an investor can use to gain exposure to a particular investment. For instance, if investors wish to own a particular investment, they can, of course, use cash to buy that particular investment outright.  Alternatively, an investor can achieve virtually identical economic exposure to an outright purchase by investing synthetically in that investment.⁴ Thus, there is financial equivalency among different financial instruments. However, under our current tax system, these instruments are often taxed quite differently. This presents an opportunity for astute investors. Taxable investors should implement their investment plans by selecting the tools that minimize their income tax liability.

The Constructive Ownership Rules

As stated above, hedge funds are generally very inefficient in terms of taxes. They produce no cash income for their participants, but each year, participants must pay taxes on their shares of partnership income. Before the passage of the constructive ownership rules in 1999, investors could ameliorate the tax burden by structuring their hedge fund investments through derivatives on individual funds. Using derivative ownership rather than direct ownership, investors deferred the realization of tax until they exited the derivative and then were taxed only at long-term gain rates, effectively converting income that would have been currently taxed at the highest marginal rates into long-term gains paid only when exiting the investment.

The optimal tool was a swap. With a swap, the investor was able to take a "wait-and-see" approach. If the investment generated a profit, the swap could be terminated prior to its stated expiration date, and the result was a long-term capital gain (assuming the swap was held open for the requisite holding period).⁵ If, on the other hand, the investment generated a loss, the investor could either (1) allow the swap to expire with the resulting loss treated as an ordinary deduction or (2) terminate the swap prior to its stated expiration, thereby generating a capital loss.⁶

The use of either a forward purchase contract or an option combination (long call and short put with the same strike price and expiration date) delivered the same deferral and conversion of profits to long-term capital gain, but did not deliver the potential for an ordinary deduction if the investment went sour. Thus, most well-advised investors used the swap structure.  

However, in 1998, in sorting through the wreckage of the Long Term Capital Management fiasco, Congress first became aware that wealthy individual investors were using swaps and other derivative structures to gain tax-efficient exposure to individual hedge funds. As a result of this perceived abuse, Congress quickly enacted Code Section 1260, referred to as the constructive ownership rules. This anti-abuse provision, which takes a "rifle shot" approach, was specifically designed to eliminate the perceived abuse of investing in "pass-thru" vehicles, such as individual hedge funds and hedge hinds of funds, through a synthetic long structure.⁷

More specifically, Code Section 1260 requires that investors be treated as entering into a "constructive ownership" transaction should they attempt to gain exposure to the investment returns generated by an underlying "pass-thru entity" (i.e., the various ways that a hedge fund might be structured by (1) entering into the long side of a total return swap, (2) entering into a forward purchase or futures contract, or (3) simultaneously buying a call and selling a put with the same strike price and maturity date.)

If the constructive ownership rules do apply to a given situation, any long-term capital gain recognized upon disposition of the derivative must be recharacterized as ordinary income, except to the extent long-term capital gain treatment would have been recognized had the investor held the underlying hedge fund investment directly. In addition, an interest charge is imposed to the extent the investor deferred the recognition of income.

Wall Street's Response to the Constructive Ownership Rules

The constructive ownership rules ended the use of derivatives to gain synthetic long exposure to either an individual fund or a hedge fund of funds. However, it remains possible to gain exposure to (1) an individual hedge fund or a fiord of funds through a call option and (2) an index, including a hedge fund index through a synthetic long structure.

Call Options

Because the economics of owning either an at-the-money or slightly in-the-money call differ significantly from outright ownership of the underlying fund, derivative dealers have offered certain call option structures (on either individual hedge funds or hedge funds of funds) to investors since the enactment of these rules. However, investor appetite for such calls has been rather muted, probably for several reasons. If the investment is structured as a "plain vanilla" call, the call premium (i.e., its purchase price) will be significant, probably in the range of 20 percent to 25 percent of the funds' cost. Because of the high cost, most investors do not find the risk/reward profile of plain vanilla calls on hedge funds to be particularly attractive.

In order to reduce the call premium and thus enhance the perceived risk/reward profile of the call structure, derivative dealers have offered "knock-out" calls to investors. In this version, the investor pays a reduced up-front premium, but should the underlying investment decline to a certain level, the call disappears (i.e., it is "knocked out") unless the investor pays an additional agreed-upon premium to the dealer at that time. Although the marketplace refers to this type of investment as a "call," it can be argued that it more closely resembles the leveraged purchase of the underlying fund along with the potential for a margin call. Some tax practitioners feel that special features such as these can change the investment's payoff profile enough to trigger the constructive ownership rules. Great care needs to be taken here.

Investable Hedge Fund Indexes

The advent of investable hedge fund indexes has created new opportunities for investors interested in obtaining exposure to hedge funds. Investable hedge fund indexes offer investors exposure to either the broad hedge fund universe or, alternatively, diversification between managers within an investment style or process, without a second layer of performance fees.

A number of investable hedge fund indexes have been developed over the past year or so. Currently, six investable hedge fund indexes are available to investors, including CSFB Tremont, HFR (Hedge Fund Research), MSCI (Morgan Stanley), S&P, and Dow Jones. Each of these indexes is created and maintained utilizing differing methodologies, which can be quite complex. Exhibit A describes the various investment processes/styles that are included in each index, the total number of managers composing each index, and how each index is weighted.

Investable hedge fund indexes allow derivative dealers to offer investors synthetic exposure to the underlying index because the dealers can hedge themselves through an investment in the index. Although a taxable investor could make a direct cash investment in an investable hedge fund index, such an investment would still suffer from tax inefficiency because the investor would be currently subject to taxation and most of the profits would be investment income taxed at the 35 percent rate.

Alternatively, investing in a hedge fund index through a derivative should be more tax efficient than direct ownership where there are yearly realizations of income passed through to partners.

As discussed previously, the constructive ownership rules eliminated the tax advantages associated with the use of derivatives to acquire exposure to pass-thru vehicles such as hedge funds. However, these advantages should still apply if investors employ derivatives to invest in an index. Derivatives on a hedge fund index should not be treated any differently than derivatives on any other index. In particular, a properly structured synthetic investment should allow taxpayers to defer the recognition of hedge fund profits and capture these profits as long-term capital gains when the derivative is closed out as long as the underlying investment is an index and not a fund itself.

When the derivative is disposed of (or terminated), any gain (or loss) realized on it should be capital in nature. So if the contract is terminated after 12 months, any gain recognized at that time should be long-term capital gain. Therefore, interest, short-term gains, and "non-qualified" dividend income that would otherwise be realized by the hedge funds and taxed currently at the ordinary rate of 35 percent should be deferred until the derivative is terminated and converted into long-term capital gain, which is taxed at only 15 percent.

It is worth noting again that an investor should be able to achieve synthetic long exposure to an investable hedge fund index (e.g., a call option structure is not necessary) without triggering the constructive ownership rules.⁸

Customized Index Investing

Larger investors (typically $5 million minimum investment) have the flexibility to utilize various over-the-counter derivative structures on several different indexes. The three derivative structures investors can utilize are a (1) forward purchase contract, (2) long call/short put combination, or (3) total return swap.

As described previously, the use of a swap would appear to deliver a potentially superior tax result because of the "wait-and-see" approach that is utilized under current law. However, investors should be aware that regulations have been proposed, with a possibly retroactive effective date, that would eliminate this advantage of a swap.⁹ Thus, most tax practitioners feel that the use of a forward purchase contract is probably the best tool as it delivers the desired tax result with a minimum of moving parts.

For example, Standard & Poors offers not only a broad hedge fund index but also narrow indexes on certain styles such as convertible arbitrage and risk arbitrage. An investor could use a derivative to gain tax-efficient exposure to either the broader index or to one or more of the narrow indexes.

Structured notes, the value of which is tied to a broad index, are
also increasingly being used by HNW investors. If structured properly, such an investment should be treated as a forward purchase contract for tax purposes. Therefore, investors should benefit from a deferral and conversion of all profits to long-term capital gain if the investment is held at least one year. There are no additional incentive fees as there typically are in a fund of funds, and the investor achieves diversified exposure to a broad index of hedge funds and therefore avoids fund-specific risk.

In addition, structured notes offer administrative efficiencies as well. Structured notes are typically offered by the dealer on a continuous basis, meaning the investor can purchase units at any time. Weekly liquidity is sometimes available. A small minimum investment (sometimes as low as $50,000) is permitted. The investor does not need to be "accredited" or "super-accredited" (of course, the investment must be "suitable" for the investor). No subscription documents are required. The notes are DTC eligible and can be custodied wherever the investor wishes. Finally, because the investor is not buying into a partnership, no K-1 or 1099 tax forms are generated.

These intriguing investment tools (OTC derivatives and structured notes) are currently generating high levels of interest from the wealth management community.

In the ultra-HNW marketplace, investors are beginning to take note of and apply the research that is being done on hedge fund returns and are using these tools (derivatives and structured notes on hedge fund indexes) to modify their hedge fund portfolio construction methodologies. More specifically, some investors are moving away from the more traditional method of gaining exposure to hedge funds (e.g., a fund of funds approach) and are using these tools to implement a "passive core/active satellite" approach to hedge fund investing.

Why is this happening? It has been argued that the main disadvantage of investing in hedge funds through indexes is that it deprives investors of the opportunity to capture the potential outperformance (i.e., alpha) of a particular manager or managers. However, if exposure to the index is achieved through a derivative, the tax advantages will often outweigh the alpha derived from superior management within a style.

For instance, a 2001 study by Professors Amenc and Martellini found that within the most popular hedge fund index management styles, individual managers' performances tend to be quite similar. The study, titled "The Brave New World of Hedge Fund Indexes," showed that for styles such as convertible arbitrage, emerging markets, event-driven, merger arbitrage, short selling, and distressed securities, correlation among managers within the style ranged from 81 percent to 92 percent.¹⁰ Because of this realization, investors are now beginning to implement a "passive core/active satellite" approach to hedge fund investing.

The idea is to achieve tax-efficient, broad-based exposure to hedge funds through an index and then use research/active management to search for alpha in those investment processes and styles in which the research indicates alpha is most likely to be found (e.g., macro).

In other words, indexes will not appeal to investors who are seeking the next "Soros" but are appropriate for those searching for a broad-based approach or exposure to investment styles where the managers' returns tend to cluster.

Exhibit B is a true "eye-opener." Under our assumptions, which we think are quite reasonable, this analysis shows that a typical fund of funds would have to generate about 480 basis points of pretax alpha each year to break even after fees and taxes with a typical index-linked note. This supports our earlier point that if exposure to a hedge fund index is achieved through a derivative, the tax advantages will often outweigh the alpha that might otherwise be derived from an active approach.

In the "mass affluent" HNW market, we see especially strong interest by modest-sized agency and trust accounts in structured notes. These include accounts that otherwise might not be able to invest in a fund of funds because of high minimum investment or net worth/income requirements. In the mass affluent marketplace, structured notes can deliver a tax-efficient, cost-efficient, and administratively convenient method for a large number of accounts to quickly gain broad-based exposure to hedge funds.

Endnotes

1. Purcell, David and Crowley, Paul, "The Reality of Hedge Funds," Journal of Investing, Fall 1999 from IMCA Wealth Management Certificate Program, Part I, Wealth Accumulation materials.

2. Liang, Bing, "Hedge Fund Performance: 1990-1999," Financial Analysts Journal, January/February 2001 from IMCA Wealth Management Certificate Program, Part I, Wealth Accumulation materials.

3. Paulson, Reece, "Integration of Hedge Funds and Wealth Transfer Structures: Where Should They Be And Why," Monitor, November/December 2003.

4. For instance, the put/call theorem suggests that investors can gain equivalent exposure to an investment by either (1) purchasing the asset outright or (2) combining an investment in the risk-free rate (e.g., Treasuries) with a purchase of a long call and the sale of a short put (each with the same strike price and all with the same maturity).

5. Code Sec. 1234A.

6. See TAM 9730007, Code Sec. 212 and Reg. Sec. 1-212-1 (q). Note that a miscellaneous itemized deduction of this sort is subject to the limitations Imposed under both Code sections 67 and 68.

7. Code Sec. 1260 applies when an investor obtains the economic ownership of a pass-thru entity via specific derivatives. Based on analogies to other Internal Revenue Code provisions, including Code Sec. 246 and Code Sec. 1092, indexes consisting of twenty or more funds should not be disaggregated. As such, a derivative based on an index that comprises twenty or more funds should not be treated as creating a constructive ownership of the underlying funds in the index.

8. See note 7 above.

9. See Prop. Reg. Sec. 1.162-30, Prop. Reg. Sec. 1.212-1(q), Proposed Amendments to Prop. Reg. Sec. 1.446-3 and Prop. Reg. Sec 
1.1234A-1. All were released on February 25, 2004.

10. Amenc, Noel, and Martinelli, Lionel, "The Brave New World of Hedge Fund Indexes," February 4, 2003.

The information and opinions contained herein have been prepared for informational purposes only and do not constitute a recommendation of, or a solicitation for, any transaction or trading strategy described herein. The strategies and transactions described herein are not suitable for every investor and require analysis by sophisticated and knowledgeable users of financial instruments. Twenty-First Securities does not render legal, accounting or tax advice, and all investors should consult with their advisers regarding the consequences of the strategies and transactions described herein.