investors hold shares in private hedge or venture funds, they may
indirectly have unrealized profits in specific stocks in the fund
portfolios. In this
situation, the hedge or venture fund investor cannot actually sell
the specific stock. However,
a passive investor may enter into completely
separate personal investments to protect his or her share of a
fundís profitable position. This strict separation of the two
holdings has interesting tax implications.
Completely Separate Personal
investors in private hedge and venture funds usually cannot make
investment decisions for the funds.
As a result, they may believe that there is no way to
protect their unrealized gains.
In most situations, however, it is possible for investors
in collective vehicles to create hedges that protect gains in
possible hedge would involve short sales. A short sale is a sale
of a stock the investor does not own. If the stock goes down, the
short seller will make money, and if the stock goes up, the short
seller will lose. Therefore, a short sale combined with the
indirect ownership should create an economic situation that is
similar to a ďregularĒ sale.
From a tax perspective, this approach might appear
problematic, because when a fund investor does a personal short
sale of a fund holding, the combination of the personal hedge and
the holding in the collective investment will include all the
elements of a short against the box.
A short against the box often constitutes a constructive
sale. In this
situation, however, if the investor has no control over the
disposition of the long stock in the fund, and if the short
position is kept strictly separate from the fund, then the
combined holdings should not constitute a constructive sale for
regulatory caveats apply to this approach. The investor canít
directly or indirectly own more than 50% of the fund; otherwise,
the combined positions will constitute a constructive sale.
Moreover, the strategy is only available to investors whose
role in the fund is strictly passive; if an investor has control
over fund decisions, then the strategy might constitute a
constructive sale. Finally,
this strategy requires collateral.
who use this approach should take steps to apprise themselves of
the fundís investment decisions.
In particular, they need to know if the fund sells the
stock that they have shorted. If this should happen, the investor
can undo the potential risks of the short sale by purchasing the
hedging of collective vehicle components can be somewhat
complicated. Investors need to apprise themselves carefully of the
effects of potential hedging transactions before they proceed.
In many situations, however, a viable hedge can be
constructed to protect an underlying stock holding without
triggering any tax.
For an interactive overview of
hedging and monetizing possibilities for different types of
appreciated securities, investors can consult Twenty-First
Securities 'hedging low-basis
stock decision tree'.
|This article and
other articles herein
information purposes only. They are not intended to be
an offer to engage in any securities transactions or to
provide specific financial, legal or tax advice. Articles may
have been rendered partly inaccurate by events that have
occurred since publication. Investors should consult
their advisers before acting on any topics discussed herein. |
Purchasers of hedge funds,
including hedge fund of funds, should carefully review the
fund's offering materials. Hedge funds and hedge fund of
funds have a high degree of risk, including, without
limitation, that these funds typically employ leverage and
other speculative investment practices, that the ability to
make withdrawals typically is very limited, that these funds
are not subject to the same regulatory requirements as mutual
funds, and that an investor can lose all or a substantial
amount of his investment.