The Achilles heel of hedge funds — tax inefficiency — could soon send investors limping toward other options.
“If investors feel they are getting less after-tax income, they will find other alternative investments,” said Ken Rubenstein, senior partner at the law firm Rubenstein & Rubenstein LLP, which specializes in hedge funds.
Historically, investors have overlooked the tax consequences of hedge fund investing because the funds have outperformed other asset classes. But last year hedge funds lost 18% of their value, on average, which although better than the 38.5% decline in the S&P 500 stock index, demonstrated that they are not invincible.
If tax rates rise, as most ob-servers expect given the ballooning federal deficit, hedge funds may find themselves in a structural bind should investors become more conscious of after-tax returns.
“The nature of what hedge funds do doesn't lead to a lot of tax efficiency,” said Jeffrey Mindlin, chief operating officer at Advanced Equities Asset Management Inc.
Hedge funds are characterized by high portfolio turnover, which leads to lots of short-term gains taxed at ordinary income rates. But managing a portfolio to avoid short-term gains can adversely affect performance and hedge fund manager income.
“Why should a hedge fund manager care about tax efficiency if he doesn't get anything out of it?” said Maury Cartine, a partner at the accounting firm Marcum LLP, which specializes in hedge fund services.
Consider what happens when a manager sells a stock held for 11 months.
If the sale generates a $50 profit, a shareholder's tax bill would be $17.50. But if the stock were sold a month later, the capital gain would be considered long term and the tax bill, based on the 15% long-term rate, would drop to $7.50.
But, if during that one-month wait the stock price fell and profits dropped to $40, the manager would see a significant decline in his or her performance fee, which typically ranges from 10% to 20% of profits.
“There are lots of examples of how a manager can do himself a disservice by trying to be more tax-efficient,” Mr. Cartine said. “Basically, providing tax efficiency to investors in a hedge fund comes with a cost that has to be absorbed by the manager.”
The tax-versus-performance dilemma can get even stickier when it comes to master feeder funds, which involve managing the same strategy for both offshore and domestic hedge fund investors.
Because most offshore investors are not subject to U.S. taxes, a hedge fund manager could be charged with shirking his fiduciary duty by managing for tax efficiency over performance.
Mr. Mindlin, whose firm oversees $500 million in separately managed account portfolios, has started focusing on alternatives to hedge funds in order to reduce the tax hit, even if those other choices are not a perfect replacement.
Several strategies use simple instruments such as mutual funds to mimic the return stream of a broad hedge fund index. Such replicators, including The Goldman Sachs Group Inc.'s Absolute Return Tracker Fund, which simulates the average return of 4,000 hedge funds, can be more tax-efficient than a pure hedge fund but aren't nearly as nimble or precise as the hedge funds themselves.
Some structured notes also can be a more tax-friendly alternative to certain hedge fund strategies, but that introduces a risk that the issuer could go belly up like Lehman Brothers Holdings Inc. did last year.
“The problem is, anytime you start playing around with engineered products to try and avoid taxes, you lose in the long run because the IRS will find a way to block it,” said Charles Gradante, managing director at Hennessee Group LLC, a hedge fund advisory firm.
“Most clients criticize hedge funds for generating a lot of short-term profits that are taxed as ordinary income,” he added. “But over a long period of time, we think it's still more beneficial to own hedge funds.”
Some advisers also prefer to stick with hedge funds despite their tax flaws.
“First and foremost, we're using hedge funds to reduce risk and enhance returns, and I would welcome more-tax-efficient strategies, but not at the expense of performance,” said Thomas Orecchio, principal at Modera Wealth Management Inc., which has $450 million under advisement.
In the meantime, advisers such as Mr. Mindlin are trying to help clients by investing in hedge funds through qualified retirement accounts.
But that channel can be narrow since most hedge funds, in an effort to avoid additional regulatory oversight, try to limit qualified assets to less than 25% of the fund.
“Going forward in an environment where capital gains taxes are likely to go up, it seems like the time is right for some tax efficiency in the hedge funds space,” Mr. Mindlin said.
Marc LoPresti, a partner in Tagliaferro & LoPresti LLP, shares that point of view. “Investors would love to see more tax efficiency, but I don't know anybody who has come up with a secret sauce.” he said.
E-mail Jeff Benjamin at [email protected].
