A Hedge Fund Tax Tragedy To Ponder

September 08, 2014

Add onerous taxes to the parade of hedge fund shortcomings.

This is part of a regular series of thought-leadership pieces from some of the more influential ETF asset management in the money management industry. Todays article is by Hafeez Esmail, San Francisco-based Main Management’s director of marketing.

Let’s hope the smart money is slowly beginning to recognize the folly of most hedge fund investing.

While there are handful of managers with strong track records—most of whom are either closed or inaccessible to affluent investors—the vast majority of hedge funds are becoming known for underperformance and self-enrichment.

In addition to anemic returns, there’s another aspect of hedge fund returns that warrants scrutiny— taxation. While hedge funds tend to be varied in their approaches, a large number of them have heavy turnover in the quest for returns. This is a reason they are loved by prime brokers, because lots of transactions and heavy volumes result in lots of trading commissions.

Short-Term Gains = Extra Tax Pain

So, in the event you’re fortunate enough to have positive returns, those returns are likely to be predominantly short-term in nature.

With tax rates going nowhere but higher, and top-earner tax rates in a state like California exceeding 50 percent (federal and state combined), it’s clear that closer examination is needed not just of after-fee returns, but of returns after taxes as well.

Let’s combine the 2 percent expense and 20 percent incentive structure typical of hedge funds with the preponderance of short-term gains—in the context of arguably rare gains—that result from significant turnover. Because Main Management is based in San Francisco, I’ll also take the liberty of assuming the client lives in California and thus has an approximate combined 50 percent federal and state tax burden.

With these assumptions, here’s how the numbers work out: To get a 5 percent net after-fee, after-tax return for a hedge fund, you need a gross return around 14 percent. Yes, 14 percent. Let that sink in—a 14 percent gross return turns into a take-home return for the client of 5 percent.

Using a back-of-the-envelope calculation, if you take away the 2 percent and 20 percent, you’re down to 9.6 percent net after fees. After federal and state taxes in California, you’re right around 5 percent, or perhaps a bit lower. For a more scientific approach, albeit with very similar conclusions, see this analysis in the New York Times.

Ultimately, my question is this: If financial advisors are fiduciaries who are obligated to act in their clients’ best interest, how can they in good conscience continue to recommend such instruments?



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