Types of Hedge Fund Investors

Suppose an individual paid individual income tax at the 37 percent
rate for ordinary income and short-term gains and paid 18 percent on
long-term gains.
2
Suppose further that capital gains can be postponed on
stock investments for five years. The after-tax return on the stock portfolio,
assuming a pretax annual return of 10 percent and a short-term discount
rate of 5 percent, is given by equation (3.1).
Long-term stock return in constant dollars:
(3.1)
To do as well in a hedge fund investment, the after-tax net return should be
at least as high. The break-even return on a hedge fund whose results are
taxed at the 37 percent ordinary rate and where there is no deferral of tax
liability is shown in equation (3.2) to be 13.4263 percent.
Short-term hedge fund return:
(3.2)
(Ignoring any possible delay in paying current tax liability)
In other words, in this scenario, a high-net-worth individual must earn 34
percent higher pretax return than stocks to do as well after taxes.
High-net-worth individuals may invest in hedge funds because they ex-
pect a sufficiently higher return to accept the tax disadvantage of the in-
vestment vehicle. These individuals may believe that hedge fund returns are
less volatile than stock returns to justify the tax-disadvantaged investment.
Finally, the hedge fund may provide a low correlation of return to other as-
sets in the portfolio so a small investment in hedge funds (say 10 percent to
20 percent) may lower the volatility of the portfolio enough to justify mak-
ing a hedge fund investment.
The answer to question 2.13 in Chapter 2 presents a formula for the
average return on a portfolio. That formula with an extension account for
taxes is shown in equation (3.3). Assume that the pretax expected return is
10 percent for both a traditional stock position and a hedge fund. Assume
also that the investor pays ordinary income tax at 37 percent and long-
term capital gains are taxed at 18 percent. Suppose that 100 percent of the
stock return is taxable as long-term capital gain and 100 percent of the
hedge fund return is taxed as ordinary income. For simplicity, assume that
After-Tax Net Return
Types of Hedge Fund Investors
37
ccc_mccrary_ch03_35-58.qxd 10/6/04 1:41 PM Page 37