Hedge Fund

Stock prices reflect the timing and magnitude of dividend payments
(among other factors). Corporations announce a dividend payment to be
paid to all holders on a particular future date (the ex-dividend date)
payable a short time later (the dividend payment date). Prices of stocks
move down on the ex-dividend date because buyers of the stock will not
receive the announced dividend and sellers of the stock will nevertheless
keep the dividend.
Pending orders on most stock exchanges are lowered by the amount
of the dividend on the ex-dividend date. However, stocks generally de-
cline on the ex-dividend date by less than the amount of the dividend. If
all investors paid tax at the same rate, the decline in price should on aver-
age equal the after-tax amount of any announced dividend. In practice,
investors pay many different tax rates, ranging from zero for pension
funds, foundations, and endowments to the maximum tax rate on ordi-
nary income (35 percent in the United States for 2003). Taxable U.S. in-
vestors may pay a lower tax rate for capital gains than for income.
Offshore investors may also have a preference for gains over income. The
price of a stock tends to fall by less than the amount of the pretax divi-
dend but more than the after-tax dividend, using the maximum personal
income tax rate.
A hedge fund can capture a dividend by buying the shares near the end
of the day preceding the ex-dividend date and selling the stock early the
next trading day. For this overnight exposure, the hedge fund can expect to
receive a dividend in a few weeks and an immediate capital loss slightly
smaller than the dividend. U.S. hedge fund investors would pay the same
tax rate on the short-term capital gain or loss as they pay on ordinary in-
come. Similarly, offshore investors pay no U.S. tax on either the price dif-
ference or the dividend income.
The hedge fund is also exposed to gains and losses during the time the
fund holds the shares. The hedge fund can hedge the general direction of
stock prices by selling an index future but will generally not hedge move-
ments in the specific securities. Over time, if index prices are flat, the hedge
fund can expect to accumulate capital losses and ordinary income. The
hedge fund must be careful not to produce losses that cannot be deducted
on the tax returns of hedge fund investors.
Convertible Arbitrage
Convertible bonds and convertible preferred stock are hybrid securities,
having many of the characteristics of debt and many of the characteristics
of equity. Investors have a built-in option to convert from the debtlike in-
strument to regular common stock. This option can be very valuable. Of-
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HEDGE FUND COURSE
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