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Hedge Fund Demystification

Hedge funds are some of the most well known, yet misunderstood, entities in the U.S. Nearly everyone has heard about them. Few, though, actually know how these funds operate. When most people hear the term “hedge fund,” they think of high risk, high stakes investing for the purpose of making the wealthy even wealthier. This may hold some truth, but the full picture is much more nuanced. The term “hedge fund” is actually a bit outdated in itself. Hedging typically refers to risk diminution, but it can actually embrace risky strategies in order to increase profits for investors. These types of funds are similar to other pooled funds – such as mutual funds – which involve multiple contributions managed by a central figure or team. However, hedge funds have a number of features which set them apart from other types of investments.

Hedge Funds are a Unique Investment

In this post, we will describe the features which make hedge funds unique among investments. We will also discuss the arrangement which hedge funds commonly utilize in order to receive optimal tax treatment. The taxation of this type of investment has become a more and more prominent issue in recent years. This is no surprise. The total value of assets managed by hedge funds in the U.S. is roughly $3.2 trillion.. Simply put, these funds have one overarching goal. The exist in order to maximize investor returns. Toward this goal, hedge funds employ a wide range of strategies and invest in different assets. But the thing which is at the heart of all funds is the maximization of profits.

Distinguishing Characteristics 

There are several main features which distinguish hedge funds from other investment vehicles. The first distinguishing feature we can mention is fee structure. A great many investment funds only charge an “expense ratio” or management fee based on asset value. If an investor places $1 million in a fund, then the fund receives 2% of this value at the end of the year. These funds, however, typically have a fee structure which includes both an expense ratio and performance-based fee. Expense ratio fees are usually 2% or around 2%, while performance-based fees float between 20% to 25%.  

Leverage To Maximize Profits

Another distinguishing feature is that funds often employ leverage. That is, they use borrowed funds in order to maximize profits. Other investment funds, by contrast, rarely employ leverage. Though leverage can increase profits, it also brings additional risk. Leveraged hedge funds suffered significantly during the Housing Crisis of 2008, for instance.  

Qualified Investors

Another unique trait of hedge funds is that they are typically only open to “accredited” or qualified investors. Accredited means an investor of a certain level of wealth or a certain annual income. The SEC imposes this requirement because these investors are capable of withstanding the risks of fund investment. Hedge funds generally have high minimum investment requirements.

Lock Up Period

What’s more, most hedge funds have what is known as a “lock up period” for investor funds. This means that investor funds are not available for withdrawal by investors for a fixed period of time. This lock up requirement allows hedge fund managers to use more aggressive investment strategies. But this requirement also increases risk and is something which should be noted carefully by prospective investors.

Flexibility

Perhaps the most important feature which sets hedge funds aside is the leeway afforded their managers. Because these managers are subject to very little regulation, they can employ a wide range of investment strategies. Hedge fund managers can invest in literally anything – stocks, bonds, real estate, currencies, derivatives, and so forth. Fund managers can utilize very risky strategies which can lead to either great returns or great losses. Hedge funds are often classified according to their particular investment style or strategy. This is precisely why investors must choose which fund they invest in with extreme caution.  

Taxation of Hedge Funds

The taxation of the profits returned to investors is fairly straightforward. Profits are taxable at the applicable capital gains tax rate, depending on the holding period. Short-term capital gains are taxable at the investor’s ordinary income tax rate. Long-term capital gains are taxable at 15% or 20% depending on the investor’s bracket.

Fund Manager Profit Taxation

The taxation of profits generated by fund managers is trickier. Because hedge funds are in the business of maximizing profits on investments, the performance fees earned could be taxable as ordinary income. This is one of the main points of debate concerning funds today. However, most hedge funds receive capital gains tax treatment on their performance fees.

Carried Interest

Performance fees are typically classified as “carried interest,” which means that these fees depend on the overall performance of the fund. Carried interest provides an incentive for managers to maximize profits as their fee will reflect the fund’s performance. Carried interest is taxable as capital gains. The classification of carried interest depends on entity structure. Hedge funds are usually partnerships. In that structure, the managers are the general partners and investors are the limited partners. When the general partners receive their performance-based fees, the IRS considers this as carried interest. Many analysts view their type of arrangement as a loophole and argue that ordinary income treatment should apply.

Call Our NYC Attorneys For Assistance

Here at Mackay, Caswell & Callahan, P.C., one of our goals is to illuminate topics so our readers can enhance their financial condition. The topic of hedge funds is vast. In the future, we will return to funds and dive more deeply into specific areas. For now, it’s enough to say that hedge funds are unique entities which mainly cater to high net worth investors. As we’ve mentioned, hedge funds have received greater scrutiny given the sheer amount of money they manage. It’s not uncommon for managers and investors to end up in tax trouble as they scramble to minimize their liability. If you run into tax debt and need competent counsel, reach out to one of our New York City tax attorneys today. 

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