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The reinsurance companies that invest in hedge funds have generally been closely associated with particular hedge fund managers

INSURANCE COMPANIES AS HEDGE FUND INVESTORS

Insurance companies in the major financial centers of the world control large amounts of financial assets but they are not large investors in hedge funds. Insurance companies themselves have two sources of funds that might be invested in hedge funds. First, insurance companies have capital, much like any other kind of business. This capital is generally called surplus. The second source of investment dollars is the deferred amounts set aside to pay future claims, called reserves. The payments are delayed for a variety of reasons. In many cases, the amount payable will be determined by a lawsuit that has not yet worked through the judicial system. Insurance companies invest the money set aside to pay claims and use the investment returns to help pay the settlement amount.

All of these balances could arguably be invested in hedge funds. Insurance companies can invest a limited amount of their funds in common stocks, real estate, and other potentially risky assets. With the average hedge fund less risky than the S&P 500, an insurance company could find hedge funds that would fit well into an insurance company portfolio. In practice, these portfolios are invested almost entirely in bonds, with small allocations to stocks and very little in alternative assets. Insurance regulations reinforce this bias toward traditional assets.

Insurance products offer significant tax advantages that could be combined with hedge funds, whose returns are generally taxed immediately at the maximum individual income tax rate. Whole-life insurance policies allow the cash value to grow free from income tax and can be structured to avoid estate tax. Deferred annuities can also allow investment balances to grow without being taxed until the return is distributed years later. These insurance products are expanding the range of allowable investments to include hedge funds, extending their favorable tax treatment to hedge fund returns.

One new development that is being used to fund tax-favored hedge fund investments involves reinsurance.10 Investors buy shares in a reinsurance company in a location with low corporate income taxes. Most reinsurance companies involved in hedge funds have been located in Bermuda, which has no corporate income tax.

It is important that the reinsurance company is located outside the United States and other locations with corporate income taxes to avoid the double taxation of the investment returns. It is important, also, that the business is an insurance company, because they alone are exempted from special provisions designed to prevent U.S. taxpayers from placing investments in an offshore company to avoid or postpone recognizing income. It is, therefore, important that the reinsurance company actually operates as an insurance company to receive this special treatment.

The business is diagrammed in Figure 3.2. Investors deposit cash as equity investments in the company. The company receives insurance premiums in return for sharing liability on insurance contracts. The reinsurance company holds the premiums until a claim or claims are made. Typically, the reinsurance company pays out all of the premium income or more but keeps the investment returns on the money while it held the reserves.

The reserves plus much of the reinsurance company surplus are invested in hedge funds. The returns on the hedge funds accumulate tax-free. The underwriting profits (premiums minus payouts) or losses (payouts minus premiums) accumulate along with the hedge fund returns. The reinsurance investors expect that when they sell their shares, the investment returns and the underwriting gains or losses will be taxed as long-term capital gains.

The reinsurance companies that invest in hedge funds have generally been closely associated with particular hedge fund managers. MaxRe recently held 40 percent of its investment portfolio in Louis Bacons Moore Holdings. Stockton Reinsurance invests in affiliated Commodity Corporation (owned by Goldman Sachs). Hampton Re (organized by J. P. Morgan) invests in J. P. Morgan products. Hirch Re invests in the Hirch funds. Asset Alliance Re invests in Asset Alliance hedge funds. These hedge fund

FUNDS OF HEDGE FUNDS

Funds of funds take money from investors, invest the funds, and charge a management and incentive fee on the gross returns. What distinguishes a fund of funds from other hedge funds is the fact that the assets held by the manager are primarily other hedge funds (which also charge a management and incentive fee).

Investors may invest in funds of funds for a variety of reasons. Fund of funds managers have considerable knowledge about hedge fund strategies and may be able to identify attractive trends. Most fund of funds managers conduct extensive due diligence research before investing in any hedge fund and may be able to reduce the chance of losing money to fraud. Funds of funds may have lower minimums and shorter lockup periods than the funds they own. Funds of funds usually invest in many hedge funds to get the risk-reducing benefit of diversification. Finally, funds of funds may have investments in hedge fund managers that are closed to new investment.

Fund of funds investors generally dont invest in new hedge funds, but many fund of funds managers seek out funds with two to five years of performance. Many larger funds of funds will not invest in small funds because they want to limit the number of funds they retain in their portfolio. Although funds of funds create portfolios reflecting the biases and preferences of the managers, funds of funds as a group tend to follow investment trends. They tend to invest in strategies that are in favor with investors (which changes over time). They tend to underweight strategies that have recently done poorly relative to other hedge fund strategies.

CONSULTANTS AND HEDGE FUND INVESTING

Many new hedge fund investors hire consultants to assist in the decisionmaking processes. Although the consultants do not invest their own money in hedge funds, they can influence on how moneys are invested.

Large institutional investors are more likely to hire consultants to review their hedge fund investments. Pension funds, endowments, and foundations are more likely to employ consultants than other types of hedge fund investors.

Consultants are more sophisticated than the typical hedge fund investor. Consultants are generally not impressed with high-risk/high-reward strategies. In general, they focus on funds that deliver consistent, high returns relative to the amount of risk involved with the strategy.

CONCLUSIONS

There are many different types of hedge fund investors with different motives and risk preferences. These investors have portfolios that respond differently to market forces. Fortunately, there are many different kinds of hedge funds. Both the investors and the hedge fund managers are best served when the investors find the hedge fund that best suits their investing needs.

QUESTIONS AND PROBLEMS

3.1 Why do individual investors put money in hedge funds, which expose

the returns to ordinary income tax rates (up to 35 percent), much higher than the long-term capital gain rate of 15 percent?

3.2 Explain why a non-U.S. investor in an offshore hedge fund (perhaps

run by a U.S. manager) should not be liable for U.S. taxes. 3.3 If an offshore fund is located in a country that has little or no tax

on the return of a hedge fund, does the investor enjoy tax-free returns?

3.4Why would an offshore investor put money in a fund managed by aU.S. manager?3.5Why would endowments and foundations invest in hedge funds thatare viewed as speculative by many?

.6 Would it be more prudent for a defined benefit pension plan or a defined contribution pension plan to invest in hedge funds? 3.7 What are some reasons why it might be undesirable for corporations to invest in hedge funds?

3.8Why do funds of hedge funds exist, considering the additional feesthat this nested structure creates?

3.9 Suppose a fund of funds invests equally in four hedge funds. The returns for three months are listed for the individual funds. Each return is before management fees and incentive fees. Assume for simplicity that each hedge fund charges an annual management fee of 2 percent and an incentive fee equal to 20 percent of returns (after management fees have been deducted). Also, assume that the fund of funds charges a management fee of 0.5 percent annually and an incentive fee of 10 percent of return (after individual fund fees and fund of funds management fee).

What is the average return on the fund of funds?

3.10 If an institutional investor replicated the four strategies, but imple

mented the strategies in-house and paid no management or incentive fees, from question 3.9, what would be the net return on the assets committed to the four hedge funds?

3.11 Assume that a single hedge fund manager created and ran the four

strategies in questions 3.9 and 3.10 and charged a management fee of 2 percent and incentive fee of 20 percent. If the manager had decided to combine the strategies into a single hedge fund, what would be the performance on that fund?



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200605-04Foundations often invest in hedge funds by hiring consultants to aid in determining a portfolio strategy

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