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Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets

Using a Leverage Facility to Limit Downside

Some lending institutions will grant nonrecourse loans to investors in hedge funds. For example, suppose an individual wanted to invest $1 million in a hedge fund. The lender may permit the investor to put up $500,000 and borrow an additional $500,000. The loan is secured by the hedge fund investment and effectively limits the investors loss to 50 percent of the amount committed to hedge funds.

The downside protection carries costs to the hedge fund investor. The most obvious cost is the interest charge on the money on loan. The lender will also get ultimate control over the hedge fund assets. The lender may not permit investments in particular hedge fund strategies if they put undue risk on the lender. The lender may sell out some or all of the hedge fund assets to protect its security interest.

Principal -Protected Notes

Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets. Unlike the total return swap, it is typical to guarantee the return of principal, regardless of hedge fund returns. As a result, this note resembles a direct investment in the fund bundled with a put designed to guarantee complete return of principal.

The notes are usually issued as privately placed securities. While these notes replicate the effect of investing in a partnership invested in hedge fund assets, some investors may be able to invest in the structured notes but not in the underlying hedge fund. The notes may offer certain tax advantages over a direct investment in either the characterization of returns or the timing of the recognition of returns, as mentioned earlier.

Paying for Downside Protection

Derivative structures that offer downside protection cannot assume the risk without charging for the risk and taking steps to hedge the risk. A structured note that offers a guaranteed return of principal may charge a protection fee that lowers the return below the returns earned by direct investors. It is also possible to give the hedge fund investor some amount of downside protection in return for the hedge fund investor giving the structured products engineer some of the upside on the hedge fund returns. Because at-the-money calls on most non-dividend-paying assets are worth more than at-the-money puts on the same assets, it is possible to engineer securities that allow the buyer to participate in some portion of the upside on a hedge fund investment in return for complete protection against losses.

HEDGE FUND INVESTMENT THROUGH LIFE INSURANCE

The insurance industry offers a variety of instruments that offer significant tax advantages over direct investment in hedge funds. Any whole-life insurance policy combines life insurance with an investment account that is not taxed. In addition, the policies can reduce the estate tax of the insurance buyer because the value of the policy is usually not taxed at the time of death.

Hedge funds are described as being tax inefficient in that most hedge fund investors are wealthy and pay high marginal tax rates. Since hedge funds generate primarily ordinary income and short-term capital gains and little long-term capital gain, they deliver the investment return with the worst tax treatment to the taxpayers with the highest taxes. Incorporating hedge fund returns into insurance policies can offer significant advantages over accumulation outside a tax-favored environment.

The column labeled Taxed shows the accumulation of value at 10 percent if taxes are paid at a 40 percent marginal rate each year on the investment return out of a portion of the returns. The column labeled TaxFree shows the accumulation of value at 10 percent if the returns are not taxed. Finally, the column labeled Tax on Exit assumes that the value in the account accumulates tax-deferred and the tax (at the same 40 percent marginal rate) applies only when the money is withdrawn. Each value in this column represents the value to the investor if the money is withdrawn in a particular year and the increase in value is taxed at 40 percent.

One goal of insurance structuring is to transform returns that would other financial objectives. Estate tax can reduce these ending amounts as much as or more than income tax lowers them.

It isnt particularly hard to modify life insurance products to allow the policyholder to invest in hedge funds. The insurance area is highly regulated and many observers believe that the Internal Revenue Service would like to prevent hedge fund managers from offering their products via life insurance products.

Short Primer on Creating Hedge Fund Insurance Products

Hedge fund policies are developed around a version of whole-life insurance called universal life insurance. Investors buy an insurance policy and pay regular premiums to get a promise of a death benefit from the insurance company. Some part of the premium is invested in a separate account for the policyholder. The investment returns are not taxed if the policyholder maintains the policy until death. Upon death, the separate account and the death benefit are paid to the beneficiary or beneficiaries. The payment usually is not taxed as income for the beneficiary and is excluded from the insured individuals estate.

Hedge funds are generally sold as private placements (see Chapter 8) exempt from registration. Most insurance products are registered with state insurance regulators. The hedge funds can avoid the insurance registration requirements by creating private placement life insurance. These policies could be issued in the United States, but most of the policies tied to hedge funds are offered by offshore insurance companies. The offshore domicile allows the hedge fund investor to avoid paying premium tax or excise tax on the insurance premium that can be 1 to 3 percent of the premium amount.

The Internal Revenue Service will contest certain insurance transactions if the transactions are deemed to be a sham to reduce or avoid taxes. If the investment products tied to the insurance policies can be purchased only via insurance products, the courts have generally held that the insurance policy is not a sham. As a result, hedge funds must create unique products that are not offered to investors except through the separate account of life insurance policies. It appears that a hedge fund manager can create a separate fund and run it substantially the same as a hedge fund offered to investors directly. It also appears that a fund of funds that accepts investments only from insurance investors can invest in hedge funds available to direct hedge fund investors.

Investors who invest through universal life insurance policies must actually buy insurance. If the size of the death benefit is small relative to the premiums paid (that is, too much of the premium is going into the separate account for investment), the policyholder risks being taxed on the investment returns. While the death benefit affects the return calculations, it is important to realize that the death benefit is not a deadweight cost of investing in hedge funds through life insurance. Rather, the impact on return ignores the hybrid nature of the product that offers both tax advantages and insurance benefits.

HEDGE FUND DERIVATIVES TODAY

Nearly all the money invested in the hedge fund industry is invested directly in hedge funds or through funds of hedge funds. The alternative entries into hedge funds offer many advantages over direct investment. In the absence of challenges from government regulators, this indirect investment will likely represent the fastest growing area of hedge fund investment in the future.

QUESTIONS AND PROBLEMS

13.1 Why might an investor be interested in leveraging hedge fund investments by using derivatives tied to hedge fund returns?

.2 Can an investor use derivatives that are based on hedge fund returns to invest in assets that are not permissible as a direct investment? 13.3 Could a hedge fund derivative be ruled a tax shelter, causing the in

vestor to lose a potential advantage of the derivative over a direct investment?

13.4Could the IRS look through the hedge fund derivative and arguethat a tax-exempt investor must pay unrelated business income tax

13.5 You enter into a total return swap for $10 million based on the performance of XYZ hedge fund. You receive 80 percent of the gross return before management and incentive fees and you pay London Interbank Offered Rate (LIBOR). After a quarter, XYZ announces a net return of 4 percent. LIBOR was 5 percent on the reset date. The hedge fund charges fees of 1 and 20. What was the net payment to/from your counterparty for the quarter?

13.6What is the net payment to/from your counterparty in question 13.5if the gross return on the hedge fund is a loss of 2 percent?13.7How much leverage does the example in question 13.5 create?13.8You invest $1 million in a hedge fund that is structured to guaranteereturn of principal over five years. Your investment is allocated 55 percent to a zero coupon bond and 45 percent to the hedge fund. After six months, the hedge fund loses all the fund capital and closes under involuntary liquidation. What is the value of the account at this point?

13.9Why might someone be willing to write a call on the performance ofa particular hedge fund?13.10Why might someone be willing to write a put on the performance ofa particular hedge fund?

13.11 You are offered a call option on the performance of a particular hedge fund index made up of 10 hedge funds. You learn that you could buy separate calls on the performance of the 10 individual funds for somewhat less than the price of the option on the index of 10 hedge funds. Which alternative is more attractive?

13.12Can you describe a situation where a call or put could be worth lessthan zero?

13.13 What are some of the limitations for using insurance policies to improve the after-tax return on hedge funds?

13.14 How does the tax rate structure in the United States affect hedge fund returns compared to other assets?

13.15 You invest $2 million in a hedge fund with a time horizon of 10

years and expect the hedge fund to return 10 percent per year after fees but before taxes of 35 percent per year. How much more value accumulates in a life insurance policy that allows the hedge fund balance to accumulate without being taxed? For simplicity, ignore the costs of providing the death benefit.

Conclusions

Hedge funds have existed for more than a half century since Alfred Winslow Jones started a revolution in asset management. During those

years, the financial markets have grown in many different ways. The average value of daily transactions has risen steadily in most asset categories. The size of most asset groups has risen dramatically. The number of issues has increased significantly. Many new types of securities have been created. Hedge funds have acted as both cause and effect of these many changes.

IMPORTANCE OF HEDGE FUNDS

Chapter 1 documents the growth in the number of hedge funds and the assets under management. These statistics understate the impact of hedge funds on the financial markets. In addition to the assets under management, many hedge funds use leverage to increase the size of trading positions relative to capital. The size of many individual hedge funds has created problems of liquidity. Both dealers and hedge funds have learned to cope with the size of the customers relative to the market makers. Even with a half century of consolidation in the broker-dealer community, many hedge funds are larger than all but the largest dealers.

Hedge funds also trade their positions much more actively than most traditional portfolios. There is, admittedly, some variation in the turnover rates (the percent of the portfolio traded in a year) among traditional asset managers. Nevertheless, while a traditional manager may be comfortable turning over 15 or 20 percent of the portfolio a year, the most active hedge fund traders may sometimes accomplish as much turnover in a day. If turnover is measured as the volume of trading relative to the capital base, turnover rates rise even higher.

The market impact of these hedge funds is greater still because hedge funds may carry similar positions. When groups of hedge funds liquidate certain types of positions, other funds may be pressed to make similar changes. This clustered exposure causes events to sometimes have an exaggerated effect on valuation of different groups of assets. Sometimes, the pressure has been enough to severely strain the capacity of the financial markets.

CHANGES IN THE NATURE OF THE HEDGE FUND MARKET

The hedge fund market has undergone many changes in the past half century. As described earlier, the sheer size of the hedge fund community has doubled and redoubled. As the size of the average fund has risen, as the size of hedge fund assets has grown, and as the funds and assets have clustered into a group of styles that has grown much more slowly, the hedge funds, their customers and their trading counterparties have had to change.

Fashions in Hedge Fund Investing Styles

Hedge fund investors have followed several styles or trends. The original hedge fund started by Jones closely resembled a long/short equity fund. Eventually, a number of these long/short equity funds evolved into a highrisk strategy called global macro hedge funds that involved currencies, stocks, and bonds that, as implied by the name, placed weight on international trading driven by macroeconomic considerations. The next popular strategy was arbitrage strategies, especially fixed income arbitrage, popular as a backlash against the high-risk trading of the global macro funds. Long/short equity strategies then became the best-selling strategy, a strategy that closely resembles the original Jones hedge fund.

New Hedge Fund Delivery Mechanisms

The hedge fund market has evolved several new delivery mechanisms that make hedge fund investing much more accessible to investors and has allowed hedge fund investing to penetrate to investors that might not invest in hedge funds but for the development of these institutions. The first development is the fund of funds. The fund of funds has pressured the hedge fund community to make its investment products more appealing to sophisticated investors, by emphasizing risk as well as return. The fund of funds managers have increased the oversight of the individual hedge fund managers by closely monitoring performance, conducting due diligence, and working together to identify rogue traders early. Fund of funds managers have also been making it easier for smaller investors to experiment with hedge funds by lowering investment minima and offering a diversified hedge fund investment to investors that could not commit enough assets to hedge fund investing to diversify.

The second delivery development is the decision to offer hedge funds as registered securities, rather than as private placements. This movement is just getting started but it promises to make hedge fund investments available to less wealthy investors. The target investors may be less experienced or sophisticated investors and may not qualify to invest in private hedge funds directly. These investors can still benefit from the advantages of hedge fund investing.

The third major change in the delivery mechanism is the advent of engineered financial products that pay off based on hedge fund returns. These products offer potential tax advantages, risk transfer, and potentially greater liquidity. Regulators are watching cautiously to decide if these innovations might increase the risk to the financial system. Tax authorities are motivated to see that these markets are taxed consistently with other financial investments.

Evolution of the Regulatory Environment

The regulatory environment has evolved greatly over the past half century. The hedge fund industry has faced greater oversight from the Commodity Futures Trading Commission, auditors, and investors. Recently, the Securities and Exchange Commission has stepped up efforts to increase disclosure requirements and may impose other regulatory requirements.

Risk Profile of the Typical Hedge Fund

The hedge fund industry grew to a size worth watching with a decade of high-risk trading. Investors looking for high returns with little regard for risk flocked to these high-profile traders. But the market really began to grow when managers began to create funds that offered somewhat lower returns but dramatically lower risks.

Investors in hedge funds were becoming more sophisticated. Investors learned that lowering the risk of a portfolio is as important as increasing the return on the portfolio. Risk-averse investors flocked to a new breed of hedge fund marketed as either low-risk or low-risk relative to the return achieved.

Today, investors measure risk in many ways. These investors reward managers than control risk and pressure managers to control risk. Most of the growth in hedge fund assets has been in strategies have had fairly high returns yet have managed to keep risk exposure to modest levels.

Trading counterparties and regulators have also pressured hedge funds to assume lower risks in their portfolios. Leverage is lower. Managers may be more inclined to look for hedges that can reduce risks without significantly lowering the return to investors.

Growth of the International Hedge Fund Market

Hedge funds have been early to extend trading to securities in foreign markets. Hedge funds have also received investments from international private banks in Switzerland and other locations.

There is an internationalism that is evolving in hedge funds that goes beyond the types of assets in the portfolio. Hedge funds are being created all over the world. Most countries are evolving a regulatory structure to monitor and sometimes control hedge fund activities of their citizens. Investors from many countries are investing in both established and new hedge funds. In addition, there are many more places that have the legal infrastructure and taxation that can act as domiciles for worldwide hedge funds.

FUTURE CONSIDERATIONS

The hedge fund industry has developed rapidly. Recent trends indicate that the industry is still evolving.

Future Growth in Assets under Management

Growth in assets in any investment product reflects the wealth accumulated by investors both from reinvested returns and from net new savings. Hedge fund growth has derived from both compounded returns and new savings, which has made the pie larger. In addition, the hedge fund industry has been accumulating a larger portion of the investment pie.

The growth in assets under management will likely continue. Many industry watchers predict slower growth in the years ahead, in part because the early adopters are already investors. The success in maintaining the nearly double-digit growth rates reflected in Figure 1.2 in Chapter 1 hinges on expanding the group of investors that can invest in hedge funds, getting a higher proportion of investors to invest in hedge funds, and influencing investors to allocate a higher percentage of their portfolios to hedge funds and other alternative assets.

Future of Hedge Fund Strategies

The number of hedge funds seems to increase every year without interruption (see Figure 1.1 in Chapter 1). The funds implement an expanding list of hedge fund strategies. This innovation is important to the future of the industry. Investors will continue to pay hedge fund fees for strategies that are meaningfully different from traditional assets and different from other hedge fund strategies. Investors will continue to pay fees for excellent performance, which may go to the funds that innovatively produce attractive returns for their investors.

Growth in Passive Hedge Fund Management

The traditional asset managers (mutual funds, trust departments, and investment advisers) have developed low-cost investment strategies such as index funds. By keeping management costs and transaction costs low, these passive strategies have produced returns that exceed the average of returns on actively managed portfolios. Early indications suggest that passively managed hedge fund products can produce competitive returns for investors and provide many of the diversification benefits of actively managed hedge funds. Barring performance problems or capacity issues, passive hedge fund portfolios will attract significant funds in the future.

Growth in the Fund of Funds Business

The fund of funds managers have grown rapidly along with the total hedge fund industryeven faster than the hedge fund total has grown because fund of funds managers have been able to convince important institutional investors to become hedge fund investors through investments in their fund of funds portfolios. The market share of fund of funds investments as a percent of total hedge fund assets will continue to rise, reflecting the strong marketing skills of these organizations. The fund of funds managers will also continue to capitalize on the need to perform thorough due diligence beyond the abilities of many hedge fund investors.

Convergence of Financial Institutions Continues

Although the hedge fund industry grew out of an effort to provide an alternative to traditional asset management, the continuing convergence of financial institutions will blur the difference between hedge funds and other financial management alternatives. Mutual funds, insurance companies, and investment counselors can hurdle the barriers to entry easily enough to create hedge fund products reflecting their expertise. Attracted by the higher fees, these traditional managers are creating hedge funds as a way of motivating their star performers to stay with their employers.

Traditional investment managers will also adopt many of the features of hedge funds into their existing products. Insurance companies dont need to tie insurance products to external hedge fund products if the insurance companies can produce nondirectional investment returns or can implement passive hedge fund portfolios. Mutual funds can implement many of the investment strategies commonly used by hedge funds without adopting hedge fund business organizations or fee structures.

Pricing and Profitability of Hedge Fund Management

Hedge fund management and incentive fees have come under pressure for years. Fees are often negotiated below the levels set in the hedge fund disclosure documents. The net fees reflect the size of the hedge fund, the size of the investor, the return history of the fund, the capacity of the manager, the existence of other hedge funds following the same strategy, and many other factors. Innovation allows the hedge fund manager to maintain pricing levels by creating excellent performance or by creating or preserving a uniqueness of value to potential investors.

Hedge fund fees will likely continue to decline. As institutional investors have begun to invest sizable portfolios in hedge funds, managers have found it both necessary and worthwhile to negotiate fees. As fee negotiation becomes more widespread, managers will suffer little by lowering the posted fee levels and should attract additional investment. The profitability of the industry will be sustained by the growth in assets under management, offsetting losses in revenue from downward pressure on fees.

Brave New Hedge Fund World

If trends continue, future generations may make no distinction between the traditional money management business and the hedge fund industry. Instead, business practices reflect the lessons of the traditional managers and the hedge fund managers. Managers in banks, insurance companies, brokers, and other financial institutions will share knowledge of investment management derived from traditional portfolio management and from alternative investment managers. With the help of constructive oversight from governmental regulators, this merger to the mainstream will make for stronger financial markets and better-managed portfolios.



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Previous Issues

200605-22Hedge funds face very few restrictions on their use of derivatives in their portfolios

200605-21Marketing and Hedge Fund Regulations in the United States

200605-20Value at risk is an adaptation of classical statistics to risk measurement

200605-19Summary of Hedge Fund Risk and Return Data

200605-18Most hedge funds create an interim closing to measure partner gain or loss

200605-17Hedge funds located in taxable jurisdictions are structured

200605-16A hedge fund, in contrast, carries a portfolio of investment securities

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