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The hedge fund will likely mark the positions to market regularly and associate the gain or loss to the investors

9.2 The position is carried as an asset worth $25 million regardless of how the position is financed. The financing position creates a $12.5 million liability, not an asset. Because the fund financed half of the position, the cash balance is $12.5 million higher than the cash position would have been if no money was borrowed. Therefore, it might be argued that the position and financing would impact $37.5 million on the hedge fund assets.

9.3 The short position would be carried as a liability, not an asset. The cash collateral of $12 million would appear as a short-term asset.

Before the sale, the fund carried 25,000 shares at $287,500 or an average cost of $11.50. If the fund uses this average as the cost basis, the accountants will remove $57,500 from the value of XYZ Common (5,000 $11.50) versus sale proceeds of $75,000.

If the hedge fund used the average cost of $11.50, the remaining position in XYZ common would be carried at $230,000 ($287,500 $57,500 or 20,000 shares $11.50). However, if the accountants removed the $10 shares:

Remove 5,000 XYZ at $10.00

Cash$75,000XYZ common$50,000Gain on sale of XYZ$25,000

This would leave a position worth $237,000 ($287,500 - $50,000 or 20,000 shares at an average price of $11.88. This method corresponds with the first in, first out (FIFO) method.

If the accountants removed the $12.50 shares:

Remove 5,000 XYZ at $12.50

Cash$75,000XYZ common$62,500Gain on sale of XYZ$12,500

This would leave a position worth $225,000 ($287,500 - $62,500 or 20,000 shares at an average price of $11.25. This method corresponds with the last in, first out (LIFO) method.

9.5 The hedge fund will likely mark the positions to market regularly and associate the gain or loss to the investors each period. The difference between the two costs will not affect the net income, as long as this unrealized gain or loss is included in the performance. The hedge fund will report a higher realized gain and a lower unrealized gain if the $10 shares are removed instead of the $12.50 lot.

The hedge fund will report the realized gain to investors, who must include their share of the gain in their income. Taxable investors will report higher taxable income if the lower-cost lot is used. However, if the fund sells the remaining shares in the same tax year, the investors will notice no difference in taxable income. For hedge funds that buy and sell frequently, the choice of lots may not matter much.

9.6 Accrual accounting permits the fund to associate revenues and expenses to periods before or after the cash payments. A partner owns a proportional interest in the fund. The accounting records are designed to accumulate results and distribute these to the partners as if each investor owned positions in all the individual assets. Because the fund is legally entitled to accrued income each day, its accounting records must reflect this economic situation in their record keeping.

In addition, the hedge fund may pay certain expenses at times not related to when the benefits of the services were received by the partners. For example, an auditor may bill the fund for the entire years services in April, after the annual audit is complete. If the fund was unable to accrue this expense throughout the year, the expense would be allocated to investors in April instead of investors who were in the fund during the time of operation being audited.

9.7 Investors demand audited financial statements for a variety of reasons. Managers may refuse to disclose required information and receive a qualified opinion from the auditor. Investors may be satisfied with the statements after talking with the manager but it would be inappropriate for the auditor to represent that statements comply with generally accepted practice when they do not comply.

9.8 It is not true that investors experienced no economic consequence, but the impact would likely be small and relate to minor differences in tax allocation to investors. However, the concept of materiality is defined much more broadly than whether an investor gets hurt. The fund should restate its results if the errors had a material effect on performance.

9.9 The fund manager is wrong but the auditor is probably wrong, too. A fund may value its long positions at a lower price within a fair range of market prices and value its short positions at a higher price within a fair range of market prices. This procedure reduces the net asset value (NAV) by a reasonable estimate of the cost of liquidating positions. As long as the method is consistently employed, it may be used to price hedge fund assets. The auditor is wrong to demand that a hedge fund use a particular methodology in determining ending values of long and short positions. Hedge funds are permitted a range of alternatives, as long as they are consistently applied.

9.10 The auditor is wrong. Hedge fund positions are not valued at the lower of cost or market. For financial reporting/performance calculations, positions are valued at market. For tax reporting, positions are valued at historical cost.

9.11 The firm does have assets. First, the fund certainly has cash balances.

Second, all of the short positions are collateralized in the stock loan or reverse repo market. These transactions are required because the fund must borrow the securities it has sold short. The cash collateral backing these securities loans are carried as short-term assets. The short-only hedge fund could take substantial short positions in futures or other derivatives. In this case, the leverage calculated from the total assets may understate the effective leverage of the fund substantially. If the leverage calculated using the total assets divided by partners capital provides a misleading measure of leverage, investors can calculate leverage using the cash market equivalent of the derivatives positions.

9.12 The fund must recognize the dividend in April because the stock has gone ex-dividend in April. On the ex-dividend date, the value of the shares falls by roughly the amount of the dividend. The package of the soon-to-be-received dividend plus the ex-dividend stock approximately equals the price of the stock before the ex-dividend date. To fairly present the NAV at month-end, the accounting records must include the future dividend payment:

In early May, the payment is received but it is of minor economic consequence because the owners of the fund in April are given credit for the income:

9.13 The equity of the fund is $50 million because the sum of the liabilities and equity must equal the value of the assets. The NAV of a unit is the equity divided by the number of units:

NAV = $50 Million/28,000 Units = $1,786 NAV per Unit

9.14 The financial statements of the hedge fund report the Treasury income and in lieu interest expenses without adjustment for taxes. The fund may subtract the interest expense on short positions from the income received and report the net Treasury interest income. The hedge fund is a flow-through tax entity so it doesnt pay taxes. Other types of businesses, such as C corporations, would make an allowance for the taxes payable on the Treasury income.

A hedge fund investor would exempt the Treasury interest from taxable income on the state income tax form. Similarly, the substitute interest payments would be treated as if the U.S. Treasury made the payments. As a result, the hedge fund investors would not be able to deduct the interest expense on state tax forms.

The hedge fund will likely receive some of the Treasury income on long positions in the form of substitute interest payments. These in lieu payments can be treated as U.S. Treasury income, even though the actual payments were remitted by other parties.

9.15 The hedge fund might accrue the management fee daily. More likely, the fund will book the management fee only once monthly and adjust the NAV during the month for a portion of the fee accrued. The annual management fee on $100 million is 1 percent or $1 million. The partnership agreement defines how this fee is split over 12 months, but often one-twelfth of the amount is assessed each month. If the fund in question follows this simple rule, it will charge a management fee of $83,333 ($1 million/12) for May. Because May has 31 days, the fund may accrue a daily management fee of $2,688 ($83,333/31). On May 5, five days of accrual would total $13,441 ($2,688 5). If the general ledger system does not accrue the fee daily, $13,441 should be subtracted from the funds capital before NAV is calculated.

9.16 If this hedge fund uses cash positions in stocks, bonds, or commodities, it would have leverage of approximately 2:1. Because the futures positions do not appear on the balance sheet, the fund would show only the cash held on deposit at the futures broker plus any excess cash. Unless analysts adjust the futures positions, this fund would appear to be unlevered and not invested in risky positions.

The manager may prefer to receive the income as a partner distribution if some portion of the return on the fund is long-term capital gain, which is taxed at a lower rate than fee income. If the hedge fund produces only coupon and dividend income and short-term gains and losses, the manager would not gain any advantage from a distribution in lieu of fee income. If the fund does generate long-term capital gains, the manager may receive income taxed at a lower rate if long-term gains are allocated to the manager.

.2 The investors would prefer to pay the manager with a management fee because any long-term gain distributed to the manager is income taxed at a lower rate that wouldnt be available to distribute to investors. For most hedge funds, the management fee is a deductible expense, so the after-tax cost of the fee is less than the amount paid. Structuring the management fee as a fee may also reduce other taxes. For example, the fee may escape self-employment tax and some state taxes such as the New York unincorporated business tax.

10.3 If a hedge fund is taxed as an investor, not a trader, then investors would prefer to grant a special allocation to the manager instead of paying a fee because the fee would be reported as a miscellaneous expense and would be subject to limitations on deductibility.

10.4 The partnership apparently realized $1 million in taxable gains during the year. This amount may not agree with the total economic profit of the partners during the year. The partnership would have paid corporate income tax of $350,000 if it had instead been organized as a corporation. The $650,000 after-tax profit would not be taxable to the investor until the corporation distributed it as a dividend. The corporation could delay distributing the dividend indefinitely.

If the corporation paid out the $650,000 and the investor received a 25 percent share ($162,500), the dividend would trigger individual income tax of (162,000 35 percent $56,875) and would be left with $ 105,625 ($162,500 - $56,875).

If the investor sold her investment before the profit was distributed, she would likely be paid more (all other things equal) for her investment stake because of the $650,000 undistributed profit. The gain on sale would be taxed at either the short-term or long-term capital gains rate.

10.5 First, it is necessary to discuss the tax situation of the investor in the mutual fund. Assuming the investor is a taxable individual, the distribution must be included in the investors taxable income. Suppose the investor had made a $100,000 investment in the mutual fund and was allocated gains of $10,000. Suppose, too, that the investor pays income tax at the marginal rate of 25 percent.

The mutual fund may distribute cash of $10,000 or just report the taxable income. In either case, the investor reports the income and pays tax of $2,500. If the mutual fund distributed no cash, the investment is still worth $100,000 but the investor has an adjusted cost of $110,000. In other words, if the investor subsequently sold the fund for proceeds of $100,000, the sale would create a loss of $10,000 that would reduce taxable income by that amount. Alternatively, if the fund appreciated to $110,000 before the investor liquidated the holding, there would be no gain if the fund was sold for $110,000 because the gain has been already reported as income.

If the mutual fund had distributed $10,000 to the investor along with the taxable gain, the value of the investors holdings would be only $90,000. But the cost basis for the investor is $100,000. If the investor liquidates the holding for $90,000, the investor would report a $10,000 loss.

In contrast, if the investor had invested in a hedge fund organized as a limited partnership that had realized gains during the tax year, the investor would have been allocated little or no gain in most cases. If the fund uses layered allocation, the investor would be allocated taxable gain for the portion of the appreciation that occurred while the investor was a partner. Since the investor has not been invested in the fund very long, this allocation would be small and would of course be based on the gain enjoyed by the investor on that particular security, not the entire portfolio.

It is possible to create situations where the investor would receive allocations of the gain under aggregate tax allocation. For example, if the investors have generally lost money in the hedge fund but the fund realized a gain on a particular security, the investor might be allocated the gain according to the economic ownership percent for all investors, even though the investor was not invested in the fund when the appreciation occurred.

In most cases, however, the tax allocation in partnerships more closely matches the economic gain of the investors. Subsequent allocations should also tend to correct any overallocation of taxable gain. In contrast, the mutual fund would not base future tax allocations on overallocations that have been made.

It is important to realize that, when the investor liquidates either the mutual fund or the hedge fund, any overallocation of income would net out. If tax rates remain constant for the investor, the impact of the overallocation of income is limited to the timing of tax payments.

10.6 The fund must flow through the income with the same characterization as the type of income received. Because the fund generated a long-term gain, it should report a long-term gain to all investors, including the newest partner, whose holding period is too short to justify receiving long-term income. However, the partners acquire the characterization of the investment activities from the partnership. In this case, more favorable tax treatment results than the new investor would expect based only on the time the investor has carried an investment in the fund.

10.7 Partnerships have considerable leeway to determine the particular rules used to allocate a loss. Hedge funds typically allocate the loss to all the partners based on the percentage of the fund owned by each partner. This will make the negative memo balances still more negative. Similarly, the total of unrecognized losses on the securities still held by the partnership will exceed the net economic loss experienced by the partners. As a result, the partners should gain some tax savings when unrecognized losses are realized.

10.8 Yes. If the cost was described as an annual expense of $360,000 ($30,000 12), it would be appropriate to allocate the expense daily, such that individual months are allocated different amounts of expense. But in this case, the fee is described as a monthly expense, so it should be booked as such, in the absence of facts suggesting otherwise.

10.9 It is customary to expense the commissions as they occur, rather than accrue the expense during the holding period of each investment. There is a case for accruing commission expenses based on volume pricing. Some brokers charge sharply discounted commissions or no commissions once a volume of commissions has been paid. In this case, it might be reasonable to accrue the expenses over the later months.

10.10 The allocation of most expenses should be made to the partners on the basis of economic ownership. For certain types of assets (futures, stocks) that charge an explicit commission, the expense should be allocated. Other types of assets (notably bonds and derivative securities), the cost of trading is built into a markup in the price. These trading costs are allocated with the layer or aggregate method as part of the gain or loss on the security.

Since the fee is described as an annual fee, it should be allocated based on the number of days in each break period. For years not containing a leap year, there are 181 days in the first six months of the year. The fund should allocate 49.59 percent (181/365) or $49,589 to the first half of the year. The fund should allocate 10 percent of that amount or $4,959 to the investor. The fund should allocate the balance of the annual expense or $50,411 to the second half of the year. The investor should be allocated 8 percent or $4,033 of this amount. For the year, the investor is allocated $8,992 or roughly 9 percent of the expense.

Exchange memberships are actually paid monthly. If the fund (contrary to the description in question 10.10) paid a monthly amount of $8,333.33, the fund would have paid $50,000 ($8,333.33 6) for both the first and second half years. The investor would be allocated 10 percent of $50,000 for the first six months and 8 percent of the $50,000 for the second six months ($4,000) for a total allocation of $9,000.

The three variations differ by only $8 and would likely not be material for any hedge fund. Nevertheless, hedge funds should set up procedures to allocate expenses in a logical and fair way.

10.11 The layered allocations can be observed directly from Table 10.3b in the text of Chapter 10. Investor 1 has gains of $9,750 on position 1. Investor 2 has gains of $14,625, and investor 3 has gains of $5,625. These allocations total to the $30,000 gain realized on the position.

10.12 It would be convenient to allocate the $245 to investor 1 ($98) and investor 2 ($147) because it would allocate taxable gains to positions on the memorandum balance that are no longer being held by the fund. However, the allocation depends on the rules established in advance, which likely arent mindful of the details in the memorandum accounts. As a result, it is impossible to say which way the gain would be allocated among many acceptable allocations about factors that cant be controlled. For example, bond models that rely on duration and convexity require little more than market pricing information. For other types of trades, the inputs may not affect the risk analysis much. For example, a position that is long one option and short another may be fairly insensitive to the level of implied volatility, the price of the underlying instrument, and the financing rate because misspecification of the inputs or changes in the inputs affect both the long positions and the short positions.

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Previous Issues

200605-26Hedge funds that do not use leverage will not generate much interest expense

200605-25The multistrategy hedge fund produces a nominal return

200605-24Some hedge funds are designed to provide very high returns and may accept high degrees of risk to attain those returns

200605-23Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets

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

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