Characteristics, Uses and Taxation of Investments - Index Securities



g. Hedge Funds
: while hedge funds may not receive much coverage on the certification exam, their ubiquity demands a discussion as planners may well encounter them in the course of their practice. After all, their origins lie in the private wealth area. These are professionally managed pools of assets offered in various structures (limited partnership, limited liability corporation, offshore investment companies) by means of a private placement to a small number of accredited[At least 65 of the 99 investors in the investment must be accredited. The individual or couple needs to have a net worth of at least $1,000,000.00 or an individual with annual income in the previous two years of at least $200,000 ($300,000 for a couple). Fund minimums range from $250,000.00 to $10,000,000.00. More recent regulations call for a hedge fund to allow up to 499 investors in a fund so long as all of them are qualified purchasers, defined as individuals with at least a $5,000,000.00 net worth.] investors. Readers should note that these types of funds are strategies that utilize various types of investments to attain a particular objective. In particular, hedge funds are distinguished by a unique fee structure with two components: an asset management fee and a percentage of the "carry" or profits. Alternatively, one pundit has offered this definition: "Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public".[L'Habitant, François-Serge Hedge Funds Quantitative Insights Wiley Finance 2004, p. 5. The rapidly changing market and regulatory environment challenges the veracity of this statement. Loose regulation is being threatened and such strategies are increasingly becoming more widely available to the public in the form of hedged mutual funds]. Relatively tax-inefficient because of the multitude and complexity of the trading arrangements and frequent use of leverage that underpin them, hedge funds need to be selected carefully to avoid generating unrelated business taxable income (UBTI). Taxable accounts would select the domestic version of the fund, whereas tax-deferred accounts may select an offshore version of the fund which is typically organized as a corporation and would not give rise to UBTI. Planners would do well to consult a tax advisor with relevant hedge fund experience.

A brief background of the hedge fund industry is in order. These sorts of arrangements have existed since the 1930s when Benjamin Graham and John Maynard Keynes began running hedged portfolios, but it was Alfred Winslow Jones who gave the practice its visibility, managing a long/short strategy (a "hedged" fund) from the late 1940s where he conducted research on this type of portfolio management while at Forbes Magazine.[ "Fashions in Forecasting" Forbes, March 1949]. His company, A.W. Jones was at the forefront of the practice. Several bouts of market turbulence parted a significant number of such investors from their money during the late 1960s and into the early 1970s, though seasoned practitioners such as George Soros, Julian Robertson, Jim Rogers and Victor Niederhoffer continued to ply their craft into the 1990s. Long-Term Capital Management (LTCM), a global macro fund whose staff's intellectual prowess (mettle) appeared to be the investment management profession's equivalent of Bell Labs or NASA, came together in the early nineties and left not quietly a mere five years later. The complex quantitative models that formed the underpinnings of the group's strategy caused the fund to come a cropper in the autumn of 1998 and for a brief time posed a threat to the orderly workings of the financial markets, but not before a number of larger firms stumped up cash for a bailout. It is the spectre of LTCM that has haunted the hedge fund industry and provided fodder for the naysayers (a gaggle of investors, professional and individual alike, policymakers, politicians and academics) who argue that the multitude of strategies pose too much risk without the commensurate benefits and lack sufficient regulation. For all of their controversy, hedge funds would appear to have found their place in the investment firmament as a valid risk management tool, all the more so since the pronounced market declines of 2000-2003 when their raison d'être was validated. They are not going away so quickly. Due diligence and monitoring of hedge funds is a full time endeavor and beyond the scope of the examination. An understanding of these strategies is warranted, however, as planners should expect to encounter them at some time in the course of their practice. Perhaps more frequently, as retail hedge mutual funds are slowly becoming more prevalent. The critical question to ask is how a hedge fund strategy would integrate into a client portfolio and provide more efficient diversification. The planner's duty to consult is of particular importance here.[Practice Standard....] Without being a specialist, the planner can take steps to become better informed and add value to his or her clients. A brief taxonomy follows.

Hedge Fund Style Types
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