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The Hidden Cost of Hedge Funds

Hedge funds are investment vehicles that pool capital from wealthy, accredited investors and deploy the cash in a way that seeks to maximize risk adjusted returns. Managers typically charge a fee of 2% of assets under management and 20% of the returns that exceed a benchmark. Investors pay those huge fees anticipating exceptional returns. What most individual investors fail to recognize, however, is that hedge funds tend to be incredibly tax inefficient and the take home return may be far less attractive than the fund’s underlying performance.  

The value provided by hedge funds is a matter of tremendous debate. Proponents of the industry highlight the risk adjusted returns and low correlation to traditional asset classes. Detractors claim that hedge funds are wonderfully marketed money pits for wealthy investors that will fail to outperform a low-cost stock index fund over a long run. The most famous investor in the latter group is Warren Buffett, who famously bet that the S&P would outperform a basket of hedge funds over a 10-year period (and it looks like he is going to win).

However, even if the bet resulted in a draw, the S&P may still be the better investment for long-term investors. (For more investment-related reading, see: 5 Steps to Getting Started in Investing.

Hedge Funds vs. Passive Funds

Imagine two investors, A and B. Both have $1 million in a taxable account. Investor A holds a passive stock fund earning an annual return of 9.2% while investor B holds an actively-managed hedge fund that buys and sells positions with regularity, generating the same 9.2% return net of fees.

To generate that 9.2% return, the hedge fund had to generate a 12% gross return. That assumes a set fee of 2% of assets under management and a performance fee of 20% of the gains above a 6% benchmark. So both investors end the year with a net return of 9.2%, or $92,000 of profit. That's not bad, but also not the end of the story.

Hedge funds are structured as partnerships and the profits and losses of the trades flow through to the investors. So while investor A, a long-term buy-and-hold investor, receives a 1099, pays tax on his qualified dividends and defers capital gains into the future, investor B receives a K-1 and must pay tax on all of the capital gains generated by the all of the fund’s transactions. Because most hedge funds hold positions for less than one year, the fund’s returns tend to be comprised mostly of short-term gains. (For related reading, see: Which Investor Personality Best Describes You?)

Now assume investors A and B are both in the highest federal tax bracket paying 39.6% on ordinary income, 39.6% on short-term capital gains and 20% on qualified dividends (ignoring surcharges and state tax). In year 1, investor A received a 2% dividend yield, deferred 7.2% of capital gains (by not selling) and paid $4,000 in tax. Investor B received a 1% dividend yield, 8.2% in short-term capital gains and paid $34,472 in tax. After-tax, investor A ended the year with net gains of $88,000 and investor B ended up with $57,528. Assuming this took place every year for 10 years (and the taxes were being paid out of the investment accounts), investor A would have a balance of $2,324,282 and B would have a balance of $1,749,519.  Assuming they both sold out at this point, investor A would pay tax on the long term capital gains and be left with $2,059,426.

To sum all of this up, investor B ends up with $309,907 less than investor A despite investor B’s hedge fund manager earning gross returns of 12% every year relative to investor A’s passive returns of 9.2%.

Finally, the next time you hear someone cite an endowment’s hedge fund allocation as a reason for allocating to the space personally, remind them that endowments don’t have to pay taxes. (For related reading, see: How to Make Your Nest Egg Last? Don't Sell Stocks When They're Down.)