Hedge funds are designed to have positive returns in all markets, bull or
bear. However, they come at a price in terms of tax liability, fees, and the time
and attention required to conduct proper
due diligence.
In regard to taxes, the point is not necessarily to minimize them, but to maximize the
after-tax return from the investment, says
John T. Alfonsi, CPA/ABV, CVA, CFE, partner, Cendrowski Selecky PC, Bloomfield
Hills. “Taxes are just like any other transaction cost that the investor needs to quantify
and consider. Certain hedge fund investments might generate a higher return, such
that even after considering taxes, the investment still makes sense.”
Smart Business asked Alfonsi for guidance on maximizing hedge fund investments returns.
How do the taxes and fees on a hedge fund
differ from those of a mutual fund?
Most hedge funds are treated as partnerships for income tax purposes. As part of
the partnership, you will be allocated a
share of the income, whether or not that
income is actually distributed. Therefore,
you need a liquidity plan for covering taxes
attributable to the income. Partnership
allocation rules are complex such that an
after-tax return could be significantly different than a pretax return. When considering an investment in a hedge fund, ask if
the fund is reporting after-tax returns. If
not, ask to see the components of the
return. The character of each item of
income and deduction could have a significant impact on the after-tax return. Unlike
mutual funds, hedge funds are subject to
little or no regulation, so close scrutiny is
extremely important.
The fees involved with hedge funds are
clearly greater than those for mutual funds.
Hedge funds typically charge a 2 percent
management fee, plus a 20 percent incentive fee or allocation.
How should the investor perform due diligence?
Every investor or his or her representative should meet with the fund team in person on a regular basis. Both quantitative
and qualitative due diligence is required.
Quantitative due diligence involves an
analysis of numbers, strategy and perspective. The goal is to get a comfort level with
the fund’s reported performance and how
it was derived. Investors should focus on
the fund’s volatility. The goal of a hedge
fund is absolute return with little correlation to the market, so there should be little,
if any, down periods. Look at the breadth of
gains. Look for across-the-board wins, not
just a home run here and there. The
investor needs to understand the fund’s
risk management. How do they handle
interest rate risk? Do they employ leverage? The quantitative due diligence should
also focus on taxability. Investors need to
understand the relationship of taxable
income to economic income. The fund’s
investment strategy also plays a part in
analyzing after-tax returns. By analyzing
their strategy, investors may be able to
devise a predictable estimate of their tax
liability.
Qualitative due diligence requires an
analysis of the organization and its
approach. Conduct background checks on
the fund manager and team. If managed by
one person, consider the risk should that person no longer be in that position. The
investor also needs to be familiar with the
fund’s service providers. Does generating
audits result in any delays? Have they
switched audit firms or attorneys? If so,
why?
What are the advantages and disadvantages
of a fund of funds?
A fund of funds is a good way to get your
feet wet with hedge fund investing, giving
you exposure to many managers that you
may not otherwise have access to. They
may also diversify risk. However, there is
often a second layer of fees. The underlying funds each charge their 2/20 fees, while
the fund of funds may also charge a 2/20
fee. From a reporting perspective, another
disadvantage could be the complexity and
timeliness of obtaining information.
Provide some advice for ongoing monitoring
of the fund.
Typically, hedge funds hold quarterly
phone conferences. Participate even if you
don’t have any questions. Read any and all
information sent to you, including the audit
report. Have your CPA analyze the information as well.
Always watch for warning flags. Have
they changed their risk philosophy?
Examine their portfolio/holdings on a regular basis. A consistent change in the
fund’s relationship of taxable income to
economic income may be a signal of other
changes at the fund.
Nothing is better than quarterly in-person
meetings. The hedge fund manager should
be someone you are in frequent contact
with on a regular basis. Remember, all the
reasons that induced you into investing in
the fund in the first place should still be
there.
JOHN T. ALFONSI, CPA/ABV, CVA, CFE, is a partner with
Cendrowski Selecky PC, Bloomfield Hills. Reach him at (248)
540-5760 or [email protected].
