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Jack Bogle, the founder of Vanguard and the man who put index funds on the map, believes that investors who pay tax should not put any money into hedge funds.
Mr Bogle says that the funds are probably the most tax-inefficient investment around – a fact that tends to be lost in the talk of their returns.
Ken Stemme, the director of hedge fund investments at Northern Trust, says: “Most hedge funds are not tax friendly, and there’s no logical answer for why not.
“It’s odd that high net worth investors were the foundation of the industry, and yet the managers never developed any sensitivity to taxes. Also, [the managers] have a lot of their own money in their funds, and they still don’t think about the taxes much.”
Essentially, any return an investor makes through a hedge fund is subject to full ordinary income tax, or short-term capital gains tax (which is the same rate as income tax). That means a hefty 42 per cent tax for residents of New York and California.
By contrast, equities held for a year or more are subject to long-term capital gains tax of only 15 per cent. Most investment options available do have some kind of tax break as part of the government plan to try to encourage savings.
But hedge funds seem oblivious to the problems. A common complaint from investors is that the funds even tend to compound the problems, and further irritate their clients, by being extremely tardy in providing them with the very complicated documentation they need for tax returns.
Michael Cembalest, chief investment officer at JPMorgan Private Bank, says: “The majority of money in hedge funds is now invested by people who don’t pay tax – endowments, foundations, pensions and individuals whose money is offshore. So over the past decade the people managing the money have not had to worry about tax.”
He says an 8 per cent annual return from a hedge fund looks better than the 5 per cent return you get from an agency bond (such as Fannie Mae). But once you take tax into account, the picture changes radically.
The 8 per cent hedge fund return is reduced to 4.65 per cent after tax – barely above the 4 per cent return that municipal bonds offer.
“In the late 1990s the returns were so high that people didn’t care about the tax even if they had to pay it,” says Mr Cembalest, who recently completed a study on which hedge funds were most or least tax-efficient.
“But since June 2003 there has been a resurgence in the stock markets, bonds and commodities, and hedge fund returns don’t look as good any more.”
The returns published by hedge funds are pre-tax, and investors do not know what their after-tax returns will be until they get the statements from the hedge fund outlining their tax obligations.
However, Mr Cembalest says not all hedge funds are equal for tax purposes. He recently trawled through their tax bills for the past two decades to see which strategies had the greatest tax benefits.
“Not every penny that hedge funds earn is subject to capital gains,” he says. “Typically investors end up paying 30 to 32 per cent tax on their earnings, a lot less than the full rate.”
For example, only about 40 per cent of returns from long/short funds are taxable at the top rate, he says. Distress funds had only about 60 per cent of their income taxed at the top rate.
The least tax-efficient were macro funds, all of whose income was taxed either as ordinary income or short-term capital gains.
As a general rule, Mr Cembalest recommends to his clients that, if they are taxed in the US, they invest 20 to 40 per cent less in hedge funds than if they were in an offshore (ie tax-free) domicile.
“We recommend that clients have about 25 per cent of their money invested in alternatives, which includes private equity and real estate. So that means an offshore client would have about 8 to 11 per cent of their money in hedge funds, as opposed to an onshore client having 6 to 7 per cent,” Mr Cembalest says.
Mr Stemme says the two most tax-friendly hedge fund strategies – long equity and distress investing – are also the two most strongly correlated to the equity markets.
Since many investors choose to put money into hedge funds in order to get diversification from the equity markets, this is a disadvantage.
But he points out that considerations other than tax play a part in portfolio planning. “You have to look at the positive impact of diversification.”
Mr Cembalest says: “The whole point of hedge funds is to operate in fast-moving markets. They are supposed to be aggressively buying and selling. They can’t be worrying about tax efficiency all the time.”
Asking the funds to change their investing strategies to take tax into account would defeat the purpose of the funds.
He says taxable clients have to be willing to invest in slightly riskier funds and strategies to get the higher returns to offset the tax bill.
“Diversified hedge funds make a lot less sense for taxable clients,” he says.