Taxes Raise Bar for a Hedge-Fund Bet

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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Thanks to the Jumpstart Our Business Startups (JOBS) Act, thousands of hedge funds will soon startadvertising to the millions of Americans who can theoreticallyafford to invest in them, but don't. They should be careful.

A new report (not online, sorry) from Greenline Partners, which advises non-institutional savers and was cofounded by a former co-worker of mine, explains that taxes paid to the government and fees paid to managers each eat about 30 percent of a hedge fund's gross profits. Investors only keep about 40 percent. (The exact split depends on the size of those profits.) A fund that claims to generate 15 percent a year is really only giving you just 5.7 percent. Keep this in mind as you start to receive unsolicited sales pitches.

The reason is that regular people who invest in hedge funds have to pay taxes on all of the fund's trades -- unlike pension funds, sovereign wealth funds, and charitable endowments. Since hedge funds often trade frequently, this means that investors have to regularly pay capital gains taxes. Those extra taxes lower an investor's net profit because of compounding.

Suppose a saver buys an asset for $100 that returns 8 percent each year and doesn't sell it for 20 years. At that point the investment is worth roughly $466. After paying 23.8 percent to the tax man (using today's long-term capital gains rate) on the $366 profit, the investor gets a total after-tax gain of about $279. If this investor had sold and then bought that asset each year, tax of 23.8 percent would have been due on each year's profit. After 20 years of this, taxes would have reduced the total take-home profit to just $227 -- about 19 percent less than what the investor would have earned under a pure buy-and-hold strategy.

Many hedge funds actually trade much more often than once a year, which means that investors almost always have to pay the short-term capital gains rate of 43.4 percent, rather than 23.8 percent. This is obviously true for algorithmic shops that execute trades within milliseconds, but it is also true for funds that aren't constantly changing positions. For example, a fund that wants to bet on higher wheat prices will generally buy a futures contract that matures in a few months. Since the fund doesn't want to take delivery of bushels of wheat and store them somewhere, it will generally sell its maturing contracts and buy the next-nearest contract once every couple of months. (Renaissance Technologies thought it had found a way around this problem using options but the Internal Revenue Service disagreed.)

These tax issues don't mean that hedge funds are a waste of time. However, they dramatically increase the hurdle rate that investors should demand before handing over their money. The following comparison from Greenline Partners makes this clear. Someone who bought shares in a low-cost index fund that tracked the Standard & Poor's 500 Index and reinvested all dividends would have made about 9.6 annually since 1970, before taxes. That turns into an annual average of about 8.3 percent if you apply today's dividend and capital-gains tax rates. To get an equivalent return after taxes and fees, an investor would have to find a hedge fund that consistently earned almost 21 percent a year. Even the best hedge funds usually earn much less than that.

Meager after-tax returns might be attractive if you can use them to diversify the rest of your portfolio. But finding those funds is always a challenge, especially for those of us who aren't managing tens or hundreds of billions of dollars on behalf of institutions. Bottom line: if you want to bet on hedge funds, do it through a charitable foundation, not your personal savings.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.