Recent market volatility has caused many investors to consider investing in hedge funds because of their ability to be both short and long the market. BlogOnWealth in Part 2 of our series on hedge fund investing discusses several items you need to be aware of before signing the hedge fund’s contract.
Liquidity and transparency. As many investors learned the hard way in 2008, there are few constraints that prevent a hedge fund manager from investing in very illiquid assets. The larger the fund, the less likely the smaller investor will get full transparency on those illiquid positions. A number of fund of funds have yet to provide investors with full liquidity on redemption requests made in 2008. Investors should be well compensated for investments that have no transparency and uncertain liquidity.
The market’s reaction to these problems has been for many hedge funds to offer a mutual fund version of their hedge fund that provides daily liquidity and price transparency. These hedge fund/mutual funds have attracted more than $6 billion of client assets in the first six months of 2011.
After Tax Returns: There are significant tax considerations that the taxable investor needs to keep in mind. While a five-year 14% annualized return might look pretty good, if those returns are 100% taxable every year, the after-tax returns look much more pedestrian. Indeed, the difference in after-tax returns for a 14% investment that is 100% taxable annually compared to one that has 100% unrealized gains is about one percentage point (at top marginal tax rates) over a five-year period. The power of compounding does not get suspended just because it is a hedge fund!
Liquidity for tax payments. The negative impact of 100% taxable gains is compounded if you have no liquidity. For example, if your hedge fund has a lock-up, you will have to find cash flow from other investments to fund the tax payments. There are obviously circumstances when high taxable returns are desirable: If an investor has other investments that generate substantial tax losses or if there are significant tax losses from prior years that need to be “harvested.”
Alignment of incentives: Look at the other investors and don’t mistake their objectives for yours. While the presence of large endowments, foundations and other tax-exempt entities might make the taxable investor comfortable that the smart money has done the due diligence work, these investors have different objectives and constraints than most taxable investors. If the majority of the investors don’t pay taxes, then the taxable investor’s need for after tax returns will not be a priority for the investment manager.
Hedge funds can be a helpful portfolio addition, but you need to read the fine print of each fund before you invest. Don’t forget 2008!