A Hedge Fund Tax Tragedy To Ponder

 This is part of a regular series of thought-leadership pieces from some of the more influential ETF asset management in the money management industry. Today’s article is by Hafeez Esmail, San Francisco-based Main Management’s director of marketing. Hafeez Esmail for ETF Trends writes: Let’s hope the smart money is slowly beginning to recognize the folly of most hedge fund investing.

While there are handful of managers with strong track records—most of whom are either closed or inaccessible to affluent investors—the vast majority of hedge funds are becoming known for underperformance and self-enrichment.

In addition to anemic returns, there’s another aspect of hedge fund returns that warrants scrutiny— taxation. While hedge funds tend to be varied in their approaches, a large number of them have heavy turnover in the quest for returns. This is a reason they are loved by prime brokers, because lots of transactions and heavy volumes result in lots of trading commissions.

Short-Term Gains = Extra Tax Pain

So, in the event you’re fortunate enough to have positive returns, those returns are likely to be predominantly short-term in nature.

With tax rates going nowhere but higher, and top-earner tax rates in a state like California exceeding 50 percent (federal and state combined), it’s clear that closer examination is needed not just of after-fee returns, but of returns after taxes as well.

Let’s combine the 2 percent expense and 20 percent incentive structure typical of hedge funds with the preponderance of short-term gains—in the context of arguably rare gains—that result from significant turnover. Because Main Management is based in San Francisco, I’ll also take the liberty of assuming the client lives in California and thus has an approximate combined 50 percent federal and state tax burden.

With these assumptions, here’s how the numbers work out: To get a 5 percent net after-fee, after-tax return for a hedge fund, you need a gross return around 14 percent. Yes, 14 percent. Let that sink in—a 14 percent gross return turns into a take-home return for the client of 5 percent.

Using a back-of-the-envelope calculation, if you take away the 2 percent and 20 percent, you’re down to 9.6 percent net after fees. After federal and state taxes in California, you’re right around 5 percent, or perhaps a bit lower. For a more scientific approach, albeit with very similar conclusions, see this analysis in the New York Times.

Ultimately, my question is this: If financial advisors are fiduciaries who are obligated to act in their clients’ best interest, how can in good conscience continue to recommend such instruments?

ETFs Vs. Hedge Funds

By contrast, let’s look at an ETF-based, option-writing approach like Main Management’s “Buy Write/Hedged Equity Strategy.”

I use this example for a few reasons.

First, the overall idea with this strategy is to achieve superior risk-adjusted returns using covered calls in a portfolio of U.S. and International equities allocated based on fundamental analysis. It is designed to deliver two-thirds of the upside and half the downside of a pure equity strategy.

In fact, over time, it has the return profile of a 65 percent equity-35 percent fixed-income allocation without any fixed-income duration risk, as ETF.com’s Olly Ludwig wrote in ETF Report recently.

Also, unlike the typical hedge fund, the strategy is also tax aware, keeping turnover under control.

This happens because monthly call writing generally creates sizable options returns when the underlying portfolio of ETFs plunges, while options typically generate losses when markets (and underlying ETFs) are surging higher. Having these two inherently inversely correlated components frequently allows Main to tax-loss-harvest or even carry losses forward.

Within a low fee structure—say 50 basis points ($50 for each $10,000 invested)—one might only require 6 to 7 percent gross returns for a net after-tax and after-fee return of 5 percent. Again, a high-turnover hedge fund, in this scenario, may need double the return to give the client the same amount of net capital. That’s the 14 percent I spoke about above.

Focus On What You Can Control

And, to return to the problem at hand for investors seeking a silver bullet with hedge funds, do you think hedge funds are really up to the task? The average hedge fund, year-to-date through Sept. 5, is up just 2 percent before fees, according to industry tracker HFR. That compares with about a 10 percent return, including dividends, for the S&P 500 over the same time frame.

Clearly hedge funds are a remarkable vehicle for hedge-fund manager enrichment and for transferring your hard-earned capital to the hedge fund manager and to the tax man. By the way, if you haven’t read Larry Swedroe’s two recent articles on ETF.com about hedge funds, they’re certainly worth a look, especially the one titled “Even Stars Knock Hedge Funds.”

In any case, I believe it’s fair to assume most advisors would prefer not to pledge significant sums of their clients’ assets to taxation and compensation to hedge fund managers.

With all this in mind, it’s clearly time to make the after-fee and after-tax discussion a centerpiece of the conversation with clients.

You can visit the author @ his website here.