Why does the taxman hope you'll invest in hedge funds this year?

March 22, 2018

 
Chris Tidmore

Chris Tidmore
Senior Investment Strategist

Because the recent tax reform legislation grants him a bigger piece of the pie.

The Tax Cuts and Jobs Act (TCJA) repeals all miscellaneous itemized deductions and, most important for hedge fund investors, deductions for management fees and other partnership expenses. Yikes! Many of those high fees that hedge fund investors are paying are no longer deductible for the taxable investor in the U.S.

Let's use a hypothetical example in which a high-net-worth investor invests in a top-performing hedge fund. We'll use Hedge Fund Research (HFR) data for the gross annualized return of the median top-quartile fund over the ten years ended December 31, 2017. We'll ignore all the biases in the data, including survivorship bias and reporting bias.

With these parameters set, the median fund's gross annualized return was 13.9%. Not too shabby. But remember, this is the median of the top quartile, or somewhere around the 87th percentile.

So what would the investor actually keep?

Let's assume this high-net-worth investor lives in one of the ten states with the highest marginal tax rates and pays a combined marginal tax rate of 50.2% on ordinary income (37.0% federal tax rate + 9.4% [average of the top ten state marginal tax rates] + 3.8% [Affordable Care Act Net Investment Income Tax] = 50.2%). So according to HFR, the median management fee and performance fee are 1.5% and 2.4%, respectively. And for this example, we'll estimate miscellaneous investment expenses, which typically appear as part of miscellaneous itemized deductions on a standard K-1, at 0.5%.

Since many of the fees are not deductible for tax purposes, almost the entire gross return is subject to tax.1 The chart below shows that the 13.9% gross annualized return becomes a 9.5% return after fees and only a 3.8% return after taxes and fees.

Fees and taxes drain top-quartile fund's return

Fees and taxes drain top-quartile fund’s return

*The Affordable Care Act allows for the deductibility of management fees and miscellaneous expenses when calculating the Net Investment Income Tax; federal and state income tax guidelines do not [(13.9%-2.4%) x (37.0%+9.4%)] + [(13.9%-2.4%-0.5%-1.5%) x 3.8%] = 5.7%%.

**Pre-TCJA, the after-tax return would have been a slightly higher (but still abysmal) 4.5%.

Ouch! So much for all the due diligence and good fortune in selecting a fund that provided the lofty top-quartile return for the taxable investor.

Now, many hedge fund investors will benchmark to equities or a mix of equities and fixed income. And over the ten years ended December 31, 2017, equities (represented by the Dow Jones U.S. Broad Stock Market Index) returned an annualized 8.7% and a 60/40 portfolio of equities and fixed income (represented by the Dow Jones U.S. Broad Stock Market Index and Bloomberg Barclays U.S. Aggregate Bond Index) returned an annualized 7.1%. Notwithstanding the fact that investments seeking to track these indexes can be had for less than 15 basis points, and according to Vanguard research,2 the ten-year tax cost of a broad-market equity index fund was about 0.41%, the appropriateness of these more traditional investments as a benchmark for hedge funds is a discussion for another day.

Muni bonds present a less volatile option

Oh, by the way, municipal bonds returned 4.5% over the same ten-year period with less than one-third the volatility of stocks. Maybe that's what clients should allocate towards. The top-quartile median annualized volatility of funds that reported to HFR and had returns for the ten years ended December 31, 2017, was 15.1%, while the annualized volatility of the Bloomberg Barclays Municipal Bond Index over the same time period was 4.5%.

Though the taxman does hope an investor will be altruistic and choose hedge funds instead. In this case the taxman would love his 5.7%. It's only 150% of what the investor keeps.

1 This is a hypothetical situation and assumes the fund is an investor fund and not a Section 475(f) trader fund. See Endicott v. Commissioner of Internal Revenue, T.C. Memo 2013-199, for an example of the difficulty in claiming this election.

2 Scott J. Donaldson, Francis M. Kinniry Jr., David J. Walker, and Justin C. Wagner, 2015. Tax-efficient equity investing: Solutions for maximizing after-tax returns. Valley Forge, Pa.: The Vanguard Group.

Notes:

  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
  • All investing is subject to risk, including possible loss of principal.

Chris Tidmore

Chris Tidmore, CFA, is a senior investment strategist in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on issues related to active management. Before joining Vanguard in 2015, Mr. Tidmore managed the Geneva Arbitrage Fund, which focused on event-driven investment strategies. Before the launch of the Geneva Arbitrage Fund, he worked as an arbitrage trader and portfolio manager for a large family office. In addition, he was an options trader on the American Stock Exchange, and prior to his work in the securities industry, he was employed as an auditor, providing audit, accounting, and consulting services.

Mr. Tidmore has developed and taught courses in financial accounting, financial statement analysis, asset valuation, equity derivatives, trading, portfolio management, alternative investments, and CFA and CPA review courses. He earned a B.S. in accounting at the University of Delaware, and is a CFA® charterholder, CPA, and past president of the CFA Society of Philadelphia.

CFA® is a registered trademark owned by CFA Institute.

 

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