Hedge funds are a means for investors to buy and sell securities as well as other types of investments to gain above-average returns. It is limited to qualified or accredited investors who had an annual income of $200,000 for the past two years or with a net worth of more than a million dollars and can afford to take higher than normal risks.

As opposed to mutual funds, hedge funds are not heavily regulated by the Securities and Exchange Commission (SEC), which provides leeway to pursue investments. Hedge funds can invest in a wide latitude of products such as real estate, stocks, currencies, and derivatives. It can practice strategies such as selling short, leverage, program trading, swaps, arbitrage, and derivatives.

Hedge funds also employ leverage wherein it usually uses borrowed money to increase its returns. Additionally, hedge funds are more expensive because it uses the “Two And Twenty” fee structure. In this fee structure, fund managers receive 2% of assets and 20% of profits each year.  For example, a hedge fund manager is managing a $1 billion fund. He could earn $20 million in overseeing the fund as compensation.

Where the Hedge Fund Got Started

In 1949, most investment strategies took only long positions. Alfred Winslow Jones, a former writer, and sociologist was inspired by his article regarding investment trends for Fortune in 1948 to create a hedge fund. A.W. Jones & Co., the company of Jones, launched the first hedge fund intending to achieve higher returns if “hedging” was implemented into an investment strategy. He raised a $100,000, $40,000 of which was his own money. To minimize the risk of holding long-term stock positions, Jones did short-sell different stocks to utilized leverage to improve returns.

In 1966, hedge funds gained popularity and outperformed mutual funds by double digits. This success gained interest from high net worth individuals and top money managers.

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As hedge funds evolved through time with the new dynamics of investing and managing money, many funds turned away from Jones’ approach, which concentrated on stock picking coupled with hedging and opted to participate in riskier long-term leverage-based strategies instead. These strategies led to large hedge fund losses and closures during the 1973 to 1974 bear market.

For more than twenty years, the industry was relatively quiet until a 1986 article in Institutional Investor touted the double-digit success of the Tiger Fund of Julian Robertson. Investors continued to move into an industry that now offered thousands of funds and an ever-increasing variety of exotic strategies. High-profile managers left the traditional mutual fund industry, but unfortunately, in the 1990s, history repeated itself as several hedge funds failed, including Robertson’s Tiger Fund.

In 2002, there are 2,000 hedge funds noted to be operating. This has increased to 15,000 in 2020 and according to research firm Hedge Fund Research.

What are the Key Characteristics of Hedge Funds?

  • It is limited to qualified or accredited investors. Securities and Exchange Commission regards qualified investors reasonable enough to deal with the potential risk associated with the investment.
  • It offers wider investment latitude than other investment vehicles. It can invest in anything.
  • It often employs leverage, which usually uses borrowed money to increase its returns.
  • It uses a “Two And Twenty” fee structure wherein a 2% asset management fee and a 20% for overall profits as fees.
  • It is illiquid. Investments in hedge funds have a lock-up period, which is at least one year. Investors are often required to keep their money in the fund for the long-term proposition.
  • The Securities and Exchange Commission does not heavily regulate hedge funds.

What are the Advantages of Hedge Funds?

  • There are investment strategies that can be utilized to earn profits in rising and falling markets
  • There are reduced risk and volatility in balanced portfolios
  • There are a variety of investment styles that can be used to customize an investment strategy for investors
  • There is access to top investment managers

What are the Disadvantages of Hedge Funds?

  • Investment strategies are concentrated. This can expose to potentially huge losses
  • Hedge funds illiquid as opposed to mutual funds
  • There is a lock-up money for years for investors
  • Using leverage or borrowed money can turn into a significant loss

What Should I Consider if I am Going to Pick a Hedge Fund?

Since there are many hedge funds in the investment universe nowadays, it is important to note that investors understand what they want so they can make timely and suitable decisions. Investors should consider the following:

  • Understand the level of risk associated with the hedge fund’s investment strategies, and the level of risk tolerance you are willing to endure.
  • Know how the assets in the funds were valued since there are assets that are difficult to sell and some which are difficult to value
  • Understand the Two And Twenty fee structure since it will affect the return of your investment
  • Recognize that investments in hedge fund have a lock-up period, which limits the opportunity to redeem its investments in the short run
  • Ensure that hedge fund managers are qualified in managing your investments
  • Obtain transparency with your investments since you are entrusting your money to someone else. It is essential to know where your money is going, how it is being managed and invested, and how you can get your investment back.

How Are Hedge Funds Profits Taxed?

Profits earned from U.S. hedge funds are subject to tax. The short-term capital gains rate is taxed at the investor’s ordinary income tax rate, which refers to returns on assets kept for less than one year. For assets kept for more than one year, most taxpayers’ average is not more than 15%, but in high tax brackets, it can go as high as 20%. This tax can be applied to both U.S. and international investors.

What are the Ways to Avoid Taxes in Hedge Funds?

The hedge fund managers are paid with the carried interest; their fund revenue is taxed as investment income as opposed to a wage or reimbursement for the services provided. Compared to ordinary income tax rates, where the highest rate is 39.6%, the bonus fee is taxed as long-term capital gains. For hedge fund managers, this represents substantial tax savings.

However, critics of this business arrangement argue that the system is a loophole that enables hedge funds to avoid paying taxes. Despite several attempts in Congress, the carried interest provision has not yet been repealed. However, the provision became a topical issue during the 2016 primary election.

As another way to reduce their tax obligations, many famous hedge funds use reinsurance firms in Bermuda as there is no corporate income tax paid in Bermuda, most hedge funds set up their own reinsurance companies in the said nation. The hedge funds then give cash to Bermuda’s reinsurance firms. In exchange, those reinsurers invest those funds back into the hedge funds. Any hedge fund gains go to the Bermuda reinsurers, where they do not owe any corporate income tax. Without any tax obligation, the gains from hedge fund investments increase and are only owed once.

It should be an insurance business in Bermuda and should be an active business. Any other form of corporation will certainly face penalties from the U.S. Internal Revenue Services (IRS) for passive foreign investment firms. To qualify as an active business, IRS defines a reinsurance firm not to have a pool of capital that is far bigger than what it needs to back up the insurance it offers.

Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.