Alternative Hedge Fund Product Performance

Abstract

In the financial press, hedge funds are often maligned for being tax inefficient. In this article, the author reviews various legal and tax regulations that impact hedge fund and mutual fund after-tax returns. She demonstrates that it is possible to employ current tax regulations in such a way as to make hedge funds more tax efficient than mutual funds with similar return patterns. This article demonstrates that the organizational form of the hedge fund and thus the partial netting and “in-kind” distributions available to them can be implemented in such a manner as to outweigh the tax detriments endured by hedge funds in the form of higher tax rates bestowed on them due to short-term capital gain distributions, the section 1256 rules, and unqualified dividend distributions. Various volatility/return combinations were tested. Results show that for the majority of positive return patterns, mutual fund taxes were greater than hedge fund taxes. There was a stark difference, however, when returns were negative. When returns were negative, at all levels of volatility tested, hedge fund taxes were higher than mutual fund taxes. The reason for this contrast is a subject for future research.