Making Hedge Funds More Tax-Efficient

Abstract

The author starts with the fundamental observation that hedge funds are generally tax-unfriendly. They often employ trading strategies that generate attractive pre-tax returns, but unfortunately these strategies also produce income taxed at the highest rate of 35%. In addition, while the funds generate no cash income for their investors, those same investors must nevertheless pay taxes each year on their shares of partnership income. He suggests that there are two approaches to minimizing the tax treatment of hedge fund investments: portfolio-level management and investor-level management. None of these ideas will wipe out taxes; they are meant to defer taxes as long as possible, and when tax is to be paid the goal is to only pay a 15% rate. Care is given to not disturbing the investment goals in achieving tax efficiency; in other words, don't let the tail wag the dog. Thus, the article breaks the possibilities into what can be done at the fund level and what investors can do on their own if the hedge funds do not employ such opportunities.