Hedge Terms

Question 1

What is a hedge fund

Answer 1

An investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds

Mutual funds are regulated investment products offered to the public and available for daily trading. Hedge funds are private investments that are only available to accredited investors. Hedge funds are known for using higher risk investing strategies with the goal of achieving higher returns for their investors.

Question 2

What is short selling

Answer 2

Investment activity in which the investor borrows securities and sells them in the hopes of then purchasing the securities at a lower price in the future. This strategy speculates on the decline in a stock’s price. A position is opened by borrowing shares of a stock from a broker-dealer or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase the shares at a lower cost. To close a short position, a trader buys the shares back on the market—hopefully at a price less than at which they borrowed the asset—and returns them to the lender or broker.

Question 3

What is the purpose of a hedge fund

Answer 3

To maximize investor returns and eliminate risk. This strategy is similar to a mutual fund except hedge funds are more aggressive, risky, and exclusive.

Question 4

Where does the name “hedge” fund derive its name?

Answer 4

The name hedge fund derives from the use of trading techniques that fund managers are permitted to perform. In keeping with the aim of these vehicles to make money, regardless of whether the stock market climbs higher or declines, managers can hedge themselves by going long (if they foresee a market rise) or shorting stocks (if they anticipate a drop).

A hedge is a method to reduce risk and secure winnings for a specified bet. In sports, it means betting the opposite side of your original wager in order to either try to middle the game, or to reduce the downside exposure of the original wager.

Question 5

What is a macro hedge fund and what does it invest in?

Answer 5

A macro hedge fund invests in stocks, bonds, and currencies hoping to profit from changes in macroeconomic variables, such as global interest rates and countries’ economic policies

Question 6

What is a equity hedge fund and what does it invest in?

Answer 6

An equity hedge fund may be global or country-specific, investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices

Question 7

What is a relative-value hedge fund and what does it invest in?

Answer 7

A relative-value hedge fund takes advantage of price or spreads’ inefficiencies

Question 8

What is an Open Fund?

Answer 8

A type of fund without restrictions on the amount of shares the fund will issue. If demand is high enough, the fund will continue to issue shares no matter how many investors there are. Open-end funds also buy back shares when investors wish to sell.
Key: investors enter/redeem at break points throughout the year. Generally when fund has liquid investments.

Question 9

What is a closed fund?

Answer 9

A collective investment model based on issuing a fixed number of shares which are not redeemable from the fund. Unlike open-end funds, new shares/units in a closed-end fund are not created by manager to meet demand from investors.
KEY: limited opportunities for investors to enter/redeem. Generally when fund has illiquid investments

Question 10

As partners enter and leave a fund, unrealized is not included in tax income or tax capital. How do we deal with the DISPARITY in basis between book and tax in relation to an investor’s interest in unrealized for an Open Ended fund

Answer 10

Allocate CY taxable trading items in proportion to each partner’s disparity in the fund

Question 11

What is a sidepocket?

Answer 11

Investment carve-outs that are common in Hedge Funds. Often used to enter illiquid investments. Sidepockets often follow different allocations than the fund’s liquid investment. Not necessarily happen at the beginning of the fund. So ask each year.

Question 12

How to calculate adjusted capital?

Answer 12

Beginning capital + contribution - distribution +/- transfers + book income/loss

Question 13

How to calculate capital/economic percentages?

Answer 13

computed by calculating the ratio that each partners’ capital bears to the total capital of the partnership

Question 14

How to calculate book allocations in a hedge fund?

Answer 14

“Book income” is determined for each break period and allocated in accordance with each partners’ relative capital percentage per period

Book income includes ordinary, realized and unrealized g/l

Provided by the client. Most client provide capital reports to investors on a monthly/annual basis

Question 15

How are tax allocations treated in a hedge fund?

Answer 15

Generally follows book per 704(b) -Allocation of ordinary items:
- interest, dividends, operating expenses
- based on partners’ current economic percentages
- WAC: monthly or yearly, break periods - Section 706
- Special allocations to certain investors or type of income (i.e. management fees)

Allocation of trading items: (realized/unrealized g/l) - Section 704(c)
- Contributed property - forward 704(c)
- Revaluation - Lot layering* or aggregation

Lot layering looks at every single asset an allocates any unrealized to the partners who were in the partnership during that time

Question 16

What are some examples of trading items?

Answer 16

STCG or L
LTCG or L
PFIC G/L
Section 1231 G/L
Market Discount upon disposition
Swaps G/L on early termination
Sec 988 G/L - minor currency contracts
Unrealized G/L

All will create book to tax difference that will drive disparity

Question 17

What are the two methodologies used to allocate taxable gains and losses?

Answer 17

Layering and Aggregate

Question 18

Explain the layering methodology of allocating taxable g/l

Answer 18

Unrealized account is established for each partner with respect to each security

G/l are allocated to each partner based on a specific security-by-security approach

Very complex - create a 704(c) layer for each asset for each partner, allocate g/l based on each partner’s 704(c) layer

Mostly used in Real Estate when there are few large deals since easy to track each investor’s interest in a few deals. Don’t see much in Hedge, unless there is a side pocket, but only in that component.

Question 19

Explain the aggregate methodology of allocating g/l

Answer 19

Securities Partnerships may aggregate g/l from “qualified financial assets” to determine partners’ reverse section 704(c) allocations

Unrealized account per partner is taken as a whole (unlike layering, where each security’s unrealized account is tracked individually per partner)

TIP: what have I picked up for book purposes cumulatively vs what have I picked up for tax purposes cumulatively? If there is a difference, that is disparity which is typically related to M-1 differences whereas reval refers to trading items.

Question 20

Under Section 1.704-3(e)(3), how are g/l during a period aggregated and allocated?

Answer 20

Based on an aggregate unrealized account (i.e. disparity/reval) as a whole on the assumption that such g/l are generally attributable to the opening unrealized (i.e. FIFO)
- Partial netting approach - realized tax gains and losses are aggregated as gross gains and losses and allocated separately according to disparity/reval
- Full netting approach - realized tax gains and losses are netted together and allocated using Section 704(c)

Look at each partner’s disparity/reval and that is how you are going to allocate your CY trading items to reduce that disparity or bring as close to zero as possible. Issue is that partners come in, typically monthly, you may have partners with negative disparity/reval or positive disparity/reval. If positive, I picked up more in book income than I have in tax income over the life of the investment. So to get my disparity to zero, I need additional taxable income. If negative, I have picked up more in TI than book income.

Question 21

Explain the concept of Disparity vs. Revaluation

Answer 21

Similar in concept and at times the terms are used interchangeably

Disparity:
- Book Capital - Tax Capital = Revaluation + Cumulative Ordinary M-1s (e.g. accrued dividends, 18a/b/c, syndication costs)
- Includes ALL M-1s

Revaluation:
- Cumulative Unrealized - Book/Tax differences with respect to trading items only

Note - TRACK can do aggregations either using revaluation or disparity both full and partial netting

Question 22

Stuffing = the Sec 754 “election” of Hedge Funds

What does it mean to “fill-up” or “fill-down” (aka “Stuffing)?

Answer 22

A special allocation which shifts g/l from continuing partners to withdrawing partner in order to equalize book and tax capital accounts

Withdrawing partner receives an inc/dec in basis and should recognize no go/l upon redemption - “Outside” basis = “Inside” Basis

Tells the outgoing partner, “this is how much TI you need to get as close to what happened economically over the life of the fund”

Stuffing based on Disparity account typically results in equalized Outside Investor tax basis and Inside Fund tax basis for withdrawing partner

Stuffing based on Reval account may still result in diff between Outside Investor tax basis and Inside Fund tax basis for withdrawing partner since Reval only accounts for trading M-1s

Stuffing provides similar to Sec 754 yet avoids the tedious calcs and compliance costs

Stuffing can be based on full or partial netting

Stuffing can be based on full or partial redemption - pro-rata based on FMV of redeemed interest

Question 23

What are Incentive Fees?

Answer 23

At the EOY or end of break period, after the partnership’s economic income has been allocated, a fee is paid or a special allocation is made to the GP to compensate for managing the fund

Question 24

Explain Incentive Fees vs Incentive Reallocation

Answer 24

Reallocation - the advantage is items retain character (e.g. preferential rate for LTCG, Qual Dividends, etc.)