Tax-aware hedge fund strategies promise outperformance and tax efficiency but are their claims overstated?
We just released a white paper titled "Tax-Aware Hedge Fund Strategies: Separating Hype from Substance" which analyzes these claims.
Tax deferral is valuable, as delaying taxes allows for greater investment growth. This value increases with longer deferral periods and higher returns. All tax-efficient investing offers this benefit, including buying and holding individual stocks and index funds.
We have quantified the value of tax deferral over different time horizons and return levels, which establishes a benchmark for evaluating the hurdle rate for these tax-aware hedge funds. The table below assumes a 10% return and 20% tax rate. The rightmost column then shows the annualized return improvement from deferring tax payment.
Hold Period (yrs) | Annualized Return (after-tax) | Annualized Value of Deferral |
1 | 8.0% | |
3 | 8.1% | +0.1% |
5 | 8.3% | +0.3% |
7 | 8.4% | +0.4% |
10 | 8.6% | +0.6% |
15 | 8.8% | +0.8% |
20 | 9.0% | +1.0% |
30 | 9.2% | +1.2% |
Tax-aware hedge funds, using long/short strategies, aim for enhanced loss realization by selling both losing long and short positions in any market, potentially leading to perpetual loss harvesting via leverage. However, our paper highlights two main risks: the difficulty of consistent alpha generation in these hedge funds and higher fees that require significant outperformance to justify.
For these strategies to add value through tax deferral, a combination of good returns and a long deferral horizon is generally needed, especially with a 20% capital gains tax. The value is somewhat greater with a 40% tax rate (short-term gains), but still often requires longer timeframes and significant returns.
If there is a use for these strategies, they may offer substantial value in converting short-term gains into long-term gains by generating short-term losses to offset frequent short-term gains. This allows for tax deferral and eventual taxation at more favorable long-term rates. Achieving the same after-tax return without this conversion may require a 2% to 5% increase in pre-tax returns.
In summary, as with most strategies sold as tax-efficient, we think the claimed tax benefits of these hedge funds are overstated. But there is a niche application for investors who have tax-inefficient portfolios that they are locked into.
You can listen to an audio discussion of our full research paper here.
We also wrote a paper in 2018 analyzing traditional long-only tax loss harvesting strategies. You can listen to an AI-generated podcast discussion this original research here.
(Note: These podcast have been generated using artificial intelligence and do not represent an endorsement of Greenline Partners. The voices and perspectives are not a reflection of members of the firm.)