Investment vehicles for hedge funds
The hedge fund industry is often erroneously associated with high risk, lack of transparency, and doubtful investment strategies. But investors who understand how hedge funds can protect their capital in volatile markets have been richly rewarded in the past. For investors who want the positive effect of exposure to hedge funds but are not familiar with the risks of the different strategies, an investment in a fund of hedge funds would be more appropriate than a direct investment in a single underlying hedge fund.
But it is not the objective here to argue the relative merits of hedge funds. In this article Lizelle Steyn, Manager: Alternative Investments at Nedgroup Investments, gives an overview of the structures through which investors can access a fund of hedge funds.
Ideally an investor wants a structure that:
1) ensures he or she will never lose more than the capital invested;
2) discloses all the fees charged at the different levels of the structure;
3) provides satisfactory liquidity (the ease of investing in and disinvesting from a fund); and
4) channels all income generated by the fund through to the investor, so that earnings are taxable in the hands of the investor, not the fund. (The actual tax implications will be dependent on the unique situation of the investor, combined with the specific investment vehicle chosen. Investors should therefore consult a tax specialist for a comprehensive assessment.)
When an individualâ€™s investment in a hedge fund is managed within a segregated account, the investor usually does not enjoy limited liability and all income earned within the account is channeled to the individual and taxable within his or her hands.
The investment vehicle with which individuals are most familiar, in all likelihood, is the endowment policy. Though it limits the liability of the investor to his capital invested, fees permeate several tiers within the structure and are sometimes not disclosed to an investor. The clientâ€™s investment is also locked in for a minimum of five years, with the exception of one partial redemption allowed during the term. Unfortunately the income generated by the hedge fund is taxable within the policyholder fund and could potentially be detrimental to lower tax rate-paying investors.
Another structure where the income is taxable within the fund is the company structure, which is particularly punitive to institutional investors, such as retirement funds. Like the endowment policy, it limits potential losses to the capital invested by the investor. Unlike the endowment policy, the reporting of costs to the client is significantly more transparent.
With a trust the income is also taxable within the hands of the investor, who enjoys limited liability, but there are risks depending whether the trust is set up with vesting or discretionary beneficiaries.
Partnerships should also be familiar to many investors. In the South African hedge fund industry they are structured to be en commandite (limited liability) structures. This investment vehicle satisfies all of our four criteria for an ideal structure but, as only twenty partners are legally allowed within one partnership, the minimum investment amount required from each investor is normally higher than that of the other investment vehicles.
There are also other creative structures, such as the variable rate debenture structure and the loan stock company, which were created to fulfil the four requirements for an ideal structure mentioned earlier, but importantly without limiting the number of investors.
Although all of the investment vehicles mentioned, except the life policy, provide reasonable liquidity (usually monthly when the investor selects a South African fund of hedge funds), the level of flexibility with regards to entering and exiting the fund is not nearly on par with that of collective investment schemes. This structure would be ideal for retail investors, but regulation under the Collective Investment Schemes Control Act remains elusive. Until such a break-through occurs, hedge funds remain unregulated and may not be marketed to the public. It remains legal to invest in them, though.
Johan du Toit Meropa Communications
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