What Every Tax Advisor Needs to Know About Hedge Funds

1
What Every Tax Advisor Needs to KnowAbout Hedge
Funds
Paul S. Lee, J.D., LL.M. National Managing
Director
2
Hedge Funds Staggering Popularity and Growth

• Over 9,000 Funds

• Over 1.4 Trillion

Source HFR Industry Report , Fourth Quarter, 2006
3
What Do You Need to Know as an Advisor?
4
Hedge Fund No Standard Legal Definition

• Lightly regulated investment vehicle
• Not registered under the Investment Company Act
  of 1940
• Securities not registered with SEC
• Limited to high net worth individuals and
  institutions
• Limited liquidity
• Flexible investment mandate
• Not just long, but also short
• Employ leverage
• Two layers of fees
• Investment management fee (1 to 3)
• Incentive fee based on profits (10 to 30)
• With a watermark
• Above benchmark

5
Categories of Hedge Fund Strategies

• Market Neutral (1/3)
• Event Driven
• Merger Arbitrage
• Distressed Securities
• Equity Market Neutral
• Arbitrage Strategies
• Fixed Income Arbitrage
• Convertible Arbitrage

• Directional Strategies (2/3)
• Long-Short Equity Strategies
• Global Asset Allocators (Macro)
• Emerging Markets

Source HFR Industry Report 2006.
6
Going Long and Short

• Financial tools and strategies
• Short sales
• Futures and forwards
• Options
• Notional principal contracts (pg. 5, fn. 4)

7
Mechanics of a Short Sale
Loan 100 shares XYZ
Short Sale 100 shares XYZ _at_ 10 per share
Short Seller (Borrower) (Hedge Fund)
Owner (Lender)
Market
Borrow Fee In Lieu Dividends
Proceeds (1,000) Interest
_at_15 per share (500) Loss Short Seller
Closing Transaction
Short Seller (Borrower) (Hedge Fund)
Owner (Lender)
Market
Return 100 shares of XYZ
Closing Purchase 100 shares XYZ
_at_5 per share 500 Profit Short Seller
8
Mechanics of a Futures/Forward Contract
Contract to Buy/Sell (No Premium or Up-Front
Payment)
Purchaser (Long Position)
Seller (Short Position)
Obligation Sell Deliver
Obligation Buy
Future Date Futures Price
Loss to Short Position
Gain to Long Position
Commodities Currencies Securities
Cash-Settled Futures Contracts and Mark to
Market System
Market vs. Futures Price
Profit to Short Position
Loss to Long Position
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Options
10
Structure of Onshore Hedge Funds
Limited Partners (Investors)

• Levels of Inquiry
• Tax classification of fund
• Subchapter K implications
• Valuation Issues
• Taxation of investments
• Investor-level issues

Hedge Fund Investments
11
Tax Classification of Fund

• Onshore hedge funds are partnerships
• Publicly traded partnership exceptions (pg. 7)
• Hedge fund status

Trader or Investor vs. Dealer
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Subchapter K Allocation of Profit and Loss
Limited Partners (Investors)
General AllocationsNet capital
appreciation(depreciation) to capital
accountsTax items allocated under 704(b) and
704(c)based on net capital
Special AllocationIncentive FeeBased on
benchmark?Index -9Return -1Incentive Fee
20 of 8
Hedge Fund Investments
All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
13
Subchapter K Contribution of Assets In-Kind
Limited Partner (Investor)
Assets-in-kindNon-taxable eventUnless hedge
fund isInvestment Company 721(b) and
351(e)Exception forDiversified
portfolioInsignificant amount
Special AllocationsDifferences inbook value
tax basis
Hedge Fund Investments
All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
14
Subchapter K Disguised Sale Rules
Limited Partner (Investor)
Presumed Disguised Sale 707(a)(2)(B)Contribut
ion of appreciated propertyDistribution of
other property or cash to contributing
partnerWithin 2 years
Triggering EventsPartial redemption or
withdrawalTax Distributions?Distributions
with corresponding allocation?
Hedge Fund Investments
All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
15
Subchapter K Mixing Bowl Transactions
Other Partner
Contributing Partner
Recognition of Gain/LossContributed
propertyDistributed to any other
partnerorReceive other propertyWithin 7 years
Capital accounts unaffectedOutside basis of
contributing partner and inside basisof property
automatically adjusted (no 754 election)
Hedge Fund Investments
Character of gain/lossdetermined at fund level
All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
16
Valuation Issues
Valuation forWealth TransferTax Purposes
Withdraw
Cure Book/Tax Lose Watermark

• Date of Transfer
• Value Received (Future)
• Previous Valuation

Restrictions

• Transferability
• Withdrawal
• No Chapter 14

Book/TaxDisparity
Valuation of theInvestments

• Accounting/Valuation Periods
• Actively traded
• Hard to value assets

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Taxation of Investments The Rules . . . And
Exceptions
CAPITAL GAIN/LOSS
Contracts under 1256 Currency Transactions (
988) pgs. 15-16 Conversion Transactions (
1258) pgs. 25-26 Constructive Ownership (
1260) pg. 35-37
CLOSE OF TRANSACTION
Contracts under 1256 Constructive Sales (
1259) Straddle Rules ( 1092)
All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
18
Taxation of Short Sales (Borrowers Standpoint)

• Gain or loss is on the closing transaction
• Short-sale proceeds less basis in replacement
  stock
• Short-term
• Unless replacement stock has a long-term holding
  period
• Special rule for converting short- to long-term
  gain
• Special rule for converting long- to short-term
  loss
• Section 1259 Constructive Sale
• Appreciated financial position (contributed or
  acquired)
• Deemed to have been sold upon the short sale

All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
19
Taxation of Futures and Forward Contracts

• Realization events
• Sale or exchange of the contract
• Physical settlement at maturity
• Offsetting contract
• Cash settlement at maturity
• Capital gain or loss
• Short term
• Options are essentially the same (pgs. 21 - 25)

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Section 1256 Contracts Mark to Market Taxation

• Includes
• Regulated Futures Contracts
• Traded on an established exchange
• Foreign Currency Contracts
• Forward contracts traded in interbank market
• Nonequity Options
• Traded on an exchange
• Broad-based equity index options (not narrow)
• Options on commodities, currencies and financial
  instruments
• Annual mark to market realization
• Tax treatment
• 60 long-term capital gain/loss
• 40 short-term capital gain/loss

All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
21
Straddle Rules (Section 1092)

• Defer loss realized from disposition of a
  straddle position
• Straddle
• Positions that are valued on an established
  market,
• That can be sold, exchanged or otherwise
  liquidated, and
• The value change in one position will result in
  an inverse change in value in the offsetting
  position.
• Included
• Short sales while holding a long position in the
  stock
• Any short position in substantially similar
  property

All section () references are to the Internal
Revenue Code of 1986, as amended, unless
otherwise noted.
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Summary of Investor Level issues

• Straddle rules apply to investors outside
  holdings (pg. 28)
• Deductibility of Interest and Short Sale Expenses
  (pgs. 30 - 31)
• Deductibility of Hedge Fund Investment Expenses
  (pgs. 31 - 32)
• Passive Activity Rules (pg. 33)
• At-Risk Limitations (pgs. 33 - 34)
• Tax Shelter Reporting Requirements (pgs. 37 - 38)

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The Hedge Fund Claim

• Produce equity-like returns
• Maintain lower volatility
• Exploit low correlation to rest of portfolio

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Hedging Market Exposures Tends to Lower Volatility
Market-Neutral
Directional Strategies

• Fully hedge market exposure
• Examples Arbitrage Event-Driven

• Retain some market exposure
• Examples Long/Short Equity Global Macro

Annualized Volatility 19962005
We group Convertible Arbitrage, Event-Driven,
Equity Market-Neutral, and Fixed-Income Arbitrage
hedge funds (as defined by the TASS database)
into our index of Market-Neutral Hedge Funds. We
group Long/Short Equity, Emerging Markets, CTAs,
and Global Macro hedge funds (as defined by the
TASS Database) into our index of Directional
Hedge Funds. See TASS Database in the Appendix
for a description of these indexes. Bonds are
represented by the Lehman Brothers U.S. Aggregate
Index, stocks by the SP 500. Source Lehman
Brothers, Standard Poors, TASS, and Bernstein
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Hedge Funds Dont Move in Tandem with the Markets
Correlations to SP 500 19962005
High Correlation
US Growth Stocks
US Value Stocks
International Stocks
Directional Hedge Funds
Market-Neutral Hedge Funds
Real Estate
Low Correlation
Bonds
Correlation between the SP 500 and other
investment alternatives, which are represented by
the followingUS Growth Stocks Russell 1000
Growth Index US Value Stocks Russell 1000 Value
Index International Stocks Morgan Stanley
Capital International (MSCI) All Country World
IndexEx-USA REITs National Association of Real
Estate Investment Trusts (NAREIT) Index Hedge
Funds TASS and Bernstein Bonds Lehman Brothers
U.S. Aggregate Index. Past correlations are not
necessarily indicative of future results.
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Analysis of Hedge Fund Database
Market-Neutral Funds
Directional Funds
12.4 (1.2) (3.1) 8.1
16.6 (2.2) (5.0) 9.4

• Full history of funds currently reporting
• Remove returns that were backfilled (Backfill
  Bias)
• Include returns of funds no longer reporting
  (Survivorship Bias)
• Adjusted Hedge Fund Returns

Backfill bias is the tendency of reported
database returns to be higher as a result of
hedge funds beginning to report returns after
they have achieved strong performance and then
retroactively filling in their history. To adjust
for this, fund returns were included only if they
appeared after the date that the fund first
reported to the database. Survivorship bias is
the tendency of reported database returns to be
higher as a result of capturing only the returns
of funds that continue to report to the database.
To adjust for this, returns of funds that dropped
out of the database were added back. All funds
with less than 10 million in assets under
management were removed from the sample. Given
the data in the TASS database, the impact of
look-ahead bias (unreported returns of funds
leaving the database) cannot be determined. See
TASS Database in the Appendix. Source TASS
and Bernstein
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Hedge Funds Superior Trade-Offs
19962005 Annualized
Directional Hedge Funds
Return ()
Market-Neutral Hedge Funds
Stocks
Bonds
T-Bills
Past performance does not guarantee future
results. Stocks are represented by the SP 500,
bonds by the Lehman Brothers U.S. Aggregate
Index maturity of Treasury bills is three
months. See TASS Database in the Appendix for
details on our hedge fund indexes. Hedge fund
performance is given after fees (1 on asset
management and 20 of profits, with a highwater
mark). Source Federal Reserve, Lehman
Brothers, Standard Poors, TASS, and Bernstein
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Traditional Allocation Models A New Paradigm?
Percentage of Total Assets
Traditional Assets Only
With Hedge Funds
40 Bonds
60 Stocks
100 Hedge Funds?
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Market vs. Manager The Traditional Approach
Sources of Returns 19962005
Manager Decisions (Alpha)
17

• Objectives
• Capture market return
• Add a premium (alpha) through long-only security
  selection

Market Movements
We measured the variation in monthly returns
attributable to the Russell 3000 Index for each
fund in our sample universes. We then took the
average result to represent the market return
driver. Though funds may have had exposures to
other market factors, we attributed all returns
not explained by the Russell 3000 movements to
active manager decisions. See Mercer Database
in the Appendix for details. Source Mercer,
Russell Investment Group, and Bernstein
30
Hedge Funds Focus on Alpha, Not the Market

• Sources of Alpha
• Long security selection
• Short-selling
• Various markets and instruments
• Leverage
• Specialized strategies(arbitrage, etc.)

Sources of Returns 19962005
Manager Decisions (Alpha)
Market Movements
We measured the variation in monthly returns
attributable to the Russell 3000 Index for each
fund in our sample universes and took the average
result to represent the market return driver.
Though funds may have had exposures to other
market factors, we attributed all returns not
explained by the Russell 3000 movements to active
manager decisions. See TASS Database in the
Appendix for details on how we analyzed hedge
fund returns and Mercer Database for a
description of how we analyzed traditionally
managed stock returns. Source Mercer, Russell
Investment Group, TASS, and Bernstein
31
Alpha Dispersion Among Hedge Funds Is Wide
Alpha /- Median Manager 19962005 Annualized
Market-Neutral Hedge Funds
DirectionalHedge Funds
Top-Decile Manager
Median
Bottom- Decile Manager
Alpha is defined as a funds total return,
minus the cash return and minus the funds
estimated sensitivity to Russell 3000 Index
returns (in excess of the rate on cash). See the
Appendix for details on how we used and adjusted
the TASS database of hedge funds and the Mercer
database of traditionally managed portfolios.
Source Federal Reserve, Mercer, Russell
Investment Group, TASS, and Bernstein
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But Much Narrower for Traditional Managers
Alpha /- Median Manager 19962005 Annualized
Market-Neutral Hedge Funds
DirectionalHedge Funds
Long-Only Stocks
Long-Only Bonds
Top-Decile Manager
1.3
0.4
Median
(0.4)
(1.2)
Bottom- Decile Manager
Alpha is defined as a funds total return,
minus the cash return and minus the funds
estimated sensitivity to Russell 3000 Index
returns (in excess of the rate on cash). See the
Appendix for details on how we used and adjusted
the TASS database of hedge funds and the Mercer
database of traditionally managed portfolios.
Source Federal Reserve, Mercer, Russell
Investment Group, TASS, and Bernstein
33
Low Volatility Masks Full Downside Risk
Worst Peak-to-Trough Loss 19962005
Bonds are represented by the Lehman Brothers
U.S. Aggregate Index. See TASS Database in the
Appendix for details on our Market-Neutral Hedge
Fund Index. Source Lehman Brothers, TASS, and
Bernstein
34
More Like Stocks at Just the Wrong Times
Correlations to SP 500 19962005
Up SP Months
Down SP Months
Bonds
Bonds
Market-Neutral Hedge Funds
Market-Neutral Hedge Funds
See TASS Database in the Appendix for details
on our Market-Neutral Hedge Fund Index. Bonds are
represented by the Lehman Brothers U.S. Aggregate
Index. Past correlations are not necessarily
indicative of future results. Source Lehman
Brothers, Standard Poors, TASS, and Bernstein
35
Choosing the Right Hedge Fund Manager

• Core competence
• History of positive alpha
• Experienced management team

Competitive Advantage

• Diversified sources of return
• Market/economic exposure quantified
• Prudent use of leverage

Risk Management

• Efficient trading and operations
• Legal compliance/independent accounting
• Detailed reporting

Infrastructure and Oversight
Superior Performance After Fees and Taxes
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Appendix
TASS Database The TASS database includes the
net-of-fee performance of individual hedge funds
whose managers have elected to report to the
database. As of December 2005, there were a total
of more than 6,000 funds included in the
database. In constructing our Market-Neutral
Hedge Fund, Directional Hedge Fund, Hedge Fund,
and Fund of Fund indexes, we included the
performance of funds only after their managers
decided to report to the database, and only for
those funds that had at least 10 million in AUM.
We also included the performance of all funds in
the database that are no longer currently
reporting. The indexes are equal-weighted. We
calculated after-tax returns using
ordinary-income and capital-gains tax rates at
the highest marginal brackets in effect each
month over the 1995-2005 period. In the case of
directional hedge funds, we assumed that 75 of
the return was characterized as ordinary income
and 25 as long-term capital gain for
market-neutral funds, we assumed 90 ordinary
income and 10 capital gain. In the calculations
for funds of funds, we assumed a weighted average
of the two fund categories. Mercer
Database of Equity and Fixed Income Managers In
analyzing traditional active long-only equity
manager and fixed income manager returns, we used
the Mercer database of large-cap equity and fixed
income managers. The database includes the
net-of-fee performance of individual managers. As
of December 2005, more than 1,400 funds were
included in the large-cap equity manager database
and more than 500 funds in the fixed income
database. In both cases, we included the
performance of all funds in the database that
were no longer currently reporting. Hedge Fund
Allocation Recommendations The recommendations
regarding the allocations to hedge funds are
based on an analysis and consideration of the
financial circumstances and risk profile of one
specific client. The allocations to hedge funds
in total recognize that there is unusual
uncertainty regarding the ability of any hedge
fund to achieve its premium goals, and therefore
long-term risk is higher than it might appear.
This leads us to limit the clients overall hedge
fund exposure in a way that varies with the risk
profile of the client. These recommendations are
intended to provide general guidance only and may
not be suitable for all clients with that type of
stock and bond allocation. The characteristics of
hedge funds vary widely and may contain
aggressive investment strategies designed for
investors who understand and are willing to
accept the risks associated with investing in
funds that may utilize various investment
strategies to enhance returns, including the use
of leverage, investment in futures and options,
and the technique of short-selling securities.
There are substantial risks associated with
investment in hedge funds, including the loss of
all capital invested. Sales of hedge funds are
restricted to investors who meet certain
qualification standards. This presentation is
neither an offer to sell nor a solicitation of an
offer to buy shares or interests in any
AllianceBernstein hedge fund. The offering of any
AllianceBernstein hedge fund is made only
pursuant to the funds Confidential Memorandum,
Subscription Agreement, and if available, current
financial statements, all of which must be read
in their entirety. No offer to purchase shares or
interests will be accepted prior to receipt by
the offeree of these documents and the completion
of all appropriate documentation.