What Every Tax Advisor
Needs to Know
About Hedge Funds
Paul S. Lee, J.D., LL.M.
National Managing Director
This presentation booklet has been provided to you for use in a private and confidential meeting to discuss a potential or existing investment advisory relationship. This
presentation is not an advertisement and is not intended for public use or distribution beyond our private meeting. Bernstein does not provide tax, legal, or accounting
advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.
Hedge Funds: Staggering Popularity and Growth
Number of Hedge Funds
 Over 9,000 Funds
8,664
9,462
3,873
2,383
610
1990
1995
2000
2005
2006
Assets ($ in Millions)
 Over $1.4 Trillion
$1,430,000
$1,110,000
Presentation Code
$491,000
$186,000
$39,000
1990
Source: HFR Industry Report , Fourth Quarter, 2006
1995
2000
2005
2006
2
What Do You Need to Know as an Advisor?
Fund Strategies & Categories
Financial Instruments
Fund Structure
Non-U.S. Funds
U.S. Funds
U.S. Trade or Business
Presentation Code
pgs.
39-44
FDAP
Tax Classification
Subchapter K
PFIC
Valuation Issues
UBTI
Taxation of Investments
CRTs
Investor Level Issues
Choosing a Fund
3
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
Presentation Code
 Investment management fee (1% to 3%)
 Incentive fee based on profits (10% to 30%)
With a “watermark”
Above “benchmark”
4
“Categories” of Hedge Fund Strategies
“Market Neutral” (~1/3)
 Event Driven
 Merger Arbitrage
 Distressed Securities
 Equity Market Neutral
 Arbitrage Strategies
Directional Strategies (~2/3)
 Long-Short Equity Strategies
 Global Asset Allocators (Macro)
 Emerging Markets
 Fixed Income Arbitrage
 Convertible Arbitrage
Event Driven
Merger Arbitrage
Distressed
Presentation Code
Market Neutral
Long/Short
Emerging
Macro
FI Arbitrage
Conv. Arbitrage
Source: HFR Industry Report 2006.
5
Going “Long” and “Short”
 Financial tools and strategies
 Short sales
 Futures and forwards
 Options
Presentation Code
 Notional principal contracts (pg. 5, fn. 4)
6
Mechanics of a Short Sale
“Short Sale”
100 shares XYZ @ $10 per share
Loan
100 shares XYZ
Short Seller
(Borrower)
(Hedge Fund)
Owner
(Lender)
Borrow Fee
+
In Lieu Dividends
Market
Proceeds ($1,000)
+
Interest
@$15 per share
($500) Loss
Short Seller
Closing Transaction
Short Seller
(Borrower)
(Hedge Fund)
Presentation Code
Owner
(Lender)
Return
100 shares of XYZ
Market
“Closing” Purchase
100 shares XYZ
@$5 per share
$500 Profit
Short Seller
7
Mechanics of a Futures/Forward Contract
Contract to Buy/Sell
(No Premium or Up-Front Payment)
Obligation:
Buy
Purchaser
(Long Position)
Seller
(Short Position)
Obligation:
Sell + Deliver
Future Date
+
Futures Price
Gain to
Long Position
Presentation Code
“Cash-Settled”
Futures Contracts
and
Mark to Market System
Loss to
Short Position
Market
vs.
Futures Price
Loss to
Long Position
Commodities
Currencies
Securities
Profit to
Short Position
8
Options
CALL
PUT
Holder
(Buyer)
Writer
(Seller)
Holder
(Buyer)
Writer
(Seller)
Right
(Buy)
Obligation
(Sell)
Right
(Sell)
Obligation
(Buy)
Maximum
Gain
Unlimited
Premium
Strike price
minus
premium
Premium
Maximum
Loss
Premium
Unlimited
unless
“covered”
Premium
Strike price
minus
premium
Right or
Obligation
Presentation Code
Outlook on
Security
9
Structure of “Onshore” Hedge Funds
Investment
Manager
General Partner
Limited Partners (Investors)
Levels of Inquiry
1) Tax classification of fund
Hedge Fund L.P. or LLC
2) Subchapter K implications
Presentation Code
3) Valuation Issues
4) Taxation of investments
Hedge Fund Investments
5) Investor-level issues
10
Tax Classification of Fund
 Onshore hedge funds are partnerships
 “Publicly traded partnership” exceptions (pg. 7)
 Hedge fund status
Limited Partner (Investor)
Trader or Investor
Hedge Fund L.P.
vs.
Presentation Code
Dealer
Hedge Fund Investments
11
Subchapter K: Allocation of Profit and Loss
General Partner
Limited Partners (Investors)
General Allocations
Special Allocation
Incentive Fee
Hedge Fund L.P.
Based on benchmark?
Presentation Code
Index: -9
Return: -1
Incentive Fee: 20% of +8%
Hedge Fund Investments
Net capital
appreciation
(depreciation) to
capital accounts
Tax items allocated
under
§ 704(b) and § 704(c)
based on net capital
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
12
Subchapter K: Contribution of Assets In-Kind
Limited Partner (Investor)
Assets-in-kind
Non-taxable event
Unless hedge fund is
“Investment Company”
§§ 721(b) and 351(e)
Special Allocations
Hedge Fund L.P.
Exception for
Differences in
book value
& tax basis
“Diversified portfolio”
Presentation Code
“Insignificant amount”
Hedge Fund Investments
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
13
Subchapter K: Disguised Sale Rules
Limited Partner (Investor)
Presumed Disguised Sale
Triggering Events
§ 707(a)(2)(B)
Partial redemption or
withdrawal
Contribution of appreciated
property
Hedge Fund L.P.
Distribution of other
property or cash to
contributing partner
Tax Distributions?
Distributions with
corresponding
allocation?
Presentation Code
Within 2 years
Hedge Fund Investments
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
14
Subchapter K: “Mixing Bowl” Transactions
Contributing Partner
Other Partner
Recognition of Gain/Loss
Capital accounts
unaffected
Contributed property
Distributed to any other
partner
Hedge Fund L.P.
or
Receive other property
Outside basis of
contributing partner and
inside basis
of property automatically
adjusted (no § 754
election)
Presentation Code
Within 7 years
Hedge Fund Investments
Character of gain/loss
determined at fund level
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
15
Valuation Issues
Donor/Decedent (Investor)
Valuation for
Wealth Transfer
Tax Purposes
Withdraw
•Date of Transfer
•Value Received (Future)
•Previous Valuation
Hedge Fund L.P.
Restrictions
Cure Book/Tax
Lose “Watermark”
§ 754
•Transferability
•Withdrawal
•No Chapter 14
Presentation Code
Hedge Fund Investments
Valuation of the
Investments
Book/Tax
Disparity
•Accounting/Valuation Periods
•Actively traded
•Hard to value assets
16
Taxation of Investments: The Rules . . . And Exceptions
CAPITAL GAIN/LOSS
X
Limited Partner
Contracts under § 1256
Currency Transactions (§ 988) [pgs. 15-16]
Conversion Transactions (§ 1258) [pgs. 25-26]
Hedge Fund L.P.
Constructive Ownership (§ 1260) [pg. 35-37]
CLOSE OF TRANSACTION
X
Presentation Code
Hedge Fund Investments
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.
17
Taxation of Short Sales (Borrower’s 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)
Presentation Code
 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.
18
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
Presentation Code
 Options are essentially the same (pgs. 21 - 25)
19
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
Presentation Code
 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.
20
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
Presentation Code
 Any short position in “substantially similar” property
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
21
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)
Presentation Code
 Tax Shelter Reporting Requirements (pgs. 37 - 38)
22
The Hedge Fund Claim
 Produce equity-like returns
 Maintain lower volatility
Presentation Code
 Exploit low correlation to rest of portfolio
23
Hedging Market Exposures Tends to Lower Volatility
Market-Neutral*
 Fully hedge market exposure
 Examples: Arbitrage; Event-Driven
Directional Strategies*
 Retain some market exposure
 Examples: Long/Short Equity;
Global Macro
Annualized Volatility: 1996–2005
16.0%
Presentation Code
9.0%
3.6%
4.0%
Market-Neutral
Hedge Funds
Bonds
Directional
Hedge Funds
Stocks
*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 S&P 500.
Source: Lehman Brothers, Standard & Poor’s, TASS, and Bernstein
24
Hedge Funds Don’t Move in Tandem with the Markets
Correlations to S&P 500*
1996–2005
High Correlation
US Growth Stocks
US Value Stocks
International Stocks
Directional Hedge Funds
Presentation Code
Market-Neutral Hedge Funds
Real Estate
Low Correlation
Bonds
*Correlation between the S&P 500 and other investment alternatives, which are represented by the following—US Growth Stocks: Russell 1000 Growth Index; US Value Stocks: Russell
1000 Value Index; International Stocks: Morgan Stanley Capital International (MSCI) All Country World Index–Ex-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.
25
Analysis of Hedge Fund Database
Directional
Funds
Market-Neutral
Funds
 Full history of funds currently reporting
16.6%
12.4%
 Remove returns that were “backfilled”
(Backfill Bias)*
(2.2)
(1.2)
 Include returns of funds no longer
reporting (Survivorship Bias)*
(5.0)
(3.1)
Presentation Code
 Adjusted Hedge Fund Returns
9.4%
8.1%
*“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
26
Hedge Funds: Superior Trade-Offs
1996–2005 Annualized*
Return (%)
Market-Neutral
Hedge Funds
10
Directional
Hedge Funds
Stocks
8
6
Bonds
4
T-Bills
2
0
Presentation Code
0
5
10
15
20
Volatility (%)
*Past performance does not guarantee future results. Stocks are represented by the S&P 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 & Poor’s, TASS, and Bernstein
27
Traditional Allocation Models: A New Paradigm?
Percentage of Total Assets
Traditional Assets Only
60%
Stocks
100% Hedge
Funds?
Presentation Code
40%
Bonds
With Hedge Funds
28
Market vs. Manager: The Traditional Approach
Sources of Returns: 1996–2005*
17%
Presentation Code
83%
Manager
Decisions
(Alpha)
Objectives
Market
Movements
■ Add a premium (alpha) through
long-only security selection
■ Capture market return
Avg. Actively
Managed Long
Portfolio
*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
29
Hedge Funds Focus on Alpha, Not the Market
Sources of Returns: 1996–2005*
Sources of Alpha
● Long security selection
● Short-selling
17%
80%
Manager Decisions
(Alpha)
83%
20%
Presentation Code
Avg. Actively
Managed Long
Portfolio
Market
Movements
● Various markets
and instruments
● Leverage
● Specialized strategies
(arbitrage, etc.)
Typical Hedge Fund
*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
30
Alpha Dispersion Among Hedge Funds Is Wide…
Alpha +/- Median Manager: 1996–2005 Annualized*
Directional
Hedge Funds
Top-Decile
Manager
Market-Neutral
Hedge Funds
12.4%
7.6%
Presentation Code
Median
BottomDecile
Manager
(8.3)%
(15.0)%
*“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s 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
31
…But Much Narrower for Traditional Managers
Alpha +/- Median Manager: 1996–2005 Annualized*
Directional
Hedge Funds
Market-Neutral
Hedge Funds
Long-Only
Stocks
Long-Only
Bonds
12.4%
Top-Decile
Manager
7.6%
1.3%
0.4%
(1.2)%
(0.4)%
Presentation Code
Median
BottomDecile
Manager
(8.3)%
(15.0)%
*“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s 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
32
Low Volatility Masks Full Downside Risk
Worst Peak-to-Trough Loss*
1996–2005
Bonds
Market-Neutral
Hedge Funds
Presentation Code
(3.6)%
(9.8)%
*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
33
More Like Stocks at Just the Wrong Times
Correlations to S&P 500*
1996–2005
Up S&P Months
Down S&P Months
0.5
0.1
0.1
Bonds
Presentation Code
Market-Neutral
Hedge Funds
Bonds
Market-Neutral
Hedge Funds
(0.4)
*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 & Poor’s, TASS, and Bernstein
34
Choosing the Right Hedge Fund Manager
Competitive
Advantage
Risk
Management
Presentation Code
Infrastructure
and Oversight

Core competence

History of positive alpha

Experienced management team

Diversified sources of return

Market/economic exposure quantified

Prudent use of leverage

Efficient trading and operations

Legal compliance/independent accounting

Detailed reporting
Superior Performance
After Fees and Taxes
35
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
Presentation Code
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 client’s 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 fund’s 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.
37