What social functions do hedge funds provide, indeed?
Renaissance Technologies avoided $6bn in taxes by using derivatives to pretend their ultra-high frequency trading profits were actually long-term capital gains.
Renaissance is one of the biggest and most successful hedge funds of all time.
SAC was another of the most successful hedge funds of all time - government couldn't get anyone to prove insider trading directly implicating the founder, but they got enough people around him to confess that they've basically cut the fund down to a personal funds only shop - Point72.
What else ...
Plenty of socially questionable legal strategies in HF land. Big one is stock buybacks - rational responses to Federal Reserve interest policies. If debt is priced too cheaply, HF will push companies to lever up to buyback stock. This is a socially useless form of activity, which increases business risk based on capital structure theory. Short term payoff, the debt will never go away.
Returns - the Hedge Fund industry in aggregate is so far off the S&P500 over the past 5 years that perhaps it ought not to exist?
There was no dishonest or misleading tactic that Renaissance tech used. They held on to options and used that legal tax structure. Options for a basket of stocks and the basket of stocks themselves are completely different things and have different risks and payouts. That they are using derivatives to avoid taxes is just drama that politicians are inventing.
"The facts indicate that the basket option structures examined in this investigation were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits. The structures rested on two fictions. The first was that the bank, rather than the hedge fund, owned the assets being traded in the designated option accounts, even though the hedge fund bought and sold the assets, was exposed to all significant risks and rewards, and profited from the trading, with little input from the bank serving as the nominal owner of the assets. In
effect, the structure purported to enable the hedge fund to purchase an “option” on its own trading activity, an arrangement that makes no economic sense outside of an effort to bypass federal taxes and leverage limits. The second fiction was that the profits from the trades controlled by the hedge fund could be treated as long-term capital gains, even for trades lasting seconds. That fiction depended upon the hedge fund claiming that the profits came from exercising the “option” rather than from executing the underlying trades. In fact, the “option” functioned as little more than a fictional derivative, permitting the hedge fund to cast short-term capital gains as long-term gains and authorizing financing at levels otherwise legally barred for a customer’s U.S. brokerage account."
So the complaint is that this was fictional derivatives used to mask ownership of the underlying assets and thereby avoid taxes. I'm going to do some more research but it does sound shady.
Earlier, the complaint points out that the IRS has already identified this as abusive behavior but has not acted:
"While that type of option product was identified as abusive in a public memorandum by the Internal Revenue Service
(IRS) in 2010, taxes have yet to be collected on many of the basket option transactions and its use to circumvent federal leverage limits has yet to be analyzed or halted."
Renaissance did not avoid $6b in taxes. They never owned the stock in the baskets that the politicians claimed they did. The payout to risk ratio of the options is most likely why they were invested. There can't be a social function to not paying because there was nothing to pay.
I don't know specifically about Renaissance's case, but they may well have avoided $6B in taxes if a lot of their fees were categorized as "carried interest". (I don't think the particular fact that they invest in derivatives has anything to do with it.) For hedge funds any fees they accrue for "performance" are carried interest and not subject to regular income tax, though they will eventually be taxed at the capital gains rate. E.g., if a hedge fund charges 2% of assets annually, plus 20% of annual increases in asset value over 8%, the 2% fee would be taxed as regular income and the performance part (20% of increases > 8%) would accrue to them as carried interest, treated as capital gains.
My not-so-informed belief is that while there may originally have been a decent rationale for treating hedge fund performance fees as carried interest, in many (most?) modern hedge fund scenarios that categorization is misapplied. In any case, the treatment as carried interest is legal, at least for now.
Those taxes are not avoided - it's just the current tax law. Money put at risk is taxed as capital gains. You don't automatically get carried interest - if you don't perform, it's zero.
Think of it as a portion of their salary that they are contractually bound to invest in the fund, with deference to the limited partners.
Do we really want to have fund managers without skin in their own funds? Carried interest is the only way to do that that does not favor the fantastically rich - who have enough advantages already. Ask yourself what might happen to the private fund industry (VC, PE, hedge funds, real estate, etc) if managers were not able to get carry. How would their compensation change? Which funds would benefit? Do we really want that?
It's not an issue of whether someone should get carried interest - it's an issue of the rate at which that carried interest is taxed.
Funds are essentially providing a service for a given investor but getting taxed as though it was all their own money in the fund - which is not the case in most funds.
Instead, what the funds are doing is essentially providing investment advice - for which the fees should be taxed at normal rates rather than at the carried rate as though it is all their own money.
So I have no issue with the manager getting carried interest or being taxed at lower rates on their own money - but when they take money from outside investors, they should be taxed at normal rates.
I won't argue that our tax code is anything but ridiculous. But treating carried interest and capital gains the same way makes sense - it's money put at risk as an investment. I don't think it's relevant that in one case cash is risked and in another case it's compensation at risk. Nobody is goign to argue that the management fee is capital gains because it isn't - it's guaranteed cash. It's different.
I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me.
"I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me."
Looks more like income to me - fees paid to people for managing money that they themselves have not put at risk.
Again, we're not talking about getting carried interest - we're talking about the taxes on that carried interest. They put the capital at risk, but this is no different than any fee-based service, thus it is income rather long term capital gains.
If they took part of their salary and opted (or were required by LP's) to invest that money in their fund, should any gains there be taxed as capital gains or ordinary income? They would clearly be capital gains.
What is the difference between that and carried interest? The only thing I can think of is that it's not taxed as ordinary income before being invested, which is a fair criticism. On the other hand, you don't get a tax benefit if you lose that money in the CI case (which happens a lot), so it balances out at least to a degree.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
> Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit.
There's a pretty good argument that some special treatment of income from long-term holdings (or, at least, something that accounts for them) is necessary in a system with progressive taxes on annual income, because otherwise small investors with infrequent realizations of income from long-term holdings would be taxed more on their income (on average) than people with the same average annual income who made constant income year-to-year.
OTOH, one can argue that the particular mechanism of long-term capital gains is a bad mechanism for that because it doesn't account for similarly irregular non-capital income (e.g., a writer whose income is mainly royalties that are concentrated immediately after new book releases who infrequently releases books that are bestsellers, but with several years of minimal income in between) and, at the same time, undertaxes capitalists that can afford enough in long-term holdings that rotate to realize constantly high income from long-term holdings.
Things like hedge funds and carried interest are sort of nibbling around the edges.
I'd have no issue with their own investments in the fund being taxed as long term capital provided they have held the investment for a year when the profit is taken.
Here's a simple way to think about it - an ordinary RIA invests money on behalf of their clients. The fees they get for that service are taxed as ordinary income. Why should carried interest be any different when the money is coming from clients? And why should carried interest be taxed at a lower rate regardless of hold time? The simple answer is that these fees aren't any different - and therefore should be taxed at the same rate in my opinion.
Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income.
To take it a step further, should entrepreneurs pay ordinary income tax on their gains when they sell their company if they didn't invest any of their own money? It's the same thing. Carried interest is just a fancy name for sweat equity.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
Comparing selling your company to carried interest isn't appropriate - apples and oranges - but to your entrepreneurs example: if they accept investment in their company, then their company has shares. Gains on those shares are treated exactly the same as any other share in any company - short term gains on stock held less than a year or long term if you've held it a year or longer. This is why many people exercise their options in a startup as a way to start that clock as soon as possible to avoid short-term tax consequences.
Again - PE firms are offering a service and will receive a good profit for their hard work. But that work often involves minimal capital on their part and therefore should not be treated as if it is their capital at risk.
"Money put at risk is taxed as capital gains." Huh? Money that hedge fund owners provide as fund capital is already theirs, they don't pay tax on it at all. Of course gains in value of their capital investment are taxed as capital gains. But the performance fees we're talking about are fees that accrue to hedge fund managers from managing _other people's money_, not the capital gains that manager's realize directly as the increase in value of their own investment.
If hedge fund managers could not performance fees categorized as carried interest they'd pay regular income tax rates on them. Not sure how that changes their management of the funds. Presumably if they believe they're the best managers out there they'll want to have their own assets in their fund (and of course will pay only capital gains tax on increases in value of their assets). By the way, high percentage of hedge fund managers are already among the "fantastically rich". . . .
> Plenty of socially questionable legal strategies in HF land. Big one is stock buybacks - rational responses to Federal Reserve interest policies. If debt is priced too cheaply, HF will push companies to lever up to buyback stock. This is a socially useless form of activity, which increases business risk based on capital structure theory. Short term payoff, the debt will never go away.
If it's useless then why does it make them money? Capitalism is a bit like a genetic algorithm - it will find a badly specified reward function faster than it will find the solution you were looking for - but if our tax policies encourage businesses to take on dangerous levels of debt, maybe we should, like, change our tax policies?
> So - to deliver middling average returns, the hedge fund industry will charge 4x to 20x the cost of an index fund.
Shouldn't we be happy about that? They take a load of rich people's money, provide liquidity to the market and do other price discovery things, and give those rich people a middling average return. What's not to like?
> Much of the money for the funds comes from public pension funds.
Maybe those pension funds should stop investing in hedge funds, like calpers just did.
> If it's useless then why does it make them money?
Is that really a line of reasoning? I can make money by drug and arms trafficking, helping other skirt the law, take advantage of legal loopholes, using violence where competitors cannot to strongarm others into submission, exploiting labor, etc.
If a hedge fund makes its money just by being faster in transactions in a way that gives no real benefit to actual creators of value, then it is of no use to society.
Thus far, the argument for liquidity seems shoddy, at best.
Hedge funds are opportunistic pools of capital. Like venture capital firms, they exist primarily to make a buck, only hedge funds play primarily in the financial markets.
Real estate firms exist to make money using real estate. Banks exist to make money using loans.
Finance exists to make money. By design, it doesn't care about real value.
> Is that really a line of reasoning? I can make money by drug and arms trafficking, helping other skirt the law, take advantage of legal loopholes, using violence where competitors cannot to strongarm others into submission, exploiting labor, etc.
By and large you can't, which is the point. We don't stop these things by appealing to people's better natures. We stop these things by making them unprofitable. When hedge funds misbehave it's usually a symptom, not a cause.
It's not the hedge funds that are paying dividends/repurchasing shares - it's the companies they invest in. The companies create value and pass the profits on to their investors. This has nothing to do with trading.
Because they also flease institional investors. While not talked about there are huge incentives for here funds to bribe money managers at pension funds etc. A hede fund managing 100 million that lost 50% of the money over 10 years makes well over 10 million, break even and there up 20 million.
The claim is that corporations will borrow money and use it to buy back shares. That's actually a nice hack - interest income is favorably treated relative to capital gains, so it's a way to turn a higher tax piece of capital (stock) into a lower tax piece of capital (bonds).
If it's advantageous to have more debt, then this is what you do. It's done by pretty much every company in the world, not just hedge funds. It's literally finance 101.
My understanding is that phones4u was paying out dividends while increasing its debt; effectively an equity-for-debt swap. The difference is that this transfers risk from the owners to the creditors, allowing the business to collapse after it's been looted.
I think there's a case to be made for a rule "always pay your creditors before your equity investors" to avoid this kind of thing.
That's how it's supposed to work. A company makes money and gives it to the shareholders. When lenders lend money to the company, they are getting a return for their risk. Companies adjust their capitalization all the time - it's a normal part of running a business. You can do it with dividends or share repurchases, and if it makes sense, you can fund either with debt. There is nothing nefarious about doing that.
Further, if you always pay your creditors first, there is no point in capitalizing with debt - you give up significant value by doing so. It is normal and healthy for some companies to finance themselves perpetually with debt.
Edit: Ok, so there are still some non-believers. Think of it this way. You own a profitable company with no debt. Your accountant tells you that you'll increase the company's value if you are 50% debt and 50% equity. This is a consequence of our tax code. Sounds like a good plan. Now what? The company already pays dividends and has as much cash as it needs for operations. You borrow money (which banks are happy to give you because you can more than afford the debt service), and pay out the proceeds as dividends. You are now have all that money in your pocket, and your company is basically worth the same amount (value = equity, which is now 1/2 what it was + debt) - a little more, actually, because of the tax consequences of the debt.
This is totally normal. Sometimes the optimal debt level is zero. Sometimes it's 90%. If companies are pulling huge amounts of cash out as a result of debt financing, it's only because they had a sub-optimal capitalization to begin with. Again - nothing nefarious here. It's all just a way of adjusting risk and optimizing returns to the shareholders.
The social function of hedge funds is to provide the expected returns for their given investor (examples: uncorrelated returns to the S&P500, downside protection, returns generated by non-stock/bond investments, et al) - the same as any investment vehicle. Those returns should then be accrued to the investors in a given fund, thereby enabling things like pensions as well as non-retirement gains.
Now, I don't believe this is what they provide, but I'm trying to answer your question.
> If debt is priced too cheaply, HF will push companies to lever up to buyback stock. This is a socially useless form of activity, which increases business risk based on capital structure theory. Short term payoff, the debt will never go away.
Aren't stock repurchases generally a more tax-efficient vehicle for providing return to shareholders than dividends?
Also, why would the debt never go away? Companies usually raise debt by selling bonds with maturity dates.
Most moral wrongs are also social wrongs. Laws and regulations exist for the good of society, and flouting those laws is bad for the public good. If you pay less in taxes than you ought to, that means that the average citizen either pays more in taxes or doesn't get the social services those taxes would have paid for. Insider trading means that the insiders profit at the expense of the outsiders, who are typically far more numerous.
> If you pay less in taxes than you ought to, that means that the average citizen either pays more in taxes or doesn't get the social services those taxes would have paid for.
No, it means SOMEONE is paying more. That someone could be a rich person, another company, or a smorgasbord of other taxpayers. You can't assume it's Joe the Plumber who's paying more taxes (on average, because proportionally, corporations and rich people pay most taxes).
Also, don't assume those taxes would have paid for social services. They could have also been used to kill innocent women and children in unspeakably nasty ways (on average, most of the budget does NOT actually go to social services).
The vast majority of trading is done by institutions, so here again, your assumption that Joe the Plumber gets hurt by the big bad hedge funds doing insider trading is faulty. Yes, 401(k)s might get hit, but it's not your average E*TRADE daytrader who's losing out (again, on average, based on trading volume).
Anyway, in the name of morality, it's irrelevant to speculate WHO pays for your wrongdoing and for WHAT your taxes would have been used.
The action is immoral and illegal. To say it's socially wrong is a big stretch. There are way too many unknowns to make a definitive statement.
That was almost entirely caused by an institution known as the BANK.
Banks and hedge funds are totally different things. Likening one to the other is like saying Google and Square are both evil just because they're technology companies.
You seem to lack a fundamental understanding of the financial system.
Oh really? So in your dictionary AIG is a bank, like say BoA. You seem like having a deep understanding of the financial system. Don't forget to edit the wikipedia page, these guys got it all wrong[2] oh yes the WSJ[1] too!
There were many types of institutions involved in the 2008 crash, from traditional banks to investment banks to ratings agencies to insurance firms to mortgage brokers to governmental bodies and more.
The root cause of the crash was unquestionably the banks. It was the banks that lowered their standards, made bad loans, and packaged them up into MBSs and CLOs to ship them off to other institutions to trade and insure so they could make more bad loans.
If the banks didn't make these loans, AIG would have had nothing to insure. Goldman would have nothing to trade. S&P would have nothing to rate. Et cetera.
Don't misconstrue what I'm saying as vindicating everyone else. They all royally messed up too. It's just that the banks started and perpetuated it all.
The 2008 financial crisis was not brought on by people avoiding taxes. I don't think any crisis can be caused this way because the US government can easily borrow money when it needs and clamp down on tax avoidance or raise taxes later.
Renaissance Technologies avoided $6bn in taxes by using derivatives to pretend their ultra-high frequency trading profits were actually long-term capital gains.
http://www.bloomberg.com/news/2014-07-21/renaissance-avoided...
Renaissance is one of the biggest and most successful hedge funds of all time.
SAC was another of the most successful hedge funds of all time - government couldn't get anyone to prove insider trading directly implicating the founder, but they got enough people around him to confess that they've basically cut the fund down to a personal funds only shop - Point72.
What else ...
Plenty of socially questionable legal strategies in HF land. Big one is stock buybacks - rational responses to Federal Reserve interest policies. If debt is priced too cheaply, HF will push companies to lever up to buyback stock. This is a socially useless form of activity, which increases business risk based on capital structure theory. Short term payoff, the debt will never go away.
Returns - the Hedge Fund industry in aggregate is so far off the S&P500 over the past 5 years that perhaps it ought not to exist?
http://www.bloomberg.com/news/2014-09-17/hedge-fund-performa...
So - to deliver middling average returns, the hedge fund industry will charge 4x to 20x the cost of an index fund.
Much of the money for the funds comes from public pension funds.
We can go on...