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Archive for the ‘Asset Allocation’ Category

The Structure of Hedge Funds

Like private equity funds, hedge funds are typically organized as either limited partnerships or limited liability corporations to protect investors from losses exceeding their initial investment and to avoid double taxation of corporate earnings.

Compensation for hedge fund managers typically is based on two components:

• A management fee of 1-2% of assets under management
• An incentive fee of 15-20% of the returns in excess of a pre-determined benchmark. Incentive fees are usually constrained by features such as high-water marks, claw-back provisions and other features.

The high fees earned by hedge fund managers has been widely criticized, particularly when the returns generated include some exposure to beta. Beta can be obtained very cheaply through passive investments such as index funds. However, to the extent that the hedge fund returns offer diversification the fees may simply represent a sort of insurance premium that investors are willing to pay  in exchange for risk reduction.

The investments made by hedge funds are often illiquid, and as such many funds require a lock-up period before investments can be withdrawn. In addition, most funds allow cash inflows and outflows only at specific times (usually quarterly.)

Posted on 28th April 2008

What Makes an Asset Class?

In order for a group of assets to be considered an asset class, they should meet the following criteria:

Posted on 20th April 2008

Why Forecasts Based on Historical Data Underestimate Risk and Overestimate Return

Many forecasts are prepared based on the past (ex-post) returns of similar assets. Using ex-post data tends to underestimate ex-ante risk and overestimate ex-ante returns.

At any given time, security prices reflect risk factors that may not materialize. When the risk fails to materialize, the security prices rise.

The rise in prices, however, did materialize and is incorporated in the data. Returns, therefore, are overestimated.

Posted on 18th April 2008

Tax Considerations in Investment Management

Taxes are faced by investors worldwide, but the various tax codes can be complex and confusing. Specific tax strategies are probably best executed by a tax attorney, but there are general considerations of which investors and investment advisers should be aware.

Common types of taxes include income taxes, taxes on the gains or profits from investments, property taxes and wealth transfer taxes. Each can play a role in investment planning.  Specific strategies include tax deferral, tax avoidance and tax reduction.

Tax deferral refers to delaying the time at which income is taxed. Periodic payments reduce the compounding effects of return, so the longer tax payment can be deferred the greater the terminal wealth will be. Longer holding periods can defer gains taxes. Loss harvesting strategies can also be used to mitigate gains.

Tax avoidance refers to legal strategies to avoid taxes (as opposed to illegal tax evasion.)  Typically such strategies come at the cost of lower returns (tax exempt bonds), lower liquidity (tax deferred accounts) or less control over the investments (trusts).

Tax reduction strategies consider differences in rates between different taxes (such as income versus gains) and seeks to maximize the most efficient type of return (i.e. favor gains over dividends.) Tax reduction strategies can also incorporate deferral and loss harvesting strategies.

Posted on 12th April 2008

Forming an Investment Return Objective

Investment return objectives should be consistent with established risk objectives. How the return objective will be measured (typically total return) is important. Will it be on a pre-tax or after-tax basis? In real (inflation-adjusted) or nominal terms?