Alternative Investments. Hossein Kazemi
by regulation. Specifically, there is a 300 % asset coverage rule that requires a mutual fund to have assets totaling at least three times the total borrowings of the fund, thus limiting borrowing to 33 % of assets. UCITS restrictions are even tighter. Second, there are regulatory constraints on concentration (i.e., lack of diversification). Third, there are illiquidity constraints (e.g., no more than 15 % of a mutual fund can be invested in illiquid assets) that prevent substantial inclusion of private equity in U.S. open-end mutual funds.
These regulatory issues are a primary reason why such alternative investments are organized through private placements. It should be noted that to qualify as a private placement vehicle, funds are severely limited as to the number of investors permitted. The severe limits on the number of investors lead fund managers to require large initial investment sizes, which steer the products away from small retail investors and toward large institutional investors. Thus, it is due to regulations regarding public products that many hedge fund and most private equity strategies cannot be directly and exactly implemented through open-end mutual funds.
Other hedge fund strategies appear quite tractable for delivery through retail products. For example, the returns of managed futures funds and hedge funds holding other liquid underlying assets can easily be delivered through retail products as long as the strategies do not require high leverage or concentration. Chapter 21 discusses the creative ways that multialternative mutual funds can be structured so as to facilitate the delivery of a large subset of hedge fund strategies through retail products.
A highly researched and debated approach to delivering hedge-fund-like strategies without necessarily using sophisticated management teams or illiquid securities is hedge fund replication. Hedge fund replication is the attempt to mimic the returns of an illiquid or highly sophisticated hedge fund strategy using liquid assets and simplified trading rules.
Another method of delivering alternative investment strategies through retail vehicles is the use of a closed-end mutual fund structure. Closed-end mutual fund structures provide investors with relatively liquid access to the returns of underlying assets even when the underlying assets are illiquid.
The field of liquid alternatives is rapidly changing and evolving. It is especially difficult to forecast the changes and innovations that will occur given the highly regulated nature of retail investment vehicles and the constantly shifting regulatory regimes.
2.4.4 Four Factors Determining Performance of Liquid Alternatives Compared to Private Placements
Liquid alternatives are relatively new products with limited historical return data. Accordingly, there is especially high uncertainty with regard to the extent to which liquid alternatives will generate return enhancement or diversification benefits comparable to the results achieved in the past for institutional investors in private placements.
Returns from private placement vehicles and liquid alternatives may differ primarily due to four important factors, two of which relate to investment flexibility and two of which relate to fees:
1. The permissible investment strategies differ. Private placements often enjoy important flexibility with regard to leverage (including the magnitude of short positions) and concentration (lack of diversification).
2. Similarly, private placements may be able to generate higher returns due to their investment flexibility to hold more illiquid assets, thereby potentially receiving higher liquidity premiums.
3. Fees differ between liquid alternatives and private placements. Liquid alternatives tend to have lower fees because most do not have incentive fees, especially asymmetric incentive fees wherein managers benefit from sharing upside profits but are limited in their exposure to downside losses.
4. Managerial skill may differ. The higher potential fees from the asymmetric incentive fees of private placements may attract managers with greater skill. Some liquid alternative funds implement simplified trading rules rather than hiring sophisticated management teams.
2.4.5 Empirical Analysis of Liquid Alternative Investment Performance
The permissible investment strategies of liquid alternatives often do not match the flexible investment strategies being implemented in private placements. However, comparing the performance in those cases in which the strategies match can be an effective way to estimate the risk and return differentials between liquid alternative funds and private placements. A 2013 study by Cliffwater (discussed further in Chapter 21) compared funds and concluded that, on average, liquid alternative funds have lower risks and slightly to moderately lower average returns than limited partnership (or LP) funds that employ the same strategy.14
This brief overview of liquid alternatives lays a foundation for more detailed discussions on the underlying assets and investment strategies of the funds. Liquid alternatives are further discussed in the context of real assets in Chapters 10 and 14, hedge funds in Chapter 21, and private equity in Chapter 22.
2.5 Taxation
Most institutional-quality alternative investments are not created or managed for the primary purpose of avoiding taxes. However, taxation can substantially affect investment returns, and therefore alternative investments are often constructed and managed to prevent additional taxation. In other words, investment pools are formed in light of taxation and with a goal of minimizing the extent to which the pooling of capital increases taxation for the investors relative to direct ownership of the underlying assets. For example, a hedge fund may be domiciled in a particular location for the purpose of preventing additional tax burdens on investors relative to the taxes that would be paid with direct investments using a separately managed and local account. Another hedge fund may be established to invest in municipal bonds for the purpose of generating tax-free income. However, the use of the hedge fund structure and its location do not make the income tax-free. Rather, it is the use of municipal bonds or other tax-free investments, whether inside or outside the hedge fund, that make the income tax-exempt.
In any case, knowledge of general global taxation is helpful in understanding the institutions and other structures involved with alternative investing. The primary objects of taxation throughout the world are income based, wealth based, and transaction based. This section summarizes taxation throughout the world primarily from the perspective of investments.
2.5.1 Income Taxation
Throughout the major economies of the world, income is taxed. Income taxation typically includes taxation on individual and corporate income. Most income taxation is progressive. Progressive taxation places higher-percentage taxation on individuals and corporations with higher incomes. Individual income taxation includes taxation of both wage income and investment income.
Although individual wage income and corporate earnings are often fully taxed, the primary issue for investing involves the potential for reduced income tax rates on investment income. Investment income is primarily dividend income, interest income, and capital gains. Investment income from dividends, interest, and capital gains is often either taxed at reduced rates or exempt from income taxation. Although most countries tax all of these types of investment income, the tax rules of individual countries differ primarily by the extent to which dividends, interest, and capital gains are exempted, partially taxed, or fully taxed.
Most major economies, including those of Austria, Brazil, China, Finland, France, Hong Kong, Italy, Japan, the Netherlands, Poland, Sweden, the United Kingdom, and the United States, tax investment income but offer reduced rates on some or all dividends, interest, and capital gains. In the United States, for example, state and municipal bond interest is exempt from federal taxation, and most corporate dividends are taxed at a reduced rate. However, some countries have investment income tax regimes that tax dividends, interest, or capital gains rather heavily or lightly compared to other nations. For example, Canada, Denmark, and Germany tend to have high tax rates on interest income. Australia, Belgium, New Zealand, Switzerland, and Taiwan tend to have low capital gains taxes.15
Other jurisdictions have no income tax or at least no income tax on particular investment pools. These jurisdictions are attractive locations
“Performance of Private versus Liquid Alternatives: How Big a Difference?” Cliffwater, June 2013, https://www.cliffwater.com/documents/1181513.
Stephen M. Horan and Thomas R. Robinson, “Taxes and Private Wealth Management in a Global Context,” www.cfainstitute.org/toolkit, Reading #70.