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.
What Every Tax Advisor Needs to Know
About Hedge Funds
Paul S. Lee, J.D., LL.M.National Managing Director
Pre
sent
atio
n C
ode
2
Hedge Funds: Staggering Popularity and Growth
Over 9,000 Funds
Over $1.4 Trillion
Source: HFR Industry Report , Fourth Quarter, 2006
Number of Hedge Funds
610
3,873
9,4628,664
2,383
1990 1995 2000 2005 2006
Assets ($ in Millions)
$39,000$186,000
$1,110,000
$1,430,000
$491,000
1990 1995 2000 2005 2006
Pre
sent
atio
n C
ode
3
What Do You Need to Know as an Advisor?
Fund Strategies & Categories
Financial Instruments
U.S. FundsNon-U.S. Funds
Fund Structure
Tax Classification
Subchapter K
Valuation Issues
Taxation of Investments
Investor Level Issues
U.S. Trade or Business
FDAP
PFIC
UBTI
CRTs
pgs.39-44
Choosing a Fund
Pre
sent
atio
n C
ode
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”
Pre
sent
atio
n C
ode
5
“Categories” of Hedge Fund Strategies
Directional Strategies (~2/3) Long-Short Equity Strategies Global Asset Allocators (Macro) Emerging Markets
Event Driven
Merger Arbitrage
Distressed
Market Neutral
FI Arbitrage
Conv. Arbitrage
Long/Short
Emerging
Macro
“Market Neutral” (~1/3) Event Driven
Merger Arbitrage Distressed Securities
Equity Market Neutral Arbitrage Strategies
Fixed Income Arbitrage
Convertible Arbitrage
Source: HFR Industry Report 2006.
Pre
sent
atio
n C
ode
6
Going “Long” and “Short”
Financial tools and strategies
Short sales
Futures and forwards
Options
Notional principal contracts (pg. 5, fn. 4)
Pre
sent
atio
n C
ode
7
Mechanics of a Short Sale
Owner(Lender)
Short Seller(Borrower)
(Hedge Fund)
Loan100 shares XYZ
Borrow Fee+
In Lieu Dividends
“Short Sale”100 shares XYZ @ $10 per share
Proceeds ($1,000)+
Interest
Market
Return100 shares of XYZ
MarketShort Seller(Borrower)
(Hedge Fund)
“Closing” Purchase100 shares XYZ
Owner(Lender)
Closing Transaction
@$5 per share$500 ProfitShort Seller
@$15 per share($500) LossShort Seller
Pre
sent
atio
n C
ode
8
Mechanics of a Futures/Forward Contract
Purchaser(Long Position)
Seller(Short Position)
Contract to Buy/Sell(No Premium or Up-Front Payment)
Loss toShort Position
Profit toShort Position
Marketvs.
Futures Price
Future Date+
Futures Price
Obligation:Sell + Deliver
Obligation:Buy
Gain toLong Position
Loss toLong Position
“Cash-Settled”Futures Contracts
andMark to Market System
CommoditiesCurrenciesSecurities
Pre
sent
atio
n C
ode
9
Options
CALL PUT
Holder (Buyer)
Writer (Seller)
Holder (Buyer)
Writer (Seller)
Right or Obligation
Right (Buy)
Obligation (Sell)
Right (Sell)
Obligation (Buy)
Outlook on Security
Maximum Gain
Unlimited Premium Strike price minus
premium
Premium
Maximum Loss
Premium Unlimited unless
“covered”
Premium Strike price minus
premium
Pre
sent
atio
n C
ode
10
Structure of “Onshore” Hedge Funds
Hedge Fund Investments
Limited Partners (Investors)
Hedge Fund L.P. or LLC
General Partner
InvestmentManager
Levels of Inquiry
1) Tax classification of fund
2) Subchapter K implications
3) Valuation Issues
4) Taxation of investments
5) Investor-level issues
Pre
sent
atio
n C
ode
11
Tax Classification of Fund
Onshore hedge funds are partnerships
“Publicly traded partnership” exceptions (pg. 7)
Hedge fund status
Limited Partner (Investor)
Hedge Fund L.P.
Hedge Fund Investments
Trader or Investor
vs.
Dealer
Pre
sent
atio
n C
ode
12
Subchapter K: Allocation of Profit and Loss
Limited Partners (Investors)
Hedge Fund L.P.
General Partner
General Allocations
Net capital appreciation
(depreciation) to capital accounts
Tax items allocated under
§ 704(b) and § 704(c)based on net capital
Special Allocation
Incentive Fee
Based on benchmark?
Index: -9Return: -1
Incentive Fee: 20% of +8%
Hedge Fund Investments
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
13
Subchapter K: Contribution of Assets In-Kind
Limited Partner (Investor)
Hedge Fund L.P.
Special Allocations
Differences inbook value& tax basis
Hedge Fund Investments
Assets-in-kind
Non-taxable event
Unless hedge fund is“Investment Company”§§ 721(b) and 351(e)
Exception for
“Diversified portfolio”
“Insignificant amount”
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
14
Subchapter K: Disguised Sale Rules
Limited Partner (Investor)
Hedge Fund L.P.
Triggering Events
Partial redemption or withdrawal
Tax Distributions?
Distributions with corresponding
allocation?
Hedge Fund Investments
Presumed Disguised Sale
§ 707(a)(2)(B)
Contribution of appreciated property
Distribution of other property or cash to contributing partner
Within 2 years
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
15
Subchapter K: “Mixing Bowl” Transactions
Contributing Partner
Hedge Fund L.P.
Capital accounts unaffected
Outside basis of contributing partner and
inside basisof property automatically
adjusted (no § 754 election)
Hedge Fund Investments
Recognition of Gain/Loss
Contributed property
Distributed to any other partner
orReceive other property
Within 7 years
Other Partner
Character of gain/lossdetermined at fund level
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
16
Valuation Issues
Donor/Decedent (Investor)
Hedge Fund L.P.
Hedge Fund Investments Valuation of theInvestments
Valuation forWealth TransferTax Purposes
Restrictions
•Transferability•Withdrawal•No Chapter 14
•Date of Transfer•Value Received (Future)•Previous Valuation
•Accounting/Valuation Periods•Actively traded•Hard to value assets
§ 754
Withdraw
Cure Book/TaxLose “Watermark”
Book/TaxDisparity
Pre
sent
atio
n C
ode
17
Taxation of Investments: The Rules . . . And Exceptions
Limited Partner
Hedge Fund L.P.
Hedge Fund Investments
Contracts under § 1256
Currency Transactions (§ 988) [pgs. 15-16]
Conversion Transactions (§ 1258) [pgs. 25-26]
Constructive Ownership (§ 1260) [pg. 35-37]
CAPITAL GAIN/LOSS
CLOSE OF TRANSACTION
Contracts under § 1256
Constructive Sales (§ 1259)
Straddle Rules (§ 1092)
X
X
All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
18
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)
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.
Pre
sent
atio
n C
ode
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)
Pre
sent
atio
n C
ode
20
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/lossAll section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.
Pre
sent
atio
n C
ode
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.
Pre
sent
atio
n C
ode
22
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)
Pre
sent
atio
n C
ode
23
The Hedge Fund Claim
Produce equity-like returns
Maintain lower volatility
Exploit low correlation to rest of portfolio
Pre
sent
atio
n C
ode
24
Hedging Market Exposures Tends to Lower Volatility
3.6% 4.0%
9.0%
16.0%
Market-NeutralHedge Funds
Bonds DirectionalHedge 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
Market-Neutral* Fully hedge market exposure
Examples: Arbitrage; Event-Driven
Retain some market exposure
Examples: Long/Short Equity; Global Macro
Directional Strategies*
Annualized Volatility: 1996–2005
Pre
sent
atio
n C
ode
25
Hedge Funds Don’t Move in Tandem with the Markets
Correlations to S&P 500*1996–2005
Low Correlation
High Correlation
Market-Neutral Hedge Funds
US Growth Stocks
International StocksUS Value Stocks
Directional Hedge Funds
Bonds
Real Estate
*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.
Pre
sent
atio
n C
ode
26
Analysis of Hedge Fund Database
Directional Funds
*“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
Market-Neutral Funds
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
16.6%
(2.2)
(5.0)
9.4%
12.4%
(1.2)
(3.1)
8.1%
Pre
sent
atio
n C
ode
27
Hedge Funds: Superior Trade-Offs
1996–2005 Annualized*
0
2
4
6
8
10
0 5 10 15 20
Volatility (%)
Directional Hedge Funds
Stocks
Bonds
T-Bills
Market-Neutral Hedge Funds
*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
Return (%)
Pre
sent
atio
n C
ode
28
Traditional Allocation Models: A New Paradigm?
Percentage of Total Assets
Traditional Assets Only
60% Stocks
40% Bonds
With Hedge Funds
100% Hedge Funds?
Pre
sent
atio
n C
ode
29
83%
Avg. ActivelyManaged Long
Portfolio
Market vs. Manager: The Traditional Approach
Sources of Returns: 1996–2005*
Manager Decisions (Alpha)
Market Movements
17%Objectives
■ Capture market return
■ Add a premium (alpha) through long-only security selection
*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
Pre
sent
atio
n C
ode
30
Hedge Funds Focus on Alpha, Not the Market
83%
20%
80%
17%
Avg. ActivelyManaged Long
Portfolio
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
Sources of Returns: 1996–2005*
Manager Decisions (Alpha)
Market Movements
Sources of Alpha
● Long security selection
● Short-selling
● Various markets and instruments
● Leverage
● Specialized strategies(arbitrage, etc.)
Pre
sent
atio
n C
ode
31
Alpha Dispersion Among Hedge Funds Is Wide…
12.4%
7.6%
(15.0)%
(8.3)%
Alpha +/- Median Manager: 1996–2005 Annualized*
Top-Decile Manager
Bottom- Decile
Manager
Market-Neutral Hedge Funds
DirectionalHedge Funds
*“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
Median
Pre
sent
atio
n C
ode
32
…But Much Narrower for Traditional Managers
12.4%
7.6%
(15.0)%
(8.3)%
Alpha +/- Median Manager: 1996–2005 Annualized*
Top-Decile Manager
Bottom- Decile
Manager
Market-Neutral Hedge Funds
DirectionalHedge Funds
*“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
Long-Only Stocks
Long-Only Bonds
1.3% 0.4%
(1.2)% (0.4)%Median
Pre
sent
atio
n C
ode
33
Low Volatility Masks Full Downside Risk
Worst Peak-to-Trough Loss*1996–2005
*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
(9.8)%
(3.6)%
BondsMarket-NeutralHedge Funds
Pre
sent
atio
n C
ode
34
More Like Stocks at Just the Wrong Times
Correlations to S&P 500*1996–2005
0.1
0.5
(0.4)
0.1
Up S&P Months Down S&P Months
BondsMarket-NeutralHedge 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 & Poor’s, TASS, and Bernstein
Bonds
Market-NeutralHedge Funds
Pre
sent
atio
n C
ode
35
Choosing the Right Hedge Fund Manager
Core competence History of positive alpha Experienced management team
Superior Performance After Fees and Taxes
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
Pre
sent
atio
n C
ode
37
AppendixTASS DatabaseThe 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 RecommendationsThe 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.