Hedge Fund Course - Wiley Finance Series

Regardless of how these break points are defined, the typical investor has a high marginal tax rate. Yet the typical hedge fund produces most of its return as short-term capital gains or ordinary income, both of which are taxed at high marginal tax rates. In contrast, other investments are taxed more favorably.

Municipal bonds are not taxed at the federal level and may be exempt from state and local income tax. Other investments, such as common stocks, provide a large part of their return in the form of capital gains that may be taxed at a lower rate for long-term gains. The tax may be postponed indefinitely (if the investment is held indefinitely), or may even escape income taxation if held until death.

Suppose an individual paid individual income tax at the 37 percent rate for ordinary income and short-term gains and paid 18 percent on long-term gains.

Suppose further that capital gains can be postponed on stock investments for five years. The after-tax return on the stock portfolio, assuming a pretax annual return of 10 percent and a short-term discount rate of 5 percent, is given by equation (3.1).
Long-term stock return in constant dollars:
Long-term stock return in constant dollars