To do as well in a hedge...

(3.1) To do as well in a hedge fund investment, the after-tax net return should be at least as high. The break-even return on a hedge fund whose results are taxed at the 37 percent ordinary rate and where there is no deferral of tax liability is shown in equation (3.2) to be 13.4263 percent.
Short-term hedge fund return:
Short-term hedge fund return

(3.2) (Ignoring any possible delay in paying current tax liability) Ignoring any possible delay in paying current tax liability In other words, in this scenario, a high-net-worth individual must earn 34 percent higher pretax return than stocks to do as well after taxes. High-net-worth individuals may invest in hedge funds because they expect a sufficiently higher return to accept the tax disadvantage of the investment vehicle.

These individuals may believe that hedge fund returns are less volatile than stock returns to justify the tax-disadvantaged investment. Finally, the hedge fund may provide a low correlation of return to other assets in the portfolio so a small investment in hedge funds (say 10 percent to 20 percent) may lower the volatility of the portfolio enough to justify making a hedge fund investment.

The answer to question 2.13 in Chapter 2 presents a formula for the average return on a portfolio. That formula with an extension account for taxes is shown in equation (3.3). Assume that the pretax expected return is 10 percent for both a traditional stock position and a hedge fund. Assume also that the investor pays ordinary income tax at 37 percent and longterm capital gains are taxed at 18 percent. Suppose that 100 percent of the stock return is taxable as long-term capital gain and 100 percent of the hedge fund return is taxed as ordinary income. For simplicity, assume that After-Tax Net Return the stock strategy does not defer the taxable gain at all.