McCrary (2008, pg. 1) defines a hedge fund as “a loosely regulated investment company that charges incentive fees and usually seeks to generate returns that are not highly correlated to returns on stocks and bonds. ” Alfred Winslow Jones established the fist hedge funds in 1949. He structured the system to allow private investors to participate and major investments were common stocks. Since then hedge funds have grown and different categories have been established (McCrary, pg. 1).
As investors seek investing in the global capital markets, the master-feeder fund structure has been introduced to facilitate the process and provide investors with enough tools for investment in a diversified environment. The paper explains hedge funds systems and provides different investment opportunities in the market. Analysis of master-feeder fund structure has been done at depth while providing both advantages and disadvantages. Hedge funds Hedge funds are regulated by the federal laws to avoid misuse by interested parties. There is a lower level of regulation for hedge funds compared to mutual funds.
Regulatory bodies in the United States have been debating about increasing regulations on hedge funds. Hedge funds are required to disclose small amount of information about their operations compared to mutual funds. Limited liability is a common feature of hedge funds; as such investors cannot cover liabilities beyond the starting capital they provide. Investors are protected from liability in case an organization fails to perform better. Similarly, hedge funds provide security to investors such that they can only cover up losses not beyond the initial capital provided.
Taxation system in the United States does not tax hedge funds like corporate organizations (McCrary, pg. 2). Differences between hedge funds and mutual funds Hedge funds charge incentive fees but mutual funds charge management fees. Under mutual funds customers are required to pay management fees ranging from o. 25% to 7% the managed assets. On the other hand, hedge funds charge management fees ranging from 1% to 2%. No incentive fees are charged under the system of hedge funds. Sales charge may or may not be provided when selling mutual funds. Instead, a commission of five percent or more is provided.
There are other fees attached to mutual funds, for example, 12b-1 fees. Under the system of hedge funds no commission is charged. Leverage is applied in most hedge funds. On the other hand, mutual funds use short-term liquidity to cover up any withdrawal (McCrary, pg. 4). Disclosure of information is compulsory under mutual funds and they are required to provide publications for financial statements for each quarter in a financial year. Investors must be informed of all activities of the mutual funds each financial year and publication of all documents required by law should be done.
On the contrary, hedge funds do not have a mandate to publicize their financial statements. Many investors have required that hedge funds provide enough information about their operations. It is only a small number of investors who would take the risk of investing blindly without accessing information about the funds. Hedge funds have a low level of liquidity compared to mutual funds in that an investor may redeem mutual funds faster than hedge funds. An investor can redeem hedge funds at specific periods of the year.
There are other restrictions which hinder regular redemption of hedge funds. Mutual funds can be redeemed at any moment. There are few or no restrictions about redemption of hedge funds. There is freedom to exit mutual funds. The fees charged to exit restrict investors but there is no barrier as to exit the market. Hedge funds provide absolute return to investors while mutual funds provide relative return (McCrary, pg. 5). The structure of Master Feeder Hedge Funds The structure of master feeder has a system where a master fund company is used.
The master fund company is located in a tax-neutral offshore country where all transactions are performed. Feeder funds can invest their funds to the master fund company. Taxable investors in the United States use this system to gain advantages by investing in limited partnership companies. This creates tax efficiency to such investors. A different offshore feeder organization is used by tax-exempt investors to avoid engaging in activities of the U. S. tax system (Vasilopoulos & Abrat, pg. 1). This system allows investors in the domestic and foreign markets access hedge fund assets in an efficient manner.
The structure provides efficient taxation and trade systems to transact in hedge fund assets. Investors can route their assets from different parts of the world into a central fund. The Master-Feeder is the central fund has its location in a specific country which has neutral policies about taxation and investment. A combination of taxable assets in the United States, tax-exempt asset and other investors from other countries are combined into one system where they can trade their assets (Vasilopoulos & Abrat, pg. 1). Source: Richard (2008).
From the diagram, an offshore company acts like the master fund where hedge funds from different investors from different parts of the world source their funds. There is investment managers involved in the entire process to communicate with all investors and to provide resources about the management of the entire process. The Master Fund collects feeds from different countries. The diagram provides that both U. S. investors and non U. S. investors are involved in the entire system. Limited partners are also involved in the system whereby they can invest in hedge funds and provide limited partnership
The process of creating a master feeder hedge fund system involves designing an offshore-domicile company. The company should be located in a tax-neutral environment, for example, Cayman Islands. This acts as the master fund where funds are only accepted through the feeders. No direct funds are allowed into the master fund. Tax exempt investors in the United States as well as non-U. S. investors are allowed to participate in the system. Shares are the only investments allowed in the master feeder. The existing hedge fund system is restructured to achieve the master fund hedge fund system.
Feeder funds are established to collect funds from U. S. limited partnerships. The feeder fund must hold shares with the master fund. The master fund and feeder funds are regulated by the U. S. tax laws. Tax elections are governed by federal tax laws of the United States. The master fund has the responsibility of maintaining optimal tax efficiency to all investors in the system. Master feeder system is widely used in the United States since it provides an efficient combination of taxation. Both taxable and tax-exempt individuals are linked by the system.
In Asia the system has not gained popularity but in the recent past many investors has realized the importance of hedge funds and they are actively participating in the system (Vasilopoulos & Abrat, pg. 1). Advantages According to “the principal advantage of utilizing a master-feeder structure is that it allows U. S. taxable investors to invest in an offshore hedge fund in a tax efficient manner that doesn’t compromise the tax position of other non-U. S. or U. S. tax-exempt investors. ” Therefore, fund managers can raise the amount of funds to achieve the investment qualify.
Hedge fund managers can increase the fees since they have a legal capacity. This provides autonomy in the management of the master fund system. Differences between master fund and hedge funds are eliminated through the master-feeder. Assets from different classes of investments are pooled together. This aspect helps reduce the conflicts between the two systems. A single trading body is allowed under the master-feeder fund system. This creates efficiencies in the management of funds under the system since there is a clear system of carrying out the activities of investment.
Investors cannot be confused about the management of their funds since the system provides a clear system of investing. Investors cannot enter into duplicated contracts with competing systems. The managers need not split the investment tools since only one system is involved. The overall effect is creation of a reduced cost system (Vasilopoulos & Abrat, pg. 1). Investors can invest in diversified markets since the system allows investment in different markets. Tax exempt and offshore investment funds are pooled by the offshore company.
Investors can access different market niches and obtain the benefits of product diversification. Through the process of master feeder hedge funds an can accumulate a pool of portfolios by acquiring funds from different market niches. Economies of scale are achieved through this system since different investors can pool their resources to come up with a central funding system. This allows investors share the costs of carrying out the investment transactions. Operational and transactional costs incurred in the managing and administering the master funds system are reduced through economies of scale.
For instance, single sets of statements are prepared by the master fund system, hence reducing the costs incurred in the entire system. There are operational efficiencies associated with this system since inter-regional transactions are not efficient for an individual to operate. The system collects investments from different individuals and costs are shared. The procedures involved are reduced and investors can obtain their funds quickly. The system enables the United States tax system achieve better influence by linking different categories of taxable individuals (Vasilopoulos & Abrat, pg.
1). Flexibility is achieved in the operation of the master-feeder fund structures. A single hedge-fund system as well as a multiple investment system can be supported by the master-feeder fund system. Different classes of investors can be catered for under the master feeder system. Different currencies can be used for subscription. Different fees structures have been established to cater for the diversified needs of investors (Vasilopoulos & Abrat, pg. 1). Master feeders system allows investors to consolidate their portfolios into a single investment.
Investors obtain financial benefits such as credit lines due to the expansion of investment portfolio. Costs involved in carrying out operations and transactions are reduced. The quantity of trade elements is reduced under the system since a single player is involved instead of a multiple trade investment system. Private feeders can be augmented to the main master feeder. This shortens the process of establishing a new system. Many private feeders can be added to the master feeder for the efficiency of operating the entire process. Fees are charged at the feeder level.
As such there the system is flexible since the feeders can use different fees. If the fees are charged at the master level it could be difficult to charge different fees from different feeders (FundCount LLC, pg. 1). Disadvantages According to the taxation system of the United States a withholding tax of 30% is provided to dividends for offshore funds. This restricts many investors from operating with the master feeder fund system. There is cross-collateralization of assets and liabilities in the system. This means that any asset can be used to settle a liability in case there is liquidation process.
This creates a risk profile especially to investors with different classes of shares. Master-feeder system allows investors from US as well as those from other countries participate in the capital market system. This system may be beneficial to US investors while offshore investors may not be favored by the system. Fees are fixed and are charged at the feeder level. This system is not appropriate since the master-feeder should be in charge of implementing the fees involved to avoid misuse of loopholes in the system.
Charging fees at the master level creates inequality and other problems of operating across the border. Investors make capital transactions with the feeders and this requires the master company to carry out its own transactions with the feeders. This creates double work which increases the costs of operating the entire system. If only one organization was involved the number of transactions would be reduced and the costs would be minimized. Accounting for taxes becomes cumbersome under the master feeder system since different taxation institutions are involved.
There are different tax systems adopted by the countries involved and this creates a lot of problems when trying to reconcile all the transactions done across the countries (FundCount LLC, pg. 1). Conclusion Under the master-feeder fund system investors from different parts of the world can access capital markets in the United States, Europe and other places. Regulations and tax systems adopted by the system favor all investors. The system provides flexibility and efficiency to investors. Hedge funds are investments which provide low risks to investors. The structure accepts both taxable and tax exempt investors in the United States.
Master Feeder hedge funds combine different investors from different parts of the world and allow the investors to pool their resources. The system creates advantages to investors by creating economies of scale and efficiencies through reducing of investment costs. The system is flexible and can accommodate a single hedge fund system or a combination of different investment funds. The master feeder system has several shortcomings which make it inapplicable in many countries. The tax system used is cumbersome since several tax laws from different countries are applied and need be reconciled.
Master-feeder fund system is a good capital management system that allows people from different countries invest in different assets. Investors considering expanding their portfolio should use this system especially when dealing with investments from different countries. International laws should come up with a unified tax system to create efficiency in the management of investments across the bounders. Works cited Detzer, Daniel. Hedge Funds. ISBN 3640216083, GRIN Verlag, 2008. FundCount LLC. For Master Feeder Fund / Partnership Structures. 2010. retrieved 13 July 2010 from:
<http://www. fundcount. com/master_feeder_fund_accounting. html> McCrary, Stuart A. Hedge fund course. ISBN 0471671584, John Wiley and Sons, 2004. Richard. Master-Feeder Fund Structure. HedgeFundBlogger. com. Retrieved 13 July 2010 from; <http://richard-wilson. blogspot. com/2008/01/master-feeder-fund-structure. html> Vasilopoulos, Effie & Abrat, Katherine. The Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund Managers. Hedge Fund Monthly. Retrieved 13 July 2010 from; <http://www. eurekahedge. com/news/04apr_archive_Sidley_master_feeder. asp>