Tokenized Hedge Funds save millions in tax for US investors

The opportunity to invest in professionally managed hedge funds has previously been limited to high net worth individuals, depriving the average investor from these very profitable investments. In addition, hedge funds have been criticized for high fees, and while they typically justify those fees with market leading performance, it does affect the net profits investors see.

However, the biggest issue hedge fund investors face is taxes. The majority of hedge funds are structured as partnerships, which means that as a limited partner, each investor received a K-1 every year and must pay taxes on the profits of the hedge fund. This creates significant issues, where investors will actually have to pay tax on profits which are earned, but have not been distributed to them. Therefore they must either pay the tax out of their own pocket, or request a distribution from their investment to cover their tax liability. In many cases, hedge funds that invest in illiquid instruments are especially difficult for investors, who must plan to meet their tax liabilities while dealing with the lockup period imposed by the fund. This is one major reason why hedge fund investing has been limited to accredited investors. Not because it is risky (any investment carries risk, and the risk adjusted returns of the top hedge funds are actually much better than those of investments “allowed” for the average non-accredited investor). Rather it is in fact because of the potential significant tax liabilities, that investors need to plan for and meet, which can be challenging for investors who do not have sophisticated tax advisers and liquidity to meet tax issues.

There is currently no legal way of deferring taxes on a hedge fund investment. If the fund organized as a C-corporation, it would be subject to double taxation, and any attempt to move offshore involves toll taxes and other provisions making such investments unattractive for US investors.

Fortunately, the IRS has clearly classified cryptocurrency tokens as property in in its 2014 guidance. As a result, it is clearly understood that taxes paid on gains from tokens are due at the time of sale when profits are realized. Quite simply this means that if an investor holds a token for 10 years, no matter how much it appreciates in the meantime, taxes will only be due when the investor sells it.

This creates a tremendous advantage that, combined with the zero fee model, allows investors to realize significantly higher profits.

Let’s look at some numbers. Assuming a $10,000 initial investment, over 10 years, with a 20% return (which is average for the hedge fund industry), and an investor who is in the 35% tax bracket. In regards to fees, we will assume the standard 2% management and 20% (of profits) incentive fee. On the other hand, we will use a Hedge Fund Token distribution model (80% of the tokens issued to investors) which has no management or incentive fees.

Hedge Fund Token vs Traditional Hedge Fund at 20% annualized return

We can see that after year 2, the traditional hedge fund model falls sharply behind. For those curious why the Hedge Fund Token has lower Initial Value, remember that each $1 invested in the Token initially is worth $0.80 (due to the token distribution model).

Also, note that the Hedge Fund Token model outperforms significantly even after the eventual “sale” in year 10, where the investor pays the 35% tax (hence the Year 10 final value).

The higher the returns of the strategy, the more significant the tax and fee savings becomes. If we take a hypothetical 50% yearly return, which is achieved by some top performing hedge fun strategies, and apply the calculation, we get the following:

Hedge Fund Token vs Traditional Hedge Fund Structure at 50% Return

While any hedge fund investor would be happy with a 15x (1500%) cumulative return after 10 years, the same investment in a strategy with the same exact yearly performance (50%), would be a staggering 40x (4,000%), even after all taxes.

If you are curious about what your actual tax and fee savings would be, you can use this calculator where you can edit all the assumptions and see your actual result

There is no doubt that tokenizing assets, and especially actively trading hedge fund strategies, provide advantages to investors that have never previously been available. We believe that as more managers, tax advisors and investors come to this realization, there will be a seismic shift of assets from traditional LP investment to token based.