Reading 17: Excerpts from Invest....ivate Investors－LOS e Investment, efficiency, contrast, private, capital

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 4: Private Wealth Management
Reading 17: Excerpts from Investment Management for Taxable Private Investors
LOS e: Compare and contrast the typical tax efficiency of investments in hedge funds, private equity, and venture capital.

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Regarding hedge funds, they are often:

A) tax efficient because to be successful their strategies rely on infrequent trading.

B) tax inefficient because to be successful their strategies rely on infrequent trading.

C) tax efficient because to be successful their strategies rely on frequent trading.

D) tax inefficient because to be successful their strategies rely on frequent trading.

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Answer and Explanation

Hedge funds are often tax inefficient because to be successful their strategies rely on frequent trading.

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Investments in hard assets, such as timber, minerals, and oil typically have:

A) favorable tax characteristics because they are taxed at long-terms gains rates.

B) favorable tax characteristics because of special features in the tax code.

C) unfavorable tax characteristics because of special features in the tax code.

D) unfavorable tax characteristics because they are taxed at short-term gains rates.

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Answer and Explanation

Investments in hard assets, such as timber, minerals, and oil typically have favorable tax characteristics because of special features in the tax code that are designed to foster investment in these industries.

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Investments in private equity and venture capital are usually:

A) tax efficient because any gains realized are ordinarily taxed at favorable short-term rates.

B) tax inefficient because any gains realized are ordinarily taxed at unfavorable long-term rates.

C) tax efficient because any gains realized are ordinarily taxed at favorable long-term rates.

D) tax inefficient because any gains realized are ordinarily taxed at unfavorable short-term rates.

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Answer and Explanation

Investments in private equity and venture capital are usually tax efficient because any gains realized are ordinarily taxed at favorable long-term rates.

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With regard to wealthy investors, which of the following statements is most correct?

A) Taxable bonds are usually tax-inefficient, hedge funds are often tax-efficient, and private equity is typically tax-efficient.

B) Taxable bonds are usually tax-inefficient, hedge funds are often tax-efficient, and private equity is typically tax-inefficient.

C) Taxable bonds are usually tax-inefficient, hedge funds are often tax-inefficient, and private equity is typically tax-inefficient.

D) Taxable bonds are usually tax-inefficient, hedge funds are often tax-inefficient, and private equity is typically tax-efficient.

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Answer and Explanation

Taxable bonds pay income that cannot be deferred, and is ordinarily taxed at a high marginal rate for wealthy investors. The implication is that this type of asset class will need a relatively large pre-tax return to be a viable investment for these investors.

Hedge funds often rely on strategies that require more positions and more frequent trading in order to be successful. Both of these factors are likely to result in tax inefficiency. Since wealthy investors have been large investors in hedge funds, apparently the pre-tax returns have been sufficiently large to offset the tax inefficiency.

Private equity is ordinarily a long-term investment that is taxed at relatively favorable long-term capital gains rates. Therefore, it is reasonable to expect that private equity investments will be attractive, from a tax standpoint, for wealthy investors.

Taxable bonds pay income that cannot be deferred, and is ordinarily taxed at a high marginal rate for wealthy investors. The implication is that this type of asset class will need a relatively large pre-tax return to be a viable investment for these investors.

Hedge funds often rely on strategies that require more positions and more frequent trading in order to be successful. Both of these factors are likely to result in tax inefficiency. Since wealthy investors have been large investors in hedge funds, apparently the pre-tax returns have been sufficiently large to offset the tax inefficiency.

Private equity is ordinarily a long-term investment that is taxed at relatively favorable long-term capital gains rates. Therefore, it is reasonable to expect that private equity investments will be attractive, from a tax standpoint, for wealthy investors.