Hedge funds are the real “rootless cosmopolitans” who go anywhere where there are tax breaks, minimal regulations, and a luxurious lifestyle.
One of the biggest attractions of hedge funds since their inception in 1949 was that they could skirt many regulations and always love the “edge.”
The “edge” is a trading term meaning “the advantage.” That advantage comes in many forms, ranging from an informational advantage over the trading crown, a leverage advantage, the ability to trade faster than the competition, a talent advantage, a niche trading advantage, and the paramount advantages, a regulatory and tax-free or reduced tax advantage.
Trading is all about net profits, including the all-in trading costs. These can seem insignificant to average investors, but these trading costs add up when hedge funds trade in huge volumes on listed exchanges in shares, options, or currencies. Things like market impact (when a big trade moves the market against the trader because the market is too thin), clearing fees, trading costs, regulatory costs, and tracking errors all impact trading profits.
Hedge funds use the all-important measure of “alpha” as their measure of profit, or out-performance, compared to a benchmark. The textbooks define Alpha as an investment strategy’s ability to beat the market or its “edge.” Alpha is thus also often referred to as “excess return” or the “abnormal rate of return” about a benchmark when adjusted for risk.
So when a hedge fund seeks Alpha, it also must consider its risk. The goal is to reduce or eliminate as much risk as possible. Some of this risk is inherent in the global markets, and another source of risk comes from regulators and taxation. If hedge funds can reduce these artificial risks, they can maximize profits better.
Managing or Eliminating Regulatory Risk
To reduce tax and regulation risks, hedge funds lobbying groups and other political pressure groups in the financial services industry have developed the most aggressive and well-funded lobbying groups in Washington. Estimates say the financial services lobby (comprised of finance, insurance, and real estate)spent $609 million in 2022 that it deploys to curtail actions by the SEC, CFTC, taxation legislation, changes in real estate taxation, and the hated Consumer Protection Financial Board.
The financial services lobby has waged war against several landmark regulatory efforts that benefit average investors, pensioners, and 401(k) participants. These include the epic seven-year campaign against the Department of Labor’s enactment of fiduciary standards that would make self-dealing and conflicts-of-interest in selling and trading investments in pension and 401(k) plans violate DOL rules. The DOL rule specifically addresses excessive fees and expenses charged to pension and 401(k) plan investors.
When the DOL’s regulations (specifically 404 (a) (5) were implemented in 2012, the DOL said it would produce savings to investors of $15 billion by cutting fees and expenses. (Source: How 401(k) Fees Destroy Wealth and What Investors Can Do to Protect Themselves, by Chuck Epstein, 2012, page 63.)
The Scourge of Carried Interest
Since taxes are one of the biggest hits to bottom-line profitability, hedge funds, private equity, and real estate developers, which all exploit this loophole, have gone to great lengths to protect their tax advantages. The little-known carried interest tax loophole is the most significant benefit to hedge funds, private equity, and real estate.
This tax loophole allows these industries to evade paying their fair share of taxes in exchange for a very preferential tax rate. As a result, average taxpayers pay more taxes than the owners and investors in the billion-dollar hedge, private equity funds, and real estate developers.
CARRIED INTEREST DEFINED
Carried interest is a nerdy accounting term that allows private equity, real estate developers, and hedge fund managers “to mischaracterize their earnings as capital gains rather than income,” according to Patriotic Millionaires University. This group says private equity and hedge funds claim “they are in a ‘partnership’ with their investors, and their earnings should be classified as capital gains instead of income (because they’re investing their time and expertise into the firm).” But this is any small business’s exact definition of how they work. The big difference is that they pay a higher tax rate.
This category of firms loves this loophole since it allows their owners to reduce tax bills by about half. This happens because they are taxed at the much lower capital gains tax rate, just 20%, rather than the top income tax rate of 37%.
The loophole hits the federal tax collection purses hard, so it has attracted the attention of more populist politicians. In the 2020 presidential election, the sociopath Donald Trump rhetorically called for the loophole to be closed, although it was another blatant lie. In the 2012 presidential campaign, candidate Barack Obama criticized Republican candidate Mitt Romney for his profits from the carried interest loophole. He made a powerful argument that should be repeated today.
“How much Mr. Romney benefited from the carried-interest loophole could not be determined since he refused to release his tax returns before 2010. But as a former Bain Capital partner, he received substantial carried interest — 31 percent of his 2010 and 2011 income, The Boston Globe reported,” according to the New York Times. Having 31% of your total multi-million dollar income linked to the carried interest loophole is worth fighting for, and that’s precisely what the financial service lobbyists do daily.
Tax Freedom and Luxury in the Desert
But fighting to keep tax loopholes alive is a constant and expensive task. So hedge funds and other predatory capitalist businesses do what anyone else does when it gets tough: move to another country.
Enter Abu Dhabi, the capital of the United Arab Emirates, which sits off the mainland on an island in the Persian (Arabian) Gulf.
According to a comprehensive article in Bloomberg News, over 100 high-powered financial trading firms have moved some staff to the capital of this desert nation. In the process, they have boosted office rents to a level comparable to London and New York.
“One in five of the world’s top 100 hedge funds now has an office in Dubai, while 10 out of 15 of the top-tier multi-strategy hedge fund platforms have a presence, according to industry tracker With Intelligence,” according to the Bloomberg article.
Accompanying the hedge funds has seen a rise in private jet use at the local airport, a surge in rents at luxury living spaces, and packed expensive restaurants. The article noted that people rent penthouses in the new waterfront development, where four- and five-bedroom apartments rent from about $9,000 to $11,000 a month. To keep the art crowd happy, Dubai has also reached a deal with the Louve and the Guggenheim to open art museums nationwide.
“People want to move to a place from a tax purpose that’s efficient, where the quality of life and connectivity is great,” said Arvind Ramamurthy, chief of market development at ADGM,” the Bloomberg article said.
But that’s an understatement. “UAE citizens and foreigners with residence visas are exempt from taxes on income, capital gains, gifts, inheritance, wealth, and luxury. When buying or selling property, individuals pay a property transfer tax,” according to PWC.
So, anyone working with hedge funds can get a residence visa and pay no taxes. As for corporations, the benefits are still huge. “Business activity in the United Arab Emirates will be subject to UAE CT at 9% where the total turnover from such business or business activity exceeds 1 million UAE dirham (AED). For this purpose, wages, personal investment income, and real estate investment income will not be considered for determining such turnover,” according to PWC.
Hedge Fund: Rootless Cosmopolitans Who Hate Taxes
So, as the world gets smaller and tax rates go higher in some localities, the best way to cut tax risk is to go to a friendly nation.
Now, Dubai offers significant tax relief. Pay less taxes in Dubai but enjoy all the benefits of the U.S. trading system infrastructure and deep, liquid markets. This gives new meaning to the old saying, “Take the money and run.”