The portfolio of individual...
13.11 The portfolio of individual call options is worth at least as much as a call option on the hedge fund index and is probably worth more than the call option on the index. The difference depends on the extent the hedge funds move together. If hedge fund returns overall are flat to down, the call on the index would be worthless but individual hedge funds might have had profits that make a call option valuable for the individual hedge fund.
13.12 The value of most options should never be less than zero because the owner can simply let the option expire. While it is possible to imagine options that carry costs to abandon them, this is not a common structure.
13.13 Some of the premium payments must go toward providing a death benefit for the insurance policy to gain the tax treatment of insurance. The death benefit has economic value but may not be highly valued by a hedge fund investor. Also, insurance policy transfers the hedge fund assets to beneficiaries. The purchaser of the policy (i.e., the hedge fund investor) cannot be a beneficiary and the purchaser cannot redeem the cash value of the policy without paying tax on the hedge fund returns. Nevertheless, the policy purchaser can borrow the cash value back if the need arises, but the amount lent reduces the payout to beneficiaries.
13.14 Hedge fund returns are taxed at higher tax rates than long-term investments in common stock because a large part of the stock return is taxed as long-term capital gains. Of course, bond income is a major component of bond returns and this income is also taxed at the higher ordinary income rate.
Assume the following combined state and federal income tax For example, ignoring the additional benefit possible from postponing capital gains tax or the avoidance of capital gains tax altogether at death, the difference in tax rate (here assumed to be 40 percent on ordinary income and short-term gains and 20 percent on long-term capital gains) means that a hedge fund must provide a return of 20 percent before tax to match the after-tax return on stocks making 15 percent if all of the stock return is long-term capital gain and all of the hedge fund return is taxed as ordinary income. Further more, if hedge fund returns escape taxation as part of a universal life insurance policy, the hedge fund need earn only 12 percent to match the after-tax return of a taxable investment earning 15 percent subject to capital gains tax or 20 percent subject to ordinary income tax.
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