Hedge Funds and You: What Individual Investors Need to Know

This is an emotional and political issue, so rather than take sides I will merely state the main arguments and how they impact the individual investor:

Incentive fees earned by hedge fund managers may be taxed as capital gains (it really depends on the "character" of the income earned by the limited partners) rather than ordinary income. The discrepancy in tax rates between capital gains and "ordinary" income is quite large.

What if those hedge fund managers' incentive/performance fees were taxed at an ordinary income rate? Then taxes could be reduced to non-hedge fund investors.

The other side of the argument is that these amounts are not significant and the character of the income is just being allocated and not transformed.

Individual investors cannot directly deduct investment expenses and interest against their investment income, regardless of the character of the income. Individual investors have to put this on tax form Schedule A and may be subject to limitations. However, hedge fund mangers can deduct certain expenses as ordinary business losses. Again, arguments can be made both ways, but in the end, individual investors seem to get the short shrift.

Hedge Fund Interest, Leverage and You

Interest and leverage work hand-in-hand and they are at the center of the hedge fund business model. Hedge funds deploy large levels of leverage and seek to do so at the lowest rate of interest. Individual investors beware. Here is what you need to know:

When individual investors invest on margin they are subject to Federal Reserve Regulation T. This is covered in greater detail in "Understanding Leverage."

Under Regulation T, an individual investor can obtain a 2-to-1 leverage ratio. However, hedge funds are able to obtain a lot more leverage. How? By structuring offshore loans or entering into complex derivative contracts such as swaps , hedge funds can negotiate leverage ratios which are multiples of 2-to-1. And in the case of Long-Term Capital Management, leverage approached infinite levels.

Again, why should an individual investor care about this activity?

When brokers make margin calls , reduce leverage to hedge funds or the hedge funds get redemptions from their limited partners, then they go into liquidation mode. When this occurs hedge funds will sell stocks and other assets with reckless abandon in panic mode.

While it does not necessarily explain all of the recent market weaknesses in both the equity and credit markets, these leveraged liquidations will exacerbate market declines. This adds to market volatility and can create panic. The individual investor who tends to be more long-term oriented can get hurt in the collateral damage of hedge fund liquidations and deleveraging.

Any investor who desires to borrow money from a broker-dealer will pay interest at a margin rate to borrow funds. Individual investors will pay the going rate posted by the broker.

Right now, Morgan Stanley MS is charging 7.25% for margin loans. Hedge funds on the other hand can negotiate rates. Typically, these rates are a spread of about 25 to 50 basis points over LIBOR (London Interbank Offered Rate). Right now, the one-month LIBOR is about 2.85%, putting the total margin rate to about 3.10% to 3.35%.

Any investor who short sells a stock will receive cash proceeds from the stock loan associated with the transaction, which will then be used to collateralize the "stock borrow." Interest is then earned by the broker-dealer on the short proceeds. This is referred to as the short interest rebate (see "How Short Selling Works"). Hedge funds will receive some of that short rebate, while individual investors will not see a dime of the rebate. This makes short selling advantageous to hedge funds relative to individual investors.

Hedge Funds and Your Portfolio

While there may be some unscrupulous hedge fund managers, most are highly ethical. The point of this lesson was to point out how the individual investor may be affected by hedge fund operations. As an individual investor, with this raised level of awareness, the next time action is taken by hedge funds, you will have a better sense of how it may impact your investments -- especially in short periods of time (see "How to Trade Off of Unusual Activity").

Know What You Own: Morgan Stanley operates in the financial services industry, and some of the other stocks in this field include Goldman Sachs GS, Merrill Lynch MER, Citigroup C, Bank of America BAC and Lehman Brothers LEH. These stocks were recently trading at ($156.75, -5.25%), ($43.68, -5.58%), ($19.77, -6.17%), ($35.66, -3.98%) and ($40.00, -13.02%) respectively. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.