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What is Hedege Fund “Carried Interest”?

What it is – How it works?

[By staff reporters]

***

Carried interest or carry, in finance, specifically in alternative investments (i.e., private equity and hedge funds), is a share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that the manager contributes to the partnership.
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As a practical matter, it is a form of performance fee that rewards the manager for enhancing performance.
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Tax Status

Carried interest, income flowing to the general partner of a private investment fund, often is treated as capital gains for the purposes of taxation.

Some view this tax preference as an unfair, market-distorting loophole.

Others argue that it is consistent with the tax treatment of other entrepreneurial income.

MORE: News about Carried Interest Tax Break

Assessment

Your thoughts are appreciated.

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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Options, Hurricanes and Hedging

Options, Hurricanes and Hedging

By Vitaliy Katsenelson CFA

We always look at our investment process and ask ourselves, “What can we do better?” How can we increase returns and lower risk? We think we have found a new, sensible way to do both.

We can hedge a portion of our market exposure with put options. Put options are contracts that trade on an exchange that give buyer (us) a right, not an obligation, to sell stock (or in our case Exchanged Traded Fund, ETF that mimics a market index) at a specific price for a certain period of time. Put options are cash settled, so when we exercise it or it expires we get cash in lieu of its value. Buying put options is very similar to buying hurricane insurance. We pay a premium, and that is the only cost we bear. Let’s restate this: The only risk we take is that the hurricane doesn’t hit or, in our case, that the stock market doesn’t decline, in which case our premium was “wasted.”

When you buy hurricane insurance you don’t suddenly start wishing for a hurricane, but you do get peace of mind from knowing that if Richard or Betty (we name hurricane like we name pets – makes TV watching so much more exciting, especially if your name is Richard or Betty) pays you a visit, the insurance company will restore your house to its original state.

We look at options “insurance” the same way we look at any asset: It can make sense at one price but make no sense at another. As you will see, at today’s price they make a lot of sense.

For the sake of simplicity let’s make a few assumptions: First, your portfolio is 100% correlated to the stock market. Second, your portfolio is 100% invested. And finally, let’s assume we’d be buying put options to insure your whole portfolio. These assumptions will simplify our example – we’ll modify them later.

Based on our assumptions, we’d buy put options on ETFs that track a particular stock market index – let’s say the S&P 500. As of January 2018, if we were to buy options on the S&P 500 ETF, SPY, that expire in one year and that are 5% out of the money (they don’t start paying us until the S&P declines 5% or more – think of this 5% as our deductible), the cost of insuring the entire portfolio would be about 4% of its total value. For a $1 million portfolio it would be $40,000.

If the stock market decline is greater than 5%, the insurance kicks in. After a 5% decline the value of our stock options starts going up proportionally to the decline in the portfolio. If stock market falls 20%, the $1 million portfolio declines to $800,000, but this $200,000 loss is offset by the appreciation of our put options, which go up by roughly $150,000. Thus the value of the portfolio is now $950,000 (remember our 5% deductible). Actually that number will most likely be less – somewhere between $910,000 and $950,000, because we paid $40,000 for the put options.

Without getting too deep into the weeds, the price of an option is driven by two additional factors: time (options are not good wine; they get cheaper with age) and expected volatility, which we’ll discuss next.

Let’s say you are insuring a home somewhere on the Florida coast. The general formula to calculate the cost of insurance is probability of loss times severity of loss. According to a study by Colorado State University, the climatological probability that the coast of Florida will get hit by a major hurricane in any particular year is 21%, so once every five years or so.

A 21% probability doesn’t mean that a hurricane will pay a visit every fifth year; no, it actually means that over a 100-year period there will on average be 20 hurricanes hitting the Florida coast. Hurricanes may, however, decide to pay a visit two or three years in a row and then take eight or ten years off.

21% is the number an insurance company uses to figure out the intrinsic cost of the insurance. But this is where we have to draw a distinction between climatological probability of loss (intrinsic or true cost) and expected probability of loss.

There are other factors that go into the total cost of the insurance contract, including the size of the policy, its duration, and the deductible. But if you hold all these factors constant, the only number that fluctuates due to supply and demand in insurance market is the expected probability of loss.

A year after a hurricane, homeowners are still licking their wounds from last year’s Richard or Betty. The pain is so recent that those who were hit expect that hurricanes will happen a lot more often and thus the expected probability (in the eyes of these consumers) rises to … pick a number; let’s say 50% (a hurricane every two years). (The insurance industry may have had its capital depleted by recent hurricanes, which will also drive prices higher, but we’ll ignore this factor in our discussion.)

However, if there is no hurricane for a while, let’s say for eight years, the memory and the pain of the last hurricane fade away. A new wave of homeowners moves in, who have seen hurricanes only from the comfort of their leather couches on the Weather Channel. Now the expectation of another hurricane drops to, let’s say, 10% (a storm every ten years).

Thus, though expected probability and thus insurance cost has fluctuated dramatically from 50% to 10%, intrinsic value has not changed; it is still 21%. This example is extremely oversimplified, but the key point is still the same: A rational homeowner would want to buy insurance when no one expected a hurricane to visit Florida and lock in that price for as long as possible. If you are an insurance company you want to write as much insurance as you can when hurricanes are priced at 50% expected probability, and you want to be out of the market when they are priced at a 10% probability.

In the options market, expected probability of loss is expressed in terms of the volatility that is priced into options. Ten years of bull market have eroded even the most unpleasant memories of the 2008 decline. Fear has been replaced by euphoria that has been further amplified by the steady daily appreciation of stocks. The mindset that markets will never decline ever again has gradually seeped into the collective stock market psyche. This is why volatility is cheap! How cheap? Average volatility priced into options since 2004 was about 18%; today it is at 10%. In 2008 it reached 80%, and it has reached 40% a few times since 2008.

Volatility is quickly becoming one of the most interesting assets in the otherwise not very interesting stock market. But the situation in the stock market is even more interesting than in the hurricane insurance market.

Stock markets are fueled by two often contradictory forces: human emotions and movement towards fair value. Human emotions may divorce stocks from their fair value for a considerable period of time, but movement towards fair value can only be postponed but not suspended. During bull markets greed begets greed and stock market valuations go from cheap to average to high to super-high to extra-super-high – we are running out of superlatives, but we hope you get the point: Valuations march ever higher … until the music stops.

It is hard to know what will trigger the “stops” part, but in the late stage of the bull market, stock market behavior is driven less and less by fundamental factors and more and more resembles a Ponzi scheme (though market commentators come up with plenty of rational explanations to wrap around their “this time is different” narrative).

Stocks march higher until the market runs out of buyers and collapses under its own weight. This is how movement towards fair value takes place – except that, historically, markets have rarely stopped at fair value; they have fallen to levels well below fair value. (Vitaliy wrote two books on this subject – we’d be happy to send you copies.)

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We are not meteorologists, but we believe there is an important difference between hurricanes and stocks. Just as when you flip a coin each flip is an independent event and completely unconnected to the previous flip, hurricanes are independent events – just because Richard paid a visit to Florida last year does not change the probability of Betty’s appearance next year. Betty is not aware of Richard’s past misdeeds.

In contrast, the probability of a significant market decline is not constant; it is dependent on past movements of stocks. As markets stretch higher and higher, bulk of the appreciation was driven by expansion of price to earnings. Market valuation which was already high went higher. The gap between the price and intrinsic value creates a rubber band-like tension. The wider the gap the greater the tension and risk of eventually embarking on the return trip towards fair value.

Thus, in the case of the hurricane the climatological probability of 21% of loss remains constant no matter whether Richard or Betty appears, but in the stock market the probability of a sharp decline (an equities hurricane) increases as the gap between price and fair value widens.

In other words, today the value of volatility has increased while its price is making new lows. This is why we believe volatility is one of the most interesting assets we see now.

We are not market timers. We have no idea what the stock market will do in 2018, but we look at buying put options as an opportunity to hedge our portfolios with what we believe is significantly undervalued insurance.

Let’s delve into the practicality of our hedging strategy and modify some assumptions we made in the oversimplified example above. First, our portfolios are not 100% correlated to market indices. Considering that we own high-quality companies that are significantly undervalued, we believe our stocks will (temporarily) decline less than the market if there is a significant correction. Second, we have a lot of cash, which doesn’t require hedging.

Let’s say your account is 60% invested. We only need to worry about hedging that 60%. And considering that our stocks will decline less than the market, we need to buy puts to protect less than 60%. How much less? Historically our stocks have declined a lot less than the market during significant sell-offs. Our average portfolio was down 17-18% in 2008 when markets were down 35-45%. Our guestimate, therefore, is that we need to hedge about half of 60% or 30% of the total portfolio. So the total cost of insuring the portfolio against a decline of 5% or greater for a year would be 1.2% (4% – the cost of “insuring” the total portfolio – times 30%).

You can see how this strategy can reduce risk, but can it increase returns? The answer is a bit more complex and has two parts: First, if the market takes a deep dive, our appreciated put options together with cash will have increased buying power, since everything around us will be cheaper. And second, depending of when it happens – how much time value is left in the option – the value of the option may jump dramatically, as the market will be pricing in not 10% volatility but a much higher number – 30%, 40%? – your guess is as good as ours.

IMA’s ultimate goal is produce good risk-adjusted returns while keeping volatility of our clients’ blood pressure level to a minimum. We try to achieve this through our conservative stock selection, our transparent (sometimes overly long) communication, and now through buying inexpensive insurance on the portion of your portfolio.

Assessment

Our view on what true risk is has not changed. To value investors, true risk is not volatility (a stock temporarily declining in price), but a permanent loss of capital (the stock price decline is permanent). Our hedging strategy goal is to take advantage of an undervalued asset – volatility – and to decrease your (future) blood pressure just a little.

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements.

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HEDGE FUNDS – A History Rooted in Medicine?

HEDGE FUNDS – Really Rooted in Medicine?

By Dr. David E. Marcinko MBA CMP™

http://www.CertifiedMedicalPlanner.org

The investment profession has come a long way since the door-to-door stock salesmen of the 1920s sold a willing public on worthless stock certificates. The stock market crash of 1929 and ensuing Great Depression of the 1930s forever changed the way investment operations are run. A bewildering array of laws and regulations sprung up, all geared to protecting the individual investor from fraud. These laws also set out specific guidelines on what types of investment can be marketed to the general public – and allowed for the creation of a set of investment products specifically not marketed to the general public.

These early-mid 20th century lawmakers specifically exempted from the definition of “general public,” for all practical purposes, those investors that meet certain minimum net worth guidelines. The lawmakers decided that wealth brings the sophistication required to evaluate, either independently or together with wise counsel, investment options that fall outside the mainstream.

Not surprisingly, an investment industry catering to such wealthy individuals, such as doctors and healthcare professionals, and qualifying institutions has sprung up.

***

READ MORE HERE

https://www.linkedin.com/pulse/hedge-funds-history-rooted-medicine-mbbs-dpm-mba-m-ed-cmp-

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Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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Hurdle Rates V. Highwater Marks V. Claw Back Provisions

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More on Hedge Funds – Oh My!

dem-2

By Dr. David Edward Marcinko MBA CMP®

Many physicians and other investors — even those that meet net worth guidelines — are surprised to learn that there exists a $500 – 999 billion, or more, alternative investment industry that is not generally marketed to the public. Such alternative investments have also been known as hedge funds or private investment funds.

Unlike mutual funds, these alternative investments can be structured in a wide variety of ways. Because of the very same regulations discussed above, these funds cannot be advertised, but they are far from illegal or illicit.

http://www.CertifiedMedicalPlanner.org

cmp

History

In fact, physicians were among the most significant early investors in one of the last century’s most successful hedge funds. Mr. Warren Buffett, Chairman of Berkshire Hathaway, Inc. and a legendary investor got his start in 1957 running the Buffett Partnership, an alternative investment fund not open to the general public. Mr. Buffett’s first public appearance as a money manager was before a group of physicians in Omaha, Nebraska. Eleven decided to put some money with him. A few of these original investors followed him into Berkshire Hathaway, now among the most highly valued companies in the world.

The alternative investment, or hedge, funds of today are similar to the original Buffett Partnership in many ways. So, we will discuss several unique terms which potential investors should be aware.

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hds

Hurdle Rate

Hedge funds may feature a hurdle rate as part of the calculation of the fund manager’s performance incentive compensation. Also known as a “benchmark,” the hurdle rate is the amount, expressed in percentage points, an investor’s capital account must appreciate before the account becomes subject to a performance incentive fee. Potential medical investors should view the hurdle rate as a form of protection in context with other features of the fee arrangement.

The hurdle rate, which benchmarks a single year’s performance, may be considered mutually exclusive of any other year, or the hurdle rate may compound each year. The former case is more common. In the latter case, a portfolio manager failing to attain a hurdle rate in the first year will find the effective hurdle rate considerably higher during the second year.

Once a fund manager attains the hurdle rate for an investor, the medical investor’s capital account may be charged a performance incentive fee only on the performance above and beyond the hurdle rate. Alternatively, the account may be charged a performance fee for the entire level of performance, including the performance required to attain the hurdle rate. Other variations on the use of the hurdle rate exist, and are limited only by the contract signed between the fund manager and the investor. The hurdle rate is not generally a negotiating point, however.

Example:

A fund charges a performance fee with a 6 percent hurdle rate, calculated in mutually exclusive manner. Dr. Lanouette, a radiologist investor places $100,000 with the fund. The first year’s performance is 5 percent. The investor therefore owes no performance fee during the first year because the portfolio manager did not attain the hurdle rate. During year two, the portfolio manager guides the fund to a 7 percent return. Because the hurdle rate is mutually exclusive of any other year, the portfolio manager has attained the 6 percent hurdle rate and is entitled to a performance fee.

Highwater Mark

Some funds feature a highwater mark provision, also known as a ”loss-carryforward” provision. As with the hurdle rate, potential investors should consider the highwater mark a form of protection. A high water mark is an amount equal to the greatest value of an investor’s capital account, adjusted for contributions and withdrawals. The high water mark ensures that the hedge fund manager charges a performance incentive fee only on the amount of appreciation over and above the highwater mark set at the time the performance fee was last charged. The current trend is for newer funds to feature this highwater mark, while older, larger funds may not feature it.

Example:

A fund charges a 20 percent performance fee with a highwater mark but no hurdle rate. Dr. Butala, a dentist investor contributes $100,000 to the fund. During the first year, the hedge fund manager grows that capital account to $110,000 and charges a 20 percent performance fee, or $2,000. The ending capital account balance and highwater mark is therefore $108,000. During year two, the account falls back to $100,000, but the highwater mark remains $108,000. During year three, in order for the manager to charge a performance fee, the manager must grow the capital account to a level above $108,000.

Clawback Provision

Rarely, a fund may provide investors with a clawback provision. This term, borrowed from the venture capital fund world, such provisions result in a refund to the investor of all or part of a previously charged performance fee if a certain level of performance is not attained in subsequent years. Such refunds in the face of poor or inadequate performance may not be legal in some states or under certain authorities.

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

 Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™  Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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The Massacre of Hedge Fund Business

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By Michael Zhuang

Michael Zhuang

The Massacre of Hedge Fund Business

 ***
I took the sensationalist title from a CNBC article I read recently. The articles talks about,  and I quote,
” … hedge funds, as a category, is experiencing the worst quarter of outflows since the bottom of the financial crisis … there were an avalanche of stories about the industry’s nearly systematic underperforming.”
Readers of my newsletter and blog, The Investment Scientist,  can thank me later for warning them years ago.
Examples
On April 28, 2011, I published “A Balanced Portfolio to Avoid (II): Hedge Funds Don’t Deliver Outstanding Returns.” Let me quote my former self:
“Hedge funds are often peddled as an unique asset class that are uncorrelated with the market. In reality, hedge funds are as much an asset class as Las Vegas is.”
The unspoken message is: you should expect to lose money.
On August 15, 2012, I published “Why You should Avoid Hedge Funds.
” I wrote that article after I read the book by former hedge fund industry insider Simon Lack, “The Hedge Fund Mirage.”  I summarized the book in one sentence for my readers: “Between 1998 and 2010, hedge fund fees totaled $440 billion vs. $9 billion profits for investors.”
Note: Hedge fund performance reporting is voluntary – unprofitable hedge funds need not report – so even the $9 billion profit figure should be taken with a grain of salt.
On June 13, 2013, I was aghast at SEC Chairwoman Mary Jo White’s proposal to allow hedge funds to market to the public. That day, I wrote a sarcastic piece “Why Allowing Hedge Funds to Market to The Public is Such A Good Idea.”
In the concluding paragraph I wrote:
“What’s unfair about the existing hedge fund rule is that only the top 1% get that bragging right. The rest of us don’t even know such a wonderful opportunity exists to transfer our puny wealth to the hedge fund managers who are really the top 0.1%.”
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dollar-1029742_640
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Assessment
I hope somewhere out there a reader or two did not buy into the hedge fund hype because of my writings. That would make all the midnight oil I have burned worth it!

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

Risk Management, Liability Insurance, and Asset Protection Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™8Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners™

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What is a Hedge Fund and I’m Here to Help?

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What is a Hedge Fund? – You’re a Moron and I’m Here to Help.

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investmentcenter5

More:

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

Comprehensive Financial Planning Strategies for Doctors and Advisors: Best Practices from Leading Consultants and Certified Medical Planners(TM)

Front Matter with Foreword by Jason Dyken MD MBA

logos

“BY DOCTORS – FOR DOCTORS – PEER REVIEWED – FIDUCIARY FOCUSED”

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The 20 Largest Private Companies in the US

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A look at the 20 largest private companies in the US

Interesting how many of them (8 of the 20) are in some way highly involved in food — Cargill, MARS, Publix, C&S Wholesale Grocers, US Foods, H-E-B, Meijer and Reyes Holdings.

And, although not grouped as such below, you could arguably add Love’s Travel Stops, Pilot Travel Centers and Aramark to that group – bringing it to 11 of the 20.

Assessment

Think any of these will go pubic; besides Facebook?

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Link: http://feeds.feedburner.com/HealthcareFinancialsthePostForcxos

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

Our Other Print Books and Related Information Sources:

Health Dictionary Series: http://www.springerpub.com/Search/marcinko

Practice Management: http://www.springerpub.com/product/9780826105752

Physician Financial Planning: http://www.jbpub.com/catalog/0763745790

Medical Risk Management: http://www.jbpub.com/catalog/9780763733421

Hospitals: http://www.crcpress.com/product/isbn/9781439879900

Physician Advisors: www.CertifiedMedicalPlanner.org

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