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What is a Hedge Fund?

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What is a Hedge Fund?

What is a Hedge Fund?

For many entry-level investors, hedge funds are shrouded in mystery and exclusivity.

It’s common, for example, for media coverage to focus on the ultra-wealthy founders and CEOs of hedge funds, such as Ray Dalio or Bill Ackman, as well as their secretive investing strategies or exclusive clientele. Like investment banks, they are seen as an elite fixture on Wall Street, and they also get scapegoated for a variety of market problems ranging from manipulation to a lack of transparency.

However, despite an image of complexity and secrecy, the basics around hedge funds are actually quite easy to understand. Today’s infographic from StocksToTrade.com highlights some of those key points.

Hedge Fund Basics

Hedge funds are generally structured in a similar manner to venture capital funds:

General partner: This partner is in charge of the fund, and invests capital based on the fund’s objectives.

Limited partner: This partner is an investor that supplies some of the capital. It’s worth noting that generally only accredited investors are allowed by the SEC to invest in hedge funds, as they are considered high-risk investments.

With the money from general and limited partners, the fund executes on its investing strategy. Hedge fund strategies can range from trading currencies with extreme leverage to using event-driven tactics such as taking activist positions in companies.

Other hedge funds, such as Renaissance Technologies, are known for their focus on trading using big data, AI, and machine learning – and for taking an outside approach to investing by hiring mathematicians, physicists, or other people with non-financial backgrounds.

It’s most common for hedge funds to use a “two and twenty” fee structure. Limited partners pay a 2% asset management fee, and a 20% cut from any profits generated.

Pros and Cons

Arguably, the biggest benefit of investing in hedge funds stems from the ability to partner with some of the world’s top investment managers, and to generate returns that do not correlate with the market. Hedge funds can help to diversify a portfolio – and when the general market is struggling, hedge funds using the right strategy can still provide a handsome return.

In terms of cons, hedge funds require investors to lock up money for extended periods of time, and also tend to charge significant fees. Lastly, the use of leverage can magnify small losses, and a lack of diversification within a given fund can lead to more concentrated losses, as well.

For more on hedge funds, see 48 key hedge fund terms every investors should know.

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Investor Education

Visualized: A Step-by-Step Guide to Tax-Loss Harvesting

In Canada, tax-loss harvesting allows investors to turn losses into tax savings. This graphic breaks down how it works in four simple steps.

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An illustrative graphic showing part of the steps in tax-loss harvesting, including selling a $50,000 investment with a $10,000 loss.

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The following content is sponsored by Fidelity Investments

A Step-by-Step Guide to Tax-Loss Harvesting

Market ups and downs can be unnerving, but the good news is that tax-loss harvesting allows investors in Canada to capture tax savings when their portfolio drops in value.

While it sounds complicated, a tax-loss harvesting strategy is actually fairly straightforward. An investor can use capital losses to offset capital gains found elsewhere in their portfolio, leading to a lower tax bill. While there are important conditions to keep in mind, investors can use this strategy to enhance portfolio returns over time by reinvesting these tax savings.

This graphic from Fidelity Investments shows how tax-loss harvesting works and why it may improve tax efficiency in an investor’s portfolio.

Breaking It Down

Consider a person who invested $50,000 in a mutual fund held in a non-registered account that has dropped by $10,000 in value. To help minimize losses, they took the following steps in a tax-loss harvesting strategy.

For the sake of this example, taxes are based on the maximum federal rate and the average maximum provincial tax rate.

  1. Sold investment with a $10,000 loss
  2. Invested $40,000 into a different mutual fund
  3. Used the $10,000 capital loss to offset capital gains realized elsewhere in the non-registered portfolio
  4. Achieved up to $2,550 in tax savings

The investor realized as much as $2,550 in tax savings by utilizing a $10,000 loss against a $10,000 capital gain. Without tax-loss harvesting, this $10,000 capital gain would be taxed at a 50% capital gains inclusion rate ($10,000 X 50% = $5,000). This $5,000 in applicable gains is then taxed at a 51% combined federal and provincial tax rate ($5,000 X 51% = $2,550 in taxes owed).

In contrast, by using tax-loss harvesting, the investor would have achieved up to $2,550 in tax savings.

What’s more, you can reinvest your tax savings over each year—which may help boost portfolio returns over time if the new investment increases in value.

Tax-Loss Harvesting Tips

With a tax-loss harvesting strategy, here are some key tips and considerations to keep in mind:

  • Investment Timeline: A capital loss can be used to offset capital gains not only in the current year, but in the three years prior and/or any year indefinitely in the future.
  • New Investment Type: After selling an investment that’s dropped in value, it’s important to buy a different investment to avoid triggering the ‘superficial loss rule’. Investors can aim to choose an investment with similar long-term returns.
  • Plan for Year-End: In order to achieve a capital loss, plan to sell an investment at least two to three days before the year’s final trading day so the investment settles before year-end.

Together, these tips can help investors strategically execute a tax-loss harvesting strategy.

Tax Made Easier

During volatile markets, investors can seize the opportunity to turn losses into tax savings using tax-loss harvesting as a key tool to help generate higher after-tax returns.

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Explore Fidelity’s tax calculator to discover tax-saving opportunities.

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