The past 10 years have seen a huge growth in hedge funds–both domestically and internationally. These funds have enjoyed some of the best (and, in some cases, the worst) investment performance in the securities business.
Once, it was easy to define a hedge fund as an entity, not registered as an investment company under federal securities laws, which used specially designed hedging techniques or leverage to avoid the volatility of the more traditional securities market.
Now, a hedge fund is more properly defined as an unregistered investment company catering to investors with sufficient sophistication to enable the fund to avoid the necessity of becoming an entity registered with the Securities and Exchange Commission.
By their very nature, hedge funds tend to be tax inefficient for Americans. The funds generally develop short-term capital gains from their investment operations, so the bulk of their yield is usually taxable at ordinary income tax rates. This has spurred considerable interest in developing variable insurance products with hedge funds as the underlying investment.
There have been numerous variable products–primarily variable universal life policies–that have hedge funds as the underlying investments. However, the vast majority of these have been available only to sophisticated investors who qualify to purchase “private placement” investments.
Meanwhile, most retail variable annuity and variable life products registered with the SEC have been unable to adapt hedge funds for use as underlying investments. This is because the technical requirements imposed under federal securities laws on registered variable insurance products make it difficult to use hedge funds as the underlying investments in the same manner as variable products traditionally use mutual funds.
The Investment Company Act of 1940, for example, requires daily valuation, forward pricing and immediacy of redemption–all elements that are inconsistent with the basic nature of most hedge funds. Moreover, most hedge fund operators tend to lack the discipline in their administrative and valuation procedures required for registered variable insurance products.
In short, in the world of registered products, time frames are absolute and discipline is a must.
Even for “private placement” variable insurance, using hedge funds as the underlying investments is not an easy matter due to other regulatory issues.
The hedge funds that have been used with variable products generally have been of the “funds of funds” type. These funds of funds permit the investment manager to allocate investments among a number of publicly available hedge funds in much the same manner as listed securities are purchased on the open market. State insurance laws require that reasonable time frames be met for valuation to enable payment of surrenders, loans and death claims.
In addition, tax laws applicable to hedge funds used with variable insurance products have been confused. The Treasury Regulations [in 1.817-5(f)(2)(ii)] seemed to permit the use of hedge funds that were organized as unregistered partnerships to be used with variable insurance products, even though not dedicated exclusively for use with such products.