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Some investing offers deferred taxation, in which investment income taxes are not assessed until the funds are withdrawn or distributed. For example, in the United States, qualified retirement savings are generally taxed only at withdrawal. Further, the contributions are often tax-deductible in the period in which the contribution is made. Other opportunities, such as some life insurance contracts, allow tax-deferred accrual of investment income.
Taxation of interest and dividends is generally assessed in the period in which the dividends and interest are distributed. Capital gains tend to be taxed when realized. Capital gains are realized in the period when there is a sale of a security for a price higher than the investor's cost, known as the cost basis. Investments therefore often offer a potentially valuable tax advantage of allowing wealth to be accumulated and accrued through capital appreciation that is not taxed as income until the asset is sold. Further, tax rates may be lower on capital gains, especially when an investment is held for a long time.
Taxation of investment income involves complex rules in most jurisdictions. Understanding taxation can be a very important part of investment management. For example, Section 1256 contracts, which include many futures and options contracts, have potentially enormous tax advantages in the United States. including having their income treated as 60 % long-term capital gain and 40 % short-term capital gain regardless of holding period. Proper decision-making based on this preferential tax treatment can enhance an investor's after-tax return.
2.5.2 Other Taxes and Withholding
In most jurisdictions, real estate taxation is an important form of taxation. Often, real estate taxes are assessed by local jurisdictions to fund local services such as schools, and governmental services such as law enforcement. Australia, Singapore, Belgium, Germany, and the United Kingdom tax real estate.17 However, some jurisdictions tax wealth as a general national tax. For example, in Colombia, a wealth tax is assessed on all assets, including financial assets. Another important category of taxation is estate taxation. For wealthy individuals, estate tax rates can be very high.
Although many countries have either drastically reduced or totally eliminated transaction taxes, several European countries continue to impose some form of tax on investment transactions. The United Kingdom uses a stamp tax of 0.5 % on purchases of domestic securities, and France levies a 19.6 % value-added tax on commissions rather than on the transaction value. When market makers trade for their own accounts, they are usually exempted from transaction taxes. In the United States, there is a small fee assessed on securities transactions that is attributed to providing the regulatory services of the SEC.
The international convention on taxing income on foreign investments is to certify that the investor pays taxes to at least one country. Withholding taxes are therefore levied on dividend payments. Although this sometimes results in double taxation, a network of international tax treaties has been signed to prevent double taxation from occurring, so that investors receive a dividend net of withholding tax plus a tax credit from the foreign government but must pay tax on the gross dividends (minus the amount of the withholding tax credit) to the government where they reside. Although this process is potentially lengthy, it allows the investor to reclaim the withholding tax in the foreign country. Depending on the individual country's tax policies, some of the withholding can be retained by the country of origin. Some countries allow tax-free foreign investors (public pension funds) to apply for direct exemptions from tax withholding.
Review Questions
1. What is the term for a private management advisory firm that serves a group of related and ultra high-net-worth investors?
2. In a large financial services organization, what is the name used to denote the people and processes that play a supportive role in the maintenance of accounts and information systems as well as in the clearance and settlement of trades?
3. Are dealer banks described as buy-side or sell-side market participants?
4. List several advantages of separately managed accounts (SMAs) relative to funds.
5. Which of the following participants is LEAST LIKELY to be classified as an outside service provider to a fund: arbitrageurs, accountants, auditors, or attorneys?
6. List four major legal documents necessary for establishing and managing a hedge fund.
7. What is systemic risk?
8. What is the acronym for fund vehicles that are regulated and allow retail access of hedge-fund-like investment pools in the European Union?
9. In terms of financial regulation, what is the FCA?
10. What is progressive taxation of income?
CHAPTER 3
Quantitative Foundations
Quantitative tools and quantitative analysis are foundational concepts in alternative assets. This chapter provides details regarding return computation and analysis.
3.1 Return and Rate Mathematics
Returns can be computed with different compounding assumptions and, over time, with intervals of different lengths. These choices have implications for the mathematics and statistics of the returns. This section demonstrates, among other things, the usefulness of basing return computations on continuous compounding, which is tantamount to saying that the returns should be expressed as log returns.
3.1.1 The Compounding Assumption
Compounding is the recognition of interest on interest or, more generally, earnings on earnings. Simple interest is an interest rate computation approach that does not incorporate compounding. But returns are often compounded. For example, earning 10 % over one year is equivalent to earning 9.64 % per year compounded quarterly: [1 + (.0964/4)]4 = 1.10.
Continuous compounding assumes that earnings can be instantaneously reinvested to generate additional earnings. Discrete compounding includes any compounding interval other than continuous compounding such as daily, monthly, or annual.
In preparation for this material, understand the mathematics of simple, discretely compounded, and continuously compounded interest, including the computation of interest rates, present values, future values, or time intervals for applications involving single or multiple cash flows.
3.1.2 Logarithmic Returns
Denote R as a total (non-annualized) return or rate with no compounding. Adding 1 to R forms a wealth ratio. A log return is a continuously compounded return that can be formed by taking the natural logarithm of a wealth ratio:
(3.1)
where ln() is the natural logarithm function, Rm = ∞ is the log return, or continuously compounded return, and m is the number of compounding intervals per year.
For example, the rate or return that discounts a value of $110 to be received in the future to a present value of $100 expressed as a total (non-annualized) rate is 0.10. Since R = .10, then the log return (Rm = ∞) is 0.0953. With continuous compounding at 9.53 % for one
Horan and Robinson, “Taxes and Private Wealth Management.”
