The advent of investable hedge fund indexes has created new opportunities for investors interested in obtaining exposure to hedge funds. Investable hedge fund indexes offer investors exposure to either the broad hedge fund universe or, alternatively, diversification between managers within an investment style or process, without a second layer of performance fees.

A number of investable hedge fund indexes have been developed over the past year or so. Currently, six investable hedge fund indexes are available to investors, including CSFB Tremont, HFR (Hedge Fund Research), MSCI (Morgan Stanley), S&P, and Dow Jones. Each of these indexes is created and maintained utilizing differing methodologies, which can be quite complex. Exhibit A describes the various investment processes/styles that are included in each index, the total number of managers composing each index, and how each index is weighted.

Investable hedge fund indexes allow derivative dealers to offer investors synthetic exposure to the underlying index because the dealers can hedge themselves through an investment in the index. Although a taxable investor could make a direct cash investment in an investable hedge fund index, such an investment would still suffer from tax inefficiency. The investor would be currently subject to taxation and most of the profits would be investment income, taxed at the 35% rate.

Alternatively, investing in a hedge fund index through a derivative should be more tax efficient than direct ownership where there are yearly realizations of income passed through to partners.

The constructive ownership rules eliminated the tax advantages associated with the use of derivatives to acquire exposure to pass-through vehicles such as hedge funds. However, these advantages should still apply if investors employ derivatives to invest in an index. Derivatives on a hedge fund index should not be treated any differently than derivatives on any other index. In particular, a properly structured synthetic investment should allow taxpayers to defer the recognition of hedge fund profits and capture these profits as long-term capital gains when the derivative is closed out as long as the underlying investment is an index and not a fund itself.

When the derivative is disposed of or terminated, any gain or loss realized on it should be capital in nature. If the contract is terminated after twelve months, any gain recognized at that time should be a long-term capital gain. Therefore, interest, short-term gains, and "non-qualified" dividend income that would otherwise be realized by the hedge funds and taxed currently at the ordinary rate of 35% should be deferred until the derivative is terminated and converted into long-term capital gain, which is taxed at only 15%.

It is worth noting again that an investor should be able to achieve synthetic long exposure to an investable hedge fund index (e.g., a call option structure is not necessary) without triggering the constructive ownership rules.