This was originally published by Trusts & Estates, an industry journal for trustees and wealth management professionals serving the needs of high-net-worth clients, family business owners, family offices, charitably inclined donors and non-profit corporations.
Yale is among the finest learning institutions in the world. It is known for many great things, but in the investment world it is probably best known for its top performing endowment, which many try to replicate with what is called an endowment model.
What can individual investors learn from the Yale endowment? Maybe how to not invest if, like most individuals I know, you have to pay taxes.
Over the past 5-10 years, I have seen a large increase in firms selling ultra-high-net-worth investors (individuals and families who have liquid investible assets excluding real estate of $50 million or more), endowment style investment portfolios and limited partnership fund of funds.
Why might this initially appear to make sense? Many ultra-high-net-worth (UHNW) investors have no debt, consume a small portion of their assets for annual expenses, and are really investing for future beneficiaries or to be able to give more in the future to charity. Some have even set up trusts in jurisdictions like Delaware that allow family trusts to run for more than 100 years (so called dynasty trusts). Because of this, UHNW investors commonly view their time horizon for family trusts in generations, not years or decades.
What does a trust that is investing over a very long-term timeframe for the benefit of generations to come sound like? Maybe an endowment?
If some UHNW trusts have characteristics that resemble endowments, and Yale is arguably the best endowment, shouldn’t more UHNW portfolios look like Yale?
Many investment managers and advisors certainly suggest this. Over the years, I have seen firms craft pitches for UHNW wealth families that sound something like the following:
“You have more money than you can possibly spend in a lifetime and are now really investing for the benefit of generations to come. Because you have such a long-term timeframe and have the access that your success brings, shouldn’t you be investing the same way some of the most successful investors in the world invest? Shouldn’t you be investing like Yale in an endowment like model? The risk-adjusted returns and strategies that we can implement on your behalf using an endowment style limited partnership or approach are compelling.”
What’s the problem with this?
Beyond, in some cases, presentations that are driven by incentives to drive sales of complex strategies with high fees, high margins and high commission charges, at least three problems: fees, performance and taxes
Every endowment approach I have ever seen has one thing in common with its peers: a sizable allocation to hedge funds.
A great deal has been written in academic studies and the media about the high fees associated with hedge funds. More is also starting to surface about hedge fund performance as compared to low cost, simple, diversified portfolios of index funds that have the same historical risk adjusted returns and volatility (feel free to reach out to us for our analysis of this – my hedge fund friends might de-friend me if I post it publicly).
Not as much has made the press, however, about what really makes UHNW investing different than endowments, namely, taxes.
Yes, taxes. Regardless of your political leanings, no one likes writing a big check to the IRS, but the IRS is a fact we cannot avoid.
Recent tax law changes have made the subject of taxes even more important as it relates to investments. Tax law changes that became effective January 1, 2013 include a top short-term gain rate of 39.6%, a long-term gain rate of 20.0%, an additional 3.8% tax on net investment income (the Medicare tax) and an effective additional 1.2% rate increase due to the phase-out of deductions for top-bracket taxpayers (the Pease phase-out). All of this combines to create a 44.6% tax on short-term gains and ordinary income, and a 25.0% tax on long-term gains and dividend income. And this is only taking into account federal taxes. Many states such as California, which has one of the largest collections of UHNW individuals in the United States, impose a substantial additional tax burden.
When I am helping UHNW investors free up funds around tax time to pay bills due for large realized gains on hedge funds, I often raise words of caution about these investments.
Endowment model investment presentations, which normally include sizable allocations to hedge funds, are complex, well done, and often presented by well educated and well heeled professionals. The pitches can be impressive and hard to resist. What they often do not point out, however, is that allocations to hedge funds often generate large short-term gains, which now carry with them a 44.6% federal tax or reduction of return for taxable investors.
So, what has made me write of this subject now? Well, the dreaded April 15th tax date is upon us soon, so conversations about this subject with our UHNW investors are top of mind.
In addition, credit must be given to a tax aware investment firm in California, Aperio Group. I shamelessly took the title of this post from one of their recent papers. The full research report can be found at the link below.
Inspiration also comes from the long-time Chief Investment Officer of the Yale endowment, David Swensen. Swensen is considered one of the most successful investors in the world and, based on his use of non-traditional investments such as hedge funds, a major contributor to the endowment investment model. Following thoughts from Swensen’s first book in 2000, Pioneering Portfolio Management, many UHNW advisors started promoting the endowment model. The UHNW investment world eagerly embraced this new “sophisticated” approach and yet, going on 15 years later, still seems to be forgetting the fact that Swensen’s book was designed for tax-exempt investors.
Even though Yale has generated top returns for its beneficiaries through the use of hedge funds, what does Swensen, like many other successful investors such as Warren Buffett, suggest for taxable investors?
Well, maybe the following quote from his second book (this one for taxable investors), Unconventional Success says it best:
“The management of taxable…assets without considering the consequences of trading activity represents a…little considered scandal. A serious fiduciary with responsibility for taxable assets recognizes that only extraordinary circumstances justify deviation from a simple strategy…”
Swensen’s quote is powerful and is book is very well done. When you have time, I encourage a read (see the link below).
What Aperio has done better than almost anyone else I have seen is provide sophisticated evidence to counter some of the sophisticated endowment style presentations. Their research suggests that when you properly account for the tax drag, hedge funds should have little, if any, place inside taxable portfolios.
The Aperio study is lengthy, but I would encourage you to click on the link above or at the bottom of this post to at least take a scan. They used well-accepted analytical processes and collected data from multiple third party sources, including an independent study the Commonfund and the National Association of College and University Business Offices (NACUBO). Every year NACUBO releases detailed information on the asset allocations, performance and rankings of U.S. endowments. If you want to know more about how your own alma mater is invested, you can view a summary of the report at the following:
As we try consistently to do, versus going on our about own views, below are quotes and charts to consider from the Aperio research. Aperio uses the term Absolute Return as a proxy for hedge funds. Notice the allocations to Absolute Return and even to more traditional active equity managers in the “yellow” and “blue” shaded columns.
Aperio Table 3: After-Tax Returns and Weights for Yale (low correlation HF index)
“The Yale P/T (pre-tax) column presupposes an investor who uses active management for public equities.”
“The Yale A/T (after-tax) with Active Equity (see yellow column) shows the weights of the Yale portfolio with the equity allocation available only through active strategies”
“The Yale A/T (after-tax) with Indexed Equity (see blue column) shows the portfolio under the same assumptions used in the yellow column, but with indexed equities now available.”
“Given that an investor now has to pay taxes on what had been a tax-exempt portfolio, suddenly active equity and absolute return (hedge fund) allocations become far less attractive.”
Yes, if you look carefully at the chart, the Aperio research suggests that you should have zero allocation to active managers and hedge funds, and this assumes that you only have hedge funds with low correlation to equities, which provide diversification benefits.
Many hedge funds have relatively high correlation to equities (a well respected hedge fund index, the HFRI Fund Weighted Composite has a 0.88 correlation to equities), which makes the case against using them for diversification even less attractive. Below is a quote from Aperio on the results of their analysis when using hedge funds with high correlation to equities.
“If a hedge fund strategy reflects the risk patterns of the HFRI index, with its higher correlation to equities, then the model never allocates anything to hedge funds”
Versus just modeling Yale’s portfolio, Aperio also used data from the previously mentioned Commonfund and NACUBO study of all U.S. endowments. Below is a chart and quotes from what they found using this approach.
Aperio Table A1: After-Tax Returns and Weights for NACUBO (low correlation HF index)
“The outcome for average endowments from NACUBO (National Association of College and University Business Offices) ends up with after-tax weights fairly similar to those for the Yale endowment (see yellow column). The high tax penalty for active management prevents the NACUBO model from holding any equity at all when only active equity is available. The blue column shows how with equity provided through traditional indexing, the outcome looks very similar to the old pension standby of 60% stocks and 40% bonds, with a light sprinkling of alternatives.”
Where does this all leave us as it relates to the title of this blog?
First, as is always the case, the assumptions that Aperio or any other researcher uses are key. I have looked at the research in depth and believe the underlying assumptions are reasonable, but as with anything, results will vary based on the actual investments that anyone might make.
Second, the Aperio research does suggest that if you use tax-effecient index strategies, such as the ones that they provide, you can allocate more to certain types of hedge funds that have low correlation to equities. I am a little suspect, however, about how much value can be added in terms of tax efficiency over and above the extreme tax efficiency of index funds, but I welcome feedback on this, and encourage you to read the full Aperio report yourself.
Finally, if you are a taxable investor, don’t be sold complex strategies that don’t factor in taxes.
All of this continues to lead us to recommend that all investors, small and large, maintain a high percentage of keep-it-simple, low fee, fully transparent, tax efficient investments.
What types of investments should more UHNW investors use to try to achieve solid returns like Yale?
The evidence continues to point to index funds.
* In the Aperio research, bonds are assumed to be taxable for the pre-tax allocation and tax-exempt municipals for the after-tax portfolios. All distributions from tax-exempt bonds are assumed to be tax-exempt, i.e. possible capital gains are ignored.
Note: P/T = Pre-Tax, A/T = After-Tax. The above weights and returns are hypothetical and are not based on actual investments. Cash has been constrained in optimization to show a weight of zero. Please refer to important disclosures at the end of the Aperio report, which can be found at the following link: