The success of the Yale Endowment has been highly publicized, leading many endowments, foundations and more recently, even high net worth individuals, to consider adopting the so-called Yale Model.
The Yale Model includes a focus on alternative investments and attempts to capture the liquidity premium available in illiquid investments (such as private equity). In addition to heavy exposure to private equity, the strategy frequently includes investments in hedge funds, many of which also invest in strategies that try to exploit the liquidity premium. And in general, hedge funds themselves are illiquid investments.
For individual investors thinking about adopting the Yale Model, it’s important to make sure that due consideration is given to the differences in the tax regime they face versus the tax-exempt environment in which Yale operates. Which raises an interesting question: What would Yale’s endowment do differently if it were taxable?
Patrick Geddes, Lisa Goldberg and Stephen Bianchi—authors of the study “What Would Yale Do If It Were Taxable?”, which appeared in the July/August 2015 issue of Financial Analysts Journal—sought to answer that question.
Don’t Forget The Taxes
The authors noted that in his book, “Unconventional Success,” Yale Chief Investment Officer David Swensen explicitly recognized the harm of ignoring tax ramifications once you change your tax environment: “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 of selling losers and holding winners.”
Because they could not know what return assumptions were being made by the managers of the Yale Endowment, Geddes, Goldberg and Bianchi begin by performing a reverse portfolio optimization. A typical mean-variance optimization uses as the inputs the returns and covariance of each asset class. The output is the allocation weights.
The reverse optimization starts with the publicly available allocation weights used by Yale’s endowment and historical covariances. The output is the expected return. Based on historical evidence, the authors then made adjustments for the tax haircut, converting pretax returns into after-tax returns, for each asset investment. Following is a summary of some of their key findings:
- Typical actively managed equity funds carry such a high tax penalty that an optimal portfolio avoids it entirely. Instead, tax-efficient index funds, ETFs or tax-managed passive strategies should be used.
- The availability of tax-efficient equity strategies lowers the allocation to public real estate and natural resources.
- Hedge funds with a low correlation to other asset classes do still receive some allocation, but much less than in the pretax version of the strategy. I’d add that you would also need Yale’s access to leading hedge funds, plus Yale’s ability to select the few top performers, to justify any investment. Swensen himself had this to say on the topic: Unless an investor has access to “incredibly high-qualified professionals,” they “should be 100 percent passive—that includes almost all individual investors and most institutional investors.”
- Correlations matter even more once taxes are introduced. An allocation to hedge funds with high correlations to other asset classes cannot be justified in the presence of taxes because they do not offer a diversification benefit.
Taxes Change Everything
The authors concluded that when taxes are introduced, “the changes in asset allocation can be so dramatic that it is incumbent on the savvy investor to combine risk and taxes in the design stage of a portfolio. The tax effect cannot be layered in after the fact as some minor tweak, such as seeking slightly more tax-efficient hedge funds versus tax-inefficient ones.”
They also stated: “Alternative strategies that are highly correlated with equities, and also generate a lot of gains from trading, cannot survive in a portfolio designed to maximize after-tax returns.”
While for some it may seem extreme to recommend that taxable investors should avoid actively managed funds, here’s what successful active manager Ted Aronson of AJO Partners (with about $26 billion in assets under management) had to say regarding this subject: “None of my clients are taxable. Because, once you introduce taxes … active management probably has an insurmountable hurdle. We have been asked to run taxable money—and declined. The costs of our active strategies are high enough without paying Uncle Sam.”
He added: “Capital-gains taxes, when combined with transactions costs and fees, make indexing profoundly advantaged, I’m sorry to say.”
While Aronson invests his personal tax-advantaged assets in his own fund, following his own advice, he invests his taxable assets in index funds. In an interview with Barron’s, he stated: “My wife, three children and I have taxable money in eight of the Vanguard index funds.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.