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: