What Would Yale Do If It Were Taxable? (corrected January 2016)

The distinctive financial goals and constraints of ultra-high-net-worth individuals together with their aggregate growth in assets have led to the emergence of “New Institutional” investing, which includes the best practices from institutional investors but also incorporates the critical element of tax management. The authors design New Institutional asset allocations that incorporate traditional investment metrics in a tax-aware setting. Specifically, they show how risk and after-tax returns need to be combined from inception when seeking an optimal after-tax asset allocation. Diversification is especially important for taxable investors because low asset class correlations can facilitate the inclusion of attractive but tax-inefficient asset classes in a tax-aware allocation. Asset allocation is an essential element of every investment process, and much thought has been devoted to the subject. Historically, the literature has revolved around institutional investors because they have accounted for the better part of growth in assets under management. Since the start of the millennium, however, and especially in the wake of the financial crisis, a “New Institutional” class of ultra-high-net-worth (UHNW) investors has emerged. Asset allocations for new and traditional institutional investors differ because UHNW investors pay taxes whereas most institutional investors do not. Taxes make the wholesale adoption of a successful pretax allocation a losing strategy for New Institutional investors. The construction of a winning strategy requires additional analysis, and we provide a framework for part of that analysis in this article. We show how tax management and risk control are inseparable elements of asset allocation for a taxable investor. To illustrate the interplay between risk and taxes, we modified the asset allocation of Yale University’s endowment to be tax efficient. The Yale endowment is an attractive starting point for our analysis for two reasons. First, Yale posts the required data—its asset class weights—on its website. Asset class weights are the most concrete representation of the asset allocation process because the weights tell us exactly how funds are invested. Second, Yale’s asset allocation is shaped by the principle of diversification, as well as the premium for illiquidity that can be wrung from private asset classes by investors who are either skilled or lucky. These features are attractive to tax-exempt and taxable investors alike. However, a taxable investor pursuing a strategy based directly on the Yale model may find the benefits of the strategy to be negated by an unwanted tax bill. We combined Yale’s asset class weights with risk estimates to obtain a consistent set of pretax implied returns for the asset classes in the Yale allocation. We accomplished this using reverse optimization, which was developed by William F. Sharpe. We penalized or augmented each implied return in accordance with its tax efficiency. These modifications are necessarily coarse estimates because taxes vary from investor to investor, from year to year, and from implementation to implementation. However, our estimates incorporate important qualitative features. For example, both active equity and hedge funds are less tax efficient than indexed equity, and municipal bonds are very tax efficient. After adjusting the implied return of each asset class for tax considerations, we used a quantitative optimizer to reallocate funds. Our framework facilitates an even-handed comparison between Yale’s actual pretax allocation and a new, after-tax allocation that we derive as an optimal portfolio if Yale were taxable. Following is a summary of the results. Accounting for taxes in an asset allocation drives funds from asset classes that are less tax efficient to those that are more tax efficient. A tax-efficient asset class that can harvest losses to offset capital gains plays a special role in a taxable asset allocation. In our study, we relied on tax-efficient equity for this. Tax-efficient equity is preferred to indexed or active equity in an after-tax allocation. There is a natural place in an after-tax asset allocation for a tax-inefficient class so long as two conditions are satisfied. First, the allocation must include a tax-efficient class that harvests capital gain–offsetting losses. Second, the tax-inefficient class must provide sufficient diversification. When we adjusted the risk estimates for tax considerations, our results became stronger. The new framework and the accompanying metrics can help investors and advisers pursue many of the benefits of the endowment model in a way that takes into account the harsh after-tax reality of the world of UHNW investors. So what would Yale do if it were taxable? A world-class shop like Yale would integrate tax considerations into its asset allocation process from the beginning rather than layering them in after the fact.