For some, this weekend will be all about taxes. But those who invest in hedge funds could be excused for forgetting. They don't seem to consider taxes nearly as much as they should. 

Hedge fund presentations can be very persuasive. Some have produced attractive returns and many suggest additional potential benefits such diversification and downside protection.

A sample of the salesmanship that I've encountered: 

"Don't you want to invest in a similar fashion to investment luminaries such as David Swensen, the chief investment officer of Yale's endowment?"

"As fiduciaries on behalf of your family, isn't it prudent to invest like Yale in an endowment-style portfolio that includes a world-class mix of hedge funds?"

But, if you consider taxes, it's not that prudent. And even Yale's vaunted endowment, which invests heavily in hedge funds would agree. Allow me to explain. 

I mentioned David Swensen because, under his leadership, Yale has produced some of the best returns of any endowment in the U.S. In addition, the publication of Swensen's first book, in 2000, Pioneering Portfolio Management, is largely credited as the blueprint for what is called the endowment investment model.

But, remember: Swensen's book was designed for tax-exempt investors. Yale's fund is tax exempt, which, of course, affects investment strategy. We may soon find out just how different Swensen's strategies might be if Yale's endowment had to pay taxes on, say, it's $2.6 billion in investment gains last year

The cash-strapped state of Connecticut is considering a law that would tax huge endowments like Yale's. If that were to happen, Swensen's celebrated strategy of investing in hedge funds wouldn't be so effective anymore. 

As mentioned above, hedge fund presentations are impressive, but they often fail to point out that they frequently generate large short-term gains, which carry taxes that can exceed 50% in states such as California. I specifically mention California not only because of its high concentration of wealthy individuals but also because it is the home of the Aperio Group, which published a study with researchers at the University of Berkeley titled, "What Would Yale Do If It Were Taxable?".

The team collected endowment asset allocations and asset class returns, volatility and correlation data from multiple third-party sources, including Yale's annual report and an independent study of endowments by the Commonfund and the National Association of College and University Business Offices (NACUBO). They then took these data and calculated pre-tax and after-tax returns for Yale's asset classes. Lastly, using an allocation optimizer, they generated a tax-adjusted optimal asset allocation -- evaluating, in other words, what Yale might do differently if it were taxable.

The chart below illustrates some of their conclusions. The yellow column presumes that the equity allocation in the portfolio is available only through active strategies, while the blue column presumes that indexed equities are also available.


Please see Aperio's important disclosures about its assumptions and methodology.

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After factoring in taxes, what does the model recommend allocating to absolute return (a term Aperio used as a proxy for hedge funds)? 

Zero.

The researchers reached this conclusion assuming that hedge fund strategies would otherwise benefit the portfolio by offering diversification through a low correlation to equities. In fact, however, many hedge funds, such as long-short strategies, have a relatively high correlation to equities (for example, the well-respected HFRI Fund Weighted Composite hedge fund index has a 0.88 correlation to equities), making the case against using them for diversification even less attractive. As the study concludes: "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."

Admittedly, coming up with metrics to evaluate returns and annual taxable gain assumptions across a range of hedge funds is difficult (transparency on returns, turnover and the mix of long-term versus short-term taxable gains is limited).

I don't think it's a stretch, though, to suggest, as John Rekenthaler from Morningstarwrote, that "hedge funds are notoriously tax-inefficient" and that a sizable portion of yearly returns comes in the form of short-term taxable gains.

The Aperio and Berkeley findings are based on many assumptions, but Matthew Klein, writing for BloombergView in 2013, highlighted research from Greenline Partners (staffed by folks who once worked at the well-regarded hedge fund Bridgewater Associates) that used relatively simple math. Greenline calculated that hedge fund investors, on average, keep only about 40% of gross returns after fees and taxes. Of the Greenline research, Klein wrote:

"To get an equivalent return after taxes and fees [to that of a low-cost index fund that tracked the S&P 500], an investor would have to find a hedge fund that consistently earned almost 21 percent a year. ... Even the best hedge funds usually earn much less than that."

Of course, some hedge fund managers are outliers and have produced attractive after-tax returns, but solid academic evidence and the simple calculations make me question the use of most hedge funds in most taxable portfolios.

"For me, what keeps me up at night is overly compensating my portfolio manager friends [performance fees], Wall Street managing directors [trading fees] and government coffers [taxes]," my friend Greg Rogers -- president and founder of Raylign Advisory and former managing director at a leading institutional investment consultant, RogersCasey -- noted. "In the case of a fund of hedge funds [how the endowment investment models are often delivered], the investor is asking heroic results from manager selection, strategy allocation and the hedge fund managers themselves -- all three competencies have proven to have limited sustainability over extended periods of time, to say the least."

This is a reality that even Swensen himself seems to be reckoning with. In his second book, Unconventional Success (this one for taxable investors), he writes:

"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."

So, the next time you hear the hedge fund or fund of funds endowment model pitch, ask the following question: "As a fiduciary, how do you factor in taxes?"

If they hedge too much in their answer, it's probably not worth it when tax day comes around.

This article is commentary by Preston McSwain as an independent contributor and does not reflect the views of Fiduciary Wealth Partners.