By Bill Martin, Guest Writer
Yale’s $42 billion endowment has the reputation of being one of the best-performing investment portfolios in American higher education. The success of the Yale endowment has led many tax-exempt investors, such as pension plans and foundations (as well as taxable high net worth individuals), to consider emulating the so-called Yale Model.
The primary characteristics of the Yale Model are:
- Broad diversification across asset classes
- Low allocations to assets with low expected returns, such as fixed income and commodities
- High allocations to illiquid assets such as hedge funds, private equity, private real estate, and venture capital
Should physicians try to mimic Yale’s investment strategy? Not exactly, as physicians face one important difference from Yale—doctors pay taxes.
This reality raises an interesting question: What would Yale’s endowment do differently if it were taxable?
A paper published in the Financial Analysts Journal sought to answer that question. The study concludes that if Yale paid taxes, it would alter its investment allocations by:
- Eliminating active equity managers and hedge funds
- Reducing allocations to private equity and real estate
- Increasing the percentage in tax-managed equity and tax-free bonds
Below is a further breakdown of the study’s findings along with Earned Wealth’s insights on how they can apply to wealth creation and preservation for today’s physicians.
Finding 1 – Overweight Tax-Efficient Assets
Accounting for taxes in optimizing an asset allocation drives funds from asset classes that are less tax-efficient to those that are more tax-efficient.
What this means: Investments in tax-inefficient investments—such as hedge funds, actively managed equity, taxable bonds, and real estate—should be used sparingly in portfolios of taxable investors.
Why it matters to physicians: Investments that generate substantial short-term capital gains and income are taxed at higher ordinary income rates than investments that generate long-term capital gains that are taxed at the lower capital gains rate. Physicians typically already pay a lot in taxes. Their investment holdings shouldn’t further exacerbate this drag on their net worth.
Finding 2 – Offset Gains by Harvesting Losses
A tax-efficient asset class that can harvest losses to offset capital gains plays a special role in a taxable asset allocation.
What this means: Equities can assume an important role in portfolios of taxable investors, especially when managed tax-efficiently using technology to systematically harvest losses to offset gains elsewhere in the portfolio. Tax-loss harvesting is an investment strategy that helps preserve the value of an investor’s portfolio over time by strategically selling securities at a loss to offset capital gains taxes from the sale of other securities at a profit.
Investors can use the proceeds of the security sold at a loss to buy a similar investment, maintaining the portfolio’s overall balance. This approach creates the potential for huge tax savings over time while reducing portfolio risk. Research indicates that 100–200 basis points in tax savings can be achieved each year through a process that intelligently and systematically harvests portfolio losses.
Why it matters to physicians: Physicians may generate capital gains from a number of sources, including from their investment portfolios and from the sale of other assets such as commercial real estate and their medical practice. By actively harvesting losses in their taxable investment accounts, this creates a “bank” of losses that can be tapped into in subsequent tax years until they are fully utilized.
Finding 3 – Leverage Custom Indexing
Tax-efficient equity is preferred to indexed or active equity in an after-tax allocation.
What this means: Actively managed equity—and even index funds—are not as tax-efficient as an investment strategy known as custom indexing. This tax-efficient equity strategy invests in select stocks to track the risk and return profile of a specific index such as the S&P 500 Index*. With custom indexing, aka direct indexing, investors can directly own all—or a subset of the underlying securities—of an index. This allows investors and their advisors to be in control of when gains and losses are recognized through direct ownership of the underlying securities.
Furthermore, custom indexing provides more opportunities for tax-loss harvesting. These opportunities to save on taxes arise because certain underlying stocks of the tracked index may be trading at a loss even if the overall index has posted a gain. Since ETFs and mutual funds are traded in baskets of securities rather than by their underlying holdings, tax-loss harvesting is limited for these pooled investment vehicles. Conversely, custom indexing holds more securities that inherently have more variability than a single investment position of a fund. The raw number of securities mathematically creates more opportunities to harvest losses with custom indexing.
Why it matters to physicians: Because of better control and more opportunities for tax-loss harvesting, custom indexing may generate better after-tax performance than comparable ETFs, mutual funds, and market indices. According to a study published in the CFA Journal, tax-loss harvesting can generate 108 basis points (1.08%) of annual tax savings. Such savings compounded over multiple years can translate into significant additional after-tax wealth for physicians over their careers.
Finding 4 – Consider an Allocation to Private Investments
There is a natural place in an after-tax asset allocation to private investments, taxable bonds, and real estate as long as two conditions are satisfied.
First, the allocation must include a tax-efficient class that harvests capital losses—offsetting gains elsewhere in the portfolio.
Second, tax-inefficient assets must provide sufficient diversification.
What this means: A majority of Yale’s assets are allocated to private equity, real estate, hedge funds, and tax-inefficient assets. However, when adjusting for taxes, an optimal allocation to these investments is often lower for taxable investors than the Yale Model. For individual investors, some exposure to these types of investments may be appropriate, especially if custom indexing and tax-loss harvesting are deployed.
Investors often favor private investments because, while not very liquid, they'll presumably result in larger returns. For instance, venture capital funds, private equity, and (for the most part) hedge funds are equity investments. Investors cannot frequently trade these funds, so their liquidity is restricted.
The benefit of forgoing this liquidity is often true for real estate, too. The dynamics of privately owned properties differ from those of publicly traded real estate investment trusts (REITs), which often highly correlate to the return and risk characteristics of small value company stocks.
Besides the potential of enhancing returns and diversification, private investments open up a much broader investment opportunity set. Of the largest 185,000 companies in the US, fewer than 2% of these are publicly traded. The remaining 98%+ are privately held enterprises.
Why it matters to physicians: On average, private equity returns have exceeded public equities by 4.3% per year. Over 30 years, this could turn into a $2.6 million advantage for every $1 million invested in this asset class. To access private investments, physicians must meet certain qualifications, namely around minimum income and asset thresholds.
The Bottom Line
The overarching principle of the Yale Model—maximizing diversification within reasonable bounds—is highly relevant to tax-exempt investors such as endowments, foundations, and pension funds. Notably, economist Harry Markowitz won a Nobel Prize for illustrating the advantages of this strategy of including assets with less-than-perfect correlations.
Physicians can also pursue many of the benefits of the Yale Model, but they must take into account the significant impact of taxes and make smart adjustments accordingly.
So, what would Yale do if it were taxable? A world-class investor like Yale would integrate tax considerations into every aspect of its investment decision-making process, including proactively overweighting tax-efficient investments like custom indexing, systematically harvesting losses to offset gains, and having some exposure to private investments.
[Founder's Note from Dr. Jim Dahle: David Swensen, the man behind the “Yale Model,” wrote two books about investing. The first was called Pioneering Portfolio Management and discussed the Yale Model, as Bill has explained. It was aimed at professional portfolio managers. He then decided he was going to write a book for the investing masses, a book that was eventually titled Unconventional Success (which Amazon tells me I bought on December 31, 2006). He expected that book to discuss the same style of investing. However, as he researched and began to write the book, he realized that it was not possible for the average investor to invest in the same way as the Yale endowment, due to a lack of access to the few talented active managers.
Unconventional Success basically ended up recommending a “Boglehead-style” index fund portfolio to the personal investor. The case was built less on tax issues (although that played into it) and more on a lack of access to alternatives such as timber. Access to alternatives has increased dramatically since the book was written, although there are still issues there for the average investor that an endowment doesn't face, such as tax issues. ]
Is the Yale Model applicable to you as an investor? How else would Yale have to change its strategy if it had to pay taxes? Comment below!
[Editor's Note: Bill Martin is a leading expert on financial wellness, having been the Chief Investment Officer of INTRUST Bank and overseeing $7 billion in assets for physicians, entrepreneurs, high net worth families, and corporations prior to joining Earned as Chief Wealth Officer. Earned is a paid advertiser and a WCI Recommended Financial Advisors partner. However, this is not a sponsored post. This article was submitted and approved according to our Guest Post Policy.]
*The S&P 500 Index is an unmanaged index containing common stocks of 500 industrial, transportation, utility, and financial companies, regarded as generally representative of the US stock market. The index reflects the reinvestment of dividends, if any, and capital gain distributions, if any, but does not reflect fees, brokerage commissions, or other expenses of investing. This index is used for comparison purposes. It is not possible to invest in an index.
General Disclaimer
This communication contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should be construed as a solicitation to buy or sell any security or as an offer to provide investment advice. All examples are for illustrative purposes only and may not be relied upon for investment decisions.
Nothing contained herein should be construed as legal or tax advice and is not intended to replace the advice of a qualified tax advisor or legal professional.
Investing involves market risk, including possible loss of principal and investment objectives are not guaranteed.
Earned Wealth is a registered investment adviser. For additional information about Earned Wealth, including its services and fees, send for the firm’s disclosure brochure using the contact information contained herein or visit https://adviserinfo.sec.gov.
Yale has preferential access to top tier private managers with their alumni network, prestige, and large assets. A physician, even with $500k to put into private assets, doesn’t.
[Note from author] I agree. Historically, top tier private managers were only accessible to institutions like Yale. However, the investment landscape is rapidly evolving through the democratization of private investments. Why? The top tier managers aren’t experiencing growth through institutional channels (e.g. pensions and endowments) as they did in the past and are developing new distribution channels and product structures to tap into the faster growing high net worth market. Managers like KKR, Sequoia, Blackstone, Warburg Pincus, and others that previously were not accessible to individual investors are now opening up their funds to a broader set of investors through platforms like iCapital and CAIS. [Note: Managers like these are still limited to accredited or qualified purchasers and should generally be used as portfolio diversifiers rather than core anchors in high net worth portfolios].
It’s kind of sad that you espouse the brilliance of the Yale Endowment fund when it has seriously underperformed the S&P index for the last 15 to 20 years. All these endowment funds are a disgrace and you should not be promoting them. Anyone can pick an S&p 500 index fund and easily beat any of these “endowments “. Why promote this David Swenson as if he’s some kind of genius?
[Note from author] Here’s the evidence: Over David Swenson’s 35-year tenure, Yale’s endowment gained an average of 13.1% annually. That crushed the 8.8% average annual return of a conventional portfolio of 60% stocks and 40% bonds (a similar risk profile to the endowment). Even compared to a more aggressive risk profile (all equities), Yale’s endowment handily beat the S&P 500.
[Ad hominem attack deleted.]
[Note from author] Raj, these responses are from Bill Martin, the guest author, not Dr. Dahle. The reason for my replies to the comments is to engage in constructive, fact-based feedback. To clarify regarding indexing, I am a huge proponent. I believe for high earning physicians, custom indexing with automated tax loss harvesting (a concept outlined in this article) is a smart way to gain the benefits of a tracking an index (e.g. S&P 500) while minimizing taxes.
Another problem. Hedge funds, PE and VC charge astronomical fees. Large institutional investors like Yale can negotiate lower costs. Only a very few individuals can bring comparable sums to the table.
PE does better than public equity BEFORE FEES. Factor in the fees and PE almost equals public equity. Of course public equity is liquid and transparent. PE is neither of these.
If you are a multi billionaire, then you might be able to get into hedge, PE and VC with a diversified portfolio and reasonable fees. But there are nearly no doctors who have that kind of money.
I wonder, do you know do of someone who has done a rigorous analysis of this? While i suspect you are correct, still nice to see some evidence.
[Note from author]: William, please see comment #7 and the corresponding responses. Afan and I both cite various research sources on this topic.
[Note from author] Afan, I agree – fees are higher with private investments, especially compared to index fund costs. However, private investment fees are trending lower, and private equity has historically outperformed public markets by 4.3% net of fees per year over the last few decades (see https://www.kkr.com/insights/regime-change-role-private-equity-traditional-portfolio) and tends to be higher during inflationary periods. Also, access points to these managers has trended lower in recent years (e.g. $100k or even lower for some funds) for the reason noted in my reply above. Please keep in my this article takes a broader view of private investments, including things like real estate – an asset class that many physicians already tap into.
I’d also suggest that the democratizing of private equity means more capital is going into that sector, likely leading to lower future returns. Even vanguard is thinking about getting into private equity with harborvest so perhaps in the future a big chunk of target date money will go there.
The future performance isn’t certain, but the fees are.
[Note from author] Greg, you raise a good point. One consideration is that among the largest 185,000 companies in the U.S., ~98% are privately held and aren’t available to invest in through the public markets. In fact, the number of publicly traded companies is shrinking, with the number now standing about half of what it was just a decade ago. Tapping into a larger opportunity set may be a strategy that’s worth evaluating for high-earning professionals like physicians. However, a key point of this article is that a core part of a physician’s portfolio often should be allocated to low-cost and tax-efficient strategies such as custom indexing.
Regular indexing is low cost and tax efficient. One doesn’t need any sort of custom indexing to do that. The size of any possible net improvement on returns from custom indexing pales in comparison to the things that really matter in reaching financial goals.
[Note from author] ETFs and MF indexes are a great way to get started investing and to use inside qualified accounts. For high-income earners with money in taxable accounts, custom indexing is a way to systematically capture tax savings in a greater magnitude than can be done inside index mutual funds and ETFs.
Holding individual securities explodes the opportunity for tax loss harvesting. During years when the market is up more than 10% from 2006 – 2020, on average, 32% of stocks finish negative for the year. This example highlights the additional opportunities to harvest losses that exist at the security level even when a portfolio is comprised of individual stocks that generates double-digit gains.
Furthermore, by getting access to the individual holdings of an index through custom indexing, year-round opportunities exist to harvest losses in a much greater way than can be done in pooled vehicles like MFs and ETFs. Take this year for example. The S&P 500 is down since its July highs (around double digits), yet a number of securities in the index are down substantially more. By proactively and systematically trading these individual securities at times like this current period, physicians can bank significant losses to offset future gains – both in the portfolio and outside the portfolio (e.g. offset gains of a real estate sale or practice sale). Plus, these losses can be carried forwarded in subsequent years to offset future capital gains.
Academic research indicates that 100 – 200 basis points in tax savings can be achieved each year through a process that intelligently and systematically harvest portfolio losses. For these reasons, physicians in high tax brackets should be willing to explore the potential of this strategy in their taxable portfolios.
I’m very much aware of the benefits of tax loss harvesting. I’m currently carrying forward 7 figures and growing. And that’s only by tax loss harvesting like 3 times in the last 4 years. It doesn’t need to be done frenetically or by owning hundreds of individual stocks. You can just wait until a bear market, harvest everything that’s down, and move on with your life. For most people, the law of diminishing returns kicks in pretty fast.You can only use $3,000 a year against ordinary income. VTI doesn’t distribute capital gains at all unless you sell. And if you’re selling the high basis shares, you may only generate $20K in gains to get $200K to spend. So unless you’ve got a business to sell or a very expensive house to sell, additional losses are only so useful. So how much in fees or how much in hassle should someone be willing to deal with in order to get more losses? So if someone has a big enough portfolio to bother considering doing direct indexing (what it’s usually called rather than your favored term of custom indexing), where it might possibly make sense fee wise, it certainly doesn’t make sense for tax loss harvesting.
So that leaves the ability to deliberately choose low dividend stocks instead of medium or high dividend stocks while still trying to match the index. I’m skeptical that can add much value over just having a growth tilt in the portfolio. Plus after listening to the man who actually runs Vanguard’s index funds, I’m not sure it’s as easy to track the index while doing so as its proponents would have you believe.
I think direct/custom indexing is mostly still just a product designed to be sold, not bought. I mean beta is basically free. Certainly less than 10 basis points. So in order to make money in financial services, you really need to offer something else. No way there is 100 basis points there for me, much less 200. And what’s it cost? Probably about that much.
[Note from author] WCI, thank you for allowing me to be a guest author on your site and share my viewpoints. I value your perspectives and agree with many of them. Examples: the importance of minimizing investment costs, the value of proactive tax planning, the role that real estate can play in generating passive income, and the importance of having asset protection strategies in place.
In a few areas, our perspectives differ. Just as two physicians can have different treatments for the same diagnosis, so can two rational investors have different ways to optimize their portfolios.
From my perspective, custom indexing (aka direct indexing) is less of a product to be sold than an innovative financial technology. Cerulli & Associates forecasts that custom indexing will be the fastest growing indexing solution over the next five years, outpacing the growth rates of both mutual fund and ETF indexing categories. Further fueling this trend is the outsized investments being made by the largest asset managers in custom indexing technology – both through acquisition of this technology and internal engineering development.
About a decade ago, I went to the ER due to severe chest pain. The ER doc did an X-ray and diagnosed me with pneumonia. After a few days, the pain worsened. I went back to the ER and with the support of advanced imaging was diagnosed with bilateral PEs. I am alive today because of the skill of an amazing team of healthcare professionals and the use of advanced imaging technology.
Just as an X-ray is an appropriate tool for many patient cases, so are index mutual funds and ETFs for many investors. Similarly, advanced imaging is the better technology for certain cases as in my story. I believe this also to be true of custom indexing technology and its use within taxable portfolios of certain high net worth investors. Why else would the likes of Vanguard, Fidelity, Blackrock, and many other asset managers be investing millions of dollars in this modern and innovative financial technology.
My prediction is that custom indexing will become the default solution for managing taxable portfolio within the next decade similar to how ETFs disrupted the mutual fund industry a few decades ago.
We’ll see. An easier solution would be to change the law such that mutual funds could pass through their losses to investors like they pass through their gains. Custom indexing is a solution to a problem that shouldn’t exist.
[Note from author] Perhaps, an even better solution is if capital gains taxes were eliminated. But that’s not likely going to happen anytime soon. Meanwhile, finding ways to minimize taxes, including capital gains taxes, is a smart strategy for any high earning professional, including physicians.
Fun fact–David Swensen’s brother, Steve, is a radiologist at Mayo and a champion of reducing burnout.
Survivorship bias for hedge funds is huge. Bad funds are merged or shut down and the poor records vanish off the record. Please read Larry Swedroe’s book on Alternative Investing.
That problem is hardly hedge fund specific. That’s a big issue with actively managed mutual funds.
[Note from author]. Please note this post does not advocate the use of hedge funds for the reasons you noted, as well as other reasons. In fact, the article states: “The study concludes that if Yale paid taxes, it would alter its investment allocations by: 1) Eliminating active equity managers and hedge funds…”
Warren Buffett: Private Equity Firms Are Typically Very Dishonest
https://m.youtube.com/watch?v=r3_41Whvr1I&pp=ygUdUHJpdmF0ZSBlcXVpdHkgd2FycmVuIGJ1ZmZldHQ%3D
With all due respect, a marketing piece from one of the largest PE firms, with no citations of the data or descriptions of the analysis, is hardly a reliable source for a claim of high returns to PE net of fees.
Consider instead the work of Phalippou, Oxford professor, who has published widely on the cost and performance of PE.
https://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=337309
He finds no support for the claim that PE has outperformed net of fees at all, let alone by anything close to 4%.
[Note from author] From 1989 – 2022, Private Equity has – on average – empirically delivered excess returns of about 4.3% on a net annualized basis. The rolling 3-year annualized excess return is calculated as Cambridge Associates U.S. PE index net returns less the total returns of the S&P 500. Data as at November 30, 2022. Source: Cambridge Associates, Bloomberg
How is the return calculated? 14-15 percent as dividend payout (return of capital is ponzi).
If I was just told my investment increases in value without paying a single penny dividend, it is a scam.
My friend had a job offer from radpartner(pe firm). The offer was 100K stock as sign on bonus. I told him to ask for 200k its junk bond or 100k cash or VTI.
[Note from author] Return calculation methodology is explained here: https://www.cambridgeassociates.com/insight/a-framework-for-benchmarking/
Please note the premise of the article is that the core portion of a taxable investors portfolio should NOT be allocated to private investments, including private equity funds and private real estate. Rather, the article suggests that most of a taxable investor’s portfolio should be allocated to low cost, tax efficient vehicles like custom indexing and municipal bonds, which is very different than how Yale invests its endowment.
The Phalippou papers at the link I provided carefully analyze the methods used to compare PE returns to public markets. As you will see if you read the papers, he disproves these claims of better performance of PE.
[Note from author] It is true that Ludovic Phalippou has done extensive research on this topic, including one of his more recent papers titled, “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory.”
In this paper, Phalippou notes, “It is true that I did not make any distinction regarding risk.” To me, this disregard of risk results in an inequitable comparison – truly not a like-for-like analysis.
Phalippou also noted in this paper, “Carlyle’s argument that it is unfair to include real estate and energy funds was also made by Apollo and Blackstone.” And he continued, “The Energy sector had poor performance over this time period. It is argued that Energy is a separate asset class and that within this sector, PE funds did relatively well.” From my perspective, including real estate and energy funds into the same category of growth equity conflates the results and minimizes the effectiveness of this comparison.
In the Cambridge paper that I cited above titled “A Framework for Benchmarking Private Investments”, the paper concludes, “Measuring and benchmarking private investment performance is an ambiguous and complex process. The lack of a single “right” measure leads to inconsistency across the industry and makes it difficult to decompose the various drivers of performance. Our framework seeks to solve that problem by identifying the key performance questions to address and then measuring success across a series of key metrics using a set of tools that can be applied in a consistent manner.”
As a result of their work, Cambridge has become the industry standard for private equity benchmarking. The excess return of PE to the S&P 500 that I referenced above is based on Cambridge Associates’ U.S. PE index – resulting in a like-for-like comparison.
As previously noted, the main thesis of this article is NOT about the merits of private equity. This post points to how this asset class and others such as private real estate should be used sparingly (if at all). The main conclusion of this articles is that low cost, tax-efficient investments should be the core foundation of high net worth taxable portfolios.