David Swenson is an icon in the investment world. His Yale “endowment model” is widely considered to be the gold standard by which all others are measured. While effective for tax-exempt entities like endowments and charitable foundations, this model becomes less compelling for the high net worth investor. Preston McSwain wrote an insightful article for WealthManagement.com in August 2015 titled “Are Hedge Funds Prudent for Taxable Investors?” His main thesis: Hedge funds (which account for a significant percentage of Swenson’s endowment model) are a tax-inefficient asset that do not really belong in the portfolio of taxable investors.
As a result of their active trading and mark-to-market accounting, hedge funds typically generate ordinary income tax—which can top out above 50 percent in New York City and California. For example, a California resident (in the top tax bracket) who invests in a hedge fund with an attractive 8 percent rate of return (net of fees) only retains 4 percent after taxes—a tax drag of 400 basis points. While many complain about the hedge fund industry’s 2 and 20 fee schedule, it is paltry in comparison to the negative effects taxes have on performance.
Asset Location
One possible solution: Strategic asset location, which can maximize the after-tax return of an investment portfolio by placing tax-inefficient assets in tax-advantaged vehicles. In its simplest form, an investor can use a 401(k) or IRA account to house tax-inefficient assets (i.e., high-yield bonds). By deferring taxes and letting gains compound, overall performance will be improved. This option works well for registered securities, but unregistered securities like hedge funds are not often compatible with 401(k)s or IRAs.
To solve this problem, accredited and qualified investors turn to customized private placement vehicles. One such option, private placement life insurance (PPLI), uses the chassis of a variable universal life policy and restructures it to perform more like an investment account. By reducing upfront loading fees and eliminating surrender charges, PPLI provides purchasers with a tax-preferred location to house unregistered investments like hedge funds and credit funds. This hybrid insurance/investment product is a valuable tool for high net worth investors interested in long-term wealth accumulation as well as wealth transfer.
If we go back to the earlier example where an 8 percent return only netted 4 percent after taxes, the investor could return close to 7 percent by using a properly structured PPLI strategy and assuming the insurance charges over the life of the investment averaged approximately 1 percent per year. That is a notable 3 percent differential. By employing an asset location strategy within their portfolio, investors have the ability to improve long-term performance.
This article is written for educational purposes and is not to be considered as a solicitation for any product.
Jason Chalmers is a director at Cohn Financial Group, a private placement life insurance distributor.