This time of year, we in the U.S. are unfortunately reminded
of a phrase written by Benjamin Franklin in a letter to French
scientist Jean-Baptiste Le Roy in 1789: Nothing is
certain except death and taxes. As taxpayers, we all know
this well. Do many investors forget this, however, when
examining hedge funds?
Consider the following true story. Last year I was hired by
a wealthy couple to help vet investment managers and private
banks. They had recently sold a business that had netted them
approximately $100 million in aftertax cash and wanted to make
sure they were making prudent long-term choices. One of the
meetings we had was with a large trust bank, which hosted an
elegant lunch. The firm brought in an impressive team that
included the president of the trust division and the chief
After the first course, the trust banks president
summarized the firms capabilities. Particular emphasis
was given to the strength of the alternatives and hedge fund
selection team. He concluded by saying, Youve done
well. Were here to make sure your family continues to do
well over generations by building you a prudently diversified
portfolio that includes global equities, bonds and a
world-class mix of alternative managers.
Although the couple appreciated the presentation, neither
fully understood the complex hedge fund strategies included in
the proposal. When they questioned the necessity of these
strategies, the CIO said, Its important that we
broadly diversify your family assets into both traditional and
alternative strategies such as hedge funds. As fiduciaries,
its not prudent to invest in an endowment-style portfolio
that doesnt include hedge funds.
Despite the persuasive presenters, and buoyed perhaps by the
knowledge that they had built a successful business by always
fully understanding strategies before executing them, the
couple decided to keep it simple and not invest in hedge
Were my clients right to keep to the simpler path?
Initially, it might appear not.
The family had set up a Delaware dynasty trust. Their time
horizon for investment and distribution of funds to
beneficiaries was going to be measured not in years or decades
but in generations. What does that sound like? Probably, an
If trusts for families falling into the ultra-high-net-worth
bracket having investable assets of at least $30 million
have characteristics that resemble endowments,
shouldnt more portfolios of ultra-high-net-worth clients
look like Yale-style endowments?
Why Yale? In the investment world, Yale is known for having
a top-performing endowment, the $22 billion Yale Investments
the investment style of which many other institutions try to
replicate. Yales endowment is helmed by
David Swensen, one of the most well-respected CIOs in the
endowment world and beyond, an esteem based on his writings and
his use at Yale of nontraditional investments such as hedge
So, whats the problem with using an endowment approach
for ultra-high-net-worth families? I could write about fees or
less-than-favorable performance by some hedge funds, but
how about taxes?
Yes, taxes. Regardless of your political leanings, Franklin
was correct. Unlike endowments, individuals cant avoid a
yearly payment to the IRS on investment gains.
Who else offers a similarly strong caution about taxes?
Following the publication of Pioneering Portfolio
Management, Swensens first book, in 2000, many
ultra-high-net-worth advisers started promoting the endowment
model he had helped to create. The ultra-high-net-worth
investment world eagerly embraced this new, apparently more
sophisticated approach but seemingly was and more than
15 years later still is forgetting the fact that
Swensens book was designed for tax-exempt investors.
As Swensen wrote in his second book, published in 2005,
Unconventional Success, this one for taxable
investors: 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
Earlier in this article, I asked the following
Do investors often forget taxes, to their detriment,
when considering hedge funds?
Were my ultra-high-net-worth clients right to keep to
the simpler path and say no to hedge funds?
Based on the evidence, I answer yes and
In light of the unavoidable tax drag that is associated with
hedge funds, all investors might be well served to follow the
advice of a Ben Franklintype figure of investing:
What does Buffett recommend, even for his family? Keep it
simple, with low-cost and tax-efficient index funds. Both
Buffett and Swensen have repeatedly discussed the evidence in
favor of index investing and consistently recommended it for
Preston McSwain is a managing partner and founder of Fiduciary Wealth Partners,
a registered investment adviser in Boston.
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