When Donald Trump entered the Oval Office in 2017, he moved quickly to make good on a long standing Republican promise to cut taxes and simplify the tax code. While the bill that eventually came into law was indeed the most ambitious and far-reaching overhaul of the tax code since the Reagan administration (and followed through on the promise of slashing tax rates for individuals and businesses), it ended up doing little to tackle the issue of complexity. That is a shame, since there are few things quite so complex as the U.S. tax code.
As with every omnibus tax reform that touches all aspects of the nation’s economic life, there are inevitably winners and losers of the Tax Cuts and Jobs Act, as the Trump tax law is formally called. But determining who those winners and losers are can take many months, or even years, to recognize. That said, some clear winners and losers are already identifiable. Commercial real estate, for example, got an especially sweet deal. Among the losers: big university endowments.
Today, we take a look at the impact of the tax law on university endowment funds, and what it means for a group of institutional investors that have significant financial power.
Not your father’s endowment
University endowments – funds established to provide for the long-term financial security of the institutions, finance expansion and development projects, back worthy causes, and provide financial aid to needier students – have grown at a rapid pace over the past few decades. That is especially true of the endowments of top-tier universities. Wealthy graduates give back, perpetuating a cycle of giving.
The endowment funds rake in the money, but do not just sit on it. While 50 years ago, endowment fund managers pursued extremely conservative allocation and investment strategies, the hunt for yield and growing internal sophistication has led them to branch out into all manner of asset classes. Yale’s endowment, for example, has been a poster-child for allocating to alternative investments. That strategy has led to mixed results, as we covered in a recent article, “It’s Warren Buffett vs. Yale on Alternative Investments.”
Whether they are deep in private equity and hedge funds, or just allocating to a more traditional stocks-and-bonds strategy, endowment funds have all enjoyed the boons of tax exempt status.
Don’t tax me bro
When endowments were relatively small affairs, the federal government was happy to leave them alone. That is no longer the case. Today, the aggregate value of the top 20 endowments tops $500 billion. That is too grand a prize for the tax man to ignore.
Thus, the Tax Cuts and Jobs Act included a tax hike for the wealthiest university endowments. From now on, university endowments with $500,000 per full-time student will be liable for a tax of 1.4% on net income.
While that figure is small, it has the administrators and fund managers at the 30-odd affected institutions scrambling. While it is a small tax, affecting relatively few exceptionally well-heeled universities, it is seen as a potential beachhead for future tax hikes. That is an understandable concern. After all, taxes do have a tendency to spread to a wider base, often while their rates gradually rise.
Revamping strategies
Even the small tax is having an impact on the affected institutions. That is because even small fees can alter the risk-reward profiles of certain asset classes and investment strategies – especially when those strategies are relatively tax-inefficient or low-yield. Tax efficiency has not been an issue for endowment funds in the past, and the low-yield plays of very conservative institutions now look less attractive.
While it is still early days, we can already see some movement. For starters, endowments are – and are likely to continue – shifting assets from less tax-efficient assets, such as short-term dividend stocks, to equities with long-term capital gains potential. It is also likely that some money will be shifted into liquid asset classes, in order to cover the costs of the tax each year.
That may also put pressure on universities like Yale that have spent years allocating heavily to illiquid alternative investments. With an added “fee” from the tax thrown on top, the high fees such alternative asset managers charge may start to look even less appealing as well.
Screaming into the void
The current miniscule tax is not going to move the needle on endowments’ strategies too much in the short term. But if, as is likely, these taxes slowly but surely spread in scale and scope, strategies will have to change.
University leaders have already signaled their disapproval. Unsurprisingly, few are thrilled about the prospect of forking over millions of dollars every year to the Fed. That said, it will probably be hard for them to muster up much public sympathy. After all, it only affects the very wealthiest of elite universities – so far anyway. Indeed, an institution such as Harvard is not likely to convince anyone it is put upon by the new tax, even when it would have had to pay $43 million if the tax was in force in 2017. Considering that it is sitting on a staggering $37 billion, few Americans are likely to shed a tear for it.
Beyond the hallowed halls of ivy
While it is very much a rich university problem today, the situation may change down the line. As the years roll along and successive governments seek new sources of revenue, university endowments will undoubtedly continue to look appealing. But individual Americans, even those with deep-rooted college pride, are unlikely to pay it much mind until it has spread significantly.
In the meantime, it would behoove investors to follow the moves of the big endowments as they shift their strategies, even at the margins. Their considerable wealth and financial clout makes them powerful allocators and movers in financial markets. It is wise to follow and understand what they are doing. Sometimes they even have a good idea or two.
Disclosure: I/We own no stocks discussed in this article.
