Donating Appreciated Assets To Charity

Donating appreciated assets to charity can provide economic benefits to charities, while also providing tax benefits to donors. The benefits to both charities and donors is amplified for donations of appreciated assets.

Non-Cash Charitable Donations

What types of non-cash assets can be donated to charity?

There are many types of non-cash assets that can be donated to charitable organizations. Below are several types and examples.

  • Liquid securities such as stocks, bonds, mutual funds, ETFs, listed options, crypto and so on. This is the focus of this post, although the below principals apply to any many of the below.
  • Illiquid assets such as insurance contracts, restricted stock, employer stock options, business interests.
  • Real assets such as real estate or commodities.
  • Other complex assets.
  • Depreciated Assets such as clothes, cars, and so on. These items are beyond the scope of this post since they do not provide the same tax benefits as appreciated assets.

What charities accept non-cash financial assets?

Not all charities can accept non-cash donations.

Many charities are setup to accept liquid securities, but most do not have the resources to accept illiquid and/or complex assets. Typically, these can only be donated to (larger) well-resourced organizations. Ultra high net worth donors often establish a foundation to handle their charitable donations and grants.

Unfortunately, many donors only donate cash because they believe that is the only way to fund the charities they support. Donors wishing to donate liquid or illiquid assets to charities that cannot accept them should consider donor-advised funds.

Tax Benefits of Donating Appreciated Assets to Charity

Fortunately for US taxpayers, the IRS provides income tax benefits for cash and non-cash charitable contributions. Additionally, donating appreciated non-cash assets can generate additional capital gains tax benefits.

Income Tax Benefits of Donating Non-Cash Assets to Charity

The value of cash or non-cash donations can generally be deducted from a donor’s income on their tax return, thus lowering their income tax liability.

  • For cash donations, the value of the donation is straightforward.
  • For non-cash assets that have been held more than one year, donors can deduct the market value (or estimated/appraised value if there is no market value).
  • For non-cash assets held less than one year, then the deduction is the lower of the cost basis or value (so donating “short-term” assets rarely, if ever, makes sense).

The above bullet points are summarized in the table below.

Capital Gains Tax Benefits of Donating Appreciated Assets to Charity

While donating non-cash assets can provide an income tax benefit, donating appreciated non-cash assets can provide a capital gains tax benefit.

The reason that donating appreciated assets is often more attractive than donating cash is because donating an appreciated asset allows donors to avoid long-term capital gains tax on the donated asset.

Appreciated assets generally have an embedded tax liability which must be paid when the gain is realized. For instance, if someone buys a stock at $10 and it rises to $100, there is a capital gains tax that is owed on the $90 gain. It may not be paid until the stock is sold, but that tax liability exists nonetheless and is embedded in the position until it is sold. However, if the stock is donated to charity, then the investor will never have to pay capital gains tax on the $90 gain (and neither will the charity since it is a non-profit organization that does not pay taxes)!

The below table shows the income tax and capital gains tax benefits of donating appreciated assets with various holding periods:

Benefits of Donating Appreciated Non-Cash Assets

Donating appreciated assets provides donors with tax benefits, but it can also benefit charities. Below is an example of the benefits of donating appreciated stock:

Assume a donor buys $5,000 of stock which appreciates to $10,000 over several years. If the donor sells the stock, they will realize a $5,000 gain which will be subject to capital gains tax. Assuming a 15% long-term capital gains tax and a 9.3% state income tax, the donor will pay $1,215 in taxes. The charity will receive $8,785 ($10,000 minus the $1,215 of taxes). Assuming a 28% federal tax rate (and 9.3% state tax rate still), the donor will receive a $3,276 deduction. But the net tax benefit to the donor will only be $2,062 ($3,276 deduction minus $1,215 capital gains tax paid, rounded).

Alternatively, if the donor donated the stock directly to the charity, they would have received a larger tax benefit AND the charity would have received more. The donor could send the entire $10,000 position to the charity and deduct the $10,000 on their tax return. The charity would receive $1,215 more AND the donor would have saved $1,668 in taxes (because they could deduct $3,730 without subtracting any capital gains, assuming the same tax rates).

The below table illustrates the benefits from the above example of donating stock to charity.

Obviously, the dual impacts of receiving an income tax deduction and avoiding capital gains tax are beneficial.

The above methods can be used to dispose of assets and/or reallocate/rebalance portfolios in a tax-efficient way. For instance, some investors hold stocks (that they wouldn’t otherwise hold) due to tax constraints. Donating shares of stock eliminates this constraint. This would also apply to mutual funds, ETFs, and other portfolio positions that donors wish to exit.

I should note that the above is a high-level overview and there are additional tax issues to consider, so donors should consult with their tax adviser before making any donations. As readers know, this site is designed to provide education rather than recommendations.

Private Equity: Preferred Returns, Catch-Ups, and Waterfalls

An important consideration when investing in private equity is the preferred return, which is not a standardized term and has many variations. At the highest level, private equity investors should understand what the preferred return is as well as how its calculated, what the catch-up is (if any) and whether there are claw back provisions. Additionally, investors should evaluate whether the preferred return is simple, compounded, cumulative, and so on.

Performance fees are also known as carry, carried interest, performance allocations, incentive allocations, or incentive fees (among other terms) and I’ll be using them interchangeably. Private equity funds are typically long-term closed-end vehicles, so the below information and examples are more conceptual than anything else. They are examples of private equity preferred returns and investors are encouraged to carefully read the legal documents of any prospective investment.

Preferred Returns: Pure vs Catch-Ups

Pure Preferred Return

Pure preferred return is also known as a “true preferred return” or a “hard preferred return” (similar to a “hard hurdle” in hedge fund lingo, although use the term in a private equity context too). A pure preferred return means that the manager only collects a fee on the performance above the preferred return. This arrangement is more investor-friendly than the alternative of a “preferred return with catch-up.” Below is a detailed example of a private equity pure preferred return:

In the above example, the manager charges a 20% performance fee above an 8% preferred return. Since the fund returned 10%, the performance fee is .4% (20% multiplied by 2%).

Preferred Return with Catch-Up

A preferred return with catch-up means that the manager collects fees back to the first dollar of performance (the manager “catches up”), assuming that gross performance exceeds the preferred return. This arrangement is more manager-friendly than a pure preferred return. Below is a detailed example of a private equity preferred return with catch up:

In the above example with catch-up, the manager also charges a 20% performance fee above an 8% preferred return. However, the fee is applied on all returns (assuming fund performance exceeds the preferred return). So the performance fee is 2% (20% multiplied by 10%).

100% Catch-up

Once performance hits 7%, all additional returns accrue to the manager until gross performance surpasses 8.24% (because 7% is 85% of 8.24%). In other words, investors receive the returns from 0% to 7% and the manager receives returns from 7% to 8.24%. Returns of 8.25% and beyond are split 85%/15% between the investors and manager.

50/50 Catch-up

A 50/50 catch-up is a common catch-up structure, although it could be 60/40, 75/25, or any other combination.

Let’s look at an example of a private equity preferred return with a 50/50 catch-up. A private equity fund fund has 20% performance fee above a 10% preferred return with a 50/50 catch-up provision. In this case, the investors would receive all of the returns up to 10%. Additional returns would be split 50/50 until gross returns hit 12.5%. At 12.5%, the manager would be fully caught-up since they would receive 50% of the returns from 10% to 12.5% or 1.25% (which is 10% of 12.5%). Returns above 12.5% would be split 90/10 between the investors and manager.

Catch-Up Modifications and Limitations

Some funds have a structure where the manager earns carried interest back to the first dollar of performance (assuming that gross performance exceeds the preferred return), but the performance fee is reduced if it would cause net returns to be lower than the preferred return. Below is a detailed example of this modified structure private equity waterfall structure.

This structure allows managers to retain the upside, while somewhat protecting investors.

Tiered Preferred Returns

Similar to how a catch-up allows managers to have more upside than a pure performance return, a tiered preferred return allows managers to capture even more upside as performance increases.

Here’s an example of a private equity fund with tiered performance fees. The performance fee may be 20% over an 8% preferred return, 30% over a 12% preferred return, and so on. The performance fee can be structured to only apply to returns above the preferred return or to go back to the first dollar of returns. So an investor may pay a 20% performance fee up to 12% and a 30% performance fee on returns above 12%. Or they might pay 30% on all returns if the performance is above 12%. The fees at different tiers can also be limited so as to not push returns below the tier that they are being charged fees for.

Some investors believe that tiered preferred returns in private equity improve the alignment of interests between managers and investors, while others believe that it incentivizes risky behavior.

Simple, Compounding, and Resetting

Regardless of whether a private equity fund has a pure preferred return or a catch-up, it is important to note how the preferred return rate is quoted and how it works.

Simple Preferred Returns

Some private equity preferred returns are quoted as a simple rate, which is generally not a great arrangement for investors. Consider the example in the below table where a fund may have a preferred return of a 7%. In this case, the fund will be entitled to its performance fee as long as it returns at least 7% on invested capital. So if the fund starts with $10 million and returns are 10% in Year 1, the manager gets the performance fee. However, if the fund returns 6.5% in Year 2, the manager still gets the performance fee. This is because the $715,000 (calculated as 6.5% x $11 million) that it earned in Year 2 is more than 7% of invested capital (of $10 million).

This model is obviously favorable to managers, although it may make sense for certain open-ended vehicles (and may not matter for some closed-end vehicles).

Compounded Preferred Returns

Some private equity preferred returns are quoted as an annually compounded rate. If the preferred return is 6%, then the fund must return at least 12.36% over a 2-year period (since a 6% return compounded for 2 years is 12.36%), 19.1% over a 3-year period (since a 6% return compounded for 3 years is 19.1%), and so on.

Non-cumulative Preferred Returns

The advent of evergreen and open-ended private equity has resulted in some preferred returns that are “non-cumulative” and reset periodically. In other words, the preferred return will reset regardless of the prior periods performance.

This is obviously manager-friendly (and unfavorable to investors). Consider a fund with an 8% preferred return that that loses 20% in Year 1 and gains 10% in Year 2. No performance fee would have been charged in Year 1, but it would have been charged in Year 2 (since the Year 2 performance exceeded the preferred the return). Investors would be down 12% and yet still have to pay a performance fee! This example is detailed in the table below.

High Water Marks

A high water mark (or high-water mark or high watermark) has primarily been used by hedge funds historically, but it is becoming more common in private equity due to the wave of evergreen offerings with non-cumulative performance fees.

A high water mark is a mechanism to address the downsides of a non-cumulative preferred return. Furthermore, it ensures that a performance fee will not be charged until cumulative performance is positive. Returning to the previous example, a high water mark would prevent the manager from collecting performance fee in Year 2 (even though the preferred return resets in the new year) because the cumulative performance is still negative. However, once the cumulative performance exceeds the 0%, then the manager would be entitled to the performance fee.

It is easy to think of other examples where a high water mark would protect investors. A common risk would be paying the performance fee twice on the same performance. In the chart below, we assume a fund returns 10% in Year 1 and -20% in Year 2 and then 30% in Year 3. The investment would have gone from 100,000 to 110,000 in Year 1 and again in Year 3 and investors would not want to pay for that twice. A high water mark ensures that they only pay a performance fee on the gains from 110,000 to 114,400 in Year 3.

Private Equity Waterfall Structures

I’ll probably write another post on this, but there are two main types of “waterfalls” or ordering of distributions.

European Waterfall

Under a European waterfall structure, investors typically receive their return of capital and preferred return before the manager begins receiving its fee carried interest catch-up. Given that many private equity funds are 10 year funds (plus extensions), managers may be waiting a very long time before receiving any carry from the waterfall.

American Waterfall

Under an American waterfall, the manager is allowed to receive advances of its carried interest catch-up on a “deal-by-deal” basis. Essentially, this allows the manager to receive some compensation earlier. Proponents of this structure argue that it allows managers to think longer-term and not sell assets prematurely in order to generate income for themselves.

Clawback Provisions

Clawback provisions are important for investors to have under an American waterfall structure. It provides a mechanism for investors to receive some compensation from the manager if the deal-by-deal carried interest fees that are advanced are ultimately more than what the manager is entitled to (once the fund is fully wound down and the actual fees known). Unfortunately for investors, clawbacks are generally net of taxes since managers argue that they cannot refund what they paid to the IRS. So investors may receive a fraction of what was overpaid to the manager.

Conclusion

Ultimately, performance fees, preferred returns, and high water marks are designed to align the interests of private equity managers and investors. The structure of these terms varies from fund to fund, depending on factors like manager size, asset class, and so on. There is no “best” set of terms, but investors should ask whether the terms create alignment in a variety of good and bad scenarios. This is also true when investing in real estate, hedge funds, and many other alternative investments beyond private equity.

Further Reading

The above primarily relates to private equity and vehicles with a “private equity structure”. However, a very similar set of concepts can be found in hedge fund hurdles, hurdle rates, and high water marks.

Hedge Fund Hurdle Rate (and High Water Marks)

A hedge fund’s hurdle rate is an important consideration when investing in hedge funds, especially since it has many variations. At the highest level, investors should understand what a hedge fund hurdle is, whether it is a hard hurdle, soft hurdle, or blended. Additionally, investors should evaluate whether the hedge fund hurdle rate is compounding or non-compounding as well as the existence and structuring of a high water mark mechanism.

Performance fees are also known as carry, carried interest, performance allocation, incentive allocations, or incentive fees (among other terms) and I’ll be using these term interchangeably. It is important to note that fees and hurdles can be assessed monthly, quarterly, annually, or longer. The below information and examples are just examples and investors are encouraged to carefully read the legal documents of any prospective investment.

Hedge Fund Hurdles

Hard Hurdle

A hard hurdle means that the manager only collects a fee on the performance above the hurdle rate. This arrangement is more investor-friendly than a soft hurdle. Below is a detailed exampled of a hedge fund with a hard hurdle:

In the above example, the manager charges a 20% performance fee above an 8% hurdle. Since the fund returned 10%, the performance fee is .4% (20% multiplied by 2%).

Soft Hurdle

A soft hurdle means that the manager collects fees back to the first dollar of performance, assuming that gross performance exceeds the hurdle rate. This arrangement is more manager-friendly than a hard hurdle. Below is a detailed example of a hedge fund with a soft hurdle:

In the above example of a soft hurdle, the manager also charges a 20% performance fee above an 8% hurdle. However, the fee is applied on all returns (assuming fund performance exceeds the hurdle rate). So the performance fee is 2% (20% multiplied by 10%).

Blended Hurdle

A blended hurdle is similar to a soft hurdle in that a manager can collect fees back to the first dollar of performance (assuming that gross performance exceeds the hurdle rate). However, the performance fee is reduced if it would cause net returns to be lower than the hurdle rate. Below is a detailed example of a hedge fund with a blended hurdle.

Blended hurdles allow the manager to capture upside, while somewhat protecting investors.

Graduated Hurdle Rates

Similar to how a hedge fund with a blended hurdle allows a manager to have more upside than a hard hurdle, a graduated hurdle allows a manager to capture even more upside as performance increases.

Consider the following example of a hedge fund with a graduated hurdle. The performance fee may be 20% over an 8% hurdle, 30% over a 12% hurdle, and so on. Again, the hurdle can be structured to only apply to returns above the hurdle or to go back to the first dollar of returns. So an investor may pay a 20% performance fee up to 12% and a 30% performance fee on returns above 12%. Or they might pay 30% on all returns if the performance is above 12%.

Some investors believe graduated here fund hurdle rates improve the alignment of interests between managers and investors, while others believe that it incentivizes reckless risk taking.

Hedge Fund Hurdle Rate: Compounding vs Non-Compounding

Regardless of whether a fund has a hard hurdle or a soft hurdle, it is important to note whether the hedge fund hurdle rate is compounding or non-compounding. If it is non-compounding, investors should determine whether the performance fee is subject to a high water mark (see below).

Compounding

A compounding hurdle rate means that the hurdle rate compounds over time. Here is an example of a hedge fund with a compounding hurdle rate. If the hurdle rate is 6%, then the fund must return at least 12.36% over a 2 year period (since a 6% return compounded for 2 years is 12.36%). A hurdle rate could also be a benchmark index like the S&P 500 or a benchmark plus a spread (such as 3-month T-bills plus 200 basis points). Using these types of benchmarks could result in a negative hurdle rate, so the hurdle rate often has a floor of 0%.

Non-Compounding

If the hurdle rate is non-compounding, then it resets periodically. In other words, the hurdle rate will reset regardless of the prior periods performance. This is obviously manager-friendly (and unfavorable to investors).

Consider this example of a hedge fund with a non-compounding 8% hurdle rate that loses 20% in Year 1 and gains 10% in Year 2. No performance fee would have been charged in Year 1, but it would have been charged in Year 2 (since the Year 2 performance exceeded the hurdle rate). Investors would be down 12% and yet still have to pay a performance fee! This example is detailed in the table below.

High Water Marks

A high water mark (or high-water mark or high watermark) is a tool frequently used to address the problems with non-compounding hurdle rates. A high water mark simply ensures that a performance fee cannot be charged until cumulative performance is positive.

Continuing from the previous example, below is an example of how a high water mark would prevent the manager from collecting performance fee in Year 2 (even though the hurdle rate is non-cumulative) because the cumulative performance is still negative. However, if the cumulative performance exceeded 0%, then the manager would be entitled to the performance fee.

It is easy to think of other examples where a high water mark would protect investors. A common risk would be paying the performance fee twice on the same performance.

In the table below, we see an example of how a high water mark protects investors from paying fees on the same performance twice. Assume a fund returns 10% in Year 1 and -20% in Year 2 and then 30% in Year 3. The investment would have gone from 100,000 to 110,000 in Year 1 and again in Year 3 and investors would not want to pay for that twice. A high water mark ensures that they only pay a performance fee on the gains from 110,000 to 114,400 in Year 3.

Problems with High Water Marks

High water marks are a mechanism to protect investors. However, it can backfire in cases where managers severely underperform. If a fund is loses 50% from its high water mark, then the fund must return 100% to get back to even and qualify for performance fees again. Some managers may be de-motivated by this and decide to shut the fund down rather than continue without the near-term prospect of performance fees. Of course, if the manager launches a new fund, they can begin collecting performance fees immediately on any positive performance. There was a high profile example of this recently when the “meme stock” craze crushed Melvin Capital. First the hedge fund manager floated the idea of modifying the hurdle rate and high water mark, before ultimately deciding to shut down and reopen. This example highlights why hedge funds are infamous for playing a game where “heads I win, tails you lose.”

Conclusion

Ultimately, hedge fund hurdle rates, performance fees, and high water marks are designed to align the interests of managers and investors. The structure of these terms varies from fund to fund, depending on factors like manager size, asset class, and so on. There is no “best” set of terms, but investors should ask whether the terms create alignment in a variety of good and bad scenarios. This is also true when investing in real estate, private equity, and many other alternative investments beyond hedge funds.

Further Reading

The above primarily relates to hedge funds and vehicles structured similarly to hedge funds. However, a very similar set of concepts can be found in private equity preferred returns, catch-ups, and waterfalls.

What Thanksgiving Teaches About Risk (Taleb’s Turkey Chart)

The life of a Thanksgiving turkey can teach us a lot about risk. I believe Nicholas Nassim Taleb’s turkey chart and accompanying quote (from The Black Swan) sums it up best:

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.

The Black Swan, by Nicholas Nassim Taleb
"A turkey before and after Thanksgiving. The history of a process over a thousand days tells you nothing about what is to happen next. This naive projection of the future from the past can be applied to anything."
Source: The Black Swan, by Nicholas Nassim Taleb; Wikimedia Commons
“A turkey before and after Thanksgiving. The history of a process over a thousand days tells you nothing about what is to happen next. This naive projection of the future from the past can be applied to anything.”
Source: The Black Swan, by Nicholas Nassim Taleb; Wikimedia Commons

The Taleb turkey chart and story is entertaining, but also offers much wisdom about risk-management.

The past does not predict the future

In Taleb’s story, nothing in the turkey’s life had indicated what would occur on Thanksgiving Day. The past had no predictive power in forecasting the future. On Taleb’s turkey chart, the days 1 through 1,000 are completely different than day 1,001 and beyond.

Similarly, we humans often assume the future will be similar to the past.

  • We believe that stability will continue. For instance, who predicted that a suicide in Tunisia would lead to the Arab Spring and the downfall of decades-long dictatorships in Egypt and Libya?
  • We believe that good times will continue. In 2019, who predicted that someone eating a bat or a lab leak would lead to a global pandemic that would reshape our society and economy for years?
  • We believe that bad times will continue. I find this assumption less common (because humans are generally optimistic, I think), but why do we call the modernization of Singapore or Oman a miracle? Perhaps because we believe it is improbable to go from mud and bricks to steel and glass in such a short-time.

In addition to the above, Taleb notes that investors often layer on and are deluded by confirmation bias. Many investors mistake their results for skill rather than luck not realizing that “a high tide lifts all boats.” In bull markets and bubbles, terrible decisions are often rewarded handsomely as hot assets soar in price. Investors double down on bad decisions until something changes, the tide goes out, and (in Buffett’s words) we find out who has been swimming naked. Unfortunately, in every market cycle some investors own assets that look like the Taleb turkey chart.

As Howard Mark’s says,”…trees don’t grow to the sky, and few things go to zero.” Understanding that the today’s conditions are likely to change is the key to not being a turkey. This is why investor protection rules have resulted in this disclaimer on nearly every piece of investment marketing : “Past performance is no guarantee of future results.”

Despite what we believe and despite how strong we believe it, the future is unknown.

Risk is difficult to model

Risks are difficult to model for many reasons, but one reason is that rare events are rare! We do not have sufficient data to estimate their probability or impact. Taleb’s turkey had never experienced what was about to happen.

We cannot predict earthquakes or their magnitudes. Nobody could have predicted what would happen if a strong earthquake occurred in the Pacific Ocean, generated an enormous tsunami, which destroyed a nuclear power plant (as well as its backup safety features), or what impact that would have on energy policy in Europe and geopolitical issues between the EU and Russia. I don’t believe anyone was even aware of these risks before the Fukushima earthquake/tsunami, much less modeled it. The events are rare and the sequential scenarios too numerous and complex to model.

Our record is not much better even when we’re aware of the risk. For instance, there have been many pandemics throughout history, but we were not well prepared for covid. Our leaders did not appreciate the scientific and/or behavioral nuances of pandemic planning. Furthermore, nothing like covid has ever occurred in such a globalized world. Previous plagues spread across cities and continents over months, years, and decades. Covid spread around the globe within weeks. The 2020 pandemic was unlike any past pandemic.

Ignorance is bliss

Since we do not know what risks exist and/or how probable they are, we often ignore the risks. We may think they don’t exist or are too improbable to worry about. That was certainly the case with covid. I recall debating with a family member who said the covid pandemic was abnormally rare even though pandemics occur with some regularity. It is just that there are rarely mulitple pandemics in single generation, so we forget.

There is also the issue of human memory and recency bias. There have not been any major airborne pandemics in the US within a generation or two and so we took the risk less seriously. We believe that we are smarter, more advanced, with better healthcare than past generations. Yet, we were still caught flat-footed during covid.

Information asymmetry

As Taleb notes in his book, the turkey’s surprise is not a surprise to the butcher. This is because the turkey does not have all of the information. If the turkey had a copy of Taleb’s chart for other turkeys, it might have known.

Unfortunately, we humans do not have complete information either and we rarely acknowledge it. In his famous book “Thinking, Fast and Slow,” Daniel Kahneman discusses his abbreviation WYSIATI or “what you see is all there is.” The concept of WYSIATI describes our tendency to create narratives based on the information that we have rather than admitting that there is a lot of information that we do not have.

What we see is not all that there is and our observations lead us to mistake the odds.

Note: Narratives can lead us astray in many areas of our life, even our giving! Here’s an example from the holiday season: Is Operation Christmas Child good or bad?

We think we know black swans to expect, but we miss the real ones

The bottom line is that we consider, anticipate, and worry about risks that we can imagine. Yet we often miss the risks that end up occurring. As Josh Wolfe says, “Failure comes from an a failure to imagine failure.” We cannot always imagine black swans, but we should try to avoid the common mistakes that Taleb’s turkey made.

FTSE Global All Cap ex US Index vs FTSE All-World ex US Index

The FTSE Global All Cap ex US Index and the FTSE All World ex US Index are two international stock indices, covering a majority of the world’s non-US investable stocks. Many investment strategies and vehicles benchmark to either one of these indices. The primary difference between the FTSE Global All-Cap ex US vs FTSE All World ex US is that the Global All Cap ex US Index broader than the All World ex US. However, performance is fairly similar, as is sector and geographic exposure.

A quick note that investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with an investable vehicle, such as the Vanguard FTSE All-World ex-US ETF (symbol: VEU) or the Vanguard Total International Stock ETF (symbol: VXUS). A reminder that these are simply examples as this site does NOT provide investment recommendations.

Historical Performance: FTSE Global All-Cap ex US vs FTSE All World ex US

Both indices were launched in the early 2000s. Since the FTSE Global All Cap ex US Index’s launch, it has trailed the FTSE All-World ex US Index by nearly .90% annually.

However, when comparing the FTSE Global All-Cap ex US vs FTSE All World ex US over the past 10 years, then the performance differential narrows to less than .20% annually. The FTSE All World ex US still outperforms the FTSE Global All-Cap ex US, but the chart shows performance is pretty close.

Differences between FTSE Global All-Cap ex US and FTSE All World ex US

These two indices are both provided by FTSE and they are nearly identical in many respects. The primary difference is that the Global All Cap ex US is more of a total market index. The Global All-Cap ex US has 7,719 constituents, while the All-World ex US “only” has 3,563 constituents (all data as of 9/30/2022)

Geographic Exposure

Country Exposure

As their names imply, each index excludes US stocks. The top five countries are identical and the weightings are very close too. Data as of 9/30/2022.

Market Classification

The only difference in developed and emerging market exposure when comparing FTSE Global All-Cap ex US vs FTSE All World ex US seems to be a rounding error!

Market Cap Exposure

As its name suggests, the FTSE Global All Cap ex US covers more mid- and small-cap stocks primarily since it has more than double the number of constituents, as of 9/30/2022.

Sector Weights

The market cap differences do not translate into any material differences in sector exposure. As the table below shows, the sector weightings of the two indices are nearly identical as of 9/30/2022.

Final Thoughts

These two indices are quite different in some ways, but not in ways that matter very much. The FTSE Global All-Cap ex-USA Index is a much broader index than the FTSE All World ex-USA Index (with more than double the number of constituents!). However, due to the market cap weighting methodology of both indices, the additional constituents do materially impact the geographic exposure, sector weights, or performance. This is very similar to the dynamic we find with the Russell 1000 and Russell 3000 where one index is essentially a subset of another.

These two indices are very similar and recent performance has very close. Investment vehicle details like expenses, fees, taxes, and liquidity in small cap names (which the Global All-Cap ex US owns a lot of!) may be more consequential than differentials in index performance. Investors cannot invest in indices directly and should do their own research before deciding to invest in a fund that tracks either index.

Further Reading

Investors looking for global exposure that includes the US may want to read our comparison of these indices’ parents, the FTSE Global All Cap Index and FTSE All World Index.

Of course, readers can also compare the differences between the flagship MSCI “ex-USA” indices, the MSCI ACWI ex-USA and MSCI World ex-USA.

FTSE Global All Cap vs FTSE All World

The FTSE Global Cap Index and the FTSE All World Index are two global indices, covering a majority of the world’s investable stocks. Many investment strategies and vehicles benchmark to either one of these indices. FTSE Global All Cap covers many more constituents and market caps than the FTSE All World, but there is little difference in performance.

A quick note that investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with an investable vehicle, such as the Vanguard Total World Stock ETF (symbol: VT) or the Vanguard FTSE All-World UCITS ETF (symbol: VWRL) which is available in the UK. Interestingly the former fund (VT) changed benchmarks from the FTSE All-World Index to the FTSE Global All Cap Index in 2011. A reminder that these are simply examples as this site does NOT provide investment recommendations.

Historical Performance: FTSE Global All-Cap vs FTSE All World

Both indices were launched in the early 2000s. Since the FTSE Global All Cap Index’s launch, it has trailed the FTSE All-World Index by nearly .50% annually. Not a huge amount, but it has added up over time.

Readers know that I like to examine different time periods as the results often change. Sure enough, the FTSE Global All-Cap vs FTSE All World chart shows performance is nearly identical. Over the past 10 years, the All-World has only outperformed by .10% annually.

Differences between FTSE Global All-Cap vs FTSE All World

These two indices are both provided by FTSE and they are nearly identical in many respects. The primary difference is that the Global All-Cap is more of a total market index. The Global All-Cap has 9,527 constituents, while the All World “only” has 4,172 constituents (all data as of 9/30/2022)

Geographic Exposure

Country Exposure

The top five countries are identical and even the weights are nearly identical, as of 9/30/2022.

Market Classification

The market classification split between developed and emerging markets is also identical! Data as of 9/30/2022.

Market Cap Exposure

Interestingly, the market cap data reveals some differences. As its name suggests, the FTSE Global All Cap covers more mid- and small-cap stocks (as of 9/30/2022)

Sector Weights

The sector weights between the two indices are also nearly identical, as of 9/30/2022.

Final Thoughts

These two indices are quite different in some ways, but not in ways that matter very much. The FTSE Global All-Cap is a much broader index than the FTSE All World (with more than double the number of constituents!). However, these indices are market-cap weighted, so the thousands of additional constituents does materially impact the geographic exposure, sector weights, or performance. This is very similar to the dynamic we find with the Russell 1000 and Russell 3000.

If I was deciding between these two indices as a benchmark, I’d be indifferent. That being said, US investors will be hard-pressed to even find a fund benchmarked to the FTSE All World. So the FTSE Global All-Cap may be the default choice in the US. For investors in the UK and other regions with both choices, factors like expenses, fees, taxes, and liquidity in small cap names (which the Global All-Cap owns a lot of!) may be the deciding factors. These factors are likely much more important than performance, since the two indices have very similar performance. Investors cannot invest in indices directly and should do their own research before deciding to invest in a fund that tracks either index.

Further Reading

Investors looking for global exposure from a non-FTSE index may want to look at the MSCI World or MSCI ACWI.

Of course, readers can also compare the differences between the FTSE Global All-Cap and MSCI ACWI.

NASDAQ Composite vs NASDAQ 100

The Nasdaq Composite Index and the Nasdaq 100 Index are two widely watched indices. Despite their popularity, people often confuse the two. “The NASDAQ” Composite Index is referred to in the news and displayed on websites/TV, while the NASDAQ 100 Index seems to be the benchmark for more investable funds and strategies. Despite their similar names, a comparison of the NASDAQ Composite vs NASDAQ 100 reveals some major differences.

The NASDAQ 100 and Composite have very different compositions, slightly different weights and exposures, and performance differences have reflected that.

A quick note that investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with an investable vehicle, such as the Fidelity NASDAQ Composite Index ETF (symbol: ONEQ) or the Invesco NASDAQ 100 ETF (symbol: QQQ). A reminder that these are simply examples as this site does NOT provide investment recommendations.

Historical Performance: NASDAQ 100 vs NASDAQ Composite

The NASDAQ Composite Index is much older with an inception date of 1970. The NASDAQ 100 Index was launched 15 years later in 1985. Since that time, the NASDAQ 100 has outperformed the NASDAQ Composite by a wide margin.

I reviewed NASDAQ Composite vs NASDAQ 100 charts from different timeframes and found the same results. The Composite has generally performed equal to or better than the 100 over all of the timeframes that I examined.

Differences between NASDAQ Composite and NASDAQ 100

Overall, the two indices are very similar, since they are both based on the same universe of stocks. The Composite includes all securities listed on the NASDAQ exchange (over 3,700 as of Q3 2022!) , while the NASDAQ 100 includes the largest 100 stocks (technically 103 as of Q3 2022) after excluding financial stocks. The NASDAQ site publishes the index methodologies for both the Composite and 100.

Geographic Exposure

Substantially all (95%+) of each index is composed of US-based companies, so I will not include the usual tables of countries, market classification, and so on.

Market Cap Exposure

The NASDAQ 100 in composed of the 100 largest stocks on the NASDAQ exchange (excluding financials), so it has a much larger weighting to large-caps than the Composite. However, both indices use methodologies based on market-cap weighting, so large-caps dominate each index.

Below is an estimate of the market cap exposure as of 9/30/2022.

Sector Weights

Given that the NASDAQ Composite is a much broader index versus the NASDAQ 100, it is not surprising that the Composite covers more sectors and is less concentrated that the 100. Below are the sector weightings of the two indices, as of 11/2/2022.

Final Thoughts

Despite “The NASDAQ” Composite’s popularity, there are relatively few investment vehicles benchmarked to it, so many investors may just default to the NASDAQ 100 because its easier. This reminds of “The Dow” Jones Industrial Average which seems to be more popular with the general public, but is dwarfed by the S&P 500 in terms of benchmark use. Investors cannot invest in indices directly and should do their own research before deciding to invest in a fund that tracks either index.

Further Reading

Investors looking for large-cap exposure in the US may also want to consider the Russell 1000 or the S&P 500 or even the MSCI USA Index.

An international example of a widely followed index without a ton a vehicles benchmarked to it is the MSCI World ex-USA Index, while pales in comparison to the MSCI ACWI ex-USA Index.

Near-Term Forward Yield Spreads

Near-term forward yield spreads are an important indicator and one that investors, economists, and policymakers monitor closely. Even the Federal Reserve Chair, Jerome Powell, has indicated that he considers near-term forward yield spreads to be better than traditional yield curve indicators (such as the 2s10s yield spread).

What is a near-term forward yield spread?

Near-term forward yield spreads are calculated by looking at what a short-term yield is expected to be minus what what the short-term yield is today. For example, the rate that a 3-month Treasury bill is expected to yield in 18 months minus the rate on a 3-month Treasury bill today. The “implied” future yield in the first half of the equation is made by extrapolating other Treasury and fixed-income data and yields.

Do near-term forward yield spreads predict recessions better?

In a blog post and press conferences, members of the Federal Reserve have argued that near-term forward spreads may be better predictors of recessions and other economic indicators than more traditional yield curve spreads. If we focus on recessions, I do not think this is true.

The 3m forward spread has a decent record of predicting recessions. It has inverted just before the last three recessions, although it also inverted in 1998 (a few years before any recession). So it does have one false positive recession signal since inception.

However, the below chart of the 3-month 10-year yield spread shows no false positives. This curve has only inverted just before the onset of a recession. Thus, I continue to believe that the 3m10y curve is the best recession indicator.

At the moment, the near-term forward spreads are not inverted, while the traditional yield curve spreads are. If the near-term spreads do not invert in the next years, we’ll have one more data point in the battle for best recession indicator!

Alpha and Beta for investors

Alpha and beta are two of the most common words used in investing conversations. Interestingly, each has a technical finance definition as well as a more common meaning. However, it can be difficult to distinguish between alpha and beta in real life. Furthermore, several famous investors believe that a framework that relies of things like alpha and beta are flawed at best and dangerous at worst.

The definition of beta (β)

At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark could be an of index an entire asset class, a specific sector, or something else entirely. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index, it’s beta is .8. Beta is a measure of relative volatility.

The common meaning of beta

When used colloquially, the word beta usually has a different meaning than it’s technical definition. Beta often refers to the risk and return characteristics of a benchmark. Some examples:

  • US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500.
  • Investment grade bond beta is often synonymous with the Bloomberg Barclays Aggregate Index.
  • Tech beta may simply refer to a tech-sector ETF.
  • International beta could be the MSCI EAFE Index or MSCI ACWI ex-USA Index.

I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:

  • Utility sector beta is sensitive to interest rates.
  • An index fund may be called beta exposure.
  • An investor holds investment grade bonds and reports a -1% return while the Bloomberg Barclays Agg return is -3%. Some might say that the beta return was -3% (and alpha was positive 2%).
  • The Russell 1000 index is large-cap beta, while the Russell 2000 index is small-cap beta, and the Russell 3000 is total market beta (read our explainer on the differences between the Russell 1000, 2000, and 3000).

The definition of alpha (α)

Within the Capital Asset Pricing Model (CAPM), beta (as technically defined) is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, an asset with more volatility should have higher returns and an asset with lower volatility should have lower returns. Reality rarely unfolds as modeled, so another CAPM equation was created to account for the difference between reality and modeled outcomes. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:

  • An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
  • An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.

Distinguishing alpha from beta-rotation

One of the challenges for alpha is that it is difficult to prove. in fact, most alpha can be explained away. Consider the following three scenarios:

  • If an investor beats the market with a portfolio of anything besides an index, observers argue that the investor took more risk or different risks. They will explain that higher returns are not from alpha, but from different factors, higher beta, or what I call beta combinations.
  • If an investor beats the market by rotating sectors or adjusting duration, people will say, “That not alpha, that’s just beta rotation.”
  • If an investor buys assets at the lows or sells at the highs, academics will explain that the resulting outperformance is due to timing the market and exposure to systematic risk.

Generating alpha through any of the above activities can be explained away generally as beta rotation, but that does not negate the skill required and/or benefits gained. The much more important question is whether the actions and benefits can be consistently repeated to generate a material risk-adjusted return (net of expenses and taxes). Thus, finding that marginal return is much more difficult than labeling it as alpha or beta.

A side note that this is partially why hedge fund hurdle rates exist, to compensate managers for alpha above some defined level.

“Beware of geeks bearing gifts”

"Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas." -Warren Buffett

As usual, Buffett says it best. In his 2008 shareholder letter in the midst of the Global Financial Crisis, he wrote:

“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.”

Warren Buffett, 2008 Berkshire Hathaway shareholder letter

A few years later, he expanded on the idea and closed with joking nod to antiquity.

“…they had advanced degrees, and they look very alert, and they came with these — they came with these things that said gamma and alpha and sigma and all that. And all I can say is beware of geeks, you know, bearing formulas.”

Warren Buffett, CNBC interview

Summary of alpha & beta in investing

  • Beta is an asset’s volatility, relative to another asset or benchmark.
  • Alpha is an asset’s return above or below it’s benchmark, after controlling for differences in volatility.
  • Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics. 
  • It is often difficult to distinguish between alpha and beta-rotation or beta-combinations.
  • Investors should be knowledgeable about beta and alpha, but I do not believe they should become too reliant on these measures. To learn more about the the challenges of risk measurement, investors should read Taleb’s story about the Thanksgiving turkey.

MSCI World ex-USA vs MSCI ACWI ex-USA

The MSCI World ex-USA Index and the MSCI ACWI ex-USA Index may sound very similar, but they are quite different. MSCI ACWI ex-USA is fairly popular index, while the MSCI World ex-USA is relatively unknown. When comparing MSCI ACWI ex-USA vs MSCI World ex-USA, the primary difference is that ACWI ex-USA includes emerging market stocks while World ex-USA does not. This is consistent with the ACWI and World parent indices (which include the USA).

A quick note that investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with an investable vehicle, such as the iShares ACWI ex-USA ETF (symbol: ACWX). A reminder that these are simply examples as this site does NOT provide investment recommendations.

Historical Performance: MSCI World ex-USA vs MSCI ACWI ex-USA

Since the MSCI ACWI ex-USA Index’s inception in 2001, it has outperformed by an ever-so-slight .20% annually. Given that the primary difference between the indices is their exposure to emerging markets, it is no surprise that ACWI ex-USA outperformed during the first decade.

Given that emerging markets have underperformed for the last decade, it is no surprise that the MSCI ACWI ex-USA vs MSCI World ex-USA chart of the last 10 years indicates the reverse. Over this time period, the MSCI World ex-USA has outperformed by nearly 1% per year.

Current Index Composition: MSCI ACWI ex-USA vs MSCI World ex-USA

The main difference between the two indices is their inclusion/exclusion of emerging markets. However, the market cap exposure and sector weights are fairly similar, which partially explains why performance has been so similar.

Geographic Exposure

ACWI stands for All Country World Index and so the MSCI ACWI ex-USA includes stocks from a broader set of countries than the World ex-USA Index. The primary difference is the inclusion and exclusion of emerging markets.

Below are the top five country weights of the two indices, as of 9/30/2022. Note that China is not included in the World ex-USA’s top holdings.

Market Cap Exposure

The ACWI ex-USA is a much broader index with 2,274 constituents vs World ex-USA’s 887 constituents (as of 9/30/2022). Not surprisingly, the mean and median market cap of ACWI ex-USA constituents is roughly half of World ex-USA’s. However, both indices are market cap weighted, so they up both being large-cap indices (which helps explain their very similar performance).

Sector Weights

As of 9/30/2022, the sector weights on the two indices are very similar.

Concluding Thoughts

Investors cannot invest in indices directly and should do their own research before deciding to invest in a strategy that tracks either index. Below are a my personal thoughts on this comparison of MSCI World ex-USA vs MSCI ACWI ex-USA:

  • The comparison might not even matter that much, since the MSCI World ex-USA Index is not a common benchmark. This is reminiscent of the NASDAQ Composite Index, which is widely followed but has relatively few vehicles benchmarked to it (versus the NASDAQ 100)
  • Selecting the MSCI ACWI ex-USA Index over the MSCI World ex-USA Index is simply a bet on emerging markets. That is main difference between the indices as the other weights and exposures are quite similar.
  • The performance differences have not been that wide and the resources used to select the “best” benchmark might be better spent on considering differences in the investment strategy (such as expenses, transaction costs, tax efficiency, and so on.

Further Reading

Investors who want to evaluate non-MSCI global indices may want to read my comparison of the FTSE Global All Cap ex US vs FTSE All World ex US indices.

Investors who want a global benchmark with US exposure should read my comparison of the MSCI ACWI vs MSCI World (the parent indices of the two compared in this post) or my comparison of the FTSE Global All Cap Index vs MSCI ACWI.