Private funds slash after-tax returns to 6.6%, index funds deliver 8%

Private funds returned 6.6% annually after tax over the past decade, trailing a simple index fund basket that delivered 8%, as advisers push $2 trillion into alternatives.

"The after-tax returns on private assets are lousy," said John West, co-founder of Flatrock Wealth Partners, an investment-advisory firm in Newport Beach, California.

West replicated a typical university endowment portfolio — roughly 50 percent in alternative funds including private equity, private credit, real estate, venture capital and hedge funds — and found it returned 8.6% annually pretax. After federal and state taxes plus the federal net investment income tax, an upper-income investor would have earned 6.6%. A basket of two stock-index ETFs and one municipal-bond fund returned nearly the same pretax figure but 8% after tax.

Cerulli Associates estimates financial advisers could push $2 trillion of client assets into alternative investments over the next five years. With individual investors facing federal tax rates at least four times the 8% cap Congress imposed on university endowments in 2025, the tax drag on private fund returns could cost upper-income investors hundreds of billions of dollars.

The tax gap stems from structural differences in how the two approaches generate income. Index ETFs holding publicly traded stocks produce minimal taxable events for as long as an investor holds them, with dividend income typically low and capital gains deferrable at will. Private-credit funds specialize in high-interest loans, many hedge funds trade rapidly and generate short-term capital gains taxed at ordinary income rates, and private-equity funds produce large payouts when they sell portfolio companies. Private real estate and other alternative strategies also tend to generate substantial tax bills.

Andrew Ang, a former managing director at BlackRock who now runs Tau Balance, a financial-planning software and research firm in New York, found that over the past century, federal income taxes reduced the 10.5% average annual return on U.S. stocks to 7%. For private funds, Ang estimates a "reasonable assumption" is that an upper-income investor's after-tax return would be roughly one-third lower than the reported pretax return.

The Yale Model Under Tax Pressure

The "Yale model" — named after David Swensen, who managed the Yale University endowment until his death in 2021 — has long been the template for institutional investing in private assets. Over the 35 years ended June 30, 2020, Swensen steered Yale to a 13.1% average annual return, far surpassing the 8.8% on a conventional 60% stock, 40% bond portfolio. But applying Ang's one-third tax haircut, that epic return falls to about 8.7% annually after tax — still better than the less than 6% after-tax return on the 60/40 portfolio, but a reminder that taxes cut even the best investors down to size.

West's study may actually understate the tax impact. Over the 10 years ended June 30, 2025, the median educational endowment returned 7.6% annualized, according to the National Association of College and University Business Officers. Among the largest endowments with more than $5 billion in assets, the median return was 8.9% annualized — figures that West's simulated portfolio of 8.6% pretax already exceeds.

Where $2 Trillion in Alternatives Could Land

Wall Street is pushing hardest to get alternative funds into 401(k)s and other retirement accounts where taxes would be deferred. But dozens of Wall Street Journal readers have told columnist Jason Zweig that their financial advisers are prodding them to put these funds in taxable accounts. West said he has seen "precious little evidence" that advisers are using them predominantly in tax-sheltered accounts.

The implications for individual investors are significant. If advisers move $2 trillion into alternative assets over the next five years as Cerulli projects, and a meaningful portion lands in taxable accounts, the tax drag could erode returns by roughly one-third for upper-income investors. Promoters will argue that the best private funds outperform — but no one knows in advance which fund will end up on top, and individual investors rarely gain access to the best private performers anyway. The lesson from West's analysis is straightforward: for taxable investors, the complexity and fees of private funds may not be worth the tax bill that comes with them.

This article is for informational purposes only and does not constitute investment advice.