A donor-advised fund (DAF) is an investment account that allows you to take a tax deduction now and give the money to charity later. When you give money to a DAF, you can deduct that money just as you would deduct a charitable contribution. The DAF invests the money tax-free until you are ready to donate it to charity. But DAFs only allow limited investment options. How can we best make use of a DAF to optimize expected investment performance?

## Caveats

Before we decide how to invest in a DAF, first we must ask: Should we use a DAF at all? Or should we keep our money in a taxable account? Or should we simply donate it all right away? The answer depends on the circumstances. I review some pros and cons of DAFs in Donor-Advised Funds vs. Taxable Accounts for Patient Donors. In this essay, I will assume we’ve already decided to use a DAF.

I only cover DAFs in the United States because that’s what I’m familiar with. Many other countries probably have similar investment vehicles.

I am not a lawyer or an investment advisor and none of this should be taken as legal or investment advice. Past performance does not indicate future results. This content is for informational purposes only. Please do your own research or seek professional advice and otherwise take reasonable precautions before making any significant investment decisions.

## What investment options do DAFs provide?

The three most prominent donor-advised fund providers are Vanguard Charitable, Schwab Charitable, and Fidelity Charitable. A fourth provider, Greater Horizons, is worth including for reasons we will discuss below. All four DAF providers charge similar fees. Fees matter, but these four providers have similar enough fees that we can ignore them for now.

The providers offer index funds covering the following markets:

Fidelity Schwab Vanguard Greater Horizons
US stocks
US small-cap
international stocks
Europe stocks
Pacific stocks
emerging stocks
US bonds
international bonds
TIPS
money market

Leveraged ETFs tend to cost more than other types of leveraged investments. In a previous essay, I estimated that leveraged ETFs on average cost about 2% plus the risk-free rate (although the exact number varies a lot over time). Investment managers typically charge around 1% for small(ish) investors and 0.5% for large investors, so holding leveraged ETFs in a managed account will cost 2.5 to 3 percentage points more than investing in a DAF’s pre-selected funds. Fidelity Charitable allows you to self-manage your DAF if you have over $5 million, so you could cut out the advisor fee. For truly risk-neutral investors, this is probably worth it. Under most plausible assumptions, leveraged ETFs have a high enough expected return to make up for the cost. For investors with logarithmic utility (which is probably still too aggressive for individual investors, but might be appropriate for altruists), the higher cost of leveraged ETFs probably cancels out their higher expected utility. (For details, see The True Cost of Leveraged ETFs.) ## Factor funds (with a managed account) The value and momentum factors have historically predicted stock performance. (There are some other factors as well, such as size, low-volatility, and quality. These aren’t as well-supported as value and momentum, but they might be worth incorporating.) Some ETFs and mutual funds provide exposure to these factors. With a managed account, your investment advisor could use factor funds to try to outperform the market. Factor funds (at least the good ones) are much cheaper than leveraged ETFs. To be worth buying, factor funds need to outperform the market after both fund expenses and the advisor’s fee. That’s probably achievable in expectation. You can run asset class momentum yourself (and skip the advisor’s fee), so it seems less likely that a factor fund portfolio can outperform asset class momentum after costs. But using an advisor means you don’t have to do any work, and the time savings might justify the extra cost. ## Concentrated stock picking (with a managed account) If we’re willing to take heavier bets on value and momentum, we can concentrate our investments in a small number of value/momentum stocks (follow the link for a more detailed explanation). Backtests suggest that the top 10% of small-cap value and momentum stocks earned about double the return of the market before fees (with more than 1x the volatility of the market, but less than 2x). A portfolio of individual stocks would have to pay trading costs plus a management fee. This would probably cost less than a leveraged ETF, but definitely more than an un-managed DAF portfolio. How good is a concentrated value/momentum strategy? That depends on how well we expect the value and momentum factors to perform in the future. It seems likely that they will continue to work at least to some extent, and the value factor in particular looks attractive relative to history (as of early 2021). Still, it’s difficult to forecast future performance. But even if a concentrated value/momentum strategy has zero risk-adjusted premium over the market, it should still outperform a leveraged ETF by having lower costs. A related approach: Instead of buying individual value/momentum stocks or a set of diversified factor funds, we could buy a concentrated mutual fund or ETF that looks particularly attractive. For example, as of this writing, the Russian stock market looks cheaper than almost any other market, so we could buy the iShares MSCI Russia ETF (ERUS). Buying ERUS is the same basic strategy as buying an emerging market index fund as discussed previously, but it’s higher risk and has the potential to deliver a higher return. We can’t get as much concentration with an ETF as with a basket of stocks, but this approach has the advantage that we only need to buy one thing. # (Even more) advanced ideas ## Create a new DAF Legally, any registered charity can operate a DAF. (At least that’s my understanding from reading IRS guidelines.) The charity just needs to accept money from donors, invest that money, and allow donors to recommend grants to other charities. But it’s a lot of work to set up all the necessary infrastructure. A sufficiently motivated organization can do it if they believe they’ll get enough assets under management to justify the effort. Charities have to abide by certain legal restrictions about how they can invest, but the restrictions are not well-specified and I don’t understand them very well. A new DAF might be able to provide better investment options than any of the ones I’ve discussed so far, or it might not, depending on the legal situation. ## Launch a new leveraged fund The leveraged ETFs on the market today have some problems that make them less than ideal for long-term investing. But a new leveraged ETF or mutual fund could fix these problems. In particular: 1. Existing leveraged ETFs charge high fees. Most people who buy leveraged ETFs use them for short-term trading, so they don’t care much about the fees. But these ETFs have high profit margins, so a few fund could undercut them while still making a profit. 2. Existing leveraged ETFs rebalance daily. A long-term risk-friendly investor doesn’t need their account to perfectly track the leveraged index on a daily basis. A new leveraged ETF could rebalance less frequently (perhaps monthly), which would reduce trading costs. 3. Existing leveraged ETFs focus on a single market or sector. This makes each individual fund riskier. It also means an investor who buys multiple leveraged ETFs will need to rebalance their holdings manually. But a new leveraged ETF could invest in the global market portfolio (or something like it). That way, long-term investors could buy a single fund and would never need to rebalance. Investors with a minimum of around$25 to $50 million could sponsor the creation of a new leveraged fund. Such a fund might be a better way to invest than any of the other options we’ve discussed. # Comparing the choices Confidence: Possible So far we’ve looked at seven investment strategies that might perform better than the global market portfolio: 1. Buy and hold an emerging markets index fund. 2. Run asset class momentum on the pre-selected asset classes. 3. With an investment manager, buy and hold leveraged ETFs. 4. With an investment manager, buy and hold some factor funds. 5. With an investment manager, invest in a concentrated basket of value/momentum stocks or a concentrated ETF. 6. Create a new DAF that offers more investment options. 7. Sponsor the creation of a new leveraged ETF or mutual fund. I don’t know what legal restrictions would apply to a new DAF, so I can’t say much about that idea. Creating a new leveraged fund looks like the best option, but isn’t possible for most investors. Existing leveraged ETFs seem not worth buying. That leaves four choices: buying an emerging markets fund, running asset class momentum, buying factor funds, or buying a concentrated basket of stocks. Investors who do not meet the minimum requirement for a managed account (usually$250,000) must pick between the first two choices.

When possible, I would prefer to invest in a concentrated basket of stocks. Historically, they offered substantially higher returns than the market, and I expect this to continue (although probably to a lesser extent). Buying and holding factor funds is less risky, but also has worse expected return. You’ll have a much easier time finding an investment advisor who’s willing to buy factor funds, so it might be a more realistic option. (Buying factor funds is a pretty normal thing that lots of advisors do. Buying a few dozen deep value/momentum stocks is a weird thing that almost nobody does.)

Between the two strategies that do not require a professionally managed account—asset class momentum and an emerging markets index fund—I lean toward asset class momentum, for three reasons:

• Asset class momentum diversifies across multiple asset classes. All else equal, diversification is good.
• According to backtests I ran, if we went back in time to 1990 and bought the asset class that performed best over the next 30 years, we still would have underperformed asset class momentum. Even with perfect foresight, asset class momentum still beat buy-and-hold.23
• According to my (very unreliable) future return projections, asset class momentum has a higher expected return than emerging markets.

I don’t put much credence in the last two points, but they provide at least weak evidence in favor of asset class momentum.

On the other hand, it seems hard to deny that emerging markets currently have a higher expected return than other parts of the world. Asset class momentum seems likely to continue working, but I’m not quite as confident about that. Holding an emerging markets funds has the added advantage that you never have to rebalance, so if you want to do as little work as possible, it might be a better choice.

# Appendix: More ideas

## Hire an advisor and let them decide how to invest

In general, this is a bad idea. Most investment advisors cannot outperform the market, and they’ll charge you a fee for essentially no added value. You’d be better off using the DAF’s pre-selected funds to build the global market portfolio (or get as close to it as you can).

If your advisor is familiar with the research on value and momentum investing, they’re more likely to invest your money well.

## Find an advisor who can generate alpha

It’s not too hard to find an investment advisor who can build you a portfolio of value/momentum factor funds that’s better than the global market portfolio. But it’s much more difficult to find someone who can generate true alpha on top of those factors. A few such people probably exist, but they’re nearly impossible to identify before the fact. In general, I don’t think it’s worth trying, although there might be exceptions.

# Notes

1. I spoke to representatives at each donor-advised fund and to a few financial advisors who manage DAFs. Based on those conversations, it appears that Greater Horizons offers the most flexibility.

2. Unfortunately, the legal requirements are not clear. A DAF provider has a fiduciary duty to make prudent investments, and it’s largely up to courts’ interpretation as to what this means. DAF providers disallow investments that they think might violate fiduciary duty. For more, see the FDIC Trust Examination Manual: Investment Principles, Policies and Products

3. Faber (2012). Global Value: Building Trading Models with the 10 Year CAPE. For more detail, see Faber’s book on the same subject, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market

4. Asness, Moskowitz & Pedersen (2013). Value and Momentum Everywhere.  2

5. Lakonishok, Shleifer & Vishny (1993). Contrarian Investment, Extrapolation, and Risk.

6. Lewellen (2011). Institutional Investors and the Limits of Arbitrage.

7. Shleifer & Vishny (1997). The Limits of Arbitrage.

8. Jedageesh & Titman (2011). Momentum.

9. Fama & French (2008). Dissecting Anomalies.

10. Berger, Israel & Moskowitz (2009). The Case for Momentum Investing.

11. D’Souza,, Srichanachaichok, Wang & Yao (2016). The Enduring Effect of Time-Series Momentum on Stock Returns Over Nearly 100-Years.  2

12. Lempérière, Deremble, Seager, Potters & Bouchaud (2014). Two Centuries of Trend Following.

13. Babu, Levine, Ooi, Pedersen & Stamelos (2019). Trends Everywhere.

14. Antonacci (2016). Risk Premia Harvesting Through Dual Momentum.

15. Faber (2010). Relative Strength Strategies for Investing.  2

16. Moskowitz & Grinblatt (1999). Do Industries Explain Momentum?

17. Blitz & van Vliet (2008). Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes.

18. This list does not include the international stock fund because that fund is simply the sum of the Europe, Pacific, and emerging stock funds. Unlike Antonacci’s Dual Momentum, I treated bonds as a risky asset. I believe Antonacci’s backtest makes bonds look better than they are because bond yields consistently decreased for most of the tested period. It makes more sense to use a money market fund as the risk-free asset.

19. We should expect the asset class momentum premium to shrink for two main reasons:

1. Bond yields are lower than they were in the backtest period. That reduces how much return an asset class momentum strategy can earn when it’s not holding stocks.
2. Momentum strategies have become more popular, which could cause them to perform worse going forward.

The first point seems hard to dispute. Regarding the second point, as a simple rule of thumb, we could assume the premium will decline by half24. Relevant research:

• McLean & Pontiff (2016)25 found that published anomalies historically shrunk by 58% after publication, of which 26% could be attributed to data mining, and 32% to markets becoming more efficient.
• Jensen, Kelly & Pedersen (2021)26 expanded McLean & Pontiff’s research and found about a 1/3 decline post-publication, all of which could be attributed to data mining.
• Blitz (2017)27 found that ETFs do not harvest the momentum premium28.

Asset class momentum appears more likely than stock momentum to survive increasing popularity because (1) it trades larger, more liquid positions, and (2) most momentum investors use stock momentum, not asset class momentum. So arguably we should make a more optimistic assumption.

20. I came to this expected return figure as follows:

1. As a baseline, assume Dual Momentum will perform as well as the average of the US and international stock markets. If we take the median of AQR’s and Research Affiliates’ projections, we get an expected return of 3.4%.
2. Based on backtests, the historical Dual Momentum premium was about 6%. Halve this to get 3% and add to the baseline performance for a total expected return of 6.4%.
3. Subtract 1% for transaction costs to get 5.4%.

21. I backtested two different pairs of asset classes: (US stocks, global ex-US stocks) and (US stocks, Japan stocks). I specifically chose Japan because Japan had the weakest performance of any major stock market over the sample period. If asset class momentum over (US, Japan) outperformed US stocks alone, that would give the strongest possible evidence in favor of asset class momentum that my data set could produce. And indeed, it turned out that asset class momentum did (slightly) outperform. I don’t consider this strong evidence in an absolute sense, but it’s the best I can do given the data I have access to (I used the Ken French Data Library).

22. In How Can a Strategy Everyone Knows About Still Work? , Cliff Asness suggests making this “conservative” assumption.

23. McLean & Pontiff (2016). Does Academic Research Destroy Stock Return Predictability?

24. Jensen, Kelly & Pedersen (2021). Is There a Replication Crisis in Finance?

25. We might be interested in how hedge funds behave rather than ETFs, because hedge funds probably represent more ‘savvy’ investors. I am not aware of any research on whether hedge funds in aggregate exploit the momentum premium. But another 2017 study by Blitz, Are Hedge Funds on the Other Side of the Low-Volatility Trade?, found that hedge funds systematically reverse load on the low volatility premium (that is, they take the losing side of the trade), which weakly suggests they may do the same for momentum.