To cushion tax shock, advisers urged to act

Investors experience heavy losses, distributions

Nov 2, 2008 @ 12:01 am

By Jeff Benjamin

As mutual fund investors brace for a likely double whammy of negative performance, coupled with above-average income and capital gains distributions, financial advisers are homing in on all manner of tax management to try to cushion the blow and add some value in a dismal market environment.

"Right now, you have to take all the losses you can and position clients for a recovery," said Herb Morgan, president and chief executive of Efficient Market Advisors LLC in San Diego.

Mr. Morgan, whose firm manages $1.2 billion for clients, said that tax management "is incredibly important right now" and that advisers need to have a strategy in place for capturing investment losses without radically altering their investment strategies.

Tax management is especially important in a down market cycle, according to Bert Whitehead, president of Cambridge Connection Inc. in Franklin, Mich.

"For every $10,000 worth of investment losses we can harvest, we're saving our clients about $2,000 in taxes, and it's important to show clients how much money you are saving them in times like these," explained Mr. Whitehead, who charges clients on a retainer and flat-fee basis.


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Mr. Whitehead, who uses separately managed accounts for his larger client accounts, compared the current market cycle to the period right after the end of the tech market bubble in 2000.

"We were able to help clients carry forward $200,000 in tax losses," he said. "Before the end of this year we'll be going into those separate accounts again to harvest losses."

Tax law limits a net investment loss to $3,500 per year, but the investment losses can be used to offset gains. The tax losses can also be carried forward to offset taxable gains in future years.

A greater focus on tax risks could play directly into the hands of the separately managed accounts industry, according to Greg Verfaillie, senior vice president at Curian Capital LLC, a Denver-based SMA platform.

"We've seen a significant in-crease in advisers gravitating toward separate accounts to take advantage of the tax-loss harvesting," he said.

Last year 44% of Curian's taxable accounts took advantage of the tax-loss harvesting capabilities, reflecting a 100% increase over 2006, Mr. Verfaillie said.

The average tax savings contributed 1.26% of additional investment return, he said.

In tax management parlance this is known as tax alpha, a concept expected to gain appeal in what will likely be a difficult period for the financial markets.

"It has been a bit mystifying to me that investors haven't focused more on after-tax returns," said Don Peters, who manages several tax-efficient strategies at T. Rowe Price Group Inc. in Baltimore.

"If you're a taxable investor, you could lose between 2% and 2.5% per year when you incorporate the distributions from mutual funds," he added. "Clearly, people hate the mutual fund distributions when the markets are down, but they should care about it all the time."

For advisers overseeing taxable accounts invested in mutual funds, this is expected to be a bountiful year for tax-loss harvesting, according to Tom Roseen, a Denver-based senior research analyst with Lipper Inc. of New York.

"We just got through a very long period of prosperity, and those four or five years of positive returns can accumulate a lot of capital gains," he said.

According to the Investment Company Institute in Washington, 2007 was a record year for mutual fund capital-gains distributions at $415 billion, and the industry's $326 billion total in 2000 was second highest.

While 2008 distributions are not expected to reach last year's record level, the fact that the average domestic equity mutual fund is already down more than 30% for the year places even more emphasis on tax management strategies.

"This is a golden opportunity for advisers to do a couple of things: harvest losses and show clients that you can still keep them in the market," said Troy Van Haefen, owner of Nashville-based Van Haefen Financial Management, a firm that advises on a flat- and retainer-fee basis.

He intends to move clients out of mutual funds prior to their yearend capital-gains distributions, move those assets into a comparable index or exchange traded fund for 31 days to avoid the wash-sale penalty and then repurchase the original fund.

"The clients will see a little silver lining during a down time," he said. "I think tax efficiency is extremely important in any type of environment, but now is a great time to reposition things to make the overall portfolio more tax efficient."

Mutual funds are required to pass through to investors realized capital gains at least annually. Ironically, a lot of those gains are being logged this year as the result of investor redemptions that forced portfolio managers to liquidate positions.

Most fund companies don't post their distributions until the end of the year, but that doesn't mean financial advisers have to wait until that point to start thinking about tax management, according to Duncan Richardson, chief equity investment officer at Eaton Vance Management in Boston.

"It's amazing how tax management is such an evergreen value-added," he said. "And it's not unpatriotic to arrange your affairs so you can manage your taxes."

Eaton Vance, which has $144 billion under management, is among the fund industry's leaders in the area of tax-efficient strategies with $40 billion of those assets in tax-managed portfolios.

"In an environment where you can hang your hat on the chances of taxes going up, particularly if the election polls are right, this is a great time for advisers to be thinking about tax management," Mr. Richardson said.

He added that advisers should consider asset location before asset allocation, pointing out that such income-generating products as bond funds will result in a bigger tax hit than equity funds and should therefore be held in qualified retirement accounts.

The focus on taxes also pits actively managed mutual funds against index funds and ETFs, a battle that active funds rarely win, according to Sue Thompson, a principal at Barclays Global Investors of San Francisco.

"Nothing in this market supports active management versus an index," she said. "In a secular bear market like this, there's little you can control, except the cost of taxes."

E-mail Jeff Benjamin at


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