Taxes may be cut under President-elect Donald Trump, but they aren't going away. That's the key thought that advisers should keep in mind as they consider adapting investment strategies for their clients in the midst of potential tax law changes.
In tax-managed separately managed accounts (SMAs), tax alpha is often earned through systematic loss harvesting and gain deferral. We estimate the value of tax management to be between 1% and 2% annualized over a 10-year period. In general, tax benefits are higher in markets characterized by lower returns and higher volatility. While the proposed tax cuts could result in relatively less capital gains, we believe that tax efficient strategies still play an important role in investors' portfolios.
Mr. Trump's tax plan includes a proposal to lower the highest marginal income tax rate and remove the 3.8% investment income tax. For top-bracket tax payers, the effective tax rate for short-term capital gains could drop from 43.3% to 33%, while long-term capital gains tax rates could fall from 23.8% to 20%. If successful, Mr. Trump's tax plan would result in relatively less tax per dollar, but the benefit from tax management is still considerable.
As a reference point, the proposed tax rates are comparable to what investors experienced for nearly a decade during the era of the Bush tax cuts and President Obama's subsequent extension of these cuts. From 2003 to 2012, short-term capital gains were taxed at 35% while long-term gains were taxed at 15% (a scenario similar to Mr. Trump's proposals). Yet even over a period when tax rates were relatively lower, tax-managed equity strategies still delivered meaningful tax alpha. Here are the reasons why tax-managed SMAs are still valuable even if tax rates are heading downwards:
• Make the most out of uncertainty.
Change was a key piece of Trump's campaign and inherent in change is uncertainty about what the future may have in store. Historically, markets have tended to react to uncertainty with volatility as investors adjust prices according to their evolving views. And while market volatility may rattle investors' nerves, the silver lining is that a tax-managed account can help them take advantage of it. A temporary market dip represents a loss-harvesting opportunity for a skilled and disciplined manager to capitalize on. In addition to being a winning long-term strategy, tactical tax management can take advantage of heightened short-term market volatility.
• Lower cost to transition.
A tax cut may help investors with a concentrated holding make the decision to transition to a more diversified portfolio. While an investor may see the benefits of diversification, a highly appreciated concentrated holding comes with a tax cost. If a high tax cost was holding the investor back before, a reduction in tax rates may be a good opportunity to revisit the analysis. A similar line of thinking applies for an investor holding on to a basket of appreciated securities they no longer like. With a lower tax cost, a transition becomes more attractive especially if it can be done thoughtfully within an SMA. To assist with this decision, we are able to run a transition analysis to show the overlap between the existing portfolio and the desired end-state, and a cost-benefit analysis between realized gains and tracking error.
• Custom-tailored for a better fit.
Finally, while much of this discussion has focused on the tax-benefit aspects of the SMA, we find that more and more of our clients take advantage of non-tax-related features such as customization. For example, our clients are applying business-involvement screens, pursuing factor tilting and in some cases excluding certain sectors in order to align with their values, achieve a particular investment goal or diversify around other parts of their larger portfolio. In fact, more than 30% of the tax-managed SMAs that we manage include some type of customization.
Whether Mr. Trump is successful with his plan to lower taxes, advisers should keep in mind that the proposed tax cuts do not eliminate the importance of tax management. While we can't foresee what the next four years may bring, we know that one thing under our control is the disciplined deferral of gains and routine harvesting of losses. Further, because the benefits of tax management are maximized within an SMA, we think it's even more critical that advisers look to utilize this vehicle under a possibly lower tax regime in order to capture every possible basis point of value for their clients. No matter who is serving as president, future returns are always uncertain, but taxes are one thing you can count on to stay.
Rey Santodomingo is managing director of investment strategy, tax managed equities Parametric Portfolio Associates, a global asset management firm headquartered in Seattle.