Benjamin Franklin astutely observed in 1789 that "…in this world nothing can be said to be certain, except death and taxes," but investors can use the latter to their advantage to potentially increase the value of their portfolios. There is often a substantial difference between a portfolio's pre-tax performance and its after-tax performance, and if investors take an active approach to tax management as part of their investment strategy, they can reap significant rewards over the long term.
Envestnet PMC's Capital Sigma: The Return on Advice study published in May 2016 found that managing an all-equity portfolio for tax optimization can add about 100 basis points in annual value. Tax management, or "tax-loss harvesting," typically involves monitoring a portfolio to identify capital losses which can offset capital gains in other parts of the portfolio. This tactic offsets capital gains taxes, which reduces the amount of taxes an investor has to pay and adds that tax savings back into the portfolio as extra alpha, in this case "tax alpha."
Don't scoff at the potential to add 100 basis points in value per year. If your $100,000 investment portfolio earns 100 basis points in tax alpha, you have $1,000 in tax savings which you can then invest and grow. Like any annual return, tax alpha can add up over time, providing investors with quite a bit of extra savings that they can put to good use in retirement, when every little bit of income helps.
Buy-and-Hold Isn't Enough
The simplest way to generate tax alpha is to deploy a buy-and-hold investment strategy. If you don't buy or sell securities during the year, then you don't have to worry about capital gains and losses. However, this passive approach will often only deliver the minimum tax alpha.
As an experiment, our quantitative research team constructed a buy-and-hold test portfolio tracking the Russell 1000 Index, and analyzed the impact of an active tax management strategy on its performance from January 1995 through December 2014. During the 20-year period, the portfolio generated average tax alpha of about 40 basis points per year on its own, and approximately 60 basis points each year when a strategy for harvesting tax losses was applied.
To further demonstrate the difference, the value of $1 in the buy-and-hold portfolio increased to $3.15 between Dec. 30, 1997 and Dec. 31, 2014, but the execution of a tax management approach pushed the value of $1 to $3.48 by the end of that period.
Given the importance of an active tax management approach for maximizing tax alpha, investors should make sure any financial advisor they sign with rebalances and monitors their taxable portfolio using tax-loss harvesting screens and perspectives. Investors should also figure out their tax bracket, which depends on the state where they live, and work with their advisors to devise methods for generating the amount of tax savings they would need to add tax alpha (investors in high-tax-bracket states like California and New York would have to offset the most capital gains to achieve alpha). In addition, investors and advisors can work together to avoid incurring tax-loss harvesting infractions under the Securities and Exchange Commission's (SEC) wash-sale rule, which prevents investors from buying an identical or similar security for at least 30 days after a sale.
Besides keeping tax brackets and the SEC wash-sale rule in mind, investors and their advisers can seek out products from asset managers that emphasize tax management as part of their investment approach. Managers who actively seek to limit portfolio turnover and prevent overtrading, and evaluate tax-loss harvesting opportunities by weighing potential benefits against risk and trading costs, are clearly dedicated to creating tax-smart portfolios for investors—and investors and their advisers can adopt these tactics when monitoring and rebalancing their own portfolios.
SMAs are More Tax-Efficient Than ETFs
While many investors prefer exchange-traded funds (ETFs) to mutual funds because of their cost and tax advantages, the ETF structure prevents investors from deferring capital gains or performing tax-loss harvesting at the security level. The passive management and low portfolio turnover of ETFs help minimize taxable gains and losses, but an ETF also can't deviate from its underlying index's predetermined weights for holdings, giving investors no say over portfolio securities and allocations.
Also, investors can't use an ETF's internal losses to offset gains elsewhere in their overall portfolios.
However, asset managers are increasingly offering access to hedge fund and mutual fund strategies through separately managed accounts (SMAs), which, in addition to requiring lower minimums from investors, enable investors to execute tax-loss harvesting strategies that align with their specific tax situations. SMAs also allow investors and their advisors to customize holdings and allocations, and therefore defer capital gains and harvest security-level tax losses. And unlike ETF losses, SMA losses can be used to offset gains anywhere in an investor's overall portfolio.
With potential changes to the U.S. tax code back in the headlines, investors and their advisers should investigate how they can harvest portfolio losses to generate tax savings and add extra alpha to their portfolios over time. Benjamin Franklin wisely noted that taxes are one of only two certainties in our world, but if investors understand how to manage a tax-smart portfolio, they can use that certainty to accomplish something positive—creating more income to enjoy in retirement.
Brandon Thomas is the co-founder and chief investment officer of Envestnet PMC, and co-chair of the Envestnet PMC Investment Committee.