Tax Planning

Tax-managed SMAs are still a best practice despite possible tax cuts

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

Jan 3, 2017 @ 5:00 pm

By Rey Santodomingo

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.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Mar 14

Conference

WOMEN to WATCH

InvestmentNews is honoring female financial advisers and industry executives who are distinguished leaders at their firms. These women have advanced the business of providing advice through their passion, creativity, inclusive approach and... Learn more

Featured video

INTV

Regional brokerages are picking up assets, advisers from wirehouses

Senior columnist Bruce Kelly discusses with deputy editor Bob Hordt the impact of big brokerage houses pulling back on recruiting and regionals promising recruits less bureaucracy.

Latest news & opinion

SEC, Finra investigating GPB fund raising: sources

Regulators are making inquiries into GPB and the broker-dealers that sold their fund shares, according to sources.

ETrade launches national adviser referral network

Giving advisers access to millions of retail investors expands the discount brokerage's move into the custodial space.

10 best cities to buy rental properties

These cities have the worst ROI when it comes to rental properties.

UBS sues Ohio National over lost variable annuity commissions

Wirehouse joins handful of other firms seeking to prevent insurer from cutting off flow of adviser trails.

Regional broker-dealers quietly making comeback now, but the future remains uncertain

After a period of decline, the regional brokerage industry is scoring recruiting gains at the expense of wirehouses.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print