Tax Management and Tracking Error: You Can’t Have One Without the Other

Investors may bristle at the mere mention of tracking error—but that’s what helps them keep more of their money while maximizing their after-tax returns.

Two words may set off more alarm bells with investors than any others: taxes and tracking error. Investors in separately managed accounts (SMAs) find themselves hearing those hot-button words from their advisors on a regular basis. That’s why it’s vital to help clients manage their taxes while also understanding the role that tracking error plays in potentially lowering their tax burden. Once investors understand how tax management and tracking error work hand in hand, the alarm bells fade away.

The importance of tax management

Taxes can have a major impact on the long-term growth of a portfolio. For many high-net-worth investors, taxes can represent a larger drag on returns than fees or trading costs. The timing of cash flows and the gains or losses embedded in the portfolio can also affect the long-term growth of a portfolio.

While many managers ignore investment taxes and focus instead on pretax performance, it’s after-tax returns that truly matter for taxable investors. Any opportunity to moderate taxes is a welcome one, and that’s what tends to draw investors to tax-managed SMAs.

SMAs allow taxable investors to focus on managing their after-tax returns by using realized losses on the sales of individual securities to offset gains in their overall investment portfolio. Investors can also use SMAs to pursue additional tax management strategies, like matching gains and losses, accelerating the realization of gains, transitioning assets, or gifting specific tax lots to charity. Because SMAs allow investors to select the type of tax management that meets their needs, they’ve become a popular tool for taxable investors.

The role of tracking error in tax management

But by choosing to use a tax-managed SMA, investors will inevitably experience tracking error. This may be an uncomfortable concept for investors who don’t want an error showing up in their portfolio. But tracking error isn’t actually an error, nor is it necessarily good or bad. It merely measures how closely a portfolio tracks its benchmark. 

Tracking error is formally defined as the standard deviation of the difference between the portfolio returns and benchmark returns, or the dispersion of the excess portfolio returns compared with its benchmark. It’s typically expressed both as an annualized number and as a percentage. For example, a portfolio might have a tracking error relative to its benchmark of 1% per year. For a portfolio with a normal distribution of excess returns and an annualized tracking error of 1%, we can expect its return to be within 1% of its benchmark return approximately two out of every three years.

Managed portfolios, like SMAs, behave slightly differently from their benchmark indexes on a day-to-day, month-to-month, and year-to-year basis. By managing a portfolio to harvest losses, transition assets, tax efficiently, or realize gains, an SMA inevitably diverges from its stated benchmark, resulting in tracking error.

The benefits of systematic tax-loss harvesting

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How tracking error occurs in tax-managed SMAs 

Let’s look at how tracking error might arise in a tax-managed SMA that’s benchmarked to the S&P 500^® Index and designed to pursue tax-loss harvesting opportunities. The portfolio is initially invested in about 250 to 400 securities selected to mimic the benchmark in terms of sector and industry weights. The portfolio is built to exhibit low tracking error, and it resembles the benchmark in terms of risk factors such as yield, beta, and market capitalization. Once the initial portfolio is invested, it’s monitored for risk and tax-loss harvesting opportunities. 

Tax-loss harvesting opportunities arise over time as the market value of various securities falls below its cost basis. When this happens, tax lots exhibiting material losses are sold, and they’re replaced with newly purchased securities. The SMA is performing as expected—it’s closely tracking the benchmark on a pretax basis while also producing excess realized losses.

But by implementing a tax-loss harvesting strategy and selling securities, the portfolio naturally underweights those particular securities relative to the benchmark. We also see a natural deviation from the benchmark in the opposite case, if an investor decides to hold an appreciated security to defer the realization of a gain. In this case the portfolio may hold those securities at an overweight position relative to the benchmark.

How to manage tracking error in a tax-managed SMA 

While tracking error may be inevitable, it can also be managed to match an investor’s risk tolerance. Investors can work with an advisor to balance tax management techniques with a resulting tracking error that suits their risk tolerance and long-term financial goals. For instance, investors who want to balance their risk tolerance with their tax management efforts can target a fairly standard tracking error of 1%. Those who are more aggressive can allow their tracking error to drift higher, closer to 2%, allowing for more potential loss harvesting and gain deferral.

While tax management introduces tracking error into an SMA, the goal is for the portfolio to provide returns similar to the benchmark while helping investors pay less in taxes. The compounding effect of this tax deferral can be quite powerful over time—even with the existence of tracking error.

The bottom line

Customizing a portfolio through tax management inevitably leads to tracking error. But advisors can work with clients to strike a comfortable balance between a portfolio’s tax management techniques and its deviation from the benchmark. At the end of the day, while tax-managed portfolios may result in tracking error, they also allow investors to keep more of their money invested while maximizing their after-tax returns.

It is not possible to invest directly in an index. S&P Dow Jones Indices are a product of S&P Dow Jones Indices LLC (“S&P DJI”) and have been licensed for use. S&P^® and S&P 500^® are registered trademarks of S&P DJI; Dow Jones^® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); S&P DJI, Dow Jones, and their respective affiliates do not sponsor, endorse, sell, or promote the strategy(s) described herein, will not have any liability with respect thereto, and do not have any liability for any errors, omissions, or interruptions of the S&P Dow Jones Indices.