Less is more: It was the guiding principle of minimalist architect Ludwig Mies van der Rohe, whose iconic glass-and-steel buildings remain jewels in the skylines of New York, Chicago, and other cities. Does his maxim apply to portfolio management too? That is, does centralized portfolio management (CPM) deliver stronger after-tax excess returns than a multiple-manager model?
We drew up a blueprint to find out.
In the spring 2018 edition of the Journal of Portfolio Management, we published a paper that simulated both standard and tax-managed historical CPM portfolios and compared them with portfolios over the same time period under simulated active managers. Our research took a variety of things into account, including tax efficiency, turnover, manager skill level, and level of portfolio diversification. The results were clear. But before we get to them, a bit of definition.
What is centralized portfolio management?
CPM is an implementation strategy that combines multiple managers into a single account in an efficient manner. In the CPM framework, managers aggregate model portfolios into a multi-manager target composite. The central manager trades the client account against this target and customizes the portfolio based on client guidelines. Security restrictions, ESG screens, and tax-management objectives are examples of client-level guidelines the CPM portfolio can manage.
What are the benefits of centralized portfolio management?
First, clients can access specialist managers at lower account minimums and lower custodial costs. Second, they can reduce turnover and trading costs because the CPM portfolio can net out redundant (and avoid de minimis) trades. And third, the CPM strategy can opportunistically realize capital losses and defer capital gains to help reduce tax liability.
Of course, there are trade-offs: For example, managers must give up the trading control normally associated with an investment mandate. Also, performance differences can arise to the extent the central manager deviates from the underlying managers’ recommendations.
What did our research show?
We focused on quantifying the cost and tax-efficiency benefits of CPM using historical US stock data over the 10-year period from 2006 to 2015. We related these benefits to manager skill as well as other characteristics of the target composite.
We found that a tax-managed CPM portfolio created an annual tax benefit ranging from 30 to 110 basis points, depending on the skill level of the manager. Investors with lower tax rates will get less benefit; if the underlying managers have trading processes that incur significant tax drag, then there’s more opportunity for the central manager to add value. The results hold even when the sample is divided into two separate five-year subperiods, one of which included a major financial and stock market crisis in 2008.
As you can see from the chart below, manager skill level plays a big role. Skill refers to the proportion of stocks in the portfolio that are “winner” stocks—those in the top half of the universe based on next one-year returns. We simulated portfolios that hold a range from 40% winner stocks (poor skill) to 70% winner stocks (excellent skill) in increments of 2%. A skill level 50 portfolio holds 50% winner stocks, which is what one would expect from a manager with no skill.
Pre- and after-tax excess return by manager skill level, 2006–2015
Managers with greater skill generate larger realized capital gains that can be sheltered by harvesting losses. Of course, at very high simulated skill levels, deviating from the manager model for tax reasons creates the potential to underperform on a pre-tax basis. However, the increase in tax alpha as managers have better skill more than offsets the reduction in pre-tax excess returns, resulting in the CPM tax-managed portfolios having better after-tax returns across all skill levels.
The bottom line
Less does appear to be more: According to our research, a central manager can improve on the trading and tax efficiency of a multimanager portfolio. Standard CPM portfolios have lower turnover, resulting in a naturally more tax-efficient strategy, since lower turnover translates to less in realized capital gains. It also translates to reduced trading costs, making standard CPM portfolios more cost efficient.
As for tax-managed CPM portfolios, they create an after-tax return improvement that’s much larger than standard CPM. We also found that the benefits of CPM are greater if the target composites are less tax efficient and if the CPM portfolios have greater latitude to deviate from their targets.
> For more details and a closer look at the numbers, download the paper (Journal of Portfolio Management subscription required—free trial available)
Potential Parametric Solution
Our CPM strategy strives to provide the pre-tax return of multiple asset managers or styles combined within a single coordinated portfolio. By combining the inputs from various strategies into a centralized single account, CPM allows for individual tax, risk, and customization decisions for each client account.
Paul Bouchey, CFA - Chief Investment Officer
Mr. Bouchey leads Parametric’s investment, research and strategy activities. His research interests include indexing, tax management, factors, and rebalancing. Paul earned a B.A. in mathematics and physics from Whitman College and an M.S. in Computational Finance and Risk Management from the University of Washington. He holds the Chartered Financial Analyst designation.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.