Investors may be missing opportunities through the wrong tax management strategy. While one size does not fit all, an organized, systematic approach that continuously monitors and adjusts can ensure investors make the most of all opportunities.
In a recent blog post, Unpacking Tax Management, we examined some tax management tactics employed in the investment industry, from the tax-aware to the tax-focused investment manager. What should be clear is that there are some basic methods that can be used. Some managers may claim tax management as central to their investment thesis when in fact it may be an afterthought, secondary to other active decisions and considerations.
Sparking joy with tax management
As we stare in dismay at the figurative heap of tax tactics we’ve piled on the floor, let’s channel our inner Marie Kondo to declutter and tidy them up into a coherent and smart, simple, tax-managed strategy. It quickly becomes clear that not all tax management is the same. What essential aspects add value to the investment process?
- Ensure tax management tactics are embedded in the investment process systematically. They indicate the degree to which taxes matter to the manager. They further reveal the relative importance of more certain after-tax outcomes in an industry often driven by less certain pretax performance expectations.
- Ensure the manager continuously looks for opportunities to harvest tax losses. The manager who explores tax-loss harvesting only as a last-minute exercise in December each year will always leave harvestable losses on the table. Take 2020, for example: The manager who looked for losses to harvest at year-end largely missed out on numerous opportunities from the pandemic downturn in the first half of the year, as markets had recovered handsomely by December. Constant monitoring of the portfolio and the market environment serves the taxable investor better than calendar-based rebalancing.
- Ensure the manager monitors risk factors common to all equity investments. Investment science has shown returns can be explained by characteristics—or factors—common to all publicly traded stocks, such as value, growth, momentum, and beta, to name a few. The use of a fundamental factor model is critical in terms of monitoring risks—just as critical to relative returns as sector inclusion and the individual constituents themselves. In particular, a tax-managed strategy can display biases among common factors as segments of the market perform differently over time. Portfolios that explicitly manage and monitor these relative risks can better tune tracking error.
- Consider a broad, less concentrated exposure. Although portfolios with limited holdings will have opportunities for tax-loss harvesting like any other portfolio, the most consistent results come from broad investment across many underlying constituents in the index. Portfolios of ETFs, for example, have their merits, but advisors are typically best served by investments in individual companies, if possible.
- Consider the turnover of the manager or index. High-turnover managers and indexes will be inherently less tax efficient. If you’re compelled by the pretax investment thesis but the turnover is high, you’re more likely looking at a tax-efficient implementation that realizes fewer gains than a strategy that generates excess losses for use against gains elsewhere outside the portfolio.
There is no one-size-fits-all solution to most investors’ circumstances. What we do know is that taxes matter to the taxable investor—and that they matter a lot. Equity markets don’t leave us happy in all market environments all the time. But decluttering and organizing into a structure leaves all investors well positioned for an outcome that will spark after-tax investment joy.
The bottom line
Look for a manager who gets fundamental tactics right by using sophisticated software on a flexible platform to continuously harvest tax losses and manage relative risks, including fundamental factors, sectors, and securities. Reconcile the manager or index to ensure the investor’s pretax and after-tax expectations are in sync.
Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision.