Four Ways to Improve After-Tax Investment Returns

Tax-loss harvesting is rightfully a large piece of the tax-management puzzle—but it’s not the only piece. Managers who know where to look can find other opportunities to minimize their clients’ tax liabilities.

Since creating our first tax-managed client portfolio in 1992, we’ve known how much active tax management can help minimize tax drag and maximize long-term wealth. But as portfolios and investor needs change over time, tax-management strategies must also change. For example, tax-loss harvesting is a powerful tool to help offset gains elsewhere in a client’s overall portfolio. But managers who focus too narrowly on the benefits of tax-loss harvesting may miss other opportunities to further minimize tax liabilities. 

Looking at how tax management may be used over the life of the portfolio can help us understand which tools can be effective in various moments. Let’s look at four of them.


Managing portfolio transitions

Creating a new tax-managed account requires transitioning existing assets in a way that avoids incurring huge tax penalties. For a new account funded with cash, this is fairly straightforward: The manager builds a portfolio of stocks that closely tracks the client’s benchmark, resulting in an initial market value equal to the portfolio’s cost basis. On the other hand, some investors fund new accounts with in-kind securities. These investors can avoid realizing taxes at inception by holding some of the existing securities in a risk-controlled way. The goal is to balance the tax cost of transitioning to the new portfolio with the risk of underperforming the benchmark. 

Some transition plans tightly track the benchmark and pay more capital gains tax. Others take more benchmark-relative risk by holding more of the existing portfolio and paying less tax. When funding a new tax-managed account with in-kind securities, the new portfolio’s market value can be much higher than the cost basis. In some cases, this leads to fewer loss-harvesting opportunities and a higher tracking-error risk that must be managed over time.

For accounts being funded with in-kind securities, the focus of portfolio management is often to reduce the risk of the account over time. Managers can do this by trading tax neutrally, with a greater emphasis on reducing tracking error, to reduce concentrations and move the exposure closer to the benchmark over time. Since the focus is on reducing risk, we can expect fewer net losses than we’d see in a portfolio funded with cash.

Whether in the early years of a portfolio, when there may be greater opportunities to harvest losses, or the later years, when opportunities for losses have decreased, portfolio managers employ risk-managed trading to balance realized losses and risk. A key trading tactic is tax-rate arbitrage. This involves making trades in such a way that the investor pays the (typically lower) long-term tax rate on those realized capital gains necessary to maintain risk, while the bulk of the losses they do realize are short-term.

Investors can use the net short-term losses they realize to offset short-term gains, which are taxed at a higher rate, in other parts of their portfolios. Some investors have an ongoing supply of outside short-term gains to shelter, typically from satellite investments such as hedge funds and other alternatives. By strategically realizing long-term gains, they can reset their portfolio’s cost basis and reinvigorate short-term loss-harvesting opportunities. This maximizes the tax-rate arbitrage benefit.

When a manager sells an asset at a capital gain, the investor owes tax on the realized gain. If the manager chooses not to sell the asset, the tax the investor would have paid continues to compound in the portfolio. If the investor later ends up paying the tax, they still get to keep the compounded returns. This essentially defers tax realization into the future and generates market-like returns on the asset in the meantime. In addition, many clients can defer gains until the assets receive a step up in cost basis when the client passes away and bequeathes the assets to their heirs.

Gain deferral is an effective tax-management tool—but implementing a gain-deferral strategy isn’t as simple as holding on to the asset and refusing to sell. An optimized gain-deferral strategy seeks to avoid the realization of capital gains while carefully managing portfolio risk relative to the investor’s custom benchmark. As index compositions change and investors incorporate customizations—such as ESG guidelines and factor tilts—the trade-offs between taxes, transaction costs, and risk become increasingly important to manage.

Portfolios appreciate in value over time, resulting in higher embedded gains and fewer opportunities to harvest losses—but this is a good problem to have. A portfolio that produces fewer realized losses has likely appreciated dramatically, increasing the market value, and provided significant amounts of realized losses, decreasing the cost basis.

Depending on the investor’s needs, managers can apply a variety of tax-management strategies to appreciated accounts:

• Investors with a strong need for short-term losses can realize long-term gains to reset the portfolio’s cost basis and reinvigorate loss-harvesting opportunities.
• Investors who are averse to realizing any taxes can continue to focus on gain deferral, allowing portfolio managers to allow tracking error to increase over time to avoid gains.
• Investors who need to make withdrawals from the appreciated portfolio can use a tax-efficient optimization process that allows the portfolio manager to focus on the least-appreciated security lots when raising cash for the withdrawal.
• Investors with charitable intent can eliminate the tax liability altogether by donating appreciated securities instead of cash. If the investor replaces these securities with cash, the cost basis of the account increases, creating more opportunities to harvest losses in the future.

Tax management is important in all market environments over the life of a portfolio. But comprehensive tax management isn’t just about finding the highest number of losses to harvest. Effective managers should always be on the lookout for strategic ways to reduce their clients’ tax risk while maintaining their preferred market exposures. From inception to bequest, tax-management tactics are plentiful.