Client Transitions from Underperforming Active Manager to Custom Core®, Maximizes Tax Efficiency

Challenge

An advisor brought on a new client who held a separately managed account (SMA) with an underperforming US large-cap value manager. Given the investor’s unhappiness with this manager’s inability to outperform, the advisor recommended a more passive and broader US large-cap index exposure. However, even though the manager underperformed its stated benchmark, the market’s upward movement meant the SMA held a number of highly appreciated securities. Simply selling out of the client’s existing SMA would trigger the realization of a large capital gain and, with it, a huge related tax cost.

So even though the client and the advisor both lost confidence in the active manager, the primary hurdle preventing them from acting was the tax ramifications of shifting the client’s SMA toward a more index-like exposure.

Parametric solution

Taxes often present a formidable hurdle for investors looking to transition from one portfolio to another. However, Parametric has designed a broad tool kit to help investors and their advisors balance the capital gains they’re willing to realize against an acceptable percentage of tracking error to the desired benchmark exposure.

In this case the advisor wanted to remove the value tilt from the client’s concentrated portfolio of large-cap value stocks and move the portfolio to a broad market exposure. Accordingly, the first step was to designate the target exposure as a US large-cap-weighted index, with no notable value tilt.

Once Parametric determined this target, we built a transition analysis to explore the tax implications of moving closer to the desired target exposure via a Parametric Custom Core^® SMA. Because the current SMA had embedded gains, the client didn’t want the transition to create a significant taxable event but was willing to incur some tax to move closer to the target benchmark.

To help understand the trade-offs of incurring taxes and reducing tracking error, Parametric created a set of custom transition analyses involving the SMA holdings and the target index. This report provided a number of scenarios, ranging from a full transition (moving the portfolio into complete alignment with the benchmark, regardless of taxes) to one with very high tracking error (and less realization of taxes). The advisor then walked through these scenarios with the client to investigate which scenario best aligned with the client’s goals. The client chose a middle path that resulted in some taxable gains being realized while maintaining a moderate degree of tracking error with the selected target exposure. As part of this transition, the advisor also asked Parametric to seek to reduce the tracking error over time via the reinvestment of dividends and the proceeds of future loss-harvesting trades.