■ Ability to accept low-cost-basis stock. The majority of separate account managers accept only cash. This is currently changing, and more investment managers are willing to accept securities, with spe- cific instructions as to how to handle them. For example, most high- net-worth investors have low-cost-basis stock, and they’re beginning to understand the inherent risk in holding the stock and the tax impli- cations of selling it to diversify. These investors are looking for man- agers who can propose solutions for the investor ranging from a total sale, to partial sale, to holding the stock and diversifying around it using other money. The manager should develop a working knowl- edge of collars and put and call strategies to hedge positions. Accept- ing low-cost-basis stock is one of the basic tenets of true separate account management.
■ Tax-lot accounting. The fundamental technique to gain tax efficiency is to employ tax lot accounting. Among other things, this allows the 172 THE PROCESS
TABLE14.2 Analysis of Tax Management Potential*
Without Tax With Loss Matching, Initial Investment: Management Loss Harvesting, and
$1 Million Techniques Managed Tracking
After-tax ending value $3,551,000 $3,756,000
After-tax return 13.5% 14.2%
*Figures shown are not reflective of any particular parametric strategy or portfolio, either actual or modeled.
manager to respond to withdrawals and required turnover by selling higher-cost-basis stock first.
■ Tax loss matching and harvesting. This strategy seeks to realize losses within a portfolio to enhance after-tax returns through (1) matching gains with losses when the realization of gains is either desirable or unavoidable, and (2) creating an inventory of losses to offset gains else- where in an investor’s portfolio. The extent to which tax loss harvesting can be exploited is partly determined by overall market returns and individual stock volatility. In periods of lower market returns and with asset classes of greater stock volatility, the after-tax value of this tech- nique increases.
■ Tax-lot optimization. Most money managers use some form of portfo- lio or security optimization—that is, calculating how to mix your hold- ings to get maximum return for varying levels of risk. The roots of optimization lie in modern portfolio theory. The simplest models look at historical price volatility versus future projections. To manage after- tax money effectively, you have to add another variable, the tax lot cost of the securities purchased.
This makes the optimization process far more complex. Not only will different clients have different cost bases, making optimization neces- sary on an account basis rather than on a firm portfolio basis, but indi- vidual clients will have different tax lots of the same securities. Adding to an already complex process, clients will be at varying tax levels. Sales and replacement purchases that make sense for one client may not make sense for another. Again, dispersion among clients should be expected and accepted.
This process sounds daunting, but new technology, available now and around the corner, makes this level of management possible even today.
■ Year-End Loss/Gain Request. Besides harvesting losses to reposition the portfolio internally, the money manager should entertain requests from the investor to offset realized gains and losses outside his/her portfolio. For example, assume an investor realizes a $50,000 gain from the sale of a condo. The manager should attempt to harvest losses to offset the gain as far as possible. This is an incredible value-added ser- vice, especially in poor-equity markets. Rather than being admonished for poor performance, the manager is congratulated for saving the investor from writing a $10,000 check to the IRS. That is tangible value Tax Management in the Separate Account 173
added and could contribute to an extended contractual arrangement with the manager even in performance downturns.
An extension of this service is to work with the other money man- agers in a multimanager household, creating communication links with the other managers to make the overall account more tax- efficient. The instigation of this type of communication usually falls to the program sponsor or advisor, but the money manager should be responsive.
■ Efficient trading strategies. Most separate account managers suffer from the defined benefit syndromein trading as well as portfolio man- agement. In their attempt to keep accounts looking similar, they buy and sell in proportions. For instance, if the investor wants to withdraw
$50,000 from a $500,000 account, the manager sells 10 percent of all 35 positions in the account. They do the reverse on a $50,000 contri- bution to the account. This is not what the high-net-worth investor expects. In fact, they view that type of management as the cookie- cutter approach, which can have negative indications for tax manage- ment efforts.
■ Managed portfolio tracking. Over time, a portfolio built to mirror an index will develop return differences (tracking) as the index con- stituents change. For many investors, taxes incurred by a portfolio manager attempting to fully replicate all index changes represent unnecessary costs.
By accepting a small degree of tracking difference (i.e., portfolios may replicate the benchmark closely but not exactly), investors can improve their after-tax performance but at the same time incur a risk of underperforming the index.
Using tax loss matching and harvesting can enhance after-tax return by matching gains with losses when turnover is necessary—and create opportunities to offset gains elsewhere in an investor’s portfolio.
Following are some common misconceptions.
Misconception 1: Only Wealthy People Need to Be Concerned with Tax Efficiency Many people associate tax-managed investments with tax-exempt invest- ments, whose lower yields are favorable only for people in the highest income brackets. It’s obvious that high-income investors are going to get the greatest benefit from tax management strategies: The difference 174 THE PROCESS
between their income tax rates (as high as 37.6 percent at the federal level) and the long-term capital gains rate (20 percent) is greater. But even investors in the 28 percent federal income tax bracket can gain from tax management strategies—particularly if the effects of state taxes are included (Table 14.3).
Misconception 2: Portfolio Turnover Is the Key Indicator of Tax Efficiency
Turnover is certainly easy to measure, but some studies suggest that it’s not always the most reliable measure of tax efficiency.
Dickson and Shoven (1993) found the statistical correlation between Tax Management in the Separate Account 175
TABLE14.3 After-Tax Yield Equivalents*
You Would To Match Need Pretax a Tax-Free If You File Singly or File Jointly Returns of Yield of and Earn . . . and Earn . . . (in %) . . . (in %) . . .
$0–$25,750 $0–$43,050 4.71 4
5.88 5
7.06 6
$25,751–$62,450 $43,051–$104,050 5.56 4
6.94 5
8.33 6
$62,451–$130,250 $104,051–$158,550 5.80 4
7.25 5
8.70 6
$130,251–$283,150 $158,551–$283,150 6.25 4
7.81 5
9.38 6
$283,151+ $283,151+ 6.62 4
8.28 5
9.93 6
*Calculations are based on federal tax rates for year 2002. State taxes would increase the pretax returns required.
portfolio turnover and tax efficiency to be quite weak. They gave their results on a scale where:
1=higher turnover always leads to higher tax efficiency.
−1=higher turnover always leads to lower tax efficiency.
0=no correlation at all.
If low turnover did correlate to tax efficiency, we would expect to see numbers close to −1. Instead, the correlations for investors in the highest tax bracket (assuming no portfolio liquidation) ranged from −0.11 for growth managers to −0.22 for growth and income managers. For investors in the lowest tax bracket with portfolio liquidation assumed, some correlations were positive, suggesting that higher turnover actually improved tax effi- ciency. While the study did show that there is a correlation, it was not the strong correlation that the simple equation of turnover with tax efficiency would suggest.
Misconception 3: Indexing Is the Best Approach to Tax-Managed Investing
It’s true that index mutual funds have a number of innate characteristics that have tended to foster strong pretax performance along with high tax effi- ciency. For one thing, index funds have exceptionally low turnover rates, which means that their transaction expenses are generally lower. They are also likely to have more long-term capital gains and fewer short-term gains compared with actively managed funds.
But even with these features, index funds are not the ultimate tax- managed investments, for several reasons:
■ Stocks within an index fund change periodically. Companies may be added or deleted by the firm that maintains the index, in response to changing market realities or events such as corporate mergers. Strict indexing requires portfolio managers to buy or sell whenever stocks are added or deleted from the index. It means they also have to own all companies, even Enron, Global Crossing, and Lucent. This type of trad- ing activity may not lead to a great deal of turnover, but it can lead to considerable recognition of gains.
■ Timing of sales may be inefficient. For example, in the course of fol- lowing its passive strategy, an index fund might end up selling a stock 176 THE PROCESS
just days before it would qualify for tax treatment as long-term capital gains.
■ The fund may have to invest in high-dividend stocks. An index fund cannot limit holdings of a stock just because it pays high dividends.
With the most popular index funds investing heavily in blue-chip stocks, index funds can generate substantial dividend income, which is taxed at the higher rate for ordinary income.
■ Rebalancing can generate capital gains. An index fund’s portfolio must be rebalanced periodically, and the manager may need to recog- nize capital gains to do so.
■ The fund cannot be managed for tax efficiency when it comes to share- holder redemptions. Because it must maintain its similarity to an index in the proportions of each stock it owns, an index fund can’t choose which stocks to sell when handling redemptions. Chances are good that it will end up having to sell many holdings that will generate short-term gains, which will affect the fund’s tax efficiency for all share- holders remaining in the fund. In addition, most index funds are carry- ing sizable unrealized gains. This could lead to considerable realized gains if a large number of redemptions take place.
Misconception 4: Any Investment Style Can Be Tax-Efficient
Certainly any investment style can be modified to improve tax efficiency. But some styles lend themselves to tax-efficient techniques far better than others.
For example, growth-oriented investment strategies seem to be more appro- priate for tax-managed investing than value-oriented strategies. This is in part because a growth approach is oriented toward capital appreciation, while a value approach will tend to lead a portfolio manager to select a portfolio that produces comparatively higher rates of income.
Peters and Miller (1998) bear this out. Their study of fund groups for the 10- and 20-year periods ending in 1996 found that growth managers provided higher average pretax returns, higher after-tax returns, and greater tax effi- ciency than growth and income managers or equity income managers. (See Table 14.4.)
Managers that focus on large-company stocks are also better candidates for tax-managed investing than small-cap managers. One reason is that small-company stock managers have a built-in reason to sell; those that are most successful eventually outgrow the small-cap category, and must be Tax Management in the Separate Account 177
sold. This can lead to a high level of realized capital gains. In addition, small companies are often bought out, leading once again to excessive realization of capital gains.
Misconception 5: All Tax-Sensitive Investors Have the Same Needs
While generalizations can be comforting, it’s essential to consider each investor’s particular situation. Federal and state marginal rates vary from individual to individual. Some taxpayers—a growing percentage each year—
are subject to the federal alternative minimum tax (AMT). This separate tax computation is applied to individuals whose deductions under the regular tax rules might otherwise eliminate their tax liability. Some investors may have other holdings or personal businesses that can provide some offsetting losses.
And, as always, it’s essential to keep in mind the individual’s ultimate invest- ment goal and time horizon.
A separate account portfolio manager can tie purchase-and-sale decisions to the individual’s specific tax situation. For smaller investors, though, the costs of managing a separate account generally make mutual funds more appropriate.
Considering the use of securities that have appreciated significantly rather than cash when making charitable gifts is a technique that can improve tax efficiency. This gives away the capital gain.
Investors who are planning to leave a taxable portfolio as part of their estate are a special case, thanks to the current tax code provision for a step- up in basis upon an investor’s death. This essentially means that when heirs withdraw money from the account, capital gains will be calculated from the fair market value of the security at the time of death. This effectively resets 178 THE PROCESS
TABLE14.4 Average Return Rankings for Asset Classes (1976–1996)*
Pretax (in %) After-Tax (in %)
Growth 15.36 Growth 11.92
Growth and income 13.75 Growth and income 9.89
Equity income 13.71 Equity income 9.31
Source: Donald J. Peters and Mary J. Miller, “Taxable Investors Need Different Strate- gies,”The Journal of Investing,Fall 1998, p. 38.
*Assumes the maximum income and capital gains tax rates in effect for each year.
the clock on basis calculations, and means that heirs need not pay taxes on the portfolio’s unrealized capital gains prior to the death of the owner.