CREATING TAX-EFFICIENT INVESTMENT PORTFOLIOS WITHIN A FRAMEWORK OF STRATEGIC ASSET ALLOCATION

By Harvey Siegel, CPA,
WS Securities Incorporated

CPAs providing investment services generally assist in setting goals, determining investment horizons, and making the risk/reward characteristics of the various asset classes understandable to their clients. Often their advice results in the development of a durable strategic asset allocation designed to fulfill their clients' previously-defined investment goals. An integral part of portfolio planning for the tax paying investor is the coordination of investments among taxable and tax-deferred accounts.

What Is Strategic Asset Allocation?

Most investors know the facts of market life. Over short time periods, stocks are the riskiest investments, bonds less so, and cash the safest. Over longer time periods, periodic downturns in the markets have less significance.

Accordingly, investors are intuitively mindful of the need for an asset allocation strategy, and as they age and their investment horizons shorten, they instinctively devote increasing portions of their investment portfolios to fixed income securities rather than stocks.

Less intuitive, yet of considerable importance to the thoughtful investor, is the asset allocation framework based largely on the work done by Nobel prize winner Harry Markowitz at the University of Chicago in the 1950s. The methodology derived from Markowitz' work allocates investments across multiple asset classes (bonds, smaller stocks, foreign stocks, growth stocks, value stocks, and the like). This premise holds that increased diversification reduces volatility (risk) and can increase returns. Simply put, combining assets that do not move in lockstep improves the tradeoff between risk and return.

Asset allocation as practiced today, uses computer programs to create theoretically-efficient portfolios, that is, those that provide the most return for a given amount of risk, or alternatively, those that exhibit the minimum amount of risk for a desired return.

The technique, known as mean-variance optimization, and the programs, known as optimizers, typically suggest portfolios that are a mix of bonds, stocks, and cash. Frequently the optimizer is asked to consider asset classes that are defined more narrowly. Domestic stocks are often categorized by capitalization--small, midcap, and large. Foreign stocks are often categorized by those trading in countries with developed securities markets and those trading in countries with emerging securities markets. Stocks in all categories of size and country of origin are often categorized by investment style, for example, value and growth.

The effectiveness of the programs depends entirely on the adequacy of the input data. Optimizers require expected return, standard deviation of expected return (risk), and expected correlation of returns, which measure the degree to which the asset class returns are related.

The investment allocations suggested by these programs are referred to as a strategic asset allocation--the long term breakdown of a portfolio into various asset classes based upon expected risk and reward characteristics of the asset classes themselves. The strategic allocation is durable and specific to an individual investor's investment objective and tolerance for market volatility. The antithesis of strategic asset allocation would be a tactical or active approach that is based upon the investor's market timing and/or security selection insights.

Implementing a Tax-Efficient Investment Strategy

Most investors have investments held in tax-deferred vehicles [IRAs, 401(k)s, etc.], as well as assets held in taxable accounts. For those who invest within the framework of a strategic asset allocation, a sound approach to minimizing the impact of taxes would consider the following when allocating between the two pools of investment assets.

Fixed income investments versus stocks. Ignoring tax efficiency as a consideration, a case is easily made for placing those assets having the most risk (stocks) in the vehicles with the longest investment horizon and, accordingly, the least likelihood of being called upon in a financial emergency (the retirement or tax-deferred accounts).

However, when factoring in after-tax returns, a different conclusion may be reached. A simplified example: an investor in the maximum marginal tax bracket, having equal assets in a tax-deferred account and a taxable account, has chosen a strategic asset allocation of 50% stocks and 50% bonds. A traditional approach would likely result in the tax-deferred account being invested in portfolio stocks, and the taxable account holding municipal bonds. Fixed income investments in the tax deferred account would only increase total pretax returns by the yield premium of taxable bonds over municipal premium of taxable bonds over municipal bonds.

In addition to using losses to offset taxable gains, allocating stocks to the taxable account creates the opportunity for unrealized gains to escape income taxation entirely, as long as they remain unrealized at death. Gains on stocks held in tax-deferred accounts, whether realized or not, are always taxed at distribution.

Investment Style--Growth Versus Value Stocks. Within the broad asset class of stocks, growth stocks are those whose earning's growth is expected to be higher than average. The market, anticipating higher earnings, values these stocks at greater multiples of earnings, sales, and book value than the average stock. Growth stocks, having good use for their cash flow, generally have much lower dividend yields than the average stock and, accordingly, have a relatively high component of total expected return from capital appreciation rather than dividend income.

Conversely, value stocks are those whose price/earnings, price to sales, or price to book value multiples are lower than that of the average stock. Generally, value stocks have higher than average dividend yields and, accordingly, a higher component of total expected return from dividend income rather than capital
appreciation.

An investor whose strategic allocation includes diversification by style should consider allocating growth stocks to taxable accounts and value stocks to tax-deferred accounts.

Assuming total expected return (capital appreciation as well as dividend income) from growth stocks is equivalent to total expected return from value stocks, the proportion of return due to dividends and taxed at ordinary income tax rates would be substantially greater from value stocks than from growth stocks.

Investment Style--Active Versus Passive Strategies. The effectiveness of any strategy that favors stock investments in taxable accounts rather than tax-deferred accounts presumes the investor does not trade actively in the taxable accounts, thereby generating taxable gains as earned and limiting natural tax-deferral by allowing capital gains to compound internally.

The goal of active investment management is to beat the market through superior security selection or fortuitously timing purchases and sales. Those attempting this strategy may use intuition; quantitative, fundamental, or technical analysis; or an infinite variety of techniques in an effort to generate higher returns than an unmanaged index of securities. Benchmarks for an active manager can be as familiar as the S&P 500 or more obscure as the Wilshire Small Cap Growth Index. Passive strategies on the other hand, seek to duplicate the returns of a benchmark index.

To equal the returns of an index on a pretax basis, an active manager must generate excess returns at least equal to the additional costs inherent in that style. These costs may include higher management fees, higher commission charges due to increased turnover of securities, and the potential impact on market price from buying and selling securities, often in large blocks.

On an after-tax basis, to generate returns comparable to a passive strategy, the active manager must also compensate for the more frequent realization of capital gains. Passive strategies are inherently low turnover and tend to realize capital gains less frequently than the average actively managed portfolio.

Beyond the scope of this writing is a full discussion of whether active strategies have, in fact, produced returns sufficient to make up for the additional costs, before and after tax. The overwhelming evidence, in this writer's opinion, is they do not. Virtually all exceptions to this generalization have been identified only in retrospect and, arguably, are inconclusive as to whether they are the result of skill or luck.

A cautionary word to planners: Virtually all investment presentations that exhibit the historical risk-and-return qualities of the various asset classes are based on unmanaged indices unadjusted for transaction costs and taxes. It is counterproductive to encourage a client to base investment expectations on the historical returns of a stock market index and, subsequently, tolerate an implementation process that selects among active strategies that, many believe, guarantee submarket returns and excessive taxes.

The Taxation of Mutual Fund Distributions. In general, tax law requires mutual funds to distribute to shareholders all but an inconsequential portion of net investment income and net realized gain. This pass-through of income and tax liability is substantially identical to the taxation of income from individually-held securities except that 1) net short-term gains are distributed as ordinary dividends and 2) net long-term capital losses are not passed through to shareholders, but used to offset future capital gains.

Tax-Efficient Mutual Funds

Traditionally, individual stock investments have been the preferred vehicle for implementing a tax-efficient policy. The primary advantages are the ability to harvest losses against gains and the possible perpetual deferral of capital gains. A disadvantage is the difficulty of securing and maintaining adequate diversification, especially if implementing a strategic asset allocation policy that includes many asset classes. An additional disadvantage would be implementation cost, particularly if portfolios are professionally supervised. If supervised by a manager that employs an active style, the style is certain to be compromised by tax considerations.

Exceptions in the overwhelming barrage of redundant mutual fund products introduced during the last decade are the few funds whose investment methodologies are explicitly or naturally tax-efficient, e.g., tax managed funds and market funds. Unlike the preponderance of funds whose methodology is institutionally-driven (taxes are not an issue), these funds exhibit modest turnover (reduced taxable distributions), reduced taxable yields, and, frequently, very low operating costs, while, at the same time, providing and maintaining adequate diversification.

Tax-managed funds are those that, as a matter of investment policy, focus on after-tax returns by maintaining positions in appreciated securities, avoiding high-yielding stocks, and selling losing positions to offset gains. Some tax-managed funds specifically identify high cost shares when selling positions.

There are mutual funds, although not specifically tax-managed, that invest in specific asset classes, such as small company growth stocks. Although the underlying investments may be naturally tax-efficient, the methodology some funds use to select and rotate investments often results in high portfolio turnover. Historical portfolio turnover and the fund's strategy should be carefully reviewed before implementing a tax-efficient portfolio.

Mutual funds that are naturally tax-efficient are index or market funds. The tax efficiency of these funds is due primarily to the nature of index fund investing. These funds' strategies are passive; that is, they are required to contain securities and to alter their balance of securities only when the underlying index undergoes a change. Generally, the turnover of indices has been small compared to actively-managed funds, thereby allowing index type funds to defer most gains.

There are few ways for the individual investor to earn positive inflation-adjusted returns after taxes. Inflation, unlike stock market returns, is remarkably consistent and has consistently increased since 1950. The imposition of taxes on investment income has been similarly consistent. Historically, owning stocks has been a reliable and, arguably, safe means over time to accomplish investment goals. Allocating those stocks to the appropriate accounts using tax-efficient strategies will make goals more attainable. *

NOTHING IS LOST BUT MONEY:
U.S. SAVINGS BOND INTEREST

By Christina Bych,
AATEC Publications

Suppose a client walks into your office with a stack of U.S. Savings Bonds his now-retired parents had purchased under a payroll savings plan from the mid-1950s through the mid-1970s. "What do I do with these?" he wants to know. Do you know what to tell him?

Savings bond export Daniel Pederson states in his reference book, U.S. Savings Bonds: A Comprehensive Guide for Bond Owners and Financial Professionals, "Savings bonds are not a 'simple investment.'... Two Series E Bonds with the same face value purchased at different times may come under different rules, which, in turn, lead to different rates of interest and different strategic timing
considerations."

U.S. Savings Bonds are the world's most widely held security. Over 55 million Americans hold $183 billion in savings bonds which, according to the Treasury Department, "account[s] for almost four percent of the privately held portion of the public debt."

Americans redeem over $10 billion in bonds each year, but by their random--and uniformed--approach to cashing them, they forfeit $100 to $200 million annually. And by not tracking their investment, Americans now hold over $25 billion in bonds that have stopped earning interest.

Why is it that such a common investment vehicle is so misunderstood and mismanaged? Pederson says it's largely because savings bonds are a do-it-yourself proposition. Unlike other investors, bond holders do not receive statements that detail their holdings. In their search for information, most people mistakenly go to a bank. Because they don't generate any income from savings bond services, many banks handle them as a courtesy to customers. Consequently, they may not place a priority on training staff in the basics or intricacies of bond maintenance and redemption. Four years as supervisor of the Savings Bond Division of the Federal Reserve Bank of Chicago, Detroit Branch, where his staff fielded between 200 to 500 calls a day asking, "Tell me....Help me...How do I...?" convinced Pederson that bond owners and professionals could use help. He founded The Savings Bond Informer, Inc., a firm which provides customized written analyses of bond holdings. This work lead to his book, referred to earlier. Written in a clear and direct manner, this well-organized guidebook provides all the information needed to understand, evaluate, and effectively manage a savings bond portfolio.

In 208 pages, Pederson details the primary misconceptions about savings bonds; he instructs on how to avoid interest forfeiture and tax traps, how to track a savings bond investment, and where to find reliable information. He explains where and how to buy, redeem, reissue, and exchange savings bonds; he defines the different series (E, EE, H, HH, and Saving Notes.); and discusses selective redemption and how to implement it. He also answers the 20 most common
questions bond owners ask; gives the results of a 400-bank bond information survey; and presents a resource list and glossary.

At $24.95, it's a great deal. The book is available from The Savings Bond Informer, Inc., (800) 927-1901. *

Editor:
Milton Miller, CPA
Consultant

Contributing Editor:
Alan Fogelman, CPA
Clarfield & Company P.C