Insights on Tax Management Best Practices
Techniques for Maximizing Portfolio Returns

By Alain Cubeles and Christopher A. Fronk

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It is important to understand tax lots and how they impact a portfolio. A tax lot is created each time a security is purchased. For example, if an investor purchased 200 shares of Pfizer, Inc., on February 15, 2007, for $36.14 per share, and 300 shares of Pfizer, Inc., on March 1, 2007, for $35.00 per share, then this investor has two tax lots of Pfizer, Inc. The two lots represent the two different purchases of Pfizer, Inc., on two different dates at two different prices.

To manage a portfolio effectively, a tax manager needs to know not only what securities are held in the portfolio but also what the underlying tax lots are for those securities. Continuing the example above, a tax manager must not only know that the investor owns 500 shares of Pfizer, but also that the investor purchased the shares on two different dates for two different prices. Furthermore, there could be two similar sets of portfolios and tax lots and yet the optimal portfolio management solution may be different because the investors’ tax circumstances and objectives differ. For example, one investor may have a significant capital loss carryforward and the other may have a net gain for the year. Therefore, the application of a single “standard” strategy cannot effectively meet all investors’ needs.

Tax managers who want to successfully maximize investors’ wealth must consider these kinds of issues. Investors can benefit from a better understanding of what to expect from their tax manager.

Customized Portfolio Management Approach

Systems. The foundation of a customized product structure is a flexible portfolio management system that provides the portfolio manager with analysis tools. The system must provide separate consideration of short- and long-term gains and losses, and objective functions designed to help an investor maximize losses and minimize gains while monitoring active risk.

Maximizing realized losses and minimizing realized gains are common objectives for individuals with taxable investments because a net realized loss can be used to offset some income (currently $3,000 for most individuals), and minimizing realized gains reduces the investor’s overall tax bill. Although this functionality may seem basic, not all portfolio management tools can perform at this level of customization. In such cases, the actual after-tax value may be significantly reduced. For example, if the portfolio management tool allows the tax manager only to generate a net loss, then the tax manager may be generating unwanted gains. The parameter of a net loss means that the system can generate both gains and losses as long as the net loss equals the desired amount. In essence, this reduces the manager’s after-tax returns by the amount of gains generated due to the inadequate tool. After-tax returns begin with the portfolio’s pretax return and then add in or subtract out the impact of taxes on the portfolio. For example, if a portfolio generates net realized gains, then the portfolio’s after-tax return will be less than the pre-tax return because the investor will have to pay taxes on the realized gains.

Exhibit 1 illustrates this point. In this example, both scenarios generate a net loss of $100,000. Scenario 1 generates gross losses of $200,000 and gross gains of $100,000 for a net loss of $100,000, while Scenario 2 generates gross losses of $100,000. Understanding how a net loss is achieved within an account is important because, in this example, Scenario 2 will have lower turnover and lower transaction costs. Furthermore, Scenario 2 retains $100,000 of unrealized losses that can be realized eventually and used to offset gains outside of this portfolio. This lack of functionality often means that the system cannot differentiate between short-term and long-term holding periods. This could mean that the tool is generating a short-term gain and a long-term loss, which creates a potential tax mismatch. Again, this lack of customization will cost the tax manager from an after-tax performance standpoint.

Ideally, the goal of a tax manager is to realize short-term and long-term losses when they become available. At times a manager may need to generate long-term gains, but at least the investor could expect to benefit from lower capital gains rates (currently 35% for short-term but 15% for long-term). One of the worst things a tax manager can do for investors is to generate an unnecessary short-term gain. A superior tax management tool better allows a tax manager to minimize these inefficiencies.

Tracking and tax trade-off. Typically, choosing between an active tax management strategy and one that aims to closely track the benchmark returns involves a trade-off. This trade-off occurs because in order to perfectly match a benchmark return, a portfolio would need to perform exactly like the benchmark. To realize a loss, the portfolio manager must sell one or several securities that have declined in value. To avoid the IRS’s wash-sale rule, these securities cannot be repurchased for at least 31 days. During this time period, the portfolio manager uses optimization techniques to mitigate the risk created by the underweight of the securities sold relative to the benchmark. Put another way, optimization techniques help the portfolio look similar to the benchmark without exactly matching it. For example, if a Pfizer tax lot is currently at a loss, then the optimization program might recommend a sell of the Pfizer lot in order to realize a loss. The optimization program then might recommend using the cash from the sale of Pfizer stock to purchase additional shares of Bristol-Myers Squibb, Johnson & Johnson, and Merck & Co. to replace the Pfizer exposure.

Exhibit 2 shows another way to view this trade-off. At one extreme, the manager will aggressively harvest losses and allow the portfolio to drift away from its benchmark if necessary (upper-right). At the other extreme (lower-left), loss-harvesting opportunities may be forgone in order to minimize risk vis-à-vis the benchmark. In many cases, however, the investor may want to strike a balance in the middle, between directly tracking the index and maximizing losses.

Once the investor’s objectives are understood, a manager should use the tax management system to help meet the tax objectives within a predefined tracking error. Terms like “active risk,” “estimated tracking error,” and “estimated deviation from the benchmark” represent how closely a portfolio manager believes the portfolio will perform on a pretax basis relative to the underlying benchmark. An important aspect of this trade-off is that a tax manager must allow an investor to dynamically change preferences throughout the year. This is extremely important because an investor’s tax situation may change due to gains realized in other portfolios or gains realized in reducing a single stock concentration. A flexible tax management system and tax manager should be able to respond to an investor’s changing needs.

The system must also be able to analyze the impact of other strategies such as charitable gifting, focusing on maximizing the amount of unrealized gains removed from the portfolio while monitoring the resulting effect on portfolio risk. In addition, basic analytical tools used to describe a portfolio, such as tax-lot analysis and industry/sector analysis, are necessary in order to understand the underlying portfolio characteristics. The primary benefit of a flexible system is that a tax manager can spend more time on analysis and developing an investment strategy. The aggregation and sharing of this information allows an investor, consultant, and tax advisor to make more-informed decisions regarding the investor’s entire portfolio.

Timely information. A tax manager must be able to provide timely information on performance (pretax and after-tax) and the portfolio’s tax situation (realized and unrealized gains and losses). Information regarding performance is important because it allows an investor to develop an understanding of the appropriate level of tolerable tracking error. If the realized volatility of returns is wider than the investor would like, then a portfolio manager may reduce the active risk in the portfolio as directed. Realized volatility of returns means how close an investor’s portfolio return is relative to the underlying benchmark’s return. The closer the two returns, the tighter the tracking error. The after-tax return provides a gauge as to how well the portfolio is performing given the investor’s specific circumstances. For example, if an investor is looking to maximize loss realization, does the after-tax return reflect that strategy given the specific portfolio characteristics regarding available unrealized losses?

Information about the timing of gains and losses is critical for an investor’s tax advisor. For example, if a mutual fund, which cannot distribute capital losses, is going to make a gains distribution, then the amount of gain generally is not known until it is made, typically in November or December. This allows a tax advisor little or no time to develop a strategy to offset these gains before year-end. In contrast, a good tax manager not only provides an investor’s tax advisor with updates throughout the year on expected gains and losses, but also, because the portfolio is managed in a separate account, typically can better control the realization of gains late in the tax year.

Transaction Costs Matter

Due to the potential for turnover associated with tax-managed strategies, a successful tax manager also must focus on minimizing transaction costs. These include both explicit costs (e.g., commissions, custody charges) that are directly visible to an investor and implicit costs (e.g., bid/ask spread, market impact) that cannot easily be seen. Portfolio turnover increases the transaction costs borne by the investor, as shown in Exhibit 3. This illustrates the potential impact of commissions depending on portfolio turnover and actual commission rate.

Turnover will increase as a consequence of two main factors: benchmark-generated turnover (securities being added or deleted from the corresponding index due to bankruptcy, mergers and acquisitions, and lack of representation) and tax strategies (loss harvesting). A tax manager must pay attention to the rebalancing rules and reconstitution schedules dictated by the selected benchmark in order to ensure proper tracking error. Index rebalancing and reconstitution occur when the index provider (e.g., Standard & Poor’s, Russell) changes the securities that make up the index.

For example, a smaller company that grows in size may move from a small-company index to a large-company index, which creates an index change. The actual commission rates paid by a client should not be ignored. For example, given a strategy with a 40% annual turnover rate, the difference between executing trades at $0.01 per share versus $0.05 per share would result in 10 basis points (bps) of difference in return to the portfolio. This drag on performance can be substantial (especially when compared to investment management fees), and a conscientious manager will strive to obtain the best possible commission rate. A manager who is part of a larger organization typically can more easily leverage the overall relationship with the broker community and obtain lower commission rates. (Incidentally, some investment managers pay higher commission rates than others. As a result, investors must consider both investment management fees and commission costs when comparing two tax managers.)

Even before a tax manager creates a list of securities to buy and sell, estimates of both explicit and implicit costs must be incorporated into the portfolio optimization process so that if all else is equal, given a choice of two securities, the security with the lower expected cost would be traded. Once this trade list is created, the trading desk can use certain algorithms in an attempt to exploit short-term trends in security price movements and find liquidity across markets. For example, if a security is traded in multiple locations and is offered at one cent lower in one location, then the portfolio manager would want to purchase the security at the lower price. While one cent may seem insignificant, Exhibit 3 shows that with 40% turnover this type of strategy would increase the investor’s return by 2.5 bps.

The algorithms, in addition to recognizing that different types of trades require different types of execution strategies, help a tax manager and trader minimize transaction costs. Applied consistently over time, the compounding effect of these strategies can significantly reduce the total transaction costs in a portfolio, which directly increases the investor’s after-tax return.

Exhibit 4 describes other special situations, such as cash flows and transitions between portfolios, that may require additional communication. During this communication, the portfolio manager would provide the investor with scenarios or options that help an investor make more informed decisions. For example, assume an investor wanted to maximize losses realized in December. Also assume the investor’s portfolio contained $1 million in unrealized losses and currently had an estimated tracking level of 25 bps. A tax manager could provide multiple scenarios detailing the amount of losses realized and the resulting estimated tracking level. The scenarios might look like this:

• Scenario 1: Realize $250,000 of losses; estimated tracking level rises to 35 bps.
• Scenario 2: Realize $500,000 of losses; estimated tracking level rises to 50 bps.
• Scenario 3: Realize $750,000 of losses; estimated tracking level rises to 75 bps.
• Scenario 4: Realize $1 million of losses; estimated tracking level rises to 175 bps.

Remember that a higher estimated tracking level simply means that the portfolio’s return may differ more from the underlying benchmark’s return. Once the investor, the tax advisor, and the consultant have this information, they can better understand what losses are available and how they will impact the estimated tracking level in the portfolio. Often this two-way flow of information can enhance the performance of a strategy by allowing the investor to tailor the account to his tax and investment needs. In addition, good investor–tax manager communication provides a better opportunity for expectations to be properly set and achieved.

It’s Not Just About Returns

An investor or consultant cannot expect to accurately measure a tax manager’s effectiveness based solely on pretax or after-tax performance. Doing so would ignore the extra value that a tax manager provides for an investor: control and customization. Returns alone do not capture the benefit of being able to gift low-cost basis securities while understanding the impact to the portfolio’s characteristics; nor do returns alone reveal the value of timely tax information or a complementary tax strategy. How does one measure the value of communication or a customized portfolio structure?

This is not to suggest that one should completely ignore performance; it is a key piece of information in judging a tax manager. It does suggest, however, that the success of the strategy is not based solely on pretax and after-tax performance. A successful tax manager provides an investor with a more comprehensive array of benefits, which should ultimately provide more efficiency for the investor’s overall portfolio.

Note: A previous version of this article was published by Northern Trust (www.ntrs.com) in 2006. Used with permission.

©2009 The New York State Society of CPAs. Legal Notices