Addition Through Subtraction: Thinking Strategically About Managing Tax Liabilities

Transcription

1 Strategic Advisory Solutions April 2015 Addition Through Subtraction: Thinking Strategically About Managing Tax Liabilities Maximizing returns is a key goal for most investors, but many overlook an important variable taxes. Tax-managed strategies may benefit some investors by improving tax efficiency while still providing attractive returns. How many investors leave a tip on each year s tax bill? Many, apparently. That, at least, is what might be inferred from the majority of investors who do not engage in tax-aware investing. We believe the issue is a lack of investor awareness and the lumpiness of tax liabilities in certain years versus others. Taxable distributions generally rise after several years of buoyant markets, which is precisely the situation investors face today. 1 Additionally, mutual funds may also make taxable distributions following a market decline. In 2008, following the S&P 500 s 37% rout, 35% of all Morningstar-tracked US large-cap blend funds institutional-class shares (75 of 214 funds) paid out capital gains distributions. 2 Integrating Tax Awareness Best practices in tax-aware investing consider not just the factors influencing today s or even next year s liabilities, but also strategically weigh the options available for incorporating tax strategies into a portfolio construction approach. Three areas in which US investors may benefit from a more strategic approach to taxes are: (1) navigation of the coming wave of capital-gains distributions; (2) harnessing the concept of asset location, in which investors utilize tax-advantaged assets and tax-advantaged structures in attempt to minimize or delay their tax liabilities; and (3) asset allocation, the expansion of a portfolio s exposures to non-traditional asset classes such as high yield corporate bonds and high yield municipal (muni) bonds. These asset classes may present attractive opportunities, especially when considered from an asset-location point of view. 1 Source: Bloomberg and Morningstar, December 31, Source: GSAM and Morningstar. GSAMFUNDS.com Goldman Sachs does not provide accounting, tax or legal advice. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved.

2 The Coming Wave of Capital Gain Distributions As illustrated by recent years rising taxable distributions, the tax vacation enjoyed by investors thanks to capital loss carry forwards in the years following the financial crisis is ending. The number of equity mutual funds making capital gains distributions has roughly doubled since 2012, largely due to the rise in equity markets. As of 2014, nearly three-quarters (74%) of US large-cap blend funds institutional class shares paid out capital-gains distributions (251 of 340 funds) a more than tenfold increase since As capital loss carry forwards shrink, the magnitude of fund distributions has also increased. Such gains can be incurred even if investors have not sold shares a subject that may create surprise and disappointment in the near future. Mutual Fund Distributions Have Been on the Rise Since 2009 Percentage of Funds Making Capital Gains Distribution (%) % of Large Cap Blend Mutual Funds Distributing a Capital Gain (Left Hand Side) Average Large Cap Blend Mutual Fund Capital Gains Distribution as % of NAV (Right Hand Side) Average Distribution as % of NAV Source: Morningstar and GSAM. As of February Chart data is from 2004 to The LHS of the chart shows the count of the US Large Cap Blend Universe managers in Morningstar (I share) making an annual capital gain divided by the total number of managers. The RHS of the chart shows the median of the annual dollar capital gains distribution of mutual fund managers in the US Large Cap Blend Universe (I shares) divided by each manager s respective year end Net Asset Value (NAV), defined as the value of a fund s assets minus the value of its liabilities. For investors experiencing these effects, understanding the potential benefits that tax-mitigation strategies can confer within a mutual fund may be helpful. These strategies, which include tax loss harvesting and limitation of portfolio turnover, can materially impact investment returns. To see the potential benefits, consider the experience of tax-managed mutual funds over the last decade. A $100,000 investment in tax-managed funds within Morningstar s Large Cap Blend category rose to $204,640 as of Feb. 28, 2015 whereas the rest of Morningstar s Large Blend category rose to $187,103. We believe this 20% higher return over a decade in otherwise comparable funds helps demonstrate the power of a tax-aware approach to equity investing. 2 Goldman Sachs Asset Management 3 Source: GSAM and Morningstar, December 31, Goldman Sachs does not provide accounting, tax or legal advice. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved.

3 As of the end of 2013, 50% of equity, bond and hybrid mutual fund assets ($6.1tn) in the US were held in tax-advantaged defined contribution retirement plans or individual retirement accounts, according to the Investment Company Institute Investment Company Fact Book Over the Last Decade, Tax-Aware Investing has Outperformed Traditional Strategies Federal Tax Rates 43.4% Short-term Capital Gains 23.8% Long-term Capital Gains 43.4% Ordinary Dividends 23.8% Qualified Dividends After-Tax Growth of $100K $250k $200k $150k $100k $50k $0 Initial Investment 20% Increase in Gains $87,103 $104,640 $100,000 $100,000 Large Cap Blend Universe Ex Tax-Managed Funds Tax-Managed Fund Universe Tax-Aware Process Year-round Tax Loss Harvesting Short- vs. Long-term Holding Periods Tax Lot Management Compounding Source: Morningstar and GSAM. As of February This table does not reflect any information for any GSAM Fund. Its purpose is to show mathematically how a strategy that reduces capital gains distributions reduces the effective tax rate paid on its returns and thus increases total return, compared to a strategy that does not reduce capital gains distributions. It uses Morningstar category data as of 4/30/2014 to identify a historical breakdown between long- and short-term cap gains distributions, and then the returns assumptions in the paragraph preceding the table. We reviewed the entire large cap blend universe and then removed all the tax managed funds from the universe to obtain the ex Tax-Managed subset of funds. The analysis and discussion ultimately show that a 7% return compounded for 25 years is higher than a 5.8% return compounded for 25 years. The Morningstar data is used to show why the difference, 7% vs. 5.8%, may be reasonable. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this document. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. These results do not reflect any Goldman Sachs product. Past performance does not guarantee future results, which may vary. Gain Understanding Asset Location and Allocation In investing, as in life, where you stand often depends upon where you sit. The same is true with regards to the concept of asset location, in which investors seek to maximize the after-tax return of their entire portfolio. A strategic approach to asset location places US tax-advantaged assets in taxable accounts and, wherever possible, places tax-generating assets in tax-deferred accounts like 401(k)s, individual retirement accounts (IRA) and variable annuities. Best practices in tax-aware investing in the US also include housing assets with more significant tax implications in tax-advantaged accounts. In such instances, investors should focus on the extent to which an asset class is likely to generate taxable events. For instance, yield, defined as the income return on an investment, is a metric that should be considered, since these distributions are generally taxed as ordinary income. Another metric of considerable importance is portfolio turnover, a proxy for the potential to throw off short-term capital gains distributions. An asset that creates significant yield and/or short-term capital gains distributions should potentially be considered for inclusion in tax-deferred accounts. Past performance does not guarantee future results, which may vary. Please see additional disclosures at the end of this document. Goldman Sachs Asset Management 3

4 The chart below shows how various Morningstar-tracked US mutual fund categories rank on the measures of average yield and portfolio turnover. Based on these metrics, high-yield bonds, for instance, make sense as an asset class to own in tax-deferred accounts. Indeed, the median asset-weighted three-year high-yield mutual fund yield was 6.2% as of December 31, 2014, 4 so an investor paying the 39.7% ordinary federal income tax rate would only see roughly 3.74% after taxes if the asset is owned in a taxable account and that assumes no state or local tax withholding. In a US tax-deferred account, taxes are paid later in life, when an investor may be in a lower tax bracket, allowing the investment to compound over a longer time horizon. In Our View, Average Yield and Turnover are Important Considerations When Building a Portfolio 7 6 High Yield Bonds Average Yield (%) EAFE Equity Global Infrastructure and MLPs US Large Cap Value US Mid Cap International Real Estate US Real Estate International Small Cap Emerging Market Equity US Small Cap Emerging Market Debt Leveraged Loans US Large Cap Growth Commodities Alternatives Average Turnover (%) Source: GSAM, Morningstar Morningstar, Inc. All Rights Reserved. Asset classes are represented by US mutual funds (lowest fee share class) in the corresponding Morningstar Categories, all US categories unless otherwise noted: US Large Cap Growth = US Large Growth; US Large Cap Value = US Large Value; US Mid Cap = US Mid Cap Blend; US Small Cap = US Small Cap Blend; International Equity = Foreign Large Blend; Emerging Markets Equity = Diversified Emerging Markets, India Equity, Latin America Stock; Emerging Market Debt = Emerging Markets Bond; High Yield Bond = High Yield Bond (includes Global and US); Leveraged Loans = Bank Loan; International Small Cap = Foreign Small/Mid Blend; International Real Estate = Global Real Estate; US Real Estate = Real Estate; Commodities = Commodities Broad Basket; Global Infrastructure and MLPs = Energy Limited Partnership category plus funds with Infrastructure in their name; Alternatives = Multialternative, Long/Short Equity, Managed Futures, Market Neutral, Europe OE Alt Systematic Futures. For illustrative purposes only. Mutual funds net realized capital gains must be distributed annually, and average turnover is shown as a proxy for the potential for those capital gains to be short-term in nature. In an effort to distinguish funds by what they own, as well as by their prospectus objectives and styles, Morningstar developed the Morningstar Categories. While the prospectus objective identifies a fund s investment goals based on the wording in the fund prospectus, the Morningstar Category identifies funds based on their actual investment styles as measured by their underlying portfolio holdings and other statistics over the past three years. In an effort to distinguish funds by what they own, as well as by their prospectus objectives and styles, Morningstar developed the Morningstar Categories. While the prospectus objective identifies a fund s investment goals based on the wording in the fund prospectus, the Morningstar Category identifies funds based on their actual investment styles as measured by their underlying portfolio holdings and other statistics over the past three years. We believe there is no time like the present to implement a tax-aware investment strategy. Being strategic about taxes is all about transforming the way investors construct portfolios, beginning with the use of tax-aware investment strategies and extending to the thoughtful matching of asset classes and account types. While taxes may be one of the few financial certainties in life, a thoughtful approach to investing can potentially help reduce their impact on long-term returns. 4 Three-year asset-weighted yield of funds included in Morningstar s U.S. open-end high-yield bond category. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this presentation. 4 Goldman Sachs Asset Management

5 Risk Considerations: Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Equity securities are more volatile than bonds and subject to greater risks. Small and mid-sized company stocks involve greater risks than those customarily associated with larger companies. Bonds are subject to interest rate, price and credit risks. Prices tend to be inversely affected by changes in interest rates. Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, call and extension risk. Investments in foreign securities entail special risks such as currency, political, economic, and market risks. These risks are heightened in emerging markets. An investment in real estate securities is subject to greater price volatility and the special risks associated with direct ownership of real estate. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including, but not limited to, currency fluctuations and political instability. High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities. Income from municipal securities is generally free from federal and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). Investments in master limited partnerships ( MLPs ) are subject to certain risks, including risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow risks, dilution risks, limited liquidity and risks related to the general partner s right to force sales at undesirable times or prices. Leverage increases a fund s sensitivity to market movements. Funds that use leverage can be expected to be more volatile than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund s shares will decrease by even more. Alternative investments may employ more complex strategies, investments, and portfolio structures. In doing so, some of these strategies are extremely speculative and may expose investors to a high degree of risks, including but not limited to short selling, leverage risk, counterparty risk, liquidity risk, commodity price volatility risk, and/or managed futures roll yield risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this presentation. Page 3 Bottom Chart Notes Continued Post-tax Return (Pre-liquidation) Based on market prices. A tax-adjusted total return that is based on a few assumptions: (1) The investor does not sell the holding at the end of the time period. (2) Distributions are taxed at the highest federal tax-rate prevailing and then reinvested. (3) State and local taxes are excluded. (4) Only the capital gains are adjusted for tax-exempt funds, because the income from these funds is nontaxable. This datapoint follows the guidelines established by the Securities and Exchange Commission (SEC) in the spring of 2001 for reporting after-tax performance. Besides the tax-adjustment, this total return is also adjusted for the effects of sales loads per the SEC s recommendation. Additional Information: Taxes on Equity Mutual Funds There are three ways an investor could be taxed on an equity mutual fund: Sale of Fund Shares Selling shares of a mutual fund generates a taxable gain or loss (difference between purchase price and NAV when sold). If investment held for over a year, gain or loss is considered long term. If investment held under a year, gain or loss is considered short term. Investment Income Dividend income created when stocks held in fund distribute dividends that are passed to fund shareholders. Qualified dividends Taxed at the preferential long-term capital gains rate. Generally, stock must be held for 60 days for dividends to be qualified. Non-qualified dividends, taxed at the higher ordinary income rate. Capital Gains Distribution Net realized gain incurred from sale of fund investments is distributed to fund shareholders, regardless of an investor s entry point Distributions generally decrease the fund NAV by the amount of the distribution. Cost basis is generally unaffected. Net realized loss incurred from sale of fund investments cannot be passed through to fund shareholders, but can be carried forward and used to offset future capital gains. In order to be taxed at the qualified dividend rate, the dividend must be paid by either U.S. or certain foreign corporations and the investor must meet certain holding period requirements: Generally the stock must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Goldman Sachs Asset Management 5

6 Risk Considerations: Potential implications of tax-advantaged investing. Tax decisions may negatively affect alpha generation and pre-tax returns. Large redemptions could potentially force gains realization, negatively affecting the tax efficiency. Deferral of gains may cause new investors to increase the risk of receiving future capital gains distributions. Disclosures: Goldman Sachs does not provide legal, tax or accounting advice. Any statement contained in this communication (including any attachments) concerning U.S. tax matters was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code, and was written to support the promotion or marketing of the transaction(s) or matter(s) addressed. Clients of Goldman Sachs should obtain their own independent tax advice based on their particular circumstances. Holdings and allocations shown are unaudited, and may not be representative of current or future investments. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not a product of Goldman Sachs Global Investment Research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes. Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices. The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of failed or closed hedge funds may mean that each index overstates the performance of hedge funds generally. The website links provided are for your convenience only and are not an endorsement or recommendation by GSAM of any of these websites or the products or services offered. GSAM is not responsible for the accuracy and validity of the content of these websites. Confidentiality No part of this material may, without GSAM s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice. Goldman, Sachs & Co., member FINRA Goldman Sachs. All rights reserved. Date of first use: April 2, MF.MED.OTU 6 Goldman Sachs Asset Management