Seeking better after-tax performance for HNW investors Tax Managed Indexing

Transcription

1 Seeking better after-tax performance for HNW investors Tax Managed Indexing By Matthew Swaffin-Smith, Private Wealth Advisor, Executive Director, Morgan Stanley Private Wealth Management Sidebar: The last ten years has witnessed a period of lower than average returns (1) and an uptick in taxes (2) raising the stakes for individual investors to ensure the drag from fees and taxes is more aggressively managed to retain as much of the available compound return as possible. While the typically lower expense ratios of traditional Index Funds and Exchange Traded Funds ETFs are widely publicized and appreciated, fewer advisors and investors may be aware of Tax Managed Index Funds that aim to minimize taxes and look to deliver better net of fee and after tax returns for taxable investors. Although the expense ratio of Tax Managed Index Funds is typically higher than that of traditional Index Funds and ETFs, the tax drag can be lower and may result in better after tax net of fee returns. In addition and for those taxable investors that can meet the minimums for a Separately Managed Account SMA, Tax Managed Indexing through an SMA may assist in further minimizing taxes in other parts of their portfolios also, if suitable, since SMA s don t share the same tax-management limitations as Index Funds or ETF s. A closer look at after-tax returns using the tax-cost ratio methodology from Morningstar used to analyze after tax and net of fee/expense returns, yields some interesting results and lead me to believe that Tax Managed Index Funds and SMA s not only deserve consideration for an investor s taxable portfolio but in some cases and if suitable, should be the cornerstone of the allocation over time. Taxes are the biggest expense that [many] investors face more than commissions [and] more than investment management fees "Taxable Portfolios: Value and Performance." Journal of Portfolio Management, Winter, 1987 James P. Garland (1) S&P 500 annualized 6.88% for the 10 years ending December 31 st 2016 versus 9.53% annualized return since For the 10 Year Treasury Bond it was 4.58% vs. 4.91% and for the 3 Month Treasury Bill it was 0.73% vs. 3.42% for the same time periods respectively (2) The last 10 years saw the 10 year trailing average top tax rate on capital gains tick back up to the highest level since

2 TAX MANAGED INDEXING Tax Managed Indexing seeks to provide a pre-tax return similar to a given Index and to outperform that Index on an after-tax basis (net of fees). Portfolios invest in a subset of the securities from within the Index to replicate the benchmark s characteristics while keeping sector weights and factor exposures as neutral as possible to that Index. Tax management techniques such as tax loss harvesting and tax lot selling (Highest-In-First-Out) are systematically applied in an attempt to reduce the impact of capital gains taxes resulting from a change of constituent in the index, for example, which in turn, aims to increase the after-tax return (net of fees). While these tax management techniques can be employed systematically at an overall portfolio level across investment products (See also Tax Management Services for Select UMA ) they are more effective still if they re also systematically employed within the underlying investment products i.e. Tax Managed Index Funds or, for investors that could use more harvested losses to offset gains elsewhere on their balance sheet over time, Tax Managed Index SMA s. Tax-aware advisory best practices require thoughtfully making the most of the after-tax return potential of each investor - Helping Your Clients Execute a Tax-Aware Investment Plan, Stephen Riley and Richard Furmanski The Tax Advisor newsletter 2016 INDEXING EFFICIENCIES & THE LIMITATIONS OF COMMINGLED FUNDS The typically lower expense ratios of traditional Index Funds and ETFs are widely publicized and appreciated, however some advisors and investors may not be aware of their limitations from a tax-management perspective. There are two essential concerns: First, Index Funds and ETF s are subject to the Investment Company Act of This prohibits them from passing on net losses to investors thereby removing a potentially valuable level of detail from an investor s tax filing. In essence, investors in these Funds have less control over their tax lots. Second, Index Funds in particular, have typically higher turnover than their equivalent SMA's all else equal. Index Fund managers are forced to buy and sell more than they otherwise might in order to accommodate inflows and outflows, generating a larger taxable footprint in the process and compounding the fact they have to, and can only, pass on net gains. This isn't a problem for a tax deferred or tax exempt account, but for a taxable account it can create an additional tax drag that reduces the after tax net of fee return. The intriguing but troublesome aspect of taxes, which obviously diminish investment returns, is that they are generated by the very activity that is intended to enhance returns, namely, turnover. Is Your Alpha Big Enough to Cover It s Taxes? Robert H. Jeffrey and Robert D. Arnott, Journal of Portfolio Management, Spring 1993

3 THE ADDITIONAL ADVANTAGE OF TAX MANAGED INDEXING VIA SMAs Unlike Tax Managed Index Funds, Tax Managed Index SMA's allow individuals to own each individual security in their own name and, with it, the tax treatment of each and every element of those securities returns. Tax Managed Index SMA s are typically more expensive than traditional Index Funds and ETF s, but also have higher minimums and a higher number of holdings that may increase the complexity of the investor s tax filing. However, SMA s increase the opportunity to employ traditional techniques to potentially reduce the impact of taxes. The full extent of all of the tools are now back on the table, including buy and hold strategies, tax loss harvesting, tax lot selling (HIFO) and gifting of individual securities with low cost basis. ADDITIONAL CONSIDERATIONS The advent, and more recent success, of traditional Index Funds and ETF's has coincided with a move among many large wealth management providers to centralize portfolio construction, asset allocation and vehicle selection for taxable, tax deferred and tax exempt accounts. This has led to an increased use of traditional Index Funds and ETF s, along with a corresponding reduction in the flexibility that individual advisors have to use Tax Managed Funds and SMA s for taxable investors, thereby compounding this issue. Interestingly, the pricing and accessibility of the SMA as an implementation vehicle has improved considerably over the last ten years as the traditional asset management industry responds to the competition from Index and Exchange Traded Funds. The centralization of portfolio construction and vehicle selection at large wealth management providers has also led traditional money managers to become more flexible with their SMA minimums. Some have reduced minimums as low as $250,000 for individual investors and providers like Morgan Stanley have negotiated fee breaks that get passed on to each individual client regardless of investment amount. The implication of this is that for a HNW client looking for a blend of stocks and bonds in their taxable account, Tax Managed Index and laddered bond SMA's are now readily available for investable asset balances as low $500,000, assuming that mix is suitable for the client. CONCLUSION The last ten years has witnessed a period of lower than average returns (1) and an uptick in taxes (2) raising the stakes for individual investors to ensure the drag from fees and taxes is more aggressively managed to retain as much of the available compound return as possible. A closer look at after-tax returns using the tax-cost ratio methodology from Morningstar leads me to believe that Tax Managed Index Funds and SMA s not only deserve consideration for an investor s taxable portfolio but in some cases and if suitable, should be the cornerstone of the allocation over time.

4 REFERENCE MATERIAL - Mutual Fund Performance. William F. Sharpe, Journal of Business, vol. 39, no. 1 (January): "Taxable Portfolios: Value and Performance," James P. Garland, Journal of Portfolio Management, Winter, The Arithmetic of Active Management. William F. Sharpe, Financial Analysts Journal, vol. 47, no. 1 (January/February): Is Your Alpha Big Enough to Cover It s Taxes? Robert H. Jeffrey and Robert D. Arnott, Journal of Portfolio Management, Spring Ranking Mutual Funds on an After-Tax Basis, Joel M. Dickinson and John B. Shoven, NBER Working Paper #4393, July Reporting After-Tax Returns: A Pragmatic Approach, David M. Stein, Brian D. Langstraat and Premkumar Narasimhan, Journal of Private Portfolio Management, Spring 1999, Vol. 1 No How Well Have Taxable Investors Been Served in the 1980 s and 1990 s? Robert D. Arnott, Andrew L. Berkin PHD, Jia Ye PHD Investment Management Reflections No 3, 2000 (Page 12) - Morningstar Tax Cost Ratio; Morningstar Methodology Paper 31 January Is Your Alpha Big Enough to Cover It s Taxes? Revisited, Robert H. Jeffrey, Robert D. Arnott and Paul Bouchey, Investment Management Consultants Association, January The Arithmetic of Investment Expenses. William F. Sharpe, Financial Analysts Journal, vol. 69, no. 2 (March/April): The Arithmetic of All-In Investment Expenses, John C. Bogle, Financial Analysts Journal Volume 70 Number Tax-Efficient Investing Tactics and Strategies Paul Bouchey, CFA, Rey Santodomingo, CFA, and Jennifer Sireklove, CFA 2015 Investment Management Consultants Association Inc. - It s Time to Make Taxes Less Taxing, Michael Allison, Peter Crowley, Jim Evans, Tom Metzold, Rey Santodomingo April 9, Are Your Clients Benefiting From Tax-Aware Investment Management? Stephen Riley and Richard Furmanski, September 10, What Would Yale Do If It Were Taxable? Patrick Geddes, Lisa R. Goldberg, and Stephen W. Bianchi, CFA Financial Analysts Journal Volume 71 Number CFA Institute - Helping Your Clients Execute a Tax-Aware Investment Plan, Stephen Riley and Richard Furmanski, June 2, Parametric - After-Tax Returns - Methodology for computing January The Tax-Loss Harvesting Life Cycle A Historical Look at the Experiences of Taxable Investors in the US, Lisa Goldberg, Pete Hand and Alan Cummings, 2017, Aperio Group LLC

5 The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material has been prepared for informational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC ( Morgan Stanley ) recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Morgan Stanley Financial Advisor or Private Wealth Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Return and principal value of investments will fluctuate and, when redeemed, may be worth more or less than their original cost. Investments are not FDIC insured or bank guaranteed, and investors may lose money. The value of an investor's shares of any fund will fluctuate and, when redeemed, may be worth more or less than the investor s cost. Past performance is no guarantee of future results. Asset allocation does not assure a profit or protect against loss. Morgan Stanley Smith Barney LLC, its affiliates and its employees are not in the business of providing tax advice. Investors should seek advice based on their own particular circumstances from an independent tax advisor before implementing any tax strategy. The performance of tax-managed accounts is likely to vary from that of nontax-managed accounts. Morgan Stanley Smith Barney LLC offers investment program services through a variety of investment programs, which are opened pursuant to written client agreements. Each program offers investment managers, funds and features that are not available in other programs; conversely, some investment managers, funds or investment strategies may be available in more than one program. Please see the applicable Morgan Stanley Smith Barney LLC ADV brochure for more information. Ask your Financial Advisor or Private Wealth Advisor for a copy or you can go to our website at Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Interest on municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one s state of residence and, local tax-exemption typically applies if securities are issued

6 within one s city of residence. The tax exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companies paying dividends can reduce or stop payouts at any time. Index Funds are offered by prospectus. An investor should read the prospectus carefully before investing. It is not possible to directly invest in an index. Index funds carry the same risks as the investments comprising the indices they track. By definition, index funds are designed to match, not beat, the performance of their underlying indices. Index funds are also subject to tracking error that may result in losses greater than those of the underlying indices. Mutual Funds and Exchange Traded Funds (ETFs) are sold by prospectus, which contains more complete information about the fund. As with any fund investment, you should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. Additionally, the prospectus of each fund contains such information and other information about the fund. Prospectuses and current performance data are available on our website at An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock prices. The investment return and principal value of ETF investments will fluctuate, so that an investor's ETF shares, if or when sold, may be worth more or less than the original cost Morgan Stanley Private Wealth Management is a division of Morgan Stanley Smith Barney LLC. Member SIPC. Morgan Stanley, Private Wealth Management, 555 California Street Suite 1400, San Francisco, CA 94104