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Tax-Aware
InvestmentManagement
THEESSENTIALGUIDE
DouglasS.Rogers
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subjecttotaxes.Offerstechniquesforcomparingtax-efficiencyofmutualfunds,hedgefunds,and
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CONTENTS
Acknowledgments................................................................ vii
Introduction........................................................................ ix
P A R T O N E |E VOLUTION OF KNOWLEDGE
PERTAINING TO TAX - AWARE
INVESTMENT MANAGEMENT 1
1 TheEvolutionofTax-AwareInvestmentManagement. ...... 3
2 TheSourcesandImpactofTaxeson
InvestmentReturns. .......................................................... 11
3 SeminalResearch.............................................................. 21
4 TheTax-AwarePractitioner. ............................................. 33
5 CreatingtheTriumvirateofQualified
Professionals..................................................................... 45
-
P A R T T W O |A FTER TAX REPORTING AND
MEASURES OF TAX EFFICIENCY 55
6 MutualFundAfter-TaxReporting.................................... 57
7 SeparateAccountAfter-TaxReporting............................. 77
-
P A R T T H R E E |T AX AWARE PORTFOLIO
MANAGEMENT 101
9 OutperformingtheIndexFund...................................... 103
10 QuantitativeTax-AwarePortfolioManagement
andConcentratedStock. ................................................. 117
11 PracticesofEliteTax-AwareEquityActiveManagers..... 133
12 P
racticesofEliteTax-AwareFixedIncome
ActiveManagers.............................................................. 149
14 AmendingtheSearchProcessforTax-Aware
ManagerSelection. .......................................................... 175
15 ChallengesWithTraditionalInvestment
PolicyDevelopment........................................................ 191
18 PositioningAssetsbytheTaxCharacteristics
oftheEntity.................................................................... 243
19 T
heRoleofSystemsSolutionsin
Tax-AwareInvesting........................................................ 271
Summary............................................................................... 281
ContinuingEducationExam............................................ 287
Index..................................................................................... 294
ACKNOWLEDGMENTS
Tax-AwareInvestmentManagement:TheEssentialGuideembodiesthecol-
lectivewisdomofmanypeoplewithwhomIhavebeenfortunateenough
tointeractduringmyinvestmentcareer.Iwanttoacknowledgethosewho
havesupportedmyeffortsandprovidedmemanyoftheinsightsneces-
sarytocompletethiswork.IapologizetoanyoneImayhaveinadvertently
missedinmyattempttogivecreditwhereitisdue.
IextendmygratitudetoRalphRittenourJr.,toJeffreyGrubb,andto
myotherassociatesatCTCConsultingfortheirbackingofthisproject.
IamespeciallymindfulofthesupportofDonLindowandChrisArvani
whorecognizedearlyoninmycareermydesiretotakeonnewandex-
citingresearchpertainingtothenucleardecommissioningtrust(NDT)
industry.MyparticipationatNDTconferencesandmyinteractionwith
ArlandBrusven,DavidKrause,JamesMeehan,JoanneHoward,MaryJo
Dempsey,ThomasTuschen,EricKnause,MaryMiller,andothersonly
heightenedmyenthusiasm.MichaelBrilleyandGeneSitencouragedme
tosubmitmyfirstarticleforpublicationontax-awareinvestmentmanage-
ment,whichsetthestageforotherprojectstofollow.Similarappreciation
isextendedtoLouiseWasso-JonikasandMichaelRadfordforencouraging
myinvolvementinCFAInstitute(formerlyAIMR)activitiesandpublic
speaking.
LeePricehasalwaysbeenarespectedmentor,andtoservewithhimon
bothAIMRSubcommitteesonAfter-TaxReportinghasbeenanhonorand
privilege.IwillalwaysbeindebtedtothemembersoftheSubcommittee.
TheirresponsetotheSECproposalforafter-taxreturnsonmutualfunds
andrecommendedrevisionstotheexistingstandardswouldnothavebeen
possiblewithouttheassistanceofPaulinePilateandAleciaLicata.Stanley
LeeandLizMilleroftheNewYorkSocietyofSecurityAnalystshavebeen
consistentsupportersofthistopicandrelatedissues.
IamtrulythankfulforthewillingnessofTadJeffrey,JamesGarland,
RobertArnott,JoelDickson,JackBogle,PeterBernstein,MarcMoulton,
Brian Langstraat, David Stein, and Bob Breshock to share their expe-
riencesoncriticalresearchandproductdevelopment.JayWhippleIII,
Ron Surz, James Hollis, and Matt Schott have played critical roles in
furtheringmyunderstandingofsystemstechnology.RobertGordonand
vii
viii Acknowledgments
ThomasBoczarplayedasimilarrolewithtaxissuesastheyrelatetohedge
fundinvesting.LeslieGiardaniandherresearchofferedvaluableinsight
intothefuturedirectionoftheinsuranceindustry.TonyRochteandhis
associatesatBarclayssharedtheirknowledgeofexchange-tradedfunds,as
didGaryGastineau.WilliamReichenstein,WilliamJennings,andJames
Poterbawerethoughtfulenoughtointroducemetotheleadingcontribu-
torsfromacademia.DonPhillipswasgraciousenoughtoallowtheuse
ofafter-taxreturndatafromMorningstarPrincipia.Whilestockpickers
alwaysseemtotakecenterstageoverthosewhosespecialexpertiseisin
fixedincome,ithasbeenajoytoshareideaswithpassionatebondportfo-
liomanagerslikeGuyDavidson,ChristineTodd,andPaulJungquist.
HaroldEvenskywasinstrumentalinintroducingmetoJaredKieling,
whohassupportedtheprojectwithsageeditorialadvice.JefferyYablon
waskindenoughtosharehisquotesfromTaxNotesthatappearasepi-
graphs throughout the book.1 Encouragement from Nancy Jacob, Jean
Brunel, and Dave Spaulding to continue to publish has been a driving
forcethathasculminatedinthiseffort.
Thisbookcouldnothavecompletedwithoutthecontinuedencour-
agementofclosefriendsandrelatives.Last,andmostimportant,Ithank
mychildrenandmywife,SoonHee,fortheirunwaveringsupportand
sacrificesmadeduringthemanyeveningsandweekendsthatwereneeded
tocompletethistext.
ChapterNotes
1. The tax-related quotations that open each part and chapter were compiled
andarrangedbyJefferyL.Yablon,“AsCertainasDeath:QuotationsAboutTaxes
(2004Edition),”TaxNotesvol.102,no.1(January5,2004):99-116.
INTRODUCTION
TheImportanceofTax-Aware
InvestmentManagement
Taxeshavebeenapermanentpartofthesocial-politicallandscapeinthe
United States since the Sixteenth Amendment to the Constitution was
ratified in 1913. Soon thereafter, President Woodrow Wilson approved
theformoffederalincometaxationthatweknowtoday.Initiallyaffect-
ingonlythewealthy,itwasnotuntilafterWorldWarIIthatthefederal
incometaxbegantohaveasignificantimpactontheeconomicwell-being
oftheaveragecitizen.1
Althoughnooneenjoyspayingthem,taxesserveanimportantpur-
pose.Taxesarethesourceofrevenuethatenablesthegovernmenttobuild
theinfrastructurenecessarytomaintainandenhanceourqualityoflife
andtoprovideforthecommondefense.Andlikethepricesofsecurities,
taxeswillchange!Thepricesofsecuritiesfluctuatedailyasmarketpartici-
pantsassesstheimportanceofthevariousforcesaffectingtheeconomy,
whereastaxrateschangemoreslowly,reflectinggovernmentpoliciesand
spending. Since the adoption of the federal income tax, tax policy has
becomeanincreasinglyimportantstimulustoolwitheachsuccessivead-
ministration.Therefore,majorchangeinthetaxcodeisexpectedtobe
thenormratherthantheexception.Forthisreason,tax-awareinvestment
practicesareessentialtomaximizingwealth.
Tax-awareinvestmentmanagementreferstotheapplicationofsound
judgmentthatresultsinoptimalresultsafteralltaxesandfeeshavebeen
paid.Itisnotaboutavoidingthepaymentoftaxesthroughquestionable
accountingorestateplanningorsimplyattemptingtopaynotax.Rather,
ix
x Introduction
itisaboutmaximizingwhatisleftaftertaxeshavebeenpaid.Forexample,
ifaninvestorhasthechoicebetweentwosecuritieswithsimilarfeatures,it
isfoolishtoavoidpurchasingtheonethatwillrequireataxpaymentifit
offersasuperiornetoverallresult.Iftheinvestorreceivesahigherafter-tax
return through effective tax-aware investment management, the money
managermakesareasonableprofit,thegovernmentcollectsitsrevenue,
and we have achieved the best of all worlds—everyone involved in the
processhasgainedsomethingofvalue.
In the more than ninety years that the federal income tax has been
withus,youwouldthinkthatacademicinstitutionsandprofessionalcer-
tificationprogramswouldhavepaidsufficientattentiontotax-awarein-
vestmentmanagementtotrainpeopleanddevelopproductstoservethe
needsofthetaxableinvestor.Unfortunately,thisisnotthecase.Ashort-
ageofeducatorsandtrainedprofessionalsintax-awareinvestingpersists
because of an earlier emphasis on retirement plans and charitable orga-
nizations, which are exempt from the payment of taxes.2 All too often,
modernportfoliotheoryconceptsthathaveemergedfromthetax-exempt
accountarenaasgospelarenaivelyappliedtotaxableaccountsbywell-
intentioned individuals, resulting in less-than-optimal, costly solutions.
Thelackofattentiontotaxesintheinvestmentprocessissoseverethat
mostprofessionalsintheinvestmentmanagementindustryareunaware
that about half of the trillions of dollars of liquid assets in the United
Statesaresubjecttotaxation.
Fortunately, it is not all gloom and doom for individual taxpayers,
trusts,andcorporationswithsignificanttaxableassets.Thereareseveral
brightspots.First,overthepastdecade,agroupofdedicatedpractitioners
hasemergedtomakesignificantcontributionstothebodyofknowledge
neededtoservetaxableaccounts.Second,uniformstandardsforreport-
ingreturnsonanafter-taxbasisarenowinplaceformostmutualfunds,
andagrowingnumberofseparateaccountmanagers3areadoptingthem
fortheirclientsandforthepurposeofconstructingcompositeresultsfor
marketing purposes. Third, some managers are modifying buy-and-sell
decisionstoincorporatetheimpactoftaxes,andinnovativetax-efficient
products,suchasexchange-tradedfunds,arerapidlygainingrecognition
andacceptance.Fourth,traditionalmethodsarebeinganalyzedinorderto
betterpositionassetsinbothtaxableandtax-exemptaccountsforultimate
wealth creation. Furthermore, advancements in systems technology are
currentlyimprovingthecapabilityandscaleoftheseprocesses.
Tax-awareinvestmentmanagementinvolvesfourcriticalelements:
1 Utilizingafter-taxassumptionsintheassetallocationprocess
2 Allocatingassetclassesandmanagers/fundsaccordingtothechar-
acteristicsofeachinvestmententity
Introduction xi
3 T ax-awareequitymanagerpositioning
4 Identifyingtax-awaremanagers/funds
Implementing these steps has the potential to add from 0.5 to 2.5
percentannuallytobottom-lineperformanceorwealthcreation.Theex-
actamountofvalueaddedcanvarysignificantlybetweentaxableaccount
relationships for each element, ranging from 0 to 1.5 percent or more
depending on the complexity of the investment opportunity.The four
elements interact and complement one another. For example, you may
allocateatax-inefficientmanagertoatax-exemptaccountwherelackof
attentiontotaxmanagementisnotanissueorreplacethemanagerwith
anotherstrategythatmaycreatetaxbenefitsthatcanbeusedbeyondthe
replacementmanager.Thisprocesslendsitselftocreativityandinnova-
tive solutions all within a simple understanding of the tax code. A tax-
aware solution will take into account the investment time horizon, tax
characteristics of the investment entities involved (e.g., personal taxable
account assets, 401(k) retirement plans, and individual retirement ac-
counts),theclient’staxprofile,projectedreturns,permissibleassetclasses,
andstructure(e.g.,fundsvs.separateaccountsvs.limitedpartnerships)
of the investment portfolios. Most important, it takes a knowledgeable
and experienced professional to implement and orchestrate a tax-aware
investmentmanagementprocess.Itisnotunrealisticforahigh-net-worth
familytogainapproximately0.5percentfromusingafter-taxassumptions
forassetallocation,1.0percentfromlocatingmanagers/fundsaccording
tothecharacteristicsofeachinvestmententity,0.4percentfromoptimally
combiningequitymanagersinamannerquitedifferentthanthepension-
consultingapproach,and0.6percentfromusingtax-awaremanagersfor
thetaxableaccounts.Allfouroftheelementsareimportantandignoring
oneormoreleadstoalessthanoptimalsolution.
Tax-awareinvestingisequallyimportanttoinvestorsregardlessofthe
magnitudeofwealth.Ifanultra-affluentfamilywith$100millioninliq-
uidassetsdoesnottakeadvantageofthebenefitsoftax-awareinvesting,it
isunlikelytochangetheirlifestyle.However,itwillcertainlyimpactthe
wealthoffuturegenerationsand,ifnotemployed,lessenthechancesof
achieving and perpetuating a family dynasty. For a twenty-five-year-old
investor, a 1 percent advantage on a $10,000 portfolio will mean hav-
inganadditional$4,889forretirementsomefouryearslater.Witha2
percentenhancementtheinitialinvestmentdoublesinslightlymorethan
thirty-fiveyears,andtheindividualwillhave$12,080extraatretirement.
Thus,fortheaverageinvestor,properlyemployingthecriticalelementsof
tax-awareinvestingcanmeanthedifferencebetweenenjoyingretirement
accordingtoplanorperhapshavingtocontinuetoworkwellbeyondage
xii Introduction
sixty-five.Whetheryouareaninvestor,aportfoliomanager,orafinancial
adviserfortaxableclients,employingtheelementsoftax-awareinvestment
managementwillallowyoutosignificantlyimprovenetafter-taxresultsto
thebenefitofwealthcreationandmaintenance.Thisisthedistinguishing
valuepropositionbetweenthemanagementoftraditionaltax-exemptac-
countsandtheevolvingbodyofknowledgepertinenttoachievingoptimal
resultswithtaxableaccounts.
Withinterestratesbottomingin2003,andtheFederalReservecon-
tinuingtoincreasethefundsrate,thefixedincomemarketsareunlikelyto
achievecompellingreturnsanytimesoon.Althoughtheequitymarketsex-
periencedafavorablereboundin2003and2004,andcorporateearnings
improved measurably, valuations are still at high levels when compared
withhistoricalnorms.Thus,theconsensusofstrategistsatthebeginning
of2005isthatthemarketsareunlikelytodelivertheirpreviousaverages
of 11 percent for stocks and 6 percent for government bonds over the
nexttenyears.Furthermore,nostrategistsarepredictingarepeatofthe
spectacularresultsachievedduringthe1980sand1990s.Inthistypeof
marketenvironment,theimpactoftaxesaccountsforagreaterpercentage
ofthetotalreturn.
ThetaxpayerintheUnitedStateshasexperiencedthreeyearsoffa-
vorable tax legislation (from 2001 through 2003) and the second Bush
administrationhasalreadyexpressedthegoalofsimplifyingthetaxcode.
Moreover,thepresidenthopestomakepermanentthetaxcodechanges
implementedduringhisfirsttermandpotentiallytoeliminatetheestate
taxaltogether.Theannualgovernmentbudgetdeficitisloomingat$400
billion,however,andthefinancialsoundnessoftheSocialSecuritysystem
remains a concern. For these reasons, many are questioning Congress’s
abilitytomaintainthefavorablemaximumfederaltaxrateof15percent
onqualifieddividendsandlong-termcapitalgains.Theseandothertaxis-
sueswillbehotlydebatedintheyearsaheadbecausenooneseemssatisfied
withthestatusquo.Forboththetaxableinvestorandtheadviserserving
taxableaccounts,personalbeliefsregardingthetaxcodearenotimpor-
tant. What does matter is how maximum value can be extracted from
the available opportunities.This is especially true today because we are
inalow-returnenvironment,andthegapbetweenapplyingatax-aware
solutionornotcanresultinanannualdifferenceof2percentormore.A
workingknowledgeoftheevolutionofthetaxcodes,reportingstandards,
portfolioconstruction,andallocationofassetsinatax-awaremannerisas
valuabletoday,ifnotmoreso,asitwaswhenthefederalincometaxwas
established.
Introduction xiii
ChapterNotes
1. Touis AllenTalley, “CRS Report on History of FederalTaxes,” CRS Report
forCongress,January19,2001,1–8,http://www.taxhistory.org/thp/readings.nsf
(accessedJuly7,2004).
2. UnderSection4940oftheInternalRevenueCode,charitableorganizations
maybesubjecttoataxof2percentonnetinvestmentincome.
3. Throughoutthisbookthetermseparateaccountisusedinitstraditionalmean-
ing, i.e., an established account with a money manager, rather than the retail-
oriented wrap account industry where a bundle of investments and services is
providedforasinglefee.
This page is intentionally blank.
PARTONE
EvolutionofKnowledge
PertainingtoTax-Aware
InvestmentManagement
Apersondoesn’tknowhowmuchhehastobethankfulforuntil
hehastopaytaxesonit.
—AnnLanders
(quotingananonymoussource)
1
This page is intentionally blank.
CHAPTER1
TheEvolutionofTax-Aware
InvestmentManagement
OnlyGodknowswherewegotourtaxsystem.
—SamGibbons
MemberofCongress
T
hecurrentbodyofknowledgepertainingtotax-awareinvestment
management emerged in the early 1990s. With the passage of
theEmployeeRetirementIncomeSecurityActof1974(ERISA),
investmentfirmsandacademicinstitutionsallocatedtheirresourceswith
aneyetowardissuesintheexpandingandhighlyprofitabletax-exempt
accountarea.1Asaresult,duringthe1970sand1980s,mostfirmsas-
signedtheirbestandbrightestmanagerstomanageportfoliosandserve
clientsforwhomtaxessimplywerenotafactor.
Whileplentyofassetswerebeingmanagedbythetrustdepartments
ofbanks,andbyaselectgroupofmanagersthatfocusedontheneedsof
propertyandcasualtyinsurancecompanies,verylittlewaspublishedon
howtomanageassetseffectivelywhentaxeswereafactor.Inaddition,the
mutualfundindustrywasgrowingrapidly,butmostfirmsviewedtheir
mutualfundofferingsasanopportunitytoenhancerevenuebyreaching
investorswhocouldnotqualifyfortheirseparateaccountminimums,uti-
lizingthesameprocessfortheirtax-exemptaccounts.Thetaxableassets
werethere,buttheinvestmentmanagementindustryneededacatalyst.
3
4 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
DecommissioningNuclearPowerPlants
Theinitialcalltoactionfortheinvestmentmanagementindustrycame,
oddlyenough,fromamarketnichethatmostpeopleareunawareof.In
1984,Title26,Section468AoftheInternalRevenueCodewasamended
toallowelectricutilitiestoclaimadeductionforcostsrelatedtodecom-
missioning the nation’s 103 nuclear-powered generating plants.2 With
theaverageestimatedcostofdecommissioningexceeding$200million,
asmallgroupofinvestmentmanagerssawamajormarketopportunity.
Theybegantoanalyzetheimpactoftaxesandtomodifytheirportfolio
strategiestodistinguishthemselvesfromthecompetition.Electricutili-
tiesfirstturnedtotheirpensionmanagersforadvice,buttheyknewthat
morehadtobedone.TheUtilityPensionFundStudyGroup,foundedin
1969,beganaseriesofannualconferencestodiscusstopicsrelatedtothe
efficientmanagementofretirementassets.3
In1989,ArlandD.Brusven,treasurerofNorthernStatesPowerCom-
pany,addedahalf-daytotheagendainordertoincludeissuespertainingto
nucleardecommissioningtrusts.4Theresponsewasoverwhelming.More
attendees sat through the sessions on nuclear decommissioning than in
thesessionsdevotedtopensionmanagement.5ThefirstNuclearDecom-
missioningTrusts(NDT)FundStudyGroupConferencetoaddressthe
interestsofelectricutilitiesandmoneymanagerswasheldinWrightsville
Beach,NorthCarolina,in1990.Inrecentyears,theeventhasattracted
morethan150attendees,andatleastthatmanyareexpectedin2006.
Thepresentationsbyinvestmentmanagersinitiallyanalyzedtheim-
pactoftaxesontheNDTfundingprocessandmightbeconsideredprimi-
tivebytoday’sstandards,buttheywereastepintherightdirection.After
onlyafewyears,thelevelofsophisticationofthepresentationsimproved
dramatically.Perhapsthemostimportantresultofthenucleardecommis-
sioningexperienceisthattheinvestmentmanagementindustrycouldno
longeroperateinavacuumandcontinuetodisregardtheimpactoftaxes
oninvestmentreturns.Furthermore,themanagerswhoachievedmean-
ingful market share in this niche were those who effectively communi-
catedallrelevantfactorsthataffecttheday-to-dayportfolioconstruction
andmanagementprocesstothepartiesinvolved.
For the NDT industry, the basic relevant factors include cost esti-
mates;theestimatedremaininglifeofthereactor;anunderstandingof
theapplicablefederal,state,andlocaltaxcodes;allocationofassetsamong
trustssubjecttodifferenttaxrates;andtheevolutionofregulatorymat-
ters.Unliketaxablecorporateassets,nuclearreactorshaveanestimated
lifeofapproximatelyfortyyears.Thefutureliabilityordecommissioning
isfundedthroughtwotrusts.Theelectricutilitiesfirstfundeda“qualified
TheEvolutionofTax-AwareInvestmentManagement 5
trust”usinganannualamountagreeduponbyregulatorsthatcouldbe
deductedfortaxpurposes.However,theamountpermittedtofundthe
qualifiedtrusttypicallyfellshortofthetotalestimatetocompletethede-
commissioningofthereactor.Asaresult,theutilitieshavebeenallowedto
fundtheshortfallina“nonqualifiedtrust.”Althoughnonqualifiedtrusts
donotreceivetheinitialfavorabletaxtreatmentofqualifiedtrusts,there
havebeenperiodswheretheyweregivengreatlatitudewithpermissible
assetclasses,andthetaxratesontaxableincomeandrealizedgainshave
beenadvantageous.Thetypesofassetclassesandthetaxprofilesofthe
twodifferenttypesoftrustshavebeenquitedifferentandhaveevolved
overtheyears.Therefore,allinvolvedintheprocesshavebeenconfronted
withanextremelycomplexformofasset/liabilitymanagement.Notonly
weremanagerschallengedtoprovidemoretax-efficientportfoliostrate-
gies,butconsultantshadtoadjusttheirtax-exemptaccountprocedures
toincludetaxesinassetclassassumptionsandconducttheoverallopti-
mizationonanafter-taxbasis.Additionally,theyhadtoaddresstheop-
timalpositioningofassetclassesbetweenthequalifiedandnonqualified
trusts, taking into account various regulatory restrictions and evolving
taxtreatment.Whiletheparametersofnucleardecommissioningtrusts
differfromthoseofothertypesoftaxableaccounts,itbecameclearthat
investmentprofessionalsneedtobecognizantofallrelevantfactorsinor-
dertoachieveoptimumafter-taxreturns.Theimportanceoftheannual
decommissioningconferencescannotbeunderstated—thisforumproved
tobeandcontinuestobetheleadingthinktankfromwhichmanyofthe
tax-awareinvestingideasandconceptsevolvedthathavebecomesecond
natureintax-awareinvestingtoday.
High-Net-WorthInvestors
Banktrustdepartmentshadbeenservingtheneedsoftaxableinvestors
for decades, but without a high level of sophistication. Recognizing a
marketforconsultingservicestailoredtohigh-net-worthfamilies,Ralph
C.RittenourJr.foundedCapitalTrustCo.inPortland,Oregon,in1981,
whicheventuallybecameCTCConsulting.NancyL.Jacob,theformer
deanoftheUniversityofWashingtonBusinessSchool,joinedRittenour
later.Whilethepartnershipwouldnotlast,andJacobwouldeventually
establishherownfirm,whatemergedduringtheirprofessionalrelation-
shiphadaprofoundeffectontheindustry.
Foryears,investmentprofessionalsandconsultantsattemptedtoad-
justreturnsofassetsfortheso-calledtaxhaircut,orimpactoninvestment
returns,andtopositiontheminawaythatimprovedoroptimizedoverall
results.Forarelationshipwithonevehicleorentity,suchasapension
6 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
plan,401(k)plan,ortrust,aspreadsheetsolutionwassatisfactory.But
whenmultiplevehiclesorentitiesenteredthepicture,thesolutionwas
oftenlessthandesirableinatleastoneaspect.WithfundingfromCTC,
JacobteamedwithMarcMoultontodevelopthefirstcommerciallyavail-
able software program that truly accounted for the impact of taxes—
PORTAX. Other consulting firms, investment management firms, and
banksweredevelopingsimilarproductsforusewiththeirinternalclients,
butnoneofthesecouldbepurchasedforindependentuse.
Although it is a complex tool to learn and master, the beauty of
PORTAXisthatitenablestheinvestortoincorporatetheimpactofthe
taximplicationsofvariousentities,cashflows,andtimeintheoptimiza-
tionprocess.Italsoallowstheusertoquantifytheimpactoftax-efficient
assetlocation,atopicthatJacob,JeanL.P.BrunelofBrunelAssociates,
and Gregory Friedman of Greycourt & Co. had addressed in previous
collaborationsforarticlesandpublicpresentations.PORTAX,available
fromWindermereInvestmentAssociates,isstillconsideredtobethesys-
temofchoicebymanagersworkingwithsophisticatedclientsandcom-
plextaxablesituations.
PublicizingtheNeed
The adage about the squeaky wheel getting the grease certainly applies
totheinvestmentcommunity’sreactiontothearticle“IsYourAlphaBig
EnoughtoCoverItsTaxes?”byR.H.(“Tad”)JeffreyandRobertArnott,
whichappearedintheJournalofPortfolioManagementinthespringof
1993.6Thearticlehighlightshowlessthan20percentofthemutualfunds
theauthorsanalyzedoutperformedtheVanguard500IndexFundonan
after-taxbasis.AtthesametimethatJeffreyandArnottwereworkingon
theirarticle,StanfordprofessorJohnB.ShovenandgraduatestudentJoel
M.Dicksoninitiatedaworkingpapertitled“RankingMutualFundson
anAfter-TaxBasis.”Althoughtherehadbeennocollaborationbetween
thetwoparties,bothstudiespointedtothefactthatmanagerswereig-
noringtheimpactoftaxes.Theresultsofthestudies,coveredingreater
detailinchapter3,providedtheevidencethatwasneededtoshockfund
managersintopayingattentiontotaxissues.Managerswereonnoticethat
theirfailuretoaddresstaxesintheportfoliomanagementprocesswasap-
parentandthattheinvestingpublicwouldbegintoholdthemtoahigher
standardofaccountability.
JeffreyandArnott,alongwithShovenandDickson,broughtthene-
glectofmanagerstocenterstage,butastandardmethodofmeasuring
results on an after-tax basis was needed. In response to requests from
clients, Lee N. Price, of Rosenberg Capital Management, approached
TheEvolutionofTax-AwareInvestmentManagement 7
theAssociationforInvestmentManagementandResearch(AIMR)with
theideaofdevelopingstandardsforreportingafter-taxreturns,similar
to what was in place for before-tax returns.7 At the 1993 NDT Fund
Conference, Price announced his vision and the AIMR Subcommittee
forAfter-TaxReportingwasformed.TheSubcommittee,co-chairedby
PriceandRobertE.Pruyne,consistedofworkingprofessionalswhohad
extensiveexperiencewithtaxableaccounts.Thestandardswereadopted
by AIMR in 1994, but only a few firms, primarily those with nuclear
decommissioningaccounts,implementedthem.
SECIssuesaProposal
The importance of this initial work, spearheaded by Price, cannot be
underestimatedsinceitaddressedmanyofthekeyconceptsandlaidthe
foundationforfutureinitiatives.Onceagain,however,amajorcatalyst
was needed to achieve a lasting result, and that catalyst proved to be
the escalation of private wealth in the late 1990s. With the favorable
returnsoftheequitymarketsduringthisperiod,anincreasingnumber
ofinvestorswerebecomingconcerned,ifnotdownrightupset,aboutthe
capitalgainsdistributionsfromtheirmutualfunds.TheSecuritiesand
ExchangeCommission(SEC)begantoresearchafter-taxreportingand
issuedaproposalforpubliccommentinMarchof2000.TheU.S.House
ofRepresentativesunderscoredtheimportanceofthesubjectbypassing
the Mutual Fund Tax Awareness Act of 2000 in April, introduced by
CongressmanPaulGilmourandadoptedbyavoteof385–2.8TheAIMR
subcommittee was reconstituted, with the author, Douglas S. Rogers,
as chairman. A dozen uniquely qualified and dedicated Subcommittee
membersworkedselflesslyoverathree-yearperiodfirsttorespondtothe
SEC’sinitiativeandlatertomakerecommendationstotheAIMRboard
andtheInvestmentPerformanceCouncil(IPC).Mostmutualfundsare
nowrequiredtoprovideafter-taxreturnsintheprospectus.Revisionsto
theseparateaccountstandardsforthosefirmswiththedesiretoadopt
themwentintoeffectinJanuary2005.
ConferencestoShareInformation
Anotherkeydevelopmentintheevolutionoftax-awareinvestmentman-
agementhasbeenineducation,orthedisseminationofinformation.Ini-
tiativesbytheFamilyOfficeExchange(FOX)andtheInstituteforPrivate
Investors (IPI), under founders Sara Hamilton and Charlotte B. Beyer,
respectively,addressedtheneedsoftheinfluentialbuyerinthemarket-
place—thehigh-net-worthfamily.BothFOXandIPImanagedtobring
8 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
together buyers and providers in a manner that facilitated an open ex-
changeofinformation,forcingallpartiestoseekahigherlevelofknowl-
edgeandsophistication.Theeffortreinforcedthelessonslearnedthrough
thenucleardecommissioningexperience.Sincehigh-profilefamiliesand
individualinvestorsareeasiertoidentifywiththannuclearreactorsand
have influence with other buyers in the marketplace, these and similar
educationeffortsbyotherorganizationsanduniversitiesarewhatfinally
broughthometotheprofessiontheimportanceoftax-awareinvesting.
Perhapsthemostimportantconferencesonthetopicoftax-aware
investinghavebeenthoseheldbyAIMR.TheInvestmentCounseling
forTaxableInvestorsConferenceheldinNovember1998wasthefirst
oftheseannualeventsthatattractedspeakerswithexpertiseinvarious
taxable-account-relatedfields.9Thesemeetingscapturedanenormous
amount of intellectual thought of the day, and the published AIMR
ConferenceProceedingscanbeorderedfromtheorganization.Forany-
oneservinghigh-net-worthindividualsandfamilies,thesepublications
areconsideredanessentialelementofthemanager’sprofessionallibrary.
Althoughsomeofthearticlesfocusontheneedsoftheultra-affluent,
the concepts presented can be applied to almost all taxable-account
opportunities.
BabyBoomersCauseaShift
Withmorethanfifteenyearsofprogressinthetheoreticalapproachtotax-
awareinvestmentmanagement,andwithafter-taxreportingstandardsnow
inplace,theemphasisisshiftingtowardimplementingstrategiesthrough
scalablesoftwaresolutionsthattakeintoaccounttheuniquecharacteris-
ticsofeachclientrelationship.Surprisingtomanyisthecurrentemphasis
onallocatingresearch-and-developmentdollarstodevelopingsystemsfor
smalleraccountsandtheretailsegmentoftheinvestmentbusiness.Thus,
ratherthansoftwaredevelopmenttricklingdownfromthemoresophisti-
catedportionofthemarket,itisnowbuildingmomentumfromdemand
thatwascreatedfollowingtheSEC’smandatethatmutualfundsprovide
after-taxreturninformation.Manybelievethisisoccurringbecauseasthe
wealthofthebabyboomersincreases,theseinvestorsareshiftingtheiras-
setsfrommutualfundstowrapaccounts.Theynaturallyaskthequestion,
“Ifyourfirmcanprovideafter-taxreturnsonyourmutualfunds,whycan’t
youdoitherewhenthefeesarehigher?”Whichportionofthemarketgets
therefirstisreallynotimportant.Whatissignificantisthatthestateof
tax-awareinvestmentmanagementhasneverbeenbetter:progressisbeing
madeandthefutureispromising.
TheEvolutionofTax-AwareInvestmentManagement 9
ChapterNotes
TheSourcesandImpactofTaxes
onInvestmentReturns
Taxation,inreality,islife.Ifyouknowthepositionapersontakes
ontaxes,youcantelltheirwholephilosophy.Thetaxcode,once
yougettoknowit,embodiesalltheessenceoflife:greed,politics,
power,goodness,charity.
—SheldonS.Cohen
FormerInternalRevenueServiceCommissioner
A
nunderstandingofhowtaxesaffectinvestmentreturnsisessential
toaportfoliomanager’sabilitytoaddvaluenetoffeesandtaxes.
Whentheknowledgeiscombinedwithskill,managerscanevolve
from reacting to tax consequences to developing proactive procedures
tobenefitfromthem.Theimpactoftaxesoninvestmentreturnscanbe
brokendownintothefollowingareas:
❑ Componentsoftotalreturnandtheleveloftaxationimposedon
each
❑ Holdingperiodoftheinvestment
❑ Taxconsequencesofsellingandbuyingsecurities
❑ Fees
Usingthismodel,theindividualwhoisnewtotax-awareinvestment
management should be able to determine, with the assistance of the
twomethodologiesmostcommonlyusedtomeasureafter-taxreturns,
whichtypesofsecuritiesandinvestmentstylesarebestsuitedfortaxable
accounts.
11
12 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
IncomeComponentofInvestmentReturn
Investment returns consist of three components: income, appreciation,
andthereinvestmentofincome.Thethirdcomponent—reinvestmentof
income—isnotasignificantfactorforshortperiodsofanalysisbuthasa
meaningfulimpactforlongerperiods.Notallincomeistreatedequally.
Forexample,theUnitedStatesandItalyaretheonlytwocountriesinthe
worldtooffertax-exemptbonds.Tociteanotherexample,asignificant
provisionoftheJobsandGrowthTaxReliefReconciliationActof2003
istheloweringofthetaxrateon“qualified”dividendsfromtheordinary
incomeratetothemorefavorablerateforlong-termcapitalgains.Yetal-
thoughmostdividendsqualifyforthelowerrate,taxedatamaximumrate
of15percent,themajorityofincomedistributedfromrealestateinvest-
menttrusts(REITs)doesnot.AsofDecember31,2004,commonstocks
in the United States provided a dividend yield of 1.6 percent, whereas
REITs were offering a yield of approximately 4.6 percent. Let’s assume
aninvestoranticipatesa10percenttotalreturnonstocksandREITsover
thenextyear,andthathecangointothemarketandpurchaseaunitof
each for $100. If the investor does not hold the units in a tax-deferred
accountandissubjecttothehighestfederaltaxrate,thenthecommon
stockinvestmentwillgenerate$1.60individends,causingataxof$0.24
($1.60 dividend taxed at 15 percent).The REIT investment, however,
willgenerate$4.60innonqualifyingdividendstaxedatthemaximumrate
onordinaryincome,resultinginataxof$1.61($4.60dividendtaxedat
35percent).Severalsourcesreportthatupto25percentofREITsgenerate
qualifieddividends,butthegeneralconsensusofportfoliomanagersserv-
ingthisnichesuggeststhatqualifieddividendsfromREITsarequiterare.
Thekeycommontotheseexamplesisthatthenatureoftheincome
matters. If you have the opportunity, place investments that generate a
highleveloftaxableincome—intheprecedingexample,REITs—intax-
deferredaccounts!
Pre-LiquidationandPost-LiquidationReturn
Priorto2003,stockdividendsintheUnitedStatesweretaxedattheordi-
naryincomerate.Thiscreatedadisparityinthepotentialafter-taxreturns
betweentwostocksofferingsimilaroverallresultswhentherewasamean-
ingfuldifferenceintheirdividendyields.Inthelasttwenty-fiveyearsor
so,themaximumrateonordinaryincomehasfallenfrom50percentto
35percent,andtherateonlong-termcapitalgainsfrom39.9percentto
15percent.Inaddition,commonstockdividendyieldshavefallenfrom
5percenttoapproximately1.6percent.Afewselectyearswereanalyzed
TheSourcesandImpactofTaxesonInvestmentReturns 13
FIGURE2.1 ProjectedAfter-TaxReturnsona10PercentTotal
ReturninCommonStocks
AVERAGE TAX
STOCK ON TAXON ONEYEAR FIVEYEARS
YEAR YIELD DIVIDENDS LTGAINS PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.
tocreateprojectedafter-taxreturnsinFIGURE2.1usingabefore-taxtotal
rateofreturnof10percentincommonstocksandapplyingtheaverage
dividendyieldsofthetime.1
Inthecalculationsweassumea10percentannualrealizationofavail-
ablecapitalgainsandshowreturnsoverone-yearandfive-yearperiodsfor
both pre- and post-liquidation returns. Pre-liquidation returns assume
that only the dividend payments and gains realized are taxed, whereas
post-liquidationreturnsincorporatethetaximpactofpre-liquidationre-
turnsandalsotakeintoaccountthecompleteliquidationofalloutstand-
ingcapitalgainsandlosses.Whileactualbefore-taxreturnsprovedtobe
quitedifferentfromtheassumed10percent,thisprocessenablesusto
see how the yield characteristics of the market and the tax code create
differentcircumstancesforthetaxableinvestorattemptingtoformulate
strategy.Inthiscase,havingknowledgeofthepastmayprovebeneficialif
historyrepeatsitselfandtaxratesbegintoriseduringthenextdecade.
Howwecalculateafter-taxreturnscaninfluenceourdecisions.There-
fore, we disclose after-tax returns on both a pre- and post-liquidation
basis.Fansofpre-liquidationreturnsbelievethesearemostappropriate
when analyzing returns of individuals, since the tax code allows for a
step-upinthecostbasisofsecuritiesatdeath.Supportersofthepost-
liquidationmethodologypointtothefactthatmostportfoliosorsecuri-
tiesareliquidatedorsoldmanytimesandthatyouneedtoemphasize
thecostofmakingthesemovestogettheinvestor’sattention.Because
therearevalidreasonsforboth,theywillbeshownwheneverpossible
throughoutthetext.A10percentbefore-taxtotalreturn,10percentan-
nualcapitalgainsgeneration,marketdividendyieldof1.6percent,and
14 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
FIGURE2.2 T rendsinPre-andPost-LiquidationAfter-Tax
Returns
1 9.47% 6.82%
10 9.16% 8.44%
20 9.04% 8.63%
Source:DouglasS.Rogers
30 8.98% 8.70%
40 8.95% 8.74%
50 8.94% 8.77%
currentprovisionsofthetaxcodewereappliedtoachievetheafter-tax
returnsshowninFIGURE2.2.Whenthereisapositiveunrealizedcapital
gainsposition,pre-liquidationafter-taxreturnswillbegreaterthanthe
post-liquidationafter-taxreturns.Asthefigureshows,thereisonepecu-
liarityofpre-andpost-liquidationsreturns:oneserieshasthetendency
todecreaseovertimewhiletheotherincreases.
AsFigure2.2shows,pre-liquidationafter-taxreturnstendtohavea
slightdownwardtrend,whereaspost-liquidationreturnsincreaseandare
appliedwheninvestmentmanagerswishtohighlightthebeautyofcom-
poundingtax-freeoverextendedperiodsoftime.Thebuy-and-holdinves-
tortakesfulladvantageofthisconcept,asheunderstandsthathisbesttax
breakmaybenottosellandthusavoidrealizingcapitalgains.Thismakes
senseaslongasthevalueofthesecurityisnotfallingandthegeneraltrend
fortaxesisdecreasingorstable.
HoldingPeriodofanInvestment
Ifwegobackjustafewyearstothetimewhendividendsweretaxedas
ordinaryincomeat39.6percentandlong-termcapitalgainsat20percent,
wecananalyzehowtheleveloftaxableincomecanhaveasignificantim-
pactonpotentialafter-taxreturns.
Therateoftaxationondividendsandshort-termcapitalgainsisthe
same, so naturally all one-year returns, regardless of the dividend yield,
showareductionof3.96percent,inFIGURE2.3,fromthebefore-taxtotal
rateofreturnof10percent.Notethemeaningfuldifferences,especially
TheSourcesandImpactofTaxesonInvestmentReturns 15
FIGURE2.3 ImpactofTaxableIncomeonAfter-TaxReturnsWhen
theTaxonDividendsIsGreaterThantheLong-Term
CapitalGainsRate
ofthepre-liquidationafter-taxreturns,whencomparingtheresultsofthe
1percentand5percentdividendyieldportfolios.Thegapnarrowswith
thefive-yearpost-liquidationafter-taxreturnsofthe1percentand5per-
centportfolios,butthedifferenceisstillsignificant.Higherportfolioyield
istypicallyassociatedwithvalue-orientedstockselection.2Althoughitis
notthepurposeofthistexttodebatewhethervalueoutperformsgrowth
onapersistentbasis,allthingsbeingequal,lower-yieldingbuy-and-hold
portfoliosofferthepotentialforhigherafter-taxreturnswhenthetaxon
dividendsisgreaterthanthetaxonlong-termcapitalgains.
Tradingactivitythatresultsintherealizationofpositivecapitalgainsis
costlytoafter-taxreturns.However,itmustbeunderstoodthatlowturn-
overisnotnecessarilyaguaranteeofahighleveloftaxefficiencyandwhen
relied on can lead to erroneous conclusions.The Dodge & Cox Stock
Fund is known to have an enviable record of long-term performance,
typically ranking in the top 10 percent of all similarly managed funds.
Althoughithasaportfolioturnoverratethataverages20percentorless
inmostyears,itstilllosesabout1.75percentannuallytothepaymentof
taxesfromdividendandcapitalgainsdistributions.3
Perhapsthebestwaytounderstandthedilemmafacedbythetaxable
investorsintheDodge&CoxStockFundisthroughthe“pipeanalogy”
developedbyGlynA.Holton.4Holtonlikensbuildinganunrealizedcapi-
talgainspositiontowaterenteringapipe.Watercontinuestofillthepipe
andeventuallywhatgoesinmustcomeouttheotherendastaxableor
realizedgains.Holtonequatesthelengthofthepipetotheleveloftrad-
ingactivity.Thelengthorcapacityofthepipedictateshowmuchtime
passesbeforethepipeisfilled,theamountofwaterheld,andtheaverage
amountoftimeittakesforwatertofillthepipe.Lowertradingactivity
16 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
FIGURE2.4 T heImpactofCapitalGainsRealizationonAfter-Tax
Returns
ONEYEAR TWENTYYEARS
RATE PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.
Source:DouglasS.Rogers
50% 6.82% 6.82% 7.80% 7.69%
100% 6.82% 6.82% 6.82% 6.82%
isequivalenttoalongerpipe,whichneedsmoretimeandwatertofillit.
TheDodge&CoxStockFundisaseasonedproductandthecapacityof
its“pipe”hasgrownwithever-increasingassets.However,waterneedsto
figurativelytricklefromitspipe,ortheturnovermustfallwellbelowthe
historical20percentlevel,ifthefundwantstolowerthetaxbite.Thisis
becauseittakesextremelylowlevelsofcapitalgainsrealizationtotrulybe
tax-efficient,asthepre-andpost-liquidationreturnsforthetwentyyears
showninFIGURE2.4highlight.
Itmaybeunrealistictothinkthataproductcanbemanagedtogener-
ate0percentcapitalgains,butitisbeingdone—andwithgreatsuccess,as
wewillseeinlaterchapters.Forthisexercise,thecapitalgainsrealization
rate is the percentage of capital gains realized when compared with the
amountofappreciationduringthepastyear,plustheamountoftheprevi-
ousunrealizedcapitalgainsoutstandingintheportfolioatthebeginning
oftheperiod.
TaxConsequencesofSellingand
BuyingSecurities
Acommonphrase—“thegood,thebad,andtheugly”—hasbeenusedto
describetradingactivity.Discussingtheseinreverseorder,“ugly”trading
activityleadstocapitalgainstaxedatthehighestleveloftaxation,which
iscurrently35percentforindividualswhensecuritiesareheldforaperiod
ofoneyearorless.TheonlyreasonFigure2.4doesnotshowa6.5percent
TheSourcesandImpactofTaxesonInvestmentReturns 17
return in both the pre- and post-liquidation columns for the one-year
time period is that qualified dividend income is currently taxed at the
morefavorablelong-termcapitalgainsrateof15percent.Thekeyhere
isthatifyouholdthesecurityforonedaymorethanayear,youcansave
20percentontherealizedportionofthecapitalgainposition!Ifyoutrade
intheshortterm,andgenerategains,youhavetooutperformthetypical
managerthroughstockselectionby2.5percentayear—adauntingtask
inmoreefficientareasofthemarket—justtokeepupwiththeaverage
manager,andthisdoesnottakeintoaccountthecostofcommissions,the
bid/askspreadbetweensecurityprices,orsettlementcosts.
“Bad”tradingactivityresultsintherealizationofcapitalgainsthatare
subjecttotherateoftaxonlong-termcapitalgains.Whilethisratehas
beenloweredfrom20percentto15percentbeginningin2003,itisstill
costlyandshouldstillbeavoided,ifpossible.Mostactivelymanagedstock
portfoliosstillhavetheirfillof“bad”tradingactivity,asthevastmajority
ofthemaremanagedbyindividualswhofailtoaccountfortheimpact
oftaxespriortosellingasecuritywithembeddedgainsandreinvesting
the proceeds in another security.This is evident in the average annual
turnoverrateforequitymutualfunds,whichhasrangedfromalowof
55percentin2003toahighof81percentin1987.5Themorefavorable
ratein2003ismostlikelyduetothegreaterflowstopassivefundsrather
thantoachangeintradinghabitsofportfoliomanagers.Asthelastcolumn
ofFigure2.4shows,ittakeslevelsofcapitalgainsrealizationoflessthan
5 percent annually to stay competitive on an after-tax basis.This may
sounddifficult,butitispossibletorealizelowlevelsofcapitalgains,which
leadsustothefinaltypeoftradingactivity.
Itisnotasintotakegains.Theobjectivefortaxable-accountmanagers
istoachievethehighestafter-taxreturnpossible,ratherthanpayingno
taxes.Therefore,ifaportfoliohasachievedasubstantialprofitinapartic-
ularstock,andthereareclearsignsthatthefundamentalsofthecompany
aredeteriorating,sellthepositioninthemostefficientmannerpossible.
Thisisnotthetimetobecomea“taxhero,”aswelearnedalltoowellwith
technologyissuesafterthespringof2000.Takinggainswhentheoutlook
isforrapidlyfallingpricesiscertainlygoodtradingactivity.Anothertype
of“good”tradingactivitythatmaybelessobviousinvolvesanalyzingthe
sale and purchase of two securities on an after-tax basis. If a purchase
candidateofferssuperiorreturnpotentialwhenthetaxpaymentonthat
securityisincorporatedintheanalysis,thenthetrademakessense.
The best-known “good” turnover in tax-aware investment manage-
ment circles is the potential for realizing losses when they are available
intaxableaccountportfolios.Thiscanbeadifficultconceptforeventhe
mostseasonedinvestorstograsp.Itmayappearatfirstthatamanageris
18 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
purposelylosingmoneyfortheclient.Wedon’twanttogetcarriedaway
likeMichaelDouglas’scharacterinthemovieWallStreetwhosays“greed
isgood,”butunlikeinthetax-exemptaccountarena,lossescanhavegen-
uineeconomicvaluefortaxableaccountswhenproperlymanaged.Ifthere
isanicefeaturewithinourtaxcode,itisthatlossescanbeusedtooffset
realizedgains.Iftheycannotbeappliedinitially,theymaybe“saved”for
the future, and in some cases indefinitely. You may also hear, “Trading
or turnover for taxable accounts is like cholesterol, in that our doctors
informustherearebothgoodandbadformsofcholesterol.”Ifcholesterol
isapermanentpartofourdailyexistence,thenwhynotfocusontaking
advantageofthegoodcholesterolandreducethenegativeimpactofthe
badformofcholesterolasmuchaspossible?Thesamethoughtshouldbe
appliedtotradingactivityandtherealizationofcapitalgains.Noportfolio
managerwantstopurposelylosemoney,butthemarketdoesnotgoup
everyday.Sotakeadvantageofthenaturallyoccurringvolatilityofsecurity
pricesand“harvest”losseswhenitmakeseconomicsensetodo.Besides,
“tax-loss harvesting” reduces the cost of the other two forms of “good”
tradingactivitywhengainshavetoberealized.
We’veoftenheardthatthereisnosuchthingasafreelunch.Tax-loss
harvestingmaynotbeafreelunch—therearetradingcostsassociatedwith
theprocess—butitmaybetheclosestthingtoafreelunchintheinvest-
mentmanagementindustry,andavoidingit may ultimately represent a
missedopportunitywithtrueeconomicvalue.Asmyfatheroncesaid,“It
maynotbethebestthinggoing,butitsurebeatswhatisinsecondplace!”
Inthepastdecade,greatstrideshavebeenmadeintheunderstandingand
executionofthetax-lossharvestingtrade.Thereissimplynolongeravalid
excuseforthefailureofmanagersservingtaxableaccountstounderstand
thestrengthsandweaknessesoftax-lossharvestingandtoknowwhenand
howitshouldbeapplied.
ImpactofFees
Feesarethelastfactorthataffectsafter-taxreturns.Becausefeestakeaway
fromnetwealthcreation,tax-awareinvestorsconsiderfeesaformoftaxa-
tion.Feescomeinmanyforms,allofwhichareworthyofscrutiny.Forthe
purposeofthisdiscussion,however,wewillfocusonall-encompassingan-
nualportfolioorfundmanagementfeesalongwithanysalesload.Study-
ing the impact of fees can be an extremely worthwhile exercise because
manyfeesarenotreadilyapparenttotheinvestor.
Liketaxes,feesserveapurpose.Thereisnothingwrongwithcharg-
ing a reasonable fee for a value-added product or service. No one is in
theinvestmentmanagementbusinesstoworkforfree.Thequestionthe
TheSourcesandImpactofTaxesonInvestmentReturns 19
FIGURE2.5 TheImpactofFeesonAfter-TaxReturns
tax-awaremanagerorinvestormustaskiswhetherthefeesarereasonable
for the value that a particular product or service contributes to wealth
creation.Thesadfactisthatinmanycasestheanswerisno,andweowe
ittoourselvesandtoclientstodeterminewhatmakesthemosteconomic
sense.Withtheaveragefeesforcommonstockmutualfundsat1.5per-
centperyearandindexfundsatorbelow0.2percent,FIGURE2.5suggests
thatfeesareaformoftaxationandthattheyreallydomatter.
The first row of information in the figure suggests a 0 percent fee
scenario,andyoumightthinkthemanagerisworkingforfree.Thefact
isthatlargeindexportfoliosoftenputtheirsecuritiesoutforlendingto
broker-dealers, which may generate sufficient revenue to create, in es-
sence, close to a free or zero-cost proposition. Fees make it extremely
difficultfortheproduct-basedadviserdealingwithalimitednumberof
offeringstocompeteinthetax-awarearenatoday.Whenyoulookatthe
lastrowinFigure2.5,itbecomesclearthatevenwithamildfront-end
load,ittakesmanyyearsbeforethistypeofproductcancatchupwith
itsno-loadcounterparts,unlessthefundisgeneratingextremelystrong
positiveresultsthroughsuperiorsecurityselectionthatislikelytogener-
ateahighlevelofcapitalgains.Thisisespeciallytrueformilitaryperson-
nel,whoareoftenapproachedbyadvisersextollingthemeritsofusing
front-end-loadedfundsanddollar-costaveragingintothemarketoveran
extended period of time.The underlying logic of these systematic sav-
ingsplansissound,sinceoverseasdeploymentsmakeitparticularlychal-
lengingformilitarypersonneltomanagetheirfinancialaffairs.However,
whentheproductisnottax-efficient,themilitaryinvestorwithlimited
20 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
upsideearningspotentialcanfindhimself,tenorsoyearsdowntheroad,
barelyabletoaffordtopaythetaxonthefund’scapitalgaindistribution
withoutliquidatingshares.Ifthemanagerhasthepotentialtoproduce
a superior return, he should be compensated with an appropriate fee.
However,whentaxesareaccountedfor,itcomesasnosurprisethatmany
managersarefallingshortofareasonableafter-taxreturnobjective.
Insummary,whentax-awarepractitionersorinvestorsarecognizant
ofthecausesandultimateimpactthattaxeshaveoninvestmentreturns,
theycanbettermanagetheprocesstomaximizefutureresults.Thismeans
identifyingproductsthatareadvantageousfortaxableaccountswhilepo-
sitioningothersintax-exemptaccountswheretheywillbeleastdetrimen-
taltowealthcreation.Toassistintheprocess,managersshouldtakeinto
accountthefollowingprinciples:
❑ Whenthetaxrateishigherontaxableincomethanonlong-term
capitalgains,allelsebeingequal,lower-yieldingportfolioshavean
advantage.
❑ Extendingtheholdingperiod,especiallybeyondoneyear,enhances
after-taxreturns.
❑ Tradingactivitycansignificantlyinfluenceafter-taxreturns.
❑ Ittakesextremelylowlevelsofcapitalgainsrealizationtobetax-
efficient.
❑ Feesareaformoftaxation,andtheydomatter.
Withanunderstandingandanappreciationoftheseprinciples,you
are in a position to fully comprehend how seminal research and the
processesandproductsthatsubsequentlydevelopedhavebenefitedthe
taxableinvestor.
ChapterNotes
1. Ibbotson2003Yearbook,Stocks,Bonds,BillsandInflation(Chicago:Ibbotson
Associates,2003).
2. DouglasS.Rogers,“After-TaxEquityReturnsforNon-QualifiedNuclearDe-
commissioningTrusts,”FinancialAnalystsJournal(July-August1992):70–73.
3. MorningstarPrincipia(June30,2004).
4. GlynA.Holton,“TransientEffectsinTaxableEquityInvestment,”Financial
AnalystsJournal(May–June1994).
5. MutualFundFactBook2004(Washington,D.C.:InvestmentCompanyIn-
stitute,2004),65.
CHAPTER3
SeminalResearch
Anditcametopassinthosedays,thattherewentoutadecreefrom
CaesarAugustusthatalltheworldshouldbetaxed.
—NewTestament
E
xperienced advisers often wonder why it took until the 1990s
beforetax-awareinvestmentmanagementbegantogaintraction.
Oneofthemanyreasonsforthiswasthelackofresearchavail-
abletotheinvestmentcommunityandinvestors.Toconductanytypeof
analysistakestwomainingredients:knowledgeableindividualstocon-
ducttheexerciseandameanstomeasureresultsonthesubjecttheywish
to investigate.The first research ingredient was present in academics,
suchasGeorgeM.Constantinides,anotedprofessorattheUniversity
ofChicago,whowroteseveraloutstandingarticlesintheearly1980s.1
Hisworkaddressesoptimaltradingofbothstocksandbonds,andhe
coauthoredanarticlewithMyronS.Scholesonassetpricingthattakes
intoaccounttheimpactofpersonaltaxes.Furthermore,areviewofhis
referencesquicklyrevealstherehadbeenagreatdealofworktakingtaxes
into account by noted individuals in the 1970s. However, the more-
sophisticatedresearchofthetimeemphasizedhowtaxesinfluencedthe
pricingofsecurities,ratherthanwhetherornotanalystsandportfolio
managerstookthemintoconsideration.Theotheressentialingredient
ishavingawaytomeasureresults.Unfortunately,westilldonothave
databasesormethodstoaccuratelymeasureafter-taxresultsofseparate
accountmanagersinanymeaningfulway.Todothiswemuststillrely
21
22 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
oninformationfrommutualfunds,whichishistoricallystillarelatively
youngindustry.WhereasthefirstfundwaslaunchedinBostonin1924,
the real structure and regulatory framework for the industry was not
putintoplaceuntil1940,andthenumberoffundsdidnotsurpass500
until1978.2
“IsYourAlphaBigEnoughtoCoverItsTaxes?”publishedintheJour-
nalofPortfolioManagementinthespringof1993,wasthefirstarticleto
usemutualfundtax-relatedinformationtotrulycapturetheimpacton
investmentreturns.3Thestorybehindthisarticleisworthsharing,asit
offersseveralvaluablelessons.4ThearticlewascoauthoredbyRobertD.
ArnottandRobertH.Jeffrey.Atthetimethearticlewasprepared,Arnott
was the president of First Quadrant, a firm recognized for quantitative
investingandinsightfulresearch.Mostrecently,hefoundedhisownfirm,
Research Affiliates, and is the portfolio manager of the highly success-
fulPIMCOAllAssetFund.Knownasaprolificauthorandcoauthorof
numerousarticlesonanarrayofinvestment-relatedsubjects,Arnottalso
servesaseditoroftheFinancialAnalystsJournal,theresearchjournalof
theCFAInstitute.Robert“Tad”Jeffreyisahands-onpractitionerandhas
publishedseveralnoteworthyarticles,aswell.
In1974,Jeffrey’sfamily’scompanysoldamanufacturingsubsidiaryfor
cash.Therefore,thefamilyhadtomakeamajoradjustmentfrommanag-
ingoperatingcompaniestooverseeingataxableportfolio.Havingbeena
historymajor,Jeffreyhadtolearnquickly.Itwasprobablyablessingin
disguisethathedidnothaveaformalinvestmenteducation,ashisthink-
ingwasnotinhibitedbytraditionalportfoliomanagementpractices.
Jeffrey made a very wise move by asking none other than Peter L.
Bernsteintoassistasaconsultanttothecompany.Bernsteinhadbeena
teacheratWilliamsCollege.Shortlyafterhisdeparture,Jeffreyenrolled
thereasastudent.Theymetlateranddevelopedawarmfriendshipover
theyears,andJeffreyaffectionatelyreferstoBernsteinashisprofessor.
BernsteinintroducedJeffreytosomeofthemostnotedpersonalitiesin
academia,investmentmanagement,andpensionconsulting.Throughout
the1980sJeffreysentletterstotheseindividuals,suchasthelatePeterO.
DietzofFrankRussellCo.,seekingmoreefficientwaystomanagetaxable
assets.5 Meanwhile, Jeffrey continued to hear of firms that could possi-
blyaddresshisspecialneedbutthattheyhadallthebusinesstheycould
handle from the mainstream and would find it uneconomical to divert
theirresources.JeffreyevensentJackBogleofVanguardalettersuggesting
launching a product similar to theWindsor Fund that would explicitly
taketheimpactoftaxesintoconsideration,butVanguardwouldnotdi-
rectlyaddresstheneeduntilsomenineyearslaterwhenitlaunchedthe
“Tax-Managed”seriesoffundsin1994.6
SeminalResearch 23
LikeTadJeffrey,RobArnottwasconcernedabouttheimpactoftaxeson
hisownportfolio.Knowingthatbothindividualshadapassionateinterest
inthesubject,BernsteinintroducedthemafteroneofArnott’sarticleson
taxableaccountinvestinghadbeenrejectedbyFinancialAnalystsJournal.
AsArnotttellsthestory,hehadwrittenaninternalpieceonhowtrading
affectsafter-taxresultsandshareditwithJeffrey.Afterreadingthearticle,
Jeffreyremarked,“Thisisgreat,butweneedtoputsomethinginEnglish
sotheaverageindividualcanunderstandit!”ToaddressJeffrey’sconcern
aboutsimplicity,theydecidedonamorereal-worldversustheoreticalap-
proach.Theycomparedtheafter-taxperformanceofallfundsclassifiedby
Morningstaras“growth”and“growthandincome”thathadatleast$100
millioninassetsthroughouttheperiodof1982to1991.Obviously,there
issurvivorbiasinthestudy,asmanylesser-performingfundsthatcouldnot
attractandmaintainthe$100millionthresholdwereeliminated.Rather
thanapplythemaximumfederaltaxratesforindividuals,theyapplieda
35percentratesothattheresultswouldapplytothevarioustypesoftax-
ableaccounts.Theresultsfromseventy-onefundsstudiedwerecompared
withtheVanguard500IndexFund,andalsowithafictional“Closed-End
Index500”asabetterbenchmark,sincemutualfundsaresubjecttotax
implications from shareholder redemption activity. The latter is a valid
comparisonbecause,asJackBoglehasstated,closescrutinyonredemption
activitydidnotbeginuntilsometimelater,andtheafter-taxresultsofthe
Vanguard500IndexFundwouldhavebeenhigherifcurrentcontrolshad
beeninplace.7FIGURE3.1givesthekeyresultsoftheirstudy.
FIGURE3.1 N umberofLargeActivelyManagedMutualFunds
Source:RobertH.JeffreyandRobertD.Arnott,“IsYourAlphaBigEnough
ofSeventy-OneThatOutperformedtheRespective
toCoverItsTaxes?”JournalofPortfolioManagement(Spring1993)
IndexFund(1982–1991)
“CLOSED-END VANGUARD
TOTALRETURN INDEX500” 500INDEX
Pretax 15 15
AfterCapitalGainsTaxes 5 10
AfterCapitalGains
andDividendTaxes 6 9
AfterAllTaxes
IncludingDeferred 10 13
24 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Readers,especiallythoseintheinvestmentmanagementcommunity,
wereshockedtodiscovernotthatonly21percent(15outof71)fundsbeat
theVanguard500IndexFundonapretaxbasisbutthatonly13percent
(9 out of 71) outperformed on an after-tax basis, once taxes on capital
gainsanddividenddistributionswereaccountedfor.Thismethodofcal-
culationisnowknownasthe“pre-liquidationmethodology,”asthetaxon
theunrealizedcapitalgainorlosspositionisnottakenintoaccount.Since
large-capitalizationstockindexfundshaveverylittleturnoverintheirhold-
ings, capital gains distributions are primarily attributable to shareholder
activityormergersandacquisitionsthatareconsummatedasataxablecash
transactionratherthanasatax-freeexchangeofshares.Therefore,allelse
being equal, index funds are likely to have greater embedded unrealized
capital gains positions than actively managed funds that are consistently
generatingcapitalgainsthroughthesaleandpurchaseofindividualsecu-
rities. Even with the most conservative post-liquidation calculation only
17percent(13out71)ofthefundsoutperformedtheVanguard500Index
Fundonanafter-taxbasis.
OfthethirteenmutualfundsthatoutperformedtheVanguard500
IndexFundonanafter-taxbasis,onlytwodidsobyameaningfulmargin
(see FIGURE 3.2).These were the CGM Capital and Fidelity Magellan
funds managed by legendary managers Ken Heebner and Peter Lynch,
respectively.The helm of Fidelity Magellan has changed hands several
timessincePeterLynchmanagedthefund,butneitherfundhasrepeated
FIGURE3.2 Ten-YearPretaxandAfter-TaxGrowthofDollars
InvestedinVariousMutualFunds(1982–1991)
Source:RobertH.JeffreyandRobertD.Arnott,“IsYourAlphaBigEnough
toCoverItsTaxes?”JournalofPortfolioManagement(Spring1993)
10
9
CGMCapital Pretax
8 Aftercapitalgainstax
Magellan Aftercapitalgainsanddividendtax
7 Afterdefferredcapitalgainstax
Closed-EndIndex500
6
Dollars
Vanguard500Index
5
4
2 Windsor
Figure3.2Rogers
SeminalResearch 25
FIGURE3.3 T en-YearAfter-TaxPerformance(fortheTenYears
Ending12-31-2004)
Source:MorningstarPrincipia(January2005)
RETURNAFTERTAXES RETURNAFTERTAXES
MUTUALFUND ONDISTRIBUTION ONDISTRIBUTION&SALE
overthepasttenyears,as FIGURE3.3shows.8Partofthetwofunds’in-
ability to outperform an index fund can be explained by their growth
styleofinvestingbeingoutoffavorforthepastfiveyears.However,the
pointofthisexampleistohighlighthowdifficultitistooutperformthe
indexonafter-taxbasisoveralongperiodoftimeandthentorepeatthe
featinthefuture.
Evenaftermorethanadecade,“IsYourAlphaBigEnoughToCover
ItsTaxes?”isstillconsideredtheseminalarticleintax-awareinvesting,asit
clearlydemonstratedthedifficultyinattemptingtooutperformalow-fee,
large-capitalization index fund on after-tax basis when relying on tradi-
tional portfolio management practices.The study also highlighted how
taxconsequencesaremoreafactoroftheholdingperiodandtheirimpact
diminishesasturnoverincreases.Itsimpactontheindustryhasbeenpro-
found,asitunderscoredtheamountofresearchthatneededtobedone
intotaxable-accountinvesting.
Over the years, financial services entrepreneur Charles Schwab de-
veloped a supportive relationship with Stanford University. He funded
theCharlesR.SchwabProfessorofEconomicsposition,whichwasfilled
by professor John B. Shoven.9 After launching the Schwab 1000 Index
Fundwiththethoughtofofferingaproductwithafavorabletaxorienta-
tion, Charles Schwab approached Shoven to conduct two studies.The
firststudywastoillustratetheimpacttaxeshaveonmutualfundreturns.
Schwabwashopingtheconclusionsofthestudywouldsupporthisvision
ofaneedforatax-awarefund,andthemarketwouldthereforeembrace
hisfirm’snewproduct.
TosatisfySchwab’srequest,ShovenenlistedJoelM.Dickson,agrad-
uatestudentwhohadaspecialinterestinmutualfunds,tocowritethe
workingpaper,titled“RankingMutualFundsonanAfter-TaxBasis.”10
26 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Theprojectkeptthecoauthorsbusy,astheysoonfoundoutthatthedata
they obtained from the Investment Company Institute (ICI) required
alotofscrubbingbeforetheycoulddrawmeaningfulconclusionswith
anydegreeofconfidence.Theyanalyzedreturnsgoingbackten,twenty,
and thirty years and applied tax rates applicable to low-, middle-, and
high-tax-bracketfamilies.DicksonandShovennoticedtheVanguard500
IndexFundimprovedinrelativeperformance,movingfrom78.9ona
before-taxbasistothe85.0onafter-taxbasis.Theyalsocalculatedthat
ifthesmallamountofcapitalgainsdistributedhadbeenzero,thenthe
performancewouldhaveendedupatthe91.8percentile.Theseresults
were consistent with findings of Arnott and Jeffrey and supported the
conclusionthatmutualfundmanagerswerepayinglittleattentiontothe
impactoftaxes.
DicksonandShovenanalyzed147ofthelargestgrowthandgrowth
andincomemutualfundsfrom1983to1992usingICIdata.Sincethe
firstindexmutualfunddidnotcomeaboutuntil1976,theyfocusedtheir
attentiononhowmanagerschangedinrelativerankingbetweenbefore-
andafter-taxperformanceinrelationtotheirturnoverrates.Whenthey
lookedattheperformanceofindividualfunds,theyfoundsomeinterest-
ing surprises. As might be expected the fund with the lowest turnover,
Franklin Growth (only 3.2 percent annually), jumped 33.8 percentiles
inranking,butthefundwiththehighestturnover,FidelityValue(296
percent),improvedmorethananyotherfundwithajumpof35.4per-
centiles.TheDicksonandShovenstudyshowsonlyasmallnegativecor-
relation between turnover and the pre- to post-tax performance ratios.
Moreover,thecoauthorsbelievedtheresultswerenotstatisticallysignifi-
cant. In essence, what their study proved is that you simply could not
makebroadsweepingstatementsaboutportfolioturnoverandtheimpact
onafter-taxperformance.Atthetimetheyprobablydidnotenvisionhow
sagethecomment“Wefeelthatmanagingafundsoastodeferallcapital
gains realizations is feasible” would prove to be some ten years later, as
the Schwab 1000 Index Fund has not made a capital gain distribution
sinceitsinceptionin1991.Actually,thisstatementwasreallyapreludeof
morethingstocome,asCharlesSchwab’ssecondrequestwasforShoven
toaddressmethodsthatcouldbeusedtooperateamutualfundwithout
generatingcapitalgains.Justayearafterpublishingthefirstpaper,they
wouldcoauthor“AStockIndexMutualFundWithoutNetCapitalGains
Realizations.”11The importance of this work will be covered in greater
detailinchapter9,whichaddressesmethodsusedtooutperformindex
fundsonanafter-taxbasisindetail.
In 2000, Rob Arnott revisited the subject he had addressed seven
yearsearlierwiththefollow-uppaper“HowWellHaveTaxableInvestors
SeminalResearch 27
ToCoverItsTaxes?TheActiveManagementDichotomy,”JournalofPortfolio
Source:RobertH.JeffreyandRobertD.Arnott,“IsYourAlphaBigEnough
FIGURE3.4 arginofGainandShortfallvs.Vanguard
M
Index500
AVG.MARGIN AVG.MARGIN
TOTALRETURN WON OFGAIN LOST OFSHORTFALL
AfterCapitalGains
andDividendTaxes 6 0.9% 65 –3.1%
AfterAllTaxes
IncludingDeferred 10 1.1% 61 –2.4%
BeenServedinthe1980’sand1990’s?”12WithhisassociatesAndrewL.
BerkinandJiaYe,hewentbacktotheoriginalstudyandcameupwith
aninterestingobservationthat,uponfurtheranalysis,themagnitudeof
theaveragemarginofshortfallbythelargenumberoffundsunderper-
formingwasmuchgreaterthantheaveragemarginofgainonthefunds
that outperformed theVanguard 500 Index Fund on an after-tax basis
(seeFIGURE3.4).
Withthegrowthinthemutualfundindustrytherewerenowmany
morefundstoanalyze.Therefore,thelongertimehorizonandthegreater
numberofobservationscouldreinforcethevalidityoforpossiblyrefute
theirearlierfindings.Theystudiedthreetimehorizons:tenyears(1989–
1998), fifteen years (1984–1988), and twenty years (1979–1988). De-
pending on the period and type of calculation method, only 4 percent
to16percentofthemutualfundsconsistently havingmore than $100
millioninassetsoutperformedtheVanguard500IndexFundonafter-tax
basis.Therefore,thisstudyproducedresultssimilartothoseoftheoriginal
studyandvalidatedtheclaimsmadeyearsearlier.
Inthisstudy,thecoauthorsalsosubtractedthebefore-taxreturndif-
ferentialfromtheafter-taxresultsbetweenthefundsandtheVanguard
500IndexFundtoachievea“puretaxeffect.”Thereareseveralinterest-
ingobservations(see FIGURE3.5).First,sincetheVanguard500Index
Fundhasoutperformedmostfundsonabefore-taxbasis,thedifferential
isnotasdramaticaspreviouslyshown.Second,thetotalcolumnisal-
waysnegative,whichshowsthattheaveragefundpaysmoretaxesthan
theindexfund.Lastly,notehowthepercentagesimproveineachcase
28 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
FIGURE3.5 MutualFundPureTaxEffectvs.Vanguard500IndexFund
AHEADOFVANGUARD500INDEX
MARGINABOVE
NUMBEROFFUNDS VANGUARD500
10-YearResults(1989–1998)
AfterCapitalGainsTaxes 6 2% 0.21%
AfterCapitalGains
andDividendTaxes 31 31% 0.39%
AfterLiquidation 125 35% 0.50%
15-YearResults(1984–1998)
AfterCapitalGainsTaxes 7 3% 0.26%
AfterCapitalGains
andDividendTaxes 17 8% 0.60%
AfterLiquidation 53 26% 0.60%
20-YearResults(1979–1998)
AfterCapitalGainsTaxes 5 3% 0.37%
AfterCapitalGains
andDividendTaxes 16 10% 0.75%
AfterLiquidation 44 27% 0.56%
when you go from the row marked “After Capital Gains” to the row
marked“AfterCapitalGainsandDividendTaxes.”Commonstockmu-
tualfundscanapplytheincomefromdividendstooffsetfundexpenses,
which lowers the tax burden to the shareholder. Since fees of actively
managedfundsaremuchhigherthanthe20basispointsorlessforthe
Vanguard500IndexFundthistaxsavingismeaningful.
This also addressed the issue of survivor bias, which was not ad-
dressedearlier.Asexpected,whenthisfactorwastakenintoaccountthe
results favored theVanguard 500 Index Fund even more. As with the
previousstudy,informationprovidedbyMorningstarmade this study
possible.
SeminalResearch 29
Source: Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980’s and 1990’s?”
BEHINDVANGUARD500INDEX
MARGINABOVE
NUMBEROFFUNDS VANGUARD500 TOTAL
349 98% –1.68% –1.65%
324 91% –1.27% –1.12%
230 65% –0.47% –0.13%
JournalofPortfolioManagementvol.26,no.4(Summer2000):84–94.
196 97% –1.63% –1.56%
186 92% –1.20% –1.05%
150 74% –0.53% –0.23%
157 97% –1.49% –1.43%
146 90% –1.00% –0.83%
118 73% –0.56% –0.25%
After-taxinvestingisanobleobjective,butisthereevidencetosuggest
thatinvestorshavetakennotice?Intheirpaper,“DoAfter-TaxReturnsAf-
fectMutualFundInflows?”authorsDanielBergstresserandJamesPoterba
of the MIT Department of Economics offered evidence to suggest that
hightaxburdensareassociatedwithlowergrossinflows,andmutualfunds
thatofferhigherafter-taxreturnsattractgreaterinflows.13Theystudieda
largesampleofequitymutualfundsfrom1993to1999.Itisencourag-
ingthatBergstresserandPoterbadiscoveredthatinvestorstooknoticeable
stepstoprotectthemselves,asitwasnotuntiltheendofthisperiodthat
thefinancialpressbegantoaddressinameaningfulwaytheadversefinan-
cialconsequencesfrompotentiallargecapitalgainsdistributions.
30 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Reviewofthekeyarticlesontax-awareinvestinghighlightsfourimpor-
tantfactors.First,changeinthefinancialmanagementindustryrequiresa
vision.BothTadJeffreyandCharlesSchwabaddressedanissuethatothers
ignored.Throughtwodecadesofpersistenceandinteractionwithcount-
lessprofessionalsJeffreyshouldbedesignatedasthe“fatheroftax-aware
investing,” and due to his financial support Charles Schwab be known
as “the godfather of tax-aware investing.” The second point is it often
takesgiftedindividualstocommunicatethedreamsofothers.Therefore,
weneedtobethankfulthatRobArnott,JohnShoven,andJoelDickson
recognizedtheissueandwereabletocommunicatetheirconclusionsina
mannerthatallowedpractitionersandinvestorstotakeaction.Third,the
contentofmaterialsavailabletotheinvestorwillcontinuetoimproveas
needsareaddressedbyserviceprovidersandregulators.Todemonstrate
howtheindustryhasprogressed,refinementsintheMorningstarPrincipia
database now allow individual investors to conduct their own after-tax
mutual fund analysis—which would rival the pioneering work done by
researcherswithadvanceddegreesonlyadecadeago—onalmostanyas-
setclassinamatterofminutes!Fourthandlastly,whilemoststockfunds
haveunderperformedtheVanguard500IndexFundonanafter-taxbasis,
it does not mean all funds should or will underperform in the future.
Since we now understand what causes lackluster after-tax performance,
enlightenedpractitionersarenowofferingandcreatingdistinctiveservices
andproducts.However,compellingresultscannotbeachievedunlessin-
vestorsortheirtrustedadvisersareabletoidentifythegrowingnumberof
uniquelyqualifiedtax-awareprofessionalsinthemarketplacetoday.
ChapterNotes
1. George M. Constantinides and Myron S. Scholes, “Optimal Liquidation of
AssetsinthePresenceofPersonalTax,”JournalofFinancevol.35,no.2(1980):
439–449;GeorgeM.Constantinides,“CapitalMarketEquilibriumWithPersonal
Tax,” Econometrica 51 (1983): 611–636; George M. Constantinides, “Optimal
Stock Trading With Personal Taxes: Implications for Prices and the Abnormal
JanuaryReturns,”JournalofFinancialEconomics,13(1984):65–89;GeorgeM.
Constantinides,“OptimalBondTradingWithPersonalTaxes,”JournalofFinan-
cialEconomics,13(1984):299–335.
2. InvestmentCompanyInstitute,MutualFundFactBook2004(Washington,
D.C.:InvestmentCompanyInstitute,2004),105.
3. RobertH.JeffreyandRobertD.Arnott,“IsYourAlphaBigEnoughToCover
ItsTaxes?TheActiveManagementDichotomy,”JournalofPortfolioManagement
(Spring1993):15–25.
SeminalResearch 31
4. RobertD.Arnott,PeterL.Bernstein,JohnC.Bogle,andJamesP.Garland
andRobertH.Jeffrey,indiscussionwiththeauthor,August30,September1,
September2,andAugust4,2004,respectively.
5. RobertH.JeffreytoPeterO.Dietz,April26,1983.
6. RobertH.JeffreytoJohnC.Bogle,May29,1985.
7. JohnC.Bogle,indiscussionwiththeauthor,September2,2004.
8. MorningstarPrincipia,June30,2004.
9. JoelM.Dickson,indiscussionwiththeauthor,September21,2004.
10. JoelM.DicksonandJohnB.Shoven,“RankingMutualFundsonanAfter-Tax
Basis,”NBERWorkingPaperno.4393,NationalBureauofEconomicResearch,
July1993.
11. JoelM.DicksonandJohnB.Shoven,“AStockIndexMutualFundWithout
NetCapitalGainsRealizations,”NBERWorkingPaperno.4717,NationalBu-
reauofEconomicResearch,April1994.
12. RobertD.Arnott,AndrewL.Berkin,andJiaYe,“HowWellHaveTaxable
InvestorsBeenServedinthe1980’sand1990’s?”JournalofPortfolioManagement
vol.26,no.4(Summer2000):84–94.
13. DanielBergstresserandJamesPoterba,“DoAfter-TaxReturnsAffectMutual
FundInflows?”JournalofEconomicsvol.63,no.3(2002):381–414.
This page is intentionally blank.
CHAPTER4
TheTax-AwarePractitioner
Whatisonereallytryingtodointheinvestmentworld?Notpay
theleasttaxes,althoughthatmaybeafactortobeconsideredin
achievingtheend.Meansandendshouldnotbeconfused,how-
ever,andtheendistocomeawaywiththelargestafter-taxrate
ofcompound.
—WarrenBuffett
W
henindividualsheartheirfirstpresentationorreadtheirfirst
articleontax-awareinvesting,theyoftenask,“Howdoyou
identifyorbecomeatax-awarepractitioner?”Thisisanexcel-
lentquestion,sincethereisnodirectrouteavailabletoacquirethebody
ofknowledgerequiredtoeffectivelyservetaxableaccounts.Althoughit
isdifficulttopinpointaspecificqualificationasthetelltalesignofexcel-
lence,therearefourtraitssharedbyallelitetax-awarepractitioners:
❑ Knowledgeability
❑ Inquisitiveness
❑ Patience
❑ Passion
Thischapterisdevotedtoindividualswhoappreciatethevalueoftax-
awareinvestmentmanagementanddesiretosharpentheirskillsforthe
benefitoftheirclients.Thesetraitsandtheirdevelopmentareespecially
important,notonlyforpeoplejustenteringtheindustrybutalsoforin-
vestorswhoareevaluatingtheirproviders’potentialtoservethemproperly
inthefuture.
33
34 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Knowledgeability
The process of acquiring knowledge begins with education. Many aca-
demicinstitutionsofferoutstandingprogramsthatbuildabaseofknowl-
edgeinfinance,accounting,andpersonalfinancialorestateplanning.The
areathattodayisperhapsmostalignedwithincorporatingtaxesinmaking
investmentdecisionsispersonalfinancialplanning.Toscreenforapoten-
tialfit,thecollege-boundstudentshouldstartwithoneofthedozenorso
collegeguidesavailableinbookstoresorontheInternet.Anotherexcellent
sourceistheCertifiedFinancialPlannerBoardofStandardswebsite(www.
cfp.net),whichlistsmorethaneightyschoolsthatofferundergraduateand
graduateprograms.
Most practitioners begin their careers by first obtaining degrees in
accounting, finance, or law. Although these academic majors consider
taxesinoneformoranother,noneofthemadequatelyaddresstheim-
pactoftaxesonsecuritybuyandselldecisions,portfolioconstruction,
policy development, or asset allocation and location.To illustrate how
little information is available to students: the leading college textbook
Investments,FifthEdition,byBodie,Kane,andMarcus,isapproximately
athousandpages,anddevotesonlythreepagestotheimpacttaxeshave
on investment considerations and asset allocation.1 The author could
mentioninstanceswherenotedtitlesactuallymisstatetheimpactoftaxes
oninvestmentreturns,buttheobjectiveofthistextistoenlightenreaders
aboutthebenefitsoftax-awareinvestingratherthantocriticizethesins
andneglectofthepast.
To add compelling value with taxable accounts, practitioners need to
haveatleastabasicworkingknowledgeofthetaxestheirclientsaresub-
jectto.Itisunrealistictoexpectoneindividualtoknoweverythingthereis
aboutinvesting,thetaxcode,orestateplanning,butwhenindoubt,tax-
awarepractitionersneedtoknowwheretolocate—orwhomtocontactto
obtain—accurateinformation.Additionally,theymustbeawareofhowthe
paymentoftaxesaffectsthereturnsofpermissiblesecuritiesidentifiedbythe
client.Moreover,theymustbeabletoseethebenefitoftheoptimalalloca-
tionofvariouscategoriesofassetsandinvestmentstylesbetweentaxableand
tax-deferredaccountstoachievethehighestafter-taxreturnspossible.Lastly,
they must understand how to measure success and realize that tax-aware
investingandreportingareevolvingartforms,asopposedtosciences.
Upon entering the private sector, sincere practitioners will generally
obtainoneofthefollowingprofessionaldesignations,dependingontheir
employmentspecialty:
❑ Chartered Financial Analyst (CFA), a globally recognized stan-
dardformeasuringthecompetencyandintegrityofanalysts—The
CFAprogram’sself-studycurriculumallowseventhebusiestinvest-
TheTax-AwarePractitioner 35
mentprofessionaltoparticipate.Thecurriculumdevelopsandrein-
forcesafundamentalknowledgeofinvestmentprinciples.Thethree
levelsofexaminationverifyacandidate’sabilitytoapplytheseprin-
ciplesacrossallareasoftheinvestmentdecision-makingprocess.And
theprogram’sprofessional-conductrequirementsdemandthatboth
CFAcandidatesandcharterholdersadheretothehigheststandards
ofethicalresponsibility.2
❑ CertifiedFinancialPlanner(CFP),acertificationthatconsumers
recognize,respectanddemand—BeforeapplyingfortheCFPcertifica-
tionexamination,candidatesneedtocompletetheeducationrequire-
mentssetbytheCFPBoard.Therearemorethan285academicpro-
gramsatcollegesanduniversitiesfromwhichtochoose,pluscertain
degreesandprofessionalcredentialsfulfilltheeducationrequirement.
Aten-hourexamteststhecandidates’abilitytoapplytheirfinancial
planningknowledgetoclientsituations.3
❑ CertifiedInvestmentManagementAnalyst(CIMA)—TheCIMA
offersanintenseeducationalfocusonassetallocation,managersearch
andselection,investmentpolicy,andperformancemeasurement.The
programbeginswithaself-studyLevel1programandexam.TheLevel
2materialsandexamcanbecompletedeitherbyattendingaone-week
classheldataleadingbusinessschooloronline.4
❑ CharteredLifeUnderwriter(CLU)—TheCLUisconferredonly
uponsuccessfulcompletionofaten-partcoursethatcoversfundamen-
tals of economics, finance, taxation, investments, and other areas of
riskmanagementastheyapplytolifeinsurance.Thecourseofstudy
can be completed through home study or by attending courses at a
branchoftheAmericanSocietyofCharteredLifeUnderwritersorat
anaffiliatedcollegeoruniversity.5
❑ Certified Public Accountant (CPA)—One of the world’s leading
licensing exams, the CPA examination serves to protect the public
interest by helping to ensure that only qualified individuals become
licensedascertifiedpublicaccountants.CPAexaminationsareoffered
throughouttheyear,andrequirementsvarybystate.6
❑ CertifiedTrustandFinancialAdvisor(CTFA)—ToearntheCTFA
credential,candidatesmustmeettheexperience,education,ethics,and
examinationrequirementsdeterminedtobecompetencymeasuresfor
personaltrustprofessionals.Applicantsmusttakeapersonaltraining
programapprovedbytheInstituteofCertifiedBankers(ICB)forpre-
certification.7
Inadditiontopassingoneormoreexams,theremayberequirements
such as signing an ethics statement, demonstrating particular types of
36 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
focusedonskillsforhigh-net-worthconsulting.Prerequisitesinclude
arecognizeddegree,aprofessionalcertification,andfiveyearsofre-
latedindustryexperience.13
Inquisitiveness
Thetax-awarepractitionerknowsthatmanymarketsandindividualsecuri-
tiesareinefficientlypricedwhentaxesareconsidered.Agreatdealoftruly
outstandingworkhasbeendoneinthemoderneraofinvestingtodevelop
well-known theories, such as the efficient market hypothesis and capital
assetpricingequation,butinmostcasestheimpactoftaxeswasnotpart
oftheprocess.Therefore,arbitrageopportunitiesareoftenavailableforthe
tax-aware practitioner who is willing to question the traditional wisdom
thatwasdevelopedfortax-exemptaccounts.Moreover,manyofthesecon-
ceptsaresimpleandrequirenomorethana“backoftheenvelope”expla-
nation.Forexample,before2003,thetaxrateondividendsintheUnited
Stateswasalmosttwicetherateforsecuritiessoldwithgainsheldtwelve
monthsormore.Let’screateascenariooftwocommonstocksthathavethe
long-termpotentialtoproduceatotalrateofreturn,dividendsplusappre-
ciation,of10percentperyear.AsFIGURE4.1shows,theresultsaresimilar
forthestocksofthetwocompanies(AandB),withtheexceptionofhow
muchoftheirearningstheypaytoshareholdersindividends.
Investorswhoareconsideringthetwosecuritiesforatax-exemptac-
countshouldbeindifferenttowhethertoholdstockAorB,astheyend
upwiththesameamountofdollarsattheendofeachyear.However,let’s
seewhathappensifwestartwitha$100purchaseofbothstocksandsell
themafterone-,five-,andten-yearperiodswithdividendssubjecttoatax
38 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
FIGURE4.1 S tocksofSimilarCompaniesWithDifferent
DividendYields
StockA StockB
Appreciation Appreciation
6% 9%
Source:DouglasS.Rogers
Income
4%
Income1%
of39.6percentandlong-termcapitalstaxedat20percent,whichwasthe
casenottoomanyyearsago(seeFIGURE4.2).
Again, we started with $100 invested in each stock. Dividends are
taxedeachyearat39.6percentandthedollaramountofthe“taxhaircut”
Figure4.1Rogers
isdeducted.Fortheone-yearscenario,weassumetheholdingperiodis
justlessthantheamountoftimerequiredtoqualifyforthemorefavorable
taxrateonlong-termcapitalgains.Therefore,bothdividendsandappre-
ciationfortheone-yearscenarioaresubjecttoataxrateof39.6percent.In
thiscase,regardlessofwhetherinvestorsholdstockAorstockBinatax-
ableaccount,theyendupwith$106.04afterpayingfederaltaxes.Astime
increases,weuncoverthepotentialofanarbitrageopportunitycreatedby
justhavingarudimentaryunderstandingofthetaxcodeforindividuals.
StockAhas3percent(4percentdividendyieldofstockAversus1percent
FIGURE4.2 T erminalDollarValueofTwoStocksWithDifferent
DividendYields
(39.6%TaxonOrdinaryIncomeand20.0%TaxonLong-TermCapitalGains)
YEARS STOCKA STOCKB
1 $106.04 $106.04
Source:DouglasS.Rogers
5 $142.69 $147.27
10 $206.62 $222.04
TheTax-AwarePractitioner 39
dividendyieldofstockB)moreofthetotalreturnattributabletodivi-
dends,whicharesubjecttothehighertaxrateof39.6percent.Plus,the
taxondividendsispaidannually,whereasthetaxoncapitalgainsatthe
lowerrateisnotpaiduntilthesaleattheendofholdingperiod.Inthisex-
ample,anindividualinvestorsubjecttothehighestfederaltaxrateswould
bebetteroffholdingstockBinsteadofthehigh-dividend-payingstockA
by$4.58and$15.42overthefive-andten-yearperiods,respectively.One
maycounterthatthisarbitrageopportunityforlongerperiodsnolonger
existssincethefederaltaxratesondividendsandlong-termsgainsarenow
equal.Thatistrue,buttheopportunityexistedforyearsandnotenough
investorsunderstooditspotentialor,moreimportant,tookadvantageof
it.Additionally,thisexamplehighlightsthevalueofbeingfamiliarwith
thehistoryofthetaxratesandrecentlegislation,asthetaxondividends
willreturntoregulartaxratesonordinaryincome,currently35percent,
in2009unlessthereisadditionallegislation.Soiftheopportunityisnot
availabletoday,weneedtobeawareofhowwemightbeabletotakead-
vantageofaparticulartax-drivenscenariointhefuture.
Arethereopportunitiesfortax-advantagedalternativestoday?Yes,for
example,listedoptionsaresubjecttoa60/40blendofthelong-termcapi-
talgainandordinaryincometaxrateseveniftheyareheldlessthanayear.
Iftheholdingperiodisshortandthemarketislikelytorally,considera
qualifiedoptionorfuturecontract,insteadofholdingamutualfund,and
pocketthesubstantialtaxsavings.Thepointhereisthattax-awareprac-
titionerslookfortheseopportunitiesandtakeadvantageofthemwhen
theymakesense.
Toobtainanunderstandingofconceptslikethoseshowninthetwo
examples above, the tax-aware practitioner will benefit from attending
conferencesandkeepingabreastofthelatestdevelopmentsintheindus-
try.This can be done by attending one or several national conferences
sponsoredbythefollowingorganizations:
❑ AmericanBankersAssociation
❑ CharteredFinancialAnalystsInstitute(formerlyAIMR)
❑ FamilyOfficeExchange(FOX)
❑ FinancialPlanningAssociation(FPA)
❑ FinancialResearchAssociates(FRI)
❑ IbbotsonAssociates
❑ InformationManagementNetwork(IMN)
❑ InstituteofCertifiedBankers(ICB)
❑ InstituteforPrivateInvestors
❑ InstitutionalInvestor
❑ InvestmentAdvisor
❑ NationalAssociationofPersonalFinancialAdvisors(NAPFA)
40 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
❑ NewYorkUniversityInstituteonFamilyWealthManagement
❑ NMSManagement
❑ NuclearDecommissioningTrust(NDT)
RegionalandlocalprogramsarealsoarealsoofferedbytheCFA,FPA,
andNAPFAorganizationsandtheirlocalchapters.TheNewYorkSociety
ofSecurityAnalysts(NYSSA),alocalchapteroftheCFAInstitute,has
accesstosomuchtalentitconsistentlyproduceshigh-caliberprogramson
aparwiththefinestnationalorganizations.Additionally,FinancialPlan-
ning publishes annually an extensive list of broker-dealer programs that
maybeofinterest.Thekeyhereistobuildanassociationwithorganiza-
tionsandindividualsthatbestsuittheneedsoftheclientsyouserveand
tostayintunewithinnovativedevelopments.
Patience
Toaccomplishsuperiorresultswithtaxableaccountstakestimeandpatience!
Someonewhohasadaytrader’smentalityandwantstobeasuccessfultax-
awarepractitionerwillhavetoattaintheself-disciplinenecessary.Thereare
noshortcutshere,andthatiswhyitissodifficulttoeducateindividualson
thebenefitsoftax-awareinvestmentmanagementwhenforyearstheymay
havebeensubjecttoatransaction-orientedarrangement.A1to2percent
enhancementinperformanceisnotoutofthequestionwhenapplyingtax-
awareprinciplesandconcepts.14Thisincrementmayinitiallyseeminsignifi-
canttosomeindividuals,butthelong-termbenefitoftax-awareinvestment
managementismeaningful,ashighlightedinFIGURE4.3.
Wewillstartwithaportfolioof$10,000.Obviously,mostclienttax-
ableportfoliosaremuchlarger,butthisamountis used for the sakeof
simplicity. For an initial $10,000 investment, the benefit of tax-aware
managementinthefirstyearis$100to$200andmayatfirstappeartobe
hardlyworththeeffort.However,astheinvestmenthorizonincreasesand
thebenefitcompounds,thetotaldollarbenefitbecomesmoremeaningful.
Notethatwitha2percentannualbenefit,assetsdoubleinvalueinslightly
morethanthirty-fiveyears.Thatmayseemlikealongtime,butitiscer-
tainlynotanunreasonableoneforyoungprofessionalsjustoutofcollege
entering the workforce who are establishing a savings plan or for long-
termtrusts.Moreover,thisisnotjustanexerciseforthewealthy.Failingto
achieveoptimalresultsmostlikelywillnotdisruptthelifestyleofwealthy
people,butitcouldmeanthedifferencebetweenenjoyingretirementand
havingtoworkforafewadditionalyearsforaverageindividualinvestors.
Toanalyzeaspecificsituation,simplydividethesizeoftheclientportfolio
by$10,000andmultiplytheresultbythelevelofbenefitfromthetable.
Forexample,ifyouhavea$1millionportfolio,andthelevelofbenefit
TheTax-AwarePractitioner 41
FIGURE4.3 D ollarBenefitofTax-AwareInvestmentManagement
(BeginningWith$10,000)
LEVELOFBENEFIT
YEARS 1% 2%
1 $100 $200
10 $1,046 $2,190
20 $2,202 $4,859
30 $3,478 $8,114
40 $4,889 $12,080
Source:DouglasS.Rogers
you estimate is 2 percent over forty years, multiply 100 ($1,000,000 /
$10,000)by$12,080toarriveatanestimatedbenefitof$1,208,000.Re-
member,fortaxableaccounts,compoundingtax-freeisabeautifulthing.
Some professionals even consider it the equivalent of getting a tax-free
loanfromthegovernment!
Passion
Tax-aware practitioners are passionate about their craft. This passion
builds over time, because they realize they are “doing the right thing.”
Manywilltakethetimetosharetheirwisdomandknowledgetofurther
thebodyofknowledge.Ariskinherentwithwritinganytextrelatingto
taxesisthataftersomeonehaslaboredforhourstocompleteit,amajor
changeinthetaxcodecanrenderitobsolete.Therefore,itisimportantto
identifysourcesofinformationthatexplainconceptsandmethodsinad-
ditiontothosethatsuggestaparticularstrategythatmaycomeaboutor
changewiththedynamicsofthetaxcode.Anotherchallengeforresearch
ontax-awareinvestingisthatinformationonpretaxreturnsforsecurities
andassetclassesisfarmorereadilyavailablethaninformationonafter-tax
returns.Perhapsthegreatestchallengeforeducationrelatingtotaxable
accountsingeneralistryingtoobtainfunding,becausethegroupthat
benefits the most from the process is typically wealthy individuals. As
onewell-knownpractitionerintheindustryputit,“Ifyouaskawealthy
42 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
individual or charitable organization to fund a charitable cause for the
less-privilegedinadistantlandtheycanrelatetotheneed,butasking
themtofundanefforttoteachthosewhoarealreadyconsideredtobe
privilegedsimplydoesnotresonatewiththem.”Thepointhereisthat
thoseofusintheindustryandourclientsarealreadydoingwell,solim-
itedresourcesshouldbesharedwiththosethathavethegreatestneed.
Many journals are supported by the certification programs mentioned
earlier.Whatfollowsisalistofthebest-knownjournalsandperiodicals.
❑ Advisor
❑ AmericanBankersAssociationTrustsandInvestments
❑ WealthManager
❑ FinancialAnalystsJournal
❑ FinancialPlanning
❑ FinancialServicesReview
❑ InvestmentAdvisor
❑ JournalofAccountancy
❑ JournalofFinancialPlanning
❑ JournalofInvesting
❑ JournalofInvestmentConsulting
❑ JournalofPortfolioManagement
❑ JournalofWealthManagement
❑ Monitor
❑ PrivateAssetManagement
❑ Trusts&Estates
ThemostprestigiousjournalwithinacademiccirclesisFinancialSer-
vicesReview,editedbyConradS.CiccotelloofGeorgiaStateUniversity.
Theonemostfocusedontax-awareinvestmentmanagementissuescur-
rentlyisJournalofWealthManagement.Itseditor,JeanC.Brunel,anin-
fluentialauthorandspeakerintheultra-affluentmarket,hasbeenableto
attractnoteworthysubmissionsfrommanyofthewell-knownpractitio-
nersyouwilllikelyencounteratnationalandregionalconferences.
Thefollowingthreebooksshouldbeinthelibraryofanyoneattempt-
ingtounderstandtaxable-accountinvestingandarerecommendedforthe
professionalabilityoftheirauthors.
❑ IntegratedWealthManagement,byJeanL.P.Brunel(Institutional
InvestorBooks)—Presentsthenewparadigmofwealthmanagement
forultra-affluentclients.
❑ WallStreetSecretsforTax-EfficientInvesting,byRobertN.Gordon
withJanM.Rosen(BloombergPress)—Offersaworkingknowledge
oflittle-knownacceptedmethodstoefficientlyconducttaxabletrans-
actions.
TheTax-AwarePractitioner 43
❑ J.K.LasserProIntegratingInvestmentsandtheTaxCode,byWil-
liamReichensteinandWilliamJennings(JohnWiley)—Explainsthe
modelingofasavingvehicle’staxstructureanddiscussesrelatedinvest-
mentimplications.
Eachofthebooksservesadistinctpurposeorparticularlevelofwealth,
asnotedabove.Tax-AwareInvestmentManagement:TheEssentialGuide
isintendedtocomplementthemandroundoutthebodyofknowledge
especiallysothoseinvolvedintheday-to-daymanagementoftaxableac-
countscanmakebetter-informedinvestmentdecisions.
Thetax-awarepractitionermustrealizethatnoteveryoneagreeswith
thisconcept,assomeputthemotiveforprofitbeforetheclient.Thereis
stillalotoftimeandeffortinvestedinthe“sinsofthepast,”andmany
clientswillbereluctanttochangeuntiltheyaremadeawareofamore
compellingstrategyorproduct.Passioncausespersistence,andalthough
the process may be long and gradual, the concepts of tax-aware invest-
ment management are gaining ground, and enhancements in products,
methods,andtechnologyarefollowingatarapidpace.Thefunofbeing
atax-awarepractitionerisinimplementingastrategythatworkstothe
advantageofallconcernedand,duringorattheendoftheprocess,seeing
solidevidencethatyouhaveaddedvaluewellinexcessofthefeethatis
charged.
Thebodyofknowledgepertainingtotax-awareinvestmentmanage-
mentcontinuestoexpand,buttorealizethefullpotentialoftheprocess
weneedtocodifysoundmethodsandprinciples.Additionally,wemust
convinceothersthatpeopleenteringtheindustryneedaccesstoeducation
toovercomethesteepandlonglearningcurvetypicallyassociatedwith
taxableaccounts.Futuretax-awarepractitionersalsoneedtobeempow-
eredwithsoftwaresolutionsthatareonlynowbeginningtoaddressthe
needfortailoredsolutionsacrossmultipleaccounts.Fortunately,fortax-
ableinvestorsorclients,thefuturefortax-awareinvestmentmanagement
ispromisingandislimitedonlybytheimaginationandthewillingnessto
devotesufficientresourcestoachievedesiredsolutions.
ChapterNotes
1. Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 5th ed. (Boston,
McGraw-Hill,2002).
2. CFAInstitute,http://www.cfainstitute.org(accessedJuly27,2004).
3. CertifiedFinancialPlannerBoardofStandards,http://www.cfp.net(accessed
July27,2004).
44 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
4. InvestmentManagementConsultantsAssociation,“CertifyYourProfession-
alism,”http://imca.org(accessedJuly27,2004).
5. CaliforniaStateUniversity,Northridge,“AGuidetoProfessionalCertification
Programs,”http://www.csun.edu(accessedJuly27,2004).
6. TheUniformCPAExamination,http://www.cpa-exam.org(accessedJuly27,
2004).
7. InstituteofCertifiedBankers,“CertifiedTrustandFinancialAdvisor(CTFA),”
http://www.aba.com(accessedJuly27,2004).
8. Institute for Private Investors, press release, May 26, 2004, http://www
.memberlink.net(accessedJuly27,2004).
9. AmericanBankersAssociation,“ABAPrivateManagementSchool,”http://www
.aba.com(accessedJuly27,2004).
10. InstituteforPrivateInvestors,“Memberlink—2004PrivateWealthManage-
mentProgram,”http://www.memberlink.net(accessedJuly27,2004).
11. Investment Management Consultants Association, “Wealth Management
CertificateProgram,”http://imca.org(accessedJuly27,2004).
12. New York University, “Certificate in Wealth Management,” http://www
.scps.nyu.edu/department/certificate.jsp?certId=851 (accessed December 27,
2004).
13. InstituteforInternationalResearch,“CharteredWealthManager,”http://www
.iirme.com/cwm/(accessedDecember27,2004).
14. J.RichardJoyner,“Tax-EfficientInvesting:CanItAdd250BasisPointsto
Your Returns?” Journal of Investment Consulting vol. 6, no. 1 (Summer 2003):
82–89.
CHAPTER5
CreatingtheTriumvirateof
QualifiedProfessionals
All the Congress, all the accountants and tax lawyers, all the
judges,andaconventionofwizardsallcannottellforsurewhat
theincometaxlawsays.
—WalterB.Wriston
T
o achieve optimal results in investment management when taxes
comeintoplayrequiresthreedistinctskillsets.Thisapplieswheth-
eryouareofferingadvicetoanindividualinvestor,high-net-worth
family,propertyandcasualtyinsurancecompany,nucleardecommission-
ingtrust,voluntaryemployeebeneficiaryassociation,oranyothertypeof
taxableaccount.Thethreeskillsetsare:investmentmanagement,tax,and
regulatoryorestatematters(see FIGURE5.1).Alltaxableaccountsrequire
theinvestmentmanagementandtaxskillsets.Thefactorthatisdifferent
fortaxableaccountsiswhetherregulatoryorestatemattersinfluencedeci-
sions.Individualsandhigh-net-worthfamiliesneedtoaccountfortheim-
pactofestatetaxes,whereastaxablecorporateentitiesmustaddressongoing
regulatorymatters.
Eachoftheskillsetsandelementsisimportantseparately,butifone
ormoreiseliminatedorovershadowed,theclientwillreceivealessthan
optimalsolution.Thedifferentrequisiteskillsshouldcomplementonean-
otherandworkinunison.Everyattemptshouldbemadetoavoidconflict
oroperatingasseparateunits.
The complexity of the assignment will dictate the level of skill or
qualification necessary to achieve a satisfactory outcome. For example,
a financial planner with an accounting and legal background operating
45
46 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
FIGURE5.1 TheTriumvirateofQualifiedProfessionals
Regulatory
Tax
orEstate
Source:DouglasS.Rogers
Investment
Management
separatelymaybeabletoprovideoutstandingserviceandadvicetoanin-
Figure5.1(Triumvirate)Rogers
dividualinvestorifthefirmisabletopreparethenecessarydocumentsfor
wills,etcetera.However,theprocessforpropertyandcasualtyinsurance
companies typically incorporates sophisticated asset/liability modeling,
custom portfolios, extensive involvement with the firm’s financial staff,
and coordination with highly specialized lawyers and accountants who
assistinguidingthefirmthroughthemazeoffederalandstateregulatory
requirements.The one aspect that permeates throughout the “qualified
triumvirate”ofskillsistheimpactoftaxes.Thisfeatureaddsanotherlayer
ofcomplexitytothetraditionaltax-exemptaccountandmakestax-aware
investmentmanagementchallenging.Itisalsowhyqualifiedpractitioners
whoarerecognizedfortheirexpertiseinthisarenacandemandapremium
fortheirservices.
Toavoidcostlyerrors,itisbesttobringtheseskillsetstogetherand
establish a plan before funding takes place. High-net-worth individuals
oftenacquiresubstantialliquidfinancialassetsthroughthesaleofaprivate
company.Inthesecases,itiscriticalthatthefamilyestablishthequalified
triumviratebeforediscussingthesaleoftheassetwithinvestmentbank-
ers.Thereisonedistinctionbetweenthevalue-addedpropositionofthe
taxandestateelementsandthatoftheinvestmentmanagementprocess.
The savings or value added from the tax and estate elements can often
beaccomplishedinashortperiodoftimeandinvolvesubstantialsums,
CreatingtheTriumvirateofQualifiedProfessionals 47
whereastheinvestmentprocesstypicallytakesanextendedperiodoftime
toproducegradual,meaningfulresults.Inthecaseofahigh-net-worth
family,havingtheproperestatestructureinplacebeforethesaleofabusi-
nessmaysavemillionsofdollars.Whiletheestateattorneyandaccountant
mayleadthediscussionduringthisphaseoftheengagement,thefinancial
adviserneedstobepresentandpreparedtoofferaprofessionalopinion
onwhetherthereturnassumptionsarereasonableandwhethertheevolu-
tionoftheestateplanorultimatestructurewillleadtoaviablelong-term
portfoliomix.
Verysimply,actionsoughtnotbetakenfortaxsavingsalone,asthey
mayresultinasituationthatwillforceacostlysolutioninthefuturethat
faroutweighstheinitialbenefits.Anexampleisusingtaxablebondsina
trust,inlieuoftax-exemptormunicipalbonds,asawealthtransferstrat-
egy,becausetheparentspaythetaxbill.Atfirstthismayseemlikeasound
idea,becausethetaxadviserandestateattorneyrecommendtransferring
asmuchwealthaspossibleoutoftheparents’estatesothatatdeaththe
dollaramountoftheestatetaxwillbeminimalorsubjecttolessthanthe
maximumtaxrate.First,tax-exemptbondstypicallydonottradeatadis-
countequaltothemaximumfederaltaxrate,sotheclientendsuppaying
unnecessarytaxesonaportionofthereturn.Moreimportant,thisapproach
doesnottakeintoaccountalternativeoptionsthatcanbeachievedusing
higher-yieldingequityportfolios,purposelytakinglong-termgains,and
raisingthecostbasisoftheequityportfolio,whichwilllikelyprovefar
morebeneficialovertimeespeciallyafterthedeathoftheparents.Without
bringingintax-awareinvestmentstrategyanalysisintheplanningprocess,
thewealthtransferstrategymayactuallybenefitthegovernmentfarmore
thanthetax-payingclient.Anotherexampleisplacinganinternationaleq-
uitymanagerinataxableinvestmententityversusatax-exemptonesolely
torecapturethedividendwithholdingtax.Therecapturemaybeabenefit,
butitistypicallyaminoroneintheoverallschemeofmanagerlocation.
Thistaxnuanceofinternationalequitiesisworthconsidering,buttherate
atwhichcapitalgainsarerealizedisgenerallyamoresignificantfactorin
thedecisiontoplacethemanagerinataxableortax-exemptinvestment
entity. Equally important, the financial adviser should not try to force
a premature asset allocation plan or the funding of managers. Patience
bythefinancialadviserduringtheinitialplanningstagesiscritical.Even
thoughyieldsmaybepaltryduringthistime,itisprudenttomaintaina
liquidpostureuntilallpartiesinvolvedagreeoncriticalelementsofthe
plan.Thiswillavoidpotentiallycostlyandembarrassingsituationslater.
Clientsoftenunderestimatetheimportanceofandtimerequiredto
develop a comprehensive plan or investment policy statement. During
thiscriticaldevelopmentperiod,thefinancialadviserneedstokeepthe
48 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
clientfocusedandengagedintheprocess.Everyattemptshouldbemade
toaddressandeliminatedistractions,especiallywhentheclientgetsoff
trackandbeginsdiscussingthevariousattributesofspecificmanagersand
funds. Having the client work closely with the qualified triumvirate to
finalizetheplaniscritical,asthetax-awarepositioningofassetclassescan
addasmuchormorevaluethantheidentificationoftherightmanagers
orfunds.Ifpreparedproperly,thefinaldocumentwillserveasablueprint
or business plan. Many professionals open their meetings by reviewing
thisdocument,asitreinforcescorevaluesanddirectsbehaviortoachieve
commongoalsandobjectives.
Membersofthequalifiedtriumvirateofferprofessionaladvicetheybe-
lievewillofferthegreatestvalue.Indoingso,theywillgraduallyposition
themselvesinrelativeimportanceintheeyesoftheclient.Thisinteraction
October15,2004: Phase1: Phase2:
ultimatelyleadstooneprofessionalachievingtheloftypositionof“trusted
Commencecalculationofthree
differentindicesfortheS&P500:
OfficialS&P500movesto
freefloatadjustedcalculation
OfficialS&P500movestoa
full-floatadjusted
adviser.”Thisisperhapsthemostoverusedterminthefinancialservices
•S&P500CLASSIC
•S&P500HALFFLOAT
basedon50%oftheintended
floatfactorforeach
calculation
industrytoday,yetitsimportancecannotbedenied.Becomingthetrusted
•S&P500FULLFLOAT constituent
adviserprovidestwodistinctadvantagesoverotheradvisersintheprocess.
First,thetrustedadviseristheonethattheclientwillusuallygotofirst
whenheorshehasaquestion,aproblemtobesolved,orevenapersonal
issuetovet.Second,throughthisadvantageouspositioning,thetrusted
adviserhassignificantinfluenceovertheflowofadditionalservicesand
products.Thereisnooneruleastowhichoftheprofessionalsinvolved
shouldserveasthetrustedadviser.Itsimplydependsonthefinancialsitu-
Source:DavidH.Maister,TheTrustedAdvisor(NewYork:Touchstone,2001),9–10
FIGURE5.2 HierarchyofClient/ProviderRelationships
Trust-Based
BreadthofBusinessIssues
Relationship-Based
Needs-Based
Service
Offering-Based
DepthofPersonalRelationship
Figure5.2Rogers
CreatingtheTriumvirateofQualifiedProfessionals 49
ation and personal chemistry between the client and each professional.
Whileallpartiesmaynaivelybelievetheyserveasthetrustedadviser,the
truedesignationisultimatelyawardedtotheprofessionalthatearnsthe
client’strustwiththemostsensitivematters.
Unfortunately,theterm“trustedadviser”maybeusedasamarketing
gimmickwithoutunderstandingthetruemeaningandsignificanceofthe
designation.DavidH.Maisteroutlinesinhisbook,TheTrustedAdvisor,
thehierarchyofclient/providerrelationships,shownin FIGURE5.2.1He
thenliststhevariouscharacteristicsoftherelationshiplevelsinatable(see
FIGURE5.3).
AsFigure5.2suggests,establishingtruststandsatthepinnacle,above
providingeducation,solvingproblems,andgeneratingideas.Trustisnot
something that is immediately achieved; it grows over time. Moreover,
it cannot be achieved solely within the physical confines of the service
organization,asinteractionwiththeclientismandatory.Itmayalsocross
the fine line from developing a professional relationship to a long-last-
ingfriendship.Fromanethicalstandpoint,developingtrustcanbestbe
achievedby“doingwhatisrightfortheclient,”whichmayinvolveoffer-
ingsolutionsthatforgoimmediateprofitsinordertodevelopamutually
rewarding,long-termrelationship.
Whyistheconceptofthetrustedadvisersoimportanttotax-aware
investment management? For the simple reason that if the adviser does
FIGURE5.3 CharacteristicsofRelationshipLevels
Source:DavidH.Maister,TheTrustedAdvisor(NewYork:Touchstone,2001),9–10
notbelieveinthephilosophyorisnotalignedwithprovidersandplat-
formsthatembracetax-awareinvestment,thenitwillbeastruggleatbest
toachieveafavorablesolution.Eveniftheinvestmentadviserisnotthe
“trustedadviser,”optimalresultscanstillbeaccomplished,buttheother
membersofthequalifiedtriumviratehavetobelieveinthetax-awareprac-
titioner’sapproachandbewillingtosupportitwhenquestionedbythecli-
ent.Thisiswhyitissoimportanttodeveloprelationshipswithpreferred
providersandtakethetimetosharethebenefitsofthetax-awareprocess.
Theabilitytoachieveatax-awaresolutionisinfluencednotonlyby
theexpertiseoftheprofessionalsofthequalifiedtriumviratebutalsoby
thecharacteristicsofthefinancialservicesplatform.Therearetwoprimary
typesofplatformsorservicearrangements:discretionaryandnondiscre-
tionary.Underadiscretionaryarrangementthefinancialadvisercanmake
decisions on the client’s behalf, whereas in a nondiscretionary platform
theultimatedecisionrestswiththeclient.Discretionaryplatformsusu-
ally work best with clients who are migrating from a retail broker, and
wheretheskillsetofthequalifiedtriumvirateisusuallycontainedwithin
the same organization. Discretionary platforms lend themselves better
tostandardizationandtheabilitytoofferproprietary,internalproducts.
Thefirmsthatservethisnichemayoffercommingledproductsthatserve
particularclientriskprofiles.Itisalsoeasiertoshowprospectspotential
results,astheoutcomesaremoreuniform.
Moreknowledgeableandhands-ontypeclientstypicallyprefernondis-
cretionaryplatforms,givingthemaccessto“bestofbreed”serviceprovid-
ers.Eachsolutionofanondiscretionaryplatformisultimatelyapproved
ordrivenbytheclient.Theclientisofferedseveralmanagerorfundop-
tionswithineachassetclassandchoosesacustomsolution.Asaresult,
thereturnsofindividualclientsmayvarywidely.Itisalsomoredifficult
forprospectstograsptheprovider’sabilitytoaddvalue,sincetheultimate
mixofassetsandmanagers/fundswasdecidedbyeachclient.
Perhapstheeasiestfeaturetounderstandaboutthenondiscretionary
platformisfees,whichtypicallyconsistofcustodian,manager,andadviser
fees.Adviserfeestypicallyincludereportingservices.Additionally,advisers
typicallynegotiatewithoutsidemanagersonbehalfofalltheirclientsen
massetoobtainamorefavorablearrangementthanifclientsapproached
themanagersontheirown.Theabilitytoaccomplishthisdifferswiththe
assetclassandwitheachmanagerontheadviser’srecommendedlist,but
thesavingsmaybesufficientwheretheadviserultimatelybecomesaprofit
center,ratherthanacostofdoingbusiness.Ontheotherhand,thepric-
ingofnondiscretionaryplatformscanbeconfusing,asfeesaretypically
bundledtogether,anditisoftendifficulttodeterminethecostofanyone
serviceorproduct.Thisisespeciallytruewhendiscountsareofferedfor
CreatingtheTriumvirateofQualifiedProfessionals 51
usinginternalproducts,suchastradingthroughthefirm’sbroker-dealer,
whichmaycreatepotentiallayersofhiddencosts.
Like marriages, relationships between clients and their providers do
not always last until death. When clients have security positions with
substantialunrealizedgains,thedecisiontoendtherelationshipcanbe
costly.Therefore,itisimportantfortheinvestorseekingtaxable-account
servicestoconsidernotonlytheinconveniencebutespeciallythefinan-
cial consequences if it becomes necessary for any reason to terminate a
relationship. With a nondiscretionary platform, the advisory, custodial,
andmanager/fundservicesareusuallymodularandcanbereplacedsepa-
rately.Replacingaparticularelementmayrequiretimetoselectanother
provider and attention to detail to transfer the responsibility, but if the
transition is conducted with new providers that appreciate and under-
standtax-awareinvestmentmanagement,thetimeanddisruptioncanbe
minimal.Atransferof“assetsinkind”ofexistingsecuritypositionstonew
managerswithoutsellingwillallowthenewteamtodowhatisbestforthe
client.Ifdoneproperly,itmaytaketax-awareportfoliomanagersayearor
moretomakethetransitiontotheirmodelportfolio.However,withthe
discretionaryplatform,especiallywhenproprietyproductsareinvolved,
clientswillbeforcedtoliquidatealltheholdingsandbeginanewifthere-
lationshipisterminated.Nondiscretionaryplatformscanbeagoodfitfor
certainclientprofiles.However,investorsthatchoosethemneedtohavea
muchhigherdegreeofconfidenceinthesoundnessoftheirdecisionmak-
ingthaninvestorsselectingdiscretionaryplatforms.
With the proliferation of high-net-worth individuals, as a result of
wealthcreatedduringthelatterhalfofthe1990s,thenumberoffirmsem-
ployingnondiscretionaryserviceplatformsalsoproliferated.Theprimary
reasonisthatittakesanextremelyexperiencedinvestmentprofessionalto
carrythesophisticatedrelationshiprequiredforadiscretionaryplatform,
andthesupplyislimited.Thissituationgetsevenmorechallengingwhen
the client desires exposure to alternative investments. Therefore, many
firmshavenochoiceinwhatplatformtheyoffer.Asaresult,individuals
seeking an independent discretionary platform will likely discover their
nicheisservedbyonlyasmallnumberoffirms.
Thepotentialofaparticularplatformtoachieveatax-awaresolution
depends on the ability to satisfy the four critical elements of tax-aware
investing:
1 Utilizingafter-taxassumptionsintheassetallocationprocess
2 Allocatingassetclassesandmanagers/fundsaccordingtothechar-
acteristicsofeachinvestmententity
3 Positioningtax-awareequitymanagers
4 Identifyingtax-awaremanagers/funds
52 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Thefirstthreeelementspertaintoprocessandthefourthtoproduct.
Having all four elements in place is optimal, but not all platforms can
achievethis.Accomplishingthefirstthreerequireseducatingthefinancial
servicesproviders,whichmanyplatformshavenotyetembraced,butthis
situationisgraduallyimproving.Ifthelimitationsofaplatformaresuch
thatitcannotdelivertax-awaremanagersandfunds,thencaveatemptor,or
buyerbeware.Thekeyfortheinvestoristoevaluatethefouressentialele-
mentstodetermineifthefinancialservicesprovideriscapableofsatisfying
orexceedinghisorherexpectation.
Thereisasayinginthefinancialplanningcommunitythat“individu-
alsarewillingtopayfortheirhealth,butnotfortheirwealth.”Thereisa
lotoftruthtothisstatement,assomeindividualsjustcannotgetoverthe
factthatapersonofferingthemfinancialadvice needs to be financially
rewardedforthatservice.Therewillalwaysbesomeindividualswho,for
whatever reason, will not pay for advice, so the only way they can be
servediswhenfeesareembeddedintheportfoliostrategiesrecommended.
This aspect segments the financial planning community into fee-based
versusproduct-basedproviders.Itisextremelydifficulttocreateoptimal
tax-awaresolutionsintheproduct-basedsegment.Unfortunately,many
of the desirable products available in the marketplace today are low-fee
innatureanddonotofferawayforproduct-basedproviderstobecom-
pensated.Itisasadfactthattheinvestorseekingtheproduct-basedroute
mayunfortunatelyenduppayinganopportunitycostthatfarexceedsthe
costofafee-basedplannerwhooffersatax-awaremenuofmanagersand
mutualfunds.
Feearrangementshaveanimpactontheabilityofserviceproviders
toaligntheirinterestswiththeclient.Thefollowingdiscussionwillal-
lowinvestorstogainabasicunderstandingofthepositiveelementsand
concernsofthemostcommonfeearrangements.First,thereisthehourly
charge,whichiscommonwithaccountantsandestateattorneys.Hourly
feesareeasyformanyclientstoaccept,becauseyouareonlychargedfor
servicesutilized.Hourlyfeesaretypicallyhigherduringtheinceptionof
therelationship,asthereismoreworknecessarytodevelopaneffective
financial plan. Second, there are clients who prefer retainer fees over
hourly fees. They believe this arrangement to be superior, since the
chargeisbasedonaddressingtheneedsoftherelationship.Clientswho
prefertheretainerfeestructurefeelitfacilitatescommunication,since
they do not feel compelled to limit the interaction to avoid excessive
charges.Additionally,theyfeelthereisnoneedfortheproviderstoin-
undatethemwithadditionalideas,asmightaretailbroker.Thethird
type of fee arrangement is to charge a percentage of the overall assets
undermanagementorsupervision.Thisisthemostcommonapproach
CreatingtheTriumvirateofQualifiedProfessionals 53
byfinancialservicesproviders,whichmayofferaslidingscaletoachieve
avolumediscount.Advocatesofthisapproachbelievethattheservice
providersarerewardedastheclient’swealthincreases.Skepticsofthis
arrangement believe it causes the providers to offer more high-return,
high-riskoptions.Forexample,theportfoliomixcouldbemoreheav-
ilyorientedtowardequitiesthannecessary,sincehistoricallytheyhave
provided higher returns than fixed income securities.The fourth type
of fee arrangement is one based on performance. The manager must
achieveareturnaboveadesignatedhurdleratebeforetheincentiveor
performancefeekicksin.Plus,theremaybeahigh-watermarktomake
surethemanagerisonlypaidtheperformancefeeswhenpreviousshare
orunitvaluesareexceeded.Itisencouragingthattherearenowmanag-
erswillingtoacceptassignmentswheretheperformancefeeisbasedon
exceedingahurdleratecalculatedaftertaxes.Thefifthandlastareais
hiddenfees.Theseillustratewhyitsoimportantforprospectstoaskthe
rightquestionstogainanunderstandingofallfeesinvolved.Thisgray
areamayincludeitemssuchasmarketingfees,softdollarcommissions,
ortradingthroughthefirm’sbroker-dealer.Theimportanceofthislast
area cannot be underestimated, because costs—like taxes—influence
thenetresult.Nofeearrangementisperfectforallsituations,andthe
low-costsolutionmaynotbetheonethatcandeliveroptimalafter-tax
results.Theinvestorverysimplyneedstodetermineifthefeearrange-
mentofferedwillmotivatetheproviderstoachieveanoptimaltax-aware
solution.
Investorsorprospectswhoareseekingfinancialserviceprovidersand
wishtodevelopaqualifiedtriumvirateofprofessionals,shouldconsider
thesequestions:
❑ Cantheskillsrequiredofthequalifiedtriumviratebesatisfiedby
one professional/firm, or does my situation necessitate multiple
“bestofbreed”specialists?
❑ CanIdevotethetimenecessarytoachievedesiredresults?
❑ Ismytrustedadvisercapableofsupportingatax-awareapproach?
❑ Will the financial services platform I am considering be able to
deliveratax-awaresolution?
❑ How costly will the transition to another provider be if I later
decidetoterminatetherelationship?
❑ Towhatdegreecanmyfinancialservicesproviderdeliverthefour
keyelementsoftax-awareinvestmentmanagement?
❑ DoIreallyunderstandthefeearrangementsofthepotentialpro-
viders’ services and products and how they affect the ability to
deliveratax-awareapproach?
54 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement
Tax-awareinvestmentmanagementrequireslong-lastingrelationships
toachievefavorableresults.Therefore,providersthatofferthequalified
triumvirate of necessary skills with servicing platforms and fee arrange-
mentsandcanultimatelyobtaintheclient’strustwillbetheonesmost
likelytosucceed.
ChapterNotes
1. DavidH.Maister,TheTrustedAdvisor(NewYork:Touchstone,2001),9–10.
PARTTWO
After-TaxReporting
andMeasuresof
TaxEfficiency
All taxes are a drag on economic growth. It’s only a question of
degree.
—AlanGreenspan
55
This page is intentionally blank.
CHAPTER6
MutualFundAfter-Tax
Reporting
It’snotwhatyoumake,it’swhatyoukeep.
—Anonymous
T
he after-tax reporting standards proposed by the Securities and 1
ExchangeCommission(SEC)weresignedintolawasthelastof- 2
ficialactoftheClintonadministration.Sinceearly2001,after-tax 3
returnshavebeenrequiredintherisk/returnsummaryoftheprospectus, 4
withtheexceptionofmoneymarketfundsandthosemarketedsolelyto 5
tax-exemptaccounts.1Thislegislationhashadaprofoundimpactontax- 6
aware investment management by ensuring that the impact of taxes on 7
investmentreturnswouldreachthemillionsofindividualinvestorswho 8
holdmutualfunds. 9
Thepaintaxablemutualfundshareholdersexperiencedduringthelat- 10
terhalfofthe1990screatedthedemandforafter-taxreporting,asFIGURE 11
6.1fromtheInvestmentCompanyInstitute(ICI)highlights.2Figure6.1 12
Asmentionedinchapter1,Congressaddressedtheconcernoffund 13
shareholdersinMarchof2000.Concurrently,theSECissuedaproposal 14
forpubliccomment.Itreceivedinputfromprofessionalorganizationssuch 15
as the Association for Investment Management and Research (AIMR), 16
whichadoptedafter-taxreportingstandardsforseparateaccountsin1994, 17
alongwithseveralhundredresponsesfromindividualmutualfundinves- 18
tors. As expected, AIMR and mutual fund shareholders were extremely 19
supportiveoftheSECinitiative.Interestinglyenough,thegreatestnum- 20
57
58 After-TaxReportingandMeasuresofTaxEfficiency
Source:InvestmentCompanyInstitute,2004MutualFundFactBook(www.ici.org).Reprintedwithpermission.
FIGURE6.1 C apitalGainDistributionsPaidbyMutualFunds,
1996–2003(billionsofdollars)
Tax-DeferredHouseholdAccounts* 326
TaxableHouseholdAccounts*
Non-HouseholdAccounts
238
194
183
165 143
97
100 97
53 95 69
60 68
49 49
30 9 7
16 5 14 5
26 27 37 14
17 18 6 2 3
1996 1997 1998 1999 2000 2001 2002 2003
*Householdsaredefinedtoexcludemutualfundassetsattributedtobusinesscorporations,financialinstitutions,
*Households are defined to exclude mutual fund assets attributed to business corporations, financial
nonprofitorganizations,fiduciaries,andotherinstitutionalinvestors.
institutions,nonprofitorganizations,fiduciaries,andotherinstitutionalinvestors.
Note:Componentsmanynotaddtothetotalbecauseofrounding.
Note:
Componentsmaynotaddtothetotalbecauseofrounding.
Figure6.1Rogers
berofcommentscamefromvisitorstotheMotleyFoolwebsite.Theweb-
site’seducationinitiativewascertainlynotfoolishwithregardtotax-aware
investmentmanagement,andvisitorswereencouragedtorespondtothe
SECinsupportoftheproposal.However,severalprofessionalorganiza-
tionslobbiedtooverturnthestandardsevenaftertheyweresignedinto
lawbyPresidentClinton.Inspiteofthesechallenges,U.S.Securitiesand
ExchangeCommission,FinalRule:DisclosureofMutualFundAfter-Tax
Returns,SectionII.D,cameaboutonApril16,2001.Readerscanobtain
acopyofthemutualfundafter-taxstandardsbyvisitingtheSEC’swebsite
(www.sec.gov). This document should certainly be part of the library
ofanyprofessionalwhointeractswithtaxableinvestorsholdingmutual
funds.
AperformancedisplayfromanactualfundreportfortheVanguard
Tax-Managed Growth and Income Fund for periods ending June 30,
2004, will highlight several key points about the standards (see FIGURE
6.2).Ithasanenviablerecordofnothavingmadeanycapitalgainsdistri-
butionssinceitsinceptionin1994.3Thisfundwasselectedforillustrative
purposes,notasanendorsementoftheproduct.
MutualFundAfter-TaxReporting 59
FIGURE6.2 S ampleDisplayofMutualFundAfter-TaxReturn
Reporting
Source:VanguardGroup,VanguardTax-ManagedFundsSemiannualReport,June30,2004,19.
VanguardTax-ManagedGrowthandIncomeFund
AverageAnnualTotalReturns*
PERIODSENDEDJUNE30,2004
SINCE
ONEYEAR FIVEYEARS INCEPTION**
*Allfundreturnsareadjustedtoreflectfees.EachoftheVanguardTax-ManagedFundsassessesa2
percentfeeonredemptionofsharesheldinthefundforlessthanoneyearanda1percentfeeonre-
demptionsofsharesheldinthefundforatleastoneyearbutlessthanfiveyears.
**InceptiondateisSeptember6,1994.
ThefigureshowsthetwodifferentmethodsrequiredbytheSECfor
presentingafter-taxreturnsinalogicalprogressionthatbuildsonthebe-
fore-taxreturns.Thefirstrow,“ReturnBeforeTaxes,”isthesameinfor-
mationrequiredfordisplayingpretaxreturnsandincludestheimpactof
fees.Thesecondrow,“ReturnAfterTaxesonDistributions,”takesinto
accountonlythetaxesonincomeandcapitalgainsdistributions.Asmen-
tioned in chapter 3, this is known as the pre-liquidation methodology
for calculating after-tax returns.The third row, “Return AfterTaxes on
DistributionsandSalesofFundShares,”isknownasthepost-liquidation
calculationmethodology.
Bothcalculationmethodologiesprovideusefulinformation.Together
theyallowthetaxablemutualfundinvestortomakebetter-informedin-
vestment decisions.There are cases where one calculation methodology
or type of after-tax return is more appropriate than the other. For ex-
ample,thepre-liquidationafter-taxreturninformationisappropriatefor
individualswhowilltakeadvantageofthestep-upinbasisatdeath.For
someonewhoisrebalancingaclient’sassetallocation,thepost-liquidation
methodologyismoreappropriate,becauseittakesintoaccounttheimpact
60 After-TaxReportingandMeasuresofTaxEfficiency
oftheclient’sunrealizedcapitalgainorlosspositionontheafter-taxreturn
whenfundsharesaresold.
TheSECrequiresthehighestfederaltaxratestobeappliedwhencal-
culatingafter-taxreturns.Althoughthismaynotrepresentthetaxprofile
oftheaverageinvestor,itdoesprovidethemostconservativescenario.If
yourowntaxsituationorthatofyourclientsisdifferent,checkthewebsite
ofyourmutualfundprovider,assomefirmshavecreatedonlinecalcula-
torsthatallowinvestorstoapplytheirpersonaltaxprofiletoanalyzehis-
toricalafter-taxresults.
Inthe“OneYear”column,thehighestfederaltaxrateisappliedeven
thoughthefundwouldqualifyforthemorefavorablelong-termcapital
gainsrateifheldforonemoreday.Thiswasoneofthemorecontrover-
sialelementsoftheafter-taxproposal,asmanyprofessionalswithinthe
fundindustrythoughtitwasunrealistic.However,theSECfeltstrongly
thiswasnecessary,sincetheaverageholdingperiodformutualfundshad
fallensignificantlyduringthe1990s.Thisrequirementhighlightsthecon-
ceptthatifyoudon’tholdafundformorethanayearitisimpossibleto
takeadvantageofthebenefitofthelowerrateforlong-termcapitalgains,
currently15percent.
Anotherkeypointisthatafter-taxreturnscanbegreaterthanpretax
returns for information shown in the row “Return AfterTaxes on Dis-
tributions and Sales of Fund Shares” calculated by the post-liquidation
methodology.Ifthefundissoldwhenthemarketvalueisbelowcost,a
creditisgiventotheafter-taxreturn,becauseliketheAIMRstandardsfor
separateaccounts,theSECstandardformutualfundsassumesthelosscan
beusedtooffsetagaininanotherfundorportfolioorbeappliedinthe
future.Forexample,ifafundisheldlessthanayear,the35percentfed-
eraltaxrateapplies.Therefore,ifthebefore-taxreturnis–10percentwith
nodividenddistributions,the“ReturnAfterTaxesonDistributionsand
SalesofFundShares”wouldbeonly–6.5percent(10%×[1–35%]).An
exampleofthissituationisinthecolumnmarked“FiveYears”inFIGURE
6.2.Allthereturnsarenegative,butthe“ReturnAfterTaxesonDistribu-
tionsandSalesofFundShares”(–2.04percent)isgreaterthanthe“Return
AfterTaxesonDistributions”(–2.56percent)and“ReturnBeforeTaxes”
(–2.16percent).Althoughthedifferencesinthisexamplearequitesmall,
theywouldbemuchlargerifthedisplayhadbeentakenfromthespring
of2003,whenlarge-capitalizationstocksonaveragehadbeensubjectto
threeyearsofnegativereturns.
While the SEC after-tax standards provide mutual fund investors
withmeaningfulinformation,twoadditionalitemsshouldbeconsidered
tomaketrulyinformedinvestmentdecisions.Thefirstpertainsprimarily
toequityfunds,whereasthesecondappliestobondfunds.Eventhough
MutualFundAfter-TaxReporting 61
itwasanAIMRSubcommitteerecommendation,theSECultimatelyde-
cidednottorequirethepercentageofunrealizedgainsorlossesinthe
performance display.4 With taxable accounts—in contrast to the tax-
exemptaccountarena—whatthefundhasdoneinthepastinfactcan
anddoeshaveasignificantimpactonfutureafter-taxreturns.Tohigh-
lightthispoint,recallthatinvestorsinthelatter1990swereconcerned
abouthowtoavoidequityfundswithsubstantialunrealizedcapitalgains
positions, which reached 50 percent of total assets or more for large-
capitalization,growth-orientedstylefunds.Forexample,theStagecoach
EquityFundIndex–AFundhadanunrealizedgainpositionof70per-
cent!5Somepractitionerseventhoughtfundswithlargeunrealizedcapi-
talgainspositionsshouldhaveincludedawarninglabel,similartothe
oneonapackofcigarettes,statingthatinvestinginthemcouldresultin
detrimental tax consequences.The situation became such a concern in
1999 that some fund groups contemplated opening vintage year index
funds for their taxable investors. By the spring of 2003 the pendulum
hadswungtotheoppositedirection,andafterthreeyearsoflossesthere
wasanopportunitytopurchasefundswithsubstantialembeddedunreal-
izedlosses.Whilethepercentageofunrealizedcapitalgainsembeddedin
afundislimitedto100percentofassets,thepercentageoflossescanbe
greaterthan100percent.Thisoccurswhenfundmanagerssellsharesand
lossescannotbepassedthroughtoshareholders,becauseoftheaccount-
ingconventionthatfundsmustapply.Iftheredemptionsaresignificant
and the manager must sell shares below cost, the amount of losses in
dollarscanexceedtheremainingassetsinthefund.AsofJune30,2004,
therewereapproximately5,900mutualfundsonMorningstarPrincipia
thatshowedanegativepercentageofunrealizedcapitalgainswithafew
closeto–1,000percent!6Adviserscanaddmeaningfulvaluefortheircli-
entsbyconsideringthepercentageofunrealizedcapitalgainsofpossible
fundalternativeswhentheymakepurchaserecommendationsforthetax-
ableportionofassets.Giventwofundsthatareequalineverydimension
except the unrealized capital gains position, the tax-aware investor will
alwayschoosetheonewiththeleastamountofunrealizedgainsorgreat-
estamountofunrealizedlosses.Aswewillseelaterinthischapter,the
accounting convention lends itself to arbitrage opportunities, or what
somemayconsidera“freelunch.”
Fortunately for the taxable investor, information pertaining to the
percentage of unrealized capital gains or losses can be obtained from a
MorningstarInvestmentDetailReport(again usingtheVanguardTax-
Managed Growth and Income Fund as an example).7 As FIGURE 6.3
shows,thisparticularfundhadaninternal+6percentunrealizedcapital
gainsposition.Thispercentagechangeswiththemarketvalueofsecuri-
62 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE6.3 E xampleofMorningstarPrincipiaDisplay
MutualFundAfter-TaxReturnInformation
Source:Morningstar
*Allfundreturnsareadjustedtoreflectfees.EachoftheVanguardTax-ManagedFundsassessesa2
percentfeeonredemptionofsharesheldinthefundforlessthanoneyearanda1percentfeeonre-
demptionsofsharesheldinthefundforatleastoneyearbutlessthanfiveyears.
**InceptiondateisSeptember6,1994.
FIGURE6.4 SampleDisplayofMutualFundAfter-TaxReturnReporting
*InceptiondateisSeptember6,1994.
MutualFundAfter-TaxReporting 63
tiesheldintheportfolioandshareholderpurchaseandredemptionactiv-
ity.Figure6.3alsoshowstheafter-taxreturns,tax-costratios,andrelative
rankinginformationMorningstarprovidesitssubscribersforthree-,five-
andten-yearperiods.Anexplanationoftheinformationprovidedinthe
fourcolumnsfollows:
1 Tax-AdjustedReturnPercentage—ThisisMorningstar’scalcula-
tionthatfollowstheSECguidanceforreturnaftertaxesondistribu-
tions,orpre-liquidationafter-taxreturns.Itshouldbenotedthatafter-
taxreturnsalsoincludetheimpactofloads,whenappropriate.
2 PercentileRankCategory—Morningstargivesthefund’srelative
percentile ranking within its peer group. Figure 6.3 shows that for
thepasttenyears,theVanguardTax-ManagedGrowthandIncome
Fundwasrankedat7,whichmeanssixoutof100fundshadsuperior
results.
3 Tax-Cost Ratio—In this column, Morningstar employs a pro-
prietarymeasuretocalculatetheamountofreturnthatwouldhave
beenlosteachyeartopaymentoftaxes.Forthepasttenyearsthis
64 After-TaxReportingandMeasuresofTaxEfficiency
fundwouldhavelost0.53percentonaverageeachyeartothepay-
mentoftaxes.
4 PercentileRankCategory—Morningstaralsogivesarelativeper-
centilerankingonthetax-costratio.Inthisexample,thefundhasa
rankingof8basedonthetax-costratiooverthepastten-yearperiodof
analysis.
Abitofexperienceandseveralpiecesofinformationarerequiredto
makesagedecisionswhenrecommendingmutualfundsfortaxableinves-
torsorforpersonalinvestment.Inadditiontoreturn-relatedinformation,
itisalsohelpfultoreviewthehistoryofincomeandcapitalgainsdistribu-
tionsplusexpenses.
Fortunately,theMorningstarInvestmentDetailReportprovidesthis
information,aswell(seeFIGURE6.4).8Reviewingthecalculation-onlyin-
formation,oneimmediatelywonders,whyisn’tthetax-costratiorelative
percentile ranking for theVanguardTax-Managed Growth and Income
Fundhigherthan23forthefive-yearperiodofanalysis?The23percen-
tilerankingisgood,butonemightexpectthemeasuretobehigher,es-
pecially since only a small percentage of stock funds truly focus on tax
management.The tax-cost ratio is driven by three factors: capital gains
distributionsfromtradingactivity,theamountofincomeordividends,
andtheexpenseratio.Asmentionedearlier,theMorningstarreportshows
this fund has never made a capital gains distribution, as evident by the
rowmarked“CapitalGains$,”sothisisnotacontributingfactor.There-
fore,theamountoftaxesmustbearesultoftheamountofnettaxable
dividends generated by the portfolio. From the figure, you can also see
thefund’s“IncomeRatio%”for2003was+1.63percent.Additionally,
thefundhashadalow“ExpenseRatio%”ofonly0.17percentforthe
pastthreeyears.Therefore,in2003itwouldhavehadagrossincomeor
dividendyieldbeforefeesof+1.80percent(1.63percent+0.17percent).
Inthiscase,theportfolioreplicatesthecompositionoftheStandard&
Poor’s500stockindex.Tolowerthetax-costratioandimprovetherelative
ranking,Vanguardcouldremovethe1percentredemptionfee,managea
portfoliothatpaysdividendsequaltoorlessthanitsfeesof+0.17percent,
orincreasethemanagementfee.Totakeanyofthesemeasureswouldnot
makesense.Sotherelativerankingof23percentforthefive-yearperiod
isaboutashighascoreasVanguardislikelytoachieve.Thissimpleex-
ample demonstrates that it often takes several pieces of information to
makesound,tax-awareinvestmentdecisions.
Theotherfactorpertainstotax-exemptormunicipalbonds.Unless
thereisachangeinthetaxcodeforindividuals,moreandmoreinvestors
willbesubjecttothealternativeminimumtax(AMT)(seeFIGURE6.5).9
Source:CongressmanJimSaxton,Chairman,JointEconomicCommittee,The MutualFundAfter-TaxReporting 65
AlternativeMinimumTaxforIndividuals:AGrowingBurden,Congressional
FIGURE6.5 IndividualAMTReturnsandTaxesCollected
18 50
16 45
AMTreturns
AMTrevenue 40
AMTreturns($millions)
14
AMTrevenue($billions)
BudgetOffice2001,U.S.Congress,May2001.
35
12
30
10
25
8
20
6
15
4 10
2 5
– –
1990 1995 2000 2005 2010
Rogers/TaxAwareFig.6.5
Mostinvestorsdonotrealizethatfundsholdinglessthan20percentof
privateactivitybondsissuedafter1986subjecttotheAMTarepermitted
tocallthemselvestax-exemptbondfunds,whereasfundsholdinggreater
than20percentofAMTissuesareclassifiedasmunicipalbondfunds.For
individualssubjecttotheAMT,privateactivitybondsaretaxedatarate
of26percentor28percent,dependingontheamountofalternativemini-
mumtaxableincome(AMTI).10Tax-awareadvisersestablishprocedures
toavoidplacingclientssubjecttotheAMTinmunicipalortax-exempt
bondfundswithAMTexposure.Todealwiththischallenge,itisessential
toperiodicallycallfundcomplexestoobtaintheirexposuretoprivateac-
tivitybondssubjecttotheAMT.
Althoughthetitleofthischapteremphasizesafter-taxreporting,we
cannotsimplyignoretheimpacttheaccountingconventionformutual
fund investing has on the actual after-tax results investors may achieve,
which can benefit certain taxable shareholders and disadvantage others.
Unlikeseparateaccounts,mutualfundscannotpasslossesthroughtoin-
vestors.Furthermore,theycanonlytakeadvantageofalossbyusingitto
offsetarealizedgainforaperioduptoeightyears,whereaswithaseparate
accountanindividualcanusethemindefinitely.
Wheninvestorspurchasesharesinamutualfund,theyestablishtheir
costbasis.Thefollowingexampleillustrateshowthetimingofapurchase
canresultinquitedifferenttaxconsequenceswhenadistributionofcapi-
talgainsismade.Let’sassumeamutualfundiscreatedonJanuary1with
a$10,000purchaseofsharesbyourfirstinvestor,andineachofthenext
66 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE6.6 MutualFundShareholderAccountingExample
MONTHLY ENDING
MONTH INVESTOR INVESTMENT VALUE SHARES VALUE
Source:DouglasS.Rogers
October 10 $10,000.00 $10.94 914.34 $11.05
Total 10 $100,000.00 9,566.02
ninemonthsanewinvestorpurchases$10,000ofshares.Additionally,the
fundappreciates1percenteachmonth(seeFIGURE6.6).
Attheendoftenmonths,thefundhasteninvestorswhohavecon-
tributedatotalof$100,000.Thenetassetvalueofthefundis$11.05.
After ten months of consistent appreciation, the fund has a total value
$105,704.52(9,566.02shares×$11.05).Thefundhasincreasedinvalue
beyond the contributions of shareholders by $5,704.52 ($105,704.52
–$100,000).OnNovember1,thedirectorsofthefundannouncethatall
shareholdersofrecordonthatdaywillreceiveacapitalgainsdistribution
of$5,704.52,or100percentoftheprofitearnedsinceJanuary1.Since
therearenow9,556.02sharesoutstanding,acapitalgainsdistributionof
$0.59($5,704.52/9,556.02shares)willbemadetoeachshare.
ThelastcolumninFIGURE6.7showsthedollaramountofthecapital
gainsdistributionmadetoeachofthetenshareholders.Notethediffer-
encebetweenthecolumnsmarked“Profit”and“CapitalGainsDistribu-
tion”forinvestors1and10.Shareholder1hasmadeaprofitof$1,050,
takingintoaccountthecurrentclosingpriceofthefund,butonlyhasto
paytaxeson$590incapitalgains,whereasshareholder10hasaprofitof
MutualFundAfter-TaxReporting 67
FIGURE6.7 utualFundExample:Profitvs.CapitalGains
M
Distributions
only$103.46andhastopaytaxeson$539.46incapitalgains.Whenyou
compare the two columns, no investor has a profit exactly equal to the
capitalgainsdistribution.Thisexampleisfairlystraightforward,butinves-
torstypicallymakeinvestmentsovermanyyearsandmostfundshaveboth
incomeandcapitalgainsdistributions.
Howdramaticcanthisinjusticebetweenshareholdersbe?Toanswer
thisquestionweneedtolookbackto1987.Duringthe“correctionof
1987,” stocks rose significantly during the summer and early fall, but
thentheyhemorrhagedinthethirdweekofOctober.Manymutualfunds
haveOctober31astheirfiscalyear-end.Therefore,therewerecaseswhere
individualinvestorspurchasedsharesinequitymutualfunds,sawtheir
investmentdrop20percentorsoinvalue,andthengothitwithasizable
capitalgainsdistribution.Fortunately,themarketgraduallyrebounded,
butmanyofthoseinvestorswereforcedtosellsharesatunfavorablepric-
estocovertheirtaxbillthefollowingyear.
Congress has attempted to rectify this situation, but though well-
intentioned,thesolutionoftendisregardsthebasicfailureofmanagersto
taketaxesintoaccountwhenmanagingtheirfunds.Forexample,Con-
gressmanJimSaxtonhasproposedlegislation(H.R.168)thatwouldallow
68 After-TaxReportingandMeasuresofTaxEfficiency
eachindividualanannualdeductionfromcapitalgainsdistributions.11
Also, Congressman Paul Ryan has introduced legislation (H.R. 1989)
thatwouldrequireindividualstopaytaxesoncapitalgainsonlywhen
theysellfundshares.12Bothproposalsareintendedtomakethingseasier
formutualfundinvestors.However,whatisoftenignoredisthatthese
billswouldonlyexacerbatetheproblemofportfoliomanagersignoring
theimpactoftaxes.Moreover,aswewilldiscoverinchapter9,thereare
alreadyfreemarketsolutionsthathavesolvedthisissue.Unfortunately,
tax-awaresolutionsdonotvoteandtheshareholderswhousethemstill
representasmallportionofthemarket.IfCongressreallywantstopro-
videinvestorswithameaningfulchange,itshouldchangetheaccounting
conventionformutualfundstoallowlossestoflowthroughtoinvestors.
Itmaytakeseveralyears,ifever,forafundmanagertotakeadvantage
of the loss position, whereas individual investors may be able to apply
themimmediatelysincetheytypicallyholdmultiplefundsandportfolios
wheregainscanbetaken.
Theactualafter-taxreturnsforindividualswhoinvestindollar-cost
averagingprogramsorreinvestfunddistributionscanbequitedifferent,
dependingonwhataccountingconventiontheypersonallyapply.There
arethreeprimaryaccountingconventionsthatinvestorsandtheiradvisers
shouldbeconcernedwith:
❑ Firstin,firstout
❑ Specificlotidentification
❑ Averagecost
TheIRSallowsinvestorslatitudeinchoosingtheirpreferredmethod.
Theaveragecostmethodistypicallythedefaultmethodusedbycustodi-
ans.Therefore,ifyoudesiretoapplyoneofthefirsttwoconventions,you
needtomakeanelectionbeforetransactionsareaccountedforbytheaver-
agecostmethod.Theparticularaccountingconventionappliedcanhave
asignificantimpactontheamountoftaxesthatwillbepaidinanyyear.
Itwillnotchangethedollaramountofcapitalgains,butitcanchangeor
shiftthetaxliabilityconsiderably.Thiscanbeseeninthefollowingexam-
ple,usingmonthlypricesfromtheVanguard500IndexFundin2003.13
TheinvestorstartswithaninitialpurchaseinJanuaryof$3,000tosatisfy
theaccountminimumandmakesadditionalpurchasesineachofthenext
sevenmonthsforatotalinvestmentof$10,000(seeFIGURE6.8).
Duringthistimeframe,themarketbottomedinthespringandrallied
stronglyfortheremainderoftheyear.Eventhoughtheinvestorintended
tohavealong-terminvestmenthorizon,inDecemberheranintoasitua-
tionthatforcedhimtosellthirtysharesatthepriceof$102.67.Hewillbe
MutualFundAfter-TaxReporting 69
FIGURE6.8 MutualFundAccountingConventionExample
requiredtopaytaxesonthetransactionatthefederalshort-termcapital
gainsrateof35percent.AsFIGURE6.9shows,thethreedifferentaccounting
conventionsresultintaxobligationsrangingfrom$326.93to$709.85.
Firstin,firstout(FIFO)accountingismechanicalinnatureandprob-
ablysatisfactoryforfixedincomefundswhereappreciationisusuallynot
a significant part of the total return. As Figure 6.9 shows, thirty shares
wereusedtoestablishthecostbasisfromthefirstpurchase.Ifmorethan
37.97shares—thenumberofsharesacquiredintheinitialpurchase,or
tax lot—were sold, it would be necessary to examine the second-oldest
purchaseandcontinuetheprocessuntilsharesequalingtheamountofthe
saletransactionwereaccountedfor.
Specificlotidentificationrequiresabitofextrawork,butthebenefit
canbewellworththeeffort.AsFigure6.9shows,thefirstlotchosen
was the one with the highest cost basis, followed by the lot with the
next-highestcostbasis,andsoonuntilatotalof30sharesisreached.
Therefore, only 8.37 of the total 11.11 shares in tax lot 6 are used.
Theremaining2.74shareswillbeaccountedforduringafuturesaleof
shares.Thismethodrequiresaccurateaccountingrecords.Theexample
aboveisquitesimpleanddidnotincludeanyreinvestmentofdistribu-
tions.Toensurethattheyarekeepingadequaterecordsandadheringto
properprocedures,taxableinvestorsandtheiradvisersshouldadoptthe
70 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE6.9 MutualFundAccountingConventionExample
Source:DouglasS.Rogers
TaxRate 35.0% 35.0% 35.0%
TaxDue $709.85 $326.93 $566.75
formatshowninIRSPublication564,MutualFundDistributions(see
FIGURE6.10).14
Highin,firstout(HIFO)isanotheraccountingconventionthatmay
encounteredwithseparateaccountmanagement,withslightlylessoner-
ousrequirementsthanspecificlotidentification.FIFOoftenyieldsaresult
equalorsimilartospecificlotidentification,butthelatterstrategyoffers
morefreedomofchoice.
Averagecostissimplycalculatedbytakingthetotalamountoffunds
usedtopurchasesharesanddividingbythetotalnumberofshares.Again,
thisisthedefaultmethodusedbymostcustodians.Inthisexample,thetax
obligationusingaveragecostfellbetweenthoseusingtheFIFOandspe-
cificlotidentificationconventions,butthismaynotalwaysbethecase.
Ourexamplefocusesonlyon2003.However,thefutureisimportant
aswell:inthiscase,thenextsalewillmostlikelycausesomeorallorthe
remainingpurchasesortaxlotstoqualifyforthemorefavorablerateon
MutualFundAfter-TaxReporting 71
FIGURE6.10 SampleMutualFundAccountingFormat
SOLDOR
1
ACQUIRED REDEEMED
NUMBER COST ADJUSTMENTTO ADJUSTED2 NUMBER
MUTUAL DATE OF PER BASISPER BASISPER OF
FUND SHARES SHARE SHARE SHARE DATE SHARES
Source:InternalRevenueServicePublication564
1Includesharereceivedfromreinvestmentofdistributions.
2Costplusorminusadjustments
long-term capital gains.The FIFO method will most likely prove even
more costly, as it would have expended most of the oldest lot with the
greatestamountofappreciationpersharetobetaxedat35percentand
asmalleramountofcapitalgainsnowremainsintheportfolio.Thisex-
ampledemonstratesthatitmaybeworththeadditionaltimeandexpense
touseanaccountingconventionotherthanaveragecostfortheparticular
typeoffundandthesizeoftheinvestment.
The tax act of 2003 may go down in history as “the tax break the
averageindividualneverreceived!”15Mutualfundscansaveshareholders
taxesbyapplyingtheincometheyreceivefromdividendstooffsetfund
expenses. Prior to 2003, this worked to the advantage of the average
shareholder,asitdoesn’tmakesensetodistributeadividendandpaya
38.6percent(themaximumfederalrateatthetime)taxonitwhenitcan
beavoided.However,whenthetaxonqualifieddividendswasreduced
to 15 percent, many holders of actively managed equity mutual funds
receivedalmostnoneofthetaxbreak.Forexample,thefeeontheaverage
activelymanageddomesticstockiscurrently1.5percentandtheaverage
dividendyieldisonly1.6percent.Sinceonly0.1percentoftaxabledivi-
72 After-TaxReportingandMeasuresofTaxEfficiency
dendsaredistributed,thereisverylittleincomeleft,ifany,afterthefund
usesittooffsetexpenses.Thegroupsofshareholdersreceivingalmostall
ofthebenefitofthefavorabletaxlegislationarethoseinvestedinlow-fee
index-oriented mutual or exchange-traded funds. For a shareholder in
afundwithafeeof0.2percent,thelowertaxondividendsresultedin
an enhancement in after-tax return of 0.33 percent ([1.6% – 0.2%] ×
[38.5%–15.0%])annuallyversus0.02percent([1.6%–1.5%]×[38.5%
– 15.0%]), or almost nothing for the average actively managed equity
fund. Once again, this example shows how important fees and a basic
understandingofthetaxcodecanbe.Whenthislegislationcameabout,
the author was interviewed by a major financial services magazine and
madethishisnumberonepoint.Doyouthinkitwasincludedwhenthe
storywenttopress?Ofcoursenot,becauselow-feefundsdon’tsupport
advertisingbudgets!Thisoccurrencesupportsthepremisethattax-aware
productsareboughtbyinformedinvestorsandnotsoldthroughexpen-
sivemarketingandadvertisingefforts.Onceagain,educationprovesto
beparamountintax-awareinvesting.
MutualfundtaxinformationisreportedtotheshareholderonForm
1099DIV,whichisshowninFIGURE6.11for2003.AswithallIRSforms,
theformatofForm1099-DIVmaychangefromyeartoyear,depending
onchangesinthetaxcode.
The most critical information that an investor will encounter is ad-
dressedinthefollowingsectionsoftheform:
1a Total ordinary dividends—includes ordinary income and short-
termcapitalgains.
1b Qualifieddividends—dividendsthatqualifyforthemorefavorable
rateonlong-termcapitalgains.
2a Totalcapitalgainsdistributions—long-termcapitalgains.
2dUnrecapturedSection1250gains—attributabletodepreciablereal
estateinvestments.
3 Nontaxabledistributions—distributionsthatarenottaxable,but
thecostbasismustbereducedbythisamount.
6 Foreigntaxespaid—aninvestormaybeabletotakeadeductionfor
thisamount.
Sections1through2aapplytomostfunds,whereassections2dand
3applytorealestateinvestmenttrustsandsection6appliestointerna-
tional stock funds. One of the problems with mutual fund tax report-
ingisthatshort-termcapitalgainsarelumpedinwithtaxableincome.
Therefore,ifaninvestorhasshort-termlossesthatcouldbeusedtooffset
theshort-termgainsfromthefundholding,thereisnowaytoobtainthe
information.16
MutualFundAfter-TaxReporting 73
FIGURE6.11 SampleIRSForm1099-DIV
Source:InternalRevenueService
Alltoooften,theinvestorpaystaxesonthedistributionwhenreported
onForm1099-DIVandthenagainwhensharesaresold.Thus,thein-
vestormayinadvertentlypaytaxesonthesameamountofcapitalgains
twice!This happens more frequently than most people realize, because
manyfundshareholdersdonotunderstandtheaccountinginvolvedand
failtokeepgoodrecords.Thisbringsustothefollowingrulesofthumb
formutualfundinvestors:
❑ Besuretocheckwhenthefund’sfiscalyearendsandtheamount
of income and capital gains distributions anticipated before making
an investment, so you will not end up paying taxes on a significant
amountofcapitalgainsyoudidnotearn.
❑ Keepinmindthatwhennewinvestorsmakecontributionstoa
fundinarisingmarket,taxablegainsarelikelytobedistributedtoa
greaternumberofshareholders,whichcanenhanceafter-taxreturns.
Ontheotherhand,wheninvestorssellsharesinadecliningmarket,
theportfoliomanagermaybeforcedtotakegains,tothedetriment
ofthedwindlingnumberofremainingshareholders.
❑ ConsiderwhetherspecificlotidentificationorFIFOisworththe
timeandefforttoachieveapotentiallymoredesirableresultthanthe
averagecostconventionofaccountingforgainsandlosses.
❑ Keepgoodrecordsofmutualfundpurchases,reinvestmentofdis-
74 After-TaxReportingandMeasuresofTaxEfficiency
tributions,andsalesoffundsharestoavoidinadvertentlypayingtaxes
twice.
TheSEC’srequirementthatmutualfundsprovideafter-taxreturnshas
beenfarmorevaluablethaninvestorsrealize.Thedisplayformatisrelatively
simple and provides useful information that not only allows investors to
makemoreinformeddecisionsbutalsoservesasawaytoeducatethemon
thebenefitoflongerholdingperiods.WiththeSEC’safter-taxstandards,
thereisnowafoundationofinformationtobuildon.Overtime,modifica-
tionscanbemadetoaddressissuessuchasthosetheauthorhasnotedto
improveonwhatisalreadyextremelyvaluableinformation.Sincemoreand
moreinvestorsarebecomingcomfortablewiththeSEC’safter-taxstandards,
theyarebeginningtoaskprovidersinothernichesofthetaxablemarket-
place,“Ifmymutualfundcanprovideafter-taxreturns,whycan’tIreceive
theminthisplatform?”Providersthatarerespondingtothiscallarealready
beginningtodistinguishthemselves.Asaresult,theyareattractingthemore
discriminatingandknowledgeabletax-awareinvestors.
ChapterNotes
1. SecuritiesandExchangeCommission,“FinalRule:DisclosureofMutualFund
After-TaxReturns(S7-09-00),”April16,2001,7.
2. InvestmentCompanyInstitute,MutualFundFactBook2004(Washington,
D.C.:ICI,2004),29.
3. VanguardGroup,VanguardTax-ManagedFundsSemiannualReport,June30,
2004,19.
4. AIMRlettertoU.S.SecuritiesandExchangeCommission,Re:ProposedRule
forDisclosureofMutualFundAfter-TaxReturns(FileReferenceNo.S7-09-00),
June29,2000,2.
5. AnneGranfieldandJamesM.Cash,“CrashTaxes,” Forbes,June14,1999,
370–372.
6. MorningstarPrincipia,December31,2004.
7. Morningstar Principia, VanguardTax-Managed Growth and Income Fund,
July2004.
8. Morningstar Principia, VanguardTax-Managed Growth and Income Fund,
December31,2004.
9. CongressmanJimSaxton,Chairman,JointEconomicCommittee,TheAlter-
native MinimumTax for Individuals: A Growing Burden, Congressional Budget
Office2001,U.S.Congress,May2001.
MutualFundAfter-TaxReporting 75
10. CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,2003),
¶1401,p.449.
11. ChairmanJimSaxton,TheTaxationofMutualFundInvestors:Performance,
SavingandInvestment,JointEconomicCommittee,U.S.Congress,April2001.
12. InvestmentCompanyInstitute,“BilltoHelpMutualFundInvestorsEarns
Strong ICI Endorsement,” May 7, 2003, http://www.ici.org (accessed October
18,2004).
13. Vanguard500IndexFund,http://finance.yahoo.com(accessedOctober17,
2004).
14. IRSPublication564,MutualFundDistributions,http://www.irs.gov/pub
lications/p564/ar02.html(accessedOctober17,2004).
15. JackC.Bogleindiscussionwiththeauthor,September2,2004.
16. Gary I. Gastineau,The Exchange-Traded Funds Manual (New York: John
Wiley,2002),99–100.
This page is intentionally blank.
CHAPTER7
SeparateAccountAfter-Tax
Reporting
Theincidenceoftaxationdependsuponthesubstanceofatrans-
action.
—HugoL.Black
T
hefirstformalattempttocreateuniformstandardsforafter-tax
reporting was initiated by Lee N. Price. His firm, Rosenberg
CapitalManagement(RCM),wasservingnucleardecommis-
sioning trust (NDT) clients and they requested after-tax returns for
managercomparisonpurposesandtosatisfyregulatoryrequirements.
PriceapproachedtheAssociationforInvestmentManagementandRe-
search, which formed aTaxable Portfolios Subcommittee chaired by
Price and Robert E. Pruyne.1Thesubcommittee consisted of working
professionalshavingextensiveexperiencewithtaxableaccounts.2Itsrec-
ommendationswereadoptedandcanbefoundintheAIMRPerformance
PresentationStandardsHandbook.3Onlyaboutahalfdozenfirmsthatwere
servingmore-demandingNDTclientsadoptedthestandards.Vendorsof
portfolioaccountingsoftwarewereslowtorespond,astheywereunwilling
to commit the resources necessary to modify their tax-exempt-account-
oriented portfolio accounting systems until there was a catalyst to do
so.ThecatalystprovedtobetheSecuritiesandExchangeCommission’s
after-taxstandards,astheretailportionofthemarketnowhadbetterin-
formationthanthemoresophisticatedanddemanding,separateaccount
segmentofthemarket.
The AIMR Subcommittee for After-Tax Return Reporting was re-
77
78 After-TaxReportingandMeasuresofTaxEfficiency
constitutedinthespringof2000,firsttorespondtotheSECproposal
andthentoreviewtheexistingafter-taxstandardsforseparateaccounts.
Ablue-ribbonpanelofexpertsinvariousrelatedfieldsvolunteeredcon-
siderabletimeandefforttorecommendrevisionstotheexistingAIMR
after-taxstandards.4LeePricewasagainasignificantcontributortothis
processandasaresultshouldbeforeverknownasthe“fatherofafter-tax
reporting.”TheAIMRboardadoptedthemodificationstotheafter-tax
standardsonFebruary8,2003.Followingthisaction,theInvestmentPer-
formance Council (IPC) then endorsed the modifications on March 6,
2003.WhileeffortsbytheSEC(inregardtomutualfunds)andAIMR(in
regardtoseparateaccounts)havepavedthewayforafter-taxstandardsin
theUnitedStates,itishopedthattheIPCwillsoonrespondwithaglobal
initiativesothatothercountriescanadoptappropriateafter-taxstandards
withrelativeeasebasedontheirrespectivetaxcodes.Thusfar,Australia
andCanadahaveshowninterest.
After-tax standards for separate account reporting composites are
optional,asnotallfirmsmanagetaxableaccounts.Therevisionstothe
existingAIMRafter-taxstandardstookeffectJanuary1,2005.Firmsfo-
cusedonservingtheneedsoftaxableinvestorshavetakenactionandhave
alignedthemselveswithserviceproviderstoallowthemtoprovideafter-
taxreturnsforindividualaccountsaswellasforcompositeconstruction
foruseinmarketingpresentations.FIGURE7.1isfromtheafter-taxprovi-
sionsoftheAIMRPerformancePresentationStandards.5
TobeincompliancewiththeAIMRstandardsforafter-taxreporting,
fiverowsofinformationbeyondwhatisrequiredforbefore-taxreporting
mustbeprovided.Theserowsareshadedinthe“required”sectionofthe
template.
Therearealsothreeadditionalrowsof“recommended”information
thatmaybeprovidedifafirmbelievesitcanaddvaluebeyondtheman-
datory elements.The first item, adjusting for nondiscretionary capital
gains,isintendednottopenalizethemanagerforarequesteddistribu-
tionfromanaccountthatisbeyondthemanager’scontrol.Thistypeof
request frequently happens with high-net-worth family accounts when
there is a need to pay taxes or fund a major purchase, such as buying
a second home. When the portfolio manager responds to a request to
liquidatefundsofthisnature,despiteattemptstominimizetheimpact
of taxes, inevitably some gains will be realized. Since this measure can
onlyworktotheadvantageofthefirm,itispossibleforthemanagerto
“game”thesituationbyclassifyingcertaingainsasnondiscretionarythat
perhapsarenot.Inallinstances,theportfoliomanagershouldworkto
thebenefitoftheclientandincludeonlythosegainsthataretheresult
ofspecificrequests.Foradetaileddiscussiononthistopic,see“Calcula-
SeparateAccountAfter-TaxReporting 79
FIGURE7.1 S ampleAIMR-PPSCompliantPresentation
foranAfter-TaxComposite
XYZU.S.EquitiesAfter-TaxComposite
2004 2005 2006 2007 2008
REQUIRED(IFCOMPLIANTWITHAIMR-PPSSTANDARDSANDSHOWINGAFTER-TAXPERFORMANCE)
RECOMMENDED
After-TaxReturnAdjustedfor
Non-DiscretionaryCapitalGains(%) 21.99 31.07 25.25 24.12 –5.99
Source:AIMR/CFAInstitute
tionandReportingofAfter-TaxPerformance”byLeeN.Price6andthe
“InterpretativeGuidance”sectionoftheAIMRStandards.7
Thenextrecommendeditemofinformationistheafter-taxbenchmark
return.Currently,thereisnocentraldepositoryforafter-taxreturnsonthe
80 After-TaxReportingandMeasuresofTaxEfficiency
mostcommonphysicalbenchmarksorindiceswherethetaxramifications
on individual security positions are taken into account. Unfortunately,
standardpracticesdonotexistforconstructingbenchmarks,andsomeof
themethodsusedbyprovidersmakethecalculationofafter-taxreturns
adaunting,ifnotimpossible,task.Justafewoftheitemsofconcernare
availabilityofdata,reconstitutionoftheindices,andtreatmentofdivi-
dends.Forfixedincomebenchmarks,pricingissues,thelargenumberof
securities,andamortizationandaccretionoffixedincomesecuritiesmake
calculatingafter-taxreturnsamostchallengingtask.
Practitioners need to be careful with the use of after-tax benchmark
information.Forexample,theyshouldnotlinkinformationwhenafter-tax
returnsarecalculatedaccordingtothepost-liquidationmethodology,asthe
inceptiondateoftheportfolioandbenchmarkwilllikelyhaveasignificant
impactonthegainsandlossesthatwillultimatelyberealized.Fortunately,
after-taxreturnscalculatedbythepre-liquidationmethodologyarenotaf-
fectedbythelevelofthemarketsattheinceptiondateofmeasurement.
Until a database for the physical benchmarks can be created and main-
tained,mostpractitionersareusingafter-taxreturnsfrompassiveportfolios
ofindexandexchange-tradedfunds(ETFs)forcomparativepurposes.A
benefitofusingmutualfundsandETFsisthatthefrequencyofdistribu-
tionsisusuallynogreaterthanmonthly,sofarlesseffortisneededtocollect
theinformationnecessarytocalculatetheafter-taxreturn.Theinformation
canbeextractedstraightfromthefund’sprospectus,butthesourceofin-
formationshouldbeproperlyfootnoted.Perhapsthemostcompellingrea-
sontouseafter-taxreturnsfromfundsforcomparisonisthatmutualfunds
andETFsareinfactinvestablealternativesforinvestors.Asaresult,this
methodisgaininginpopularitywithtax-awaremanagers.However,when
managerswhodonotconsidertaxesinthesecurityselectionprocesscom-
paretheirresultswithanindexmutualfund,theyquicklydiscoverhow
difficultitistooutperformthisproxyonanafter-taxbasis,asthearticles
byArnottandJeffreyandbyDicksonandShovenconcludedadecadeago.
Sincemanymanagersareevenlesscompetitiveonarelativebasisthanwith
before-taxresults,mostfirmscontinuetoavoiddevelopingaprocesstoof-
ferafter-taxreturnstoprospectsandclients.Thosereaderswishinggreater
detailwithregardtoafter-taxbenchmarksshouldseekarticlesbyJeffrey
L.Minck(1998),DavidM.Stein(1999),andJamesM.Poterba(1999).8
Oneissuethatrequiresspecialtreatmentissignificantcashflows.Innova-
tivesolutionshavebeensuggested,like“shadowportfolios”byRonL.Surz,
wherethebenchmarkexperiencesflowssimilartotheclientportfolio’s.9
Thelastitemofrecommendedinformationisthepercentagebenefit
fromtax-lossharvesting.Itshouldbenotedthattax-lossharvestingistypi-
callymostprolificandvaluableindecliningmarketsandattheinception
SeparateAccountAfter-TaxReporting 81
ofalong-termrelationship.Therefore,thebenefitdisplayedmayvarysig-
nificantlyamongclientportfolioswithdifferentinceptiondates,sothis
information should be used only as a guide.The degree of the tax-loss
harvestingbenefitmaynotbereplicableforfutureinvestors,asthedirec-
tionofthemarketmaynotcreateasimilaropportunisticenvironment.
Firms with strategies that rely heavily on tax-loss harvesting should ac-
companythisrowofinformationwithafootnoteexplainingtheconcept,
asthiscanbeamajorsourceoftaxalphafortax-awaremanagers.Alpha
istheincrementalreturnforagivenlevelofrisktakenbythemanager.If
hetakesthesamelevelofmarketrisk(beta)astheStandard&Poor’s500
stock index and outperforms it by 2 percent, then this is considered to
behisalpha.Bygeneratinglossesthatcanbeusedtooffsetgainsinother
portfolios,themanagergenerateswhatisreferredtoastaxalpha.Atthe
sametime,amanagercouldhaveabefore-taxalphalessthan,equalto,
orgreaterthen0percentthatcomesfromsuchtraditionalsourcesofin-
crementalvalueassectorallocationandsecurityselection.Obviously,the
idealisforamanagertohaveapositivealphabothbeforeandaftertaxes.
Thisistheultimategoal,andmoreseparateaccountmanagersarejoining
aselectgroupofelitepractitionersthatareaccomplishingboth,aswillbe
discussedinchapter12.
Oneoftheconcernsoftheinvestmentmanagementindustrywasthe
possibilitythattheadditionalcostofcalculatingafter-taxreturnsforclient
reportingandmarketingcouldonlybeabsorbedbylarger,moreprofit-
ablefirms.Interestinglyenough,oneofthefirstfirms,ifnotthefirst,to
conquer the task of preparing composite information according to the
AIMRafter-taxstandardswasGratry&Associates,asmallboutiquein
Cleveland,Ohio,specializingininternationalAmericandepositaryreceipt
(ADR)portfolios.BymonitoringtheactivityoftheAIMRSubcommittee
andworkingcloselywiththeirproviders,Gratrywasabletoachievethis
accomplishmentalmostimmediatelyfollowingtheannouncementofthe
proposedrevisionsandmorethanayearandahalfbeforetheJanuary1,
2005,implementationdate.ToGratry,havingthecapabilitytoshareits
after-taxperformanceresultswasextremelyimportant,asthefirmhasa
history of adding incremental value for its clients through tax-loss har-
vesting,inadditiontowhatisachievedfromcountrypositioning,sector
allocation,andsecurityselection.
With the enhancement in trade management systems over the past
decade, firms managing tax-exempt accounts have been able to achieve
extremely low variability or dispersion of individual account returns. If
thefirmisconsideringtheimpactoftaxesduringthebuy-and-selldeci-
sionprocess,dispersionwithtaxableaccountreturnsshouldnaturallybe
greater.Significantlyhigherdispersionmayinfactreinforcethatthefirm
82 After-TaxReportingandMeasuresofTaxEfficiency
is adhering to a philosophy of managing each taxable account accord-
ingtoitsownuniqueobjective.Thefirmshouldevaluatethekeyfactors
itbelievesdifferentiatesitstaxableaccountsresultsanddevelopafter-tax
returncompositesthatreflectthemajordifferences.Therefore,afirmmay
have multiple taxable-account composites for a given portfolio strategy
but only one composite for tax-exempt accounts. If sufficient time and
effort is put into developing the composites, dispersion of the after-tax
returnswillmostlikelybecomelessofaconcern.Thefollowingisalistof
factorsafirmmightconsiderwhenconstructingcompositeswhenreport-
ingafter-taxreturns:
❑ Thetypeoftaxableaccount—forexample,individualorhigh-net-
worth family, nuclear decommissioning trust, voluntary employee
beneficiaryassociation,orpropertyandcasualtyinsurancecompany
❑ Theclients’anticipatedormaximumfederaltaxrate
❑ Theclients’stateofresidencefortaxpurposesandtherespective
taxrate
❑ Vintageyearoryearoftheinceptionoftherelationship
❑ Accountsstartingwithacashportfolioversusexistingholdingsor
aconcentratedposition
❑ Accountsthattreatexpensesdifferently,suchasmutualfundsand
trustsversustaxableseparateaccounts
Thetypeoftaxableaccountcanhaveasignificantimpactonportfo-
lio management decisions. For example, the methodology employed to
effectively manage property and casualty insurance company portfolios
periodicallyemphasizesrealizingcapitalgainsforannualfinancialreport-
ingpurposes.
The federal tax rate to which individual investors are subject to has
agreaterinfluenceonsecurityselectionforfixedincomeaccountsinthe
United States, because we have both taxable and tax-exempt bonds. At
low-enoughfederaltaxrates,clientsmaybebetteroffholdingaportion
ortheentireportfoliointaxablebonds,astheirafter-taxyieldsmaybe
greater than what is offered from similar effective maturity tax-exempt
bonds.Fixedincomeportfoliosthattakeintoaccounttheclient’staxpro-
fileandadjusttheallocationtotaxableandtax-exemptbondsdepending
ontheirafter-taxreturnpotentialarereferredtoas“crossover”portfolios.
Additionally, the percentage of tax-exempt bonds held from the client’s
stateofresidencefortaxpurposesintheportfoliomightbequitedifferent
foraclientinahigh-taxstatelikeNewYork,comparedwithTexaswhere
theresidentsarenotsubjecttoastateincometax.
Thevintageyearisespeciallyimportantforequityportfoliostrategies
thatemphasizetax-lossharvesting.Obviously,forthefirstthreeyearsof
SeparateAccountAfter-TaxReporting 83
therelationship,theopportunitiestoaddvaluefromthisprocesswould
havebeenfargreaterforaccountsbeginningin2000,ascomparedwith
thoseinitiatedin1996.
Somefirmshavemadethedecisiontoincludeonlyaccountsthatstart
with100percentcashintheircomposites,astheybelievethisistheway
toensuretheaccountsrepresenttheirdiscretionarymanagementprocess.
Thefirmislikelytoinheritportfolioswithsubstantialunrealizedcapital
gains,whicharelikelytoproduceafter-taxresultsinconsistentwiththe
discretionarycomposite.Itmaytakemonthsoryearsbeforesomeofthese
portfoliosmirrorthediscretionaryportfolio.Theyshouldbemonitored
andmovedtothediscretionarywhentheyachieveasatisfactorylevelof
consistency.
Thelastelementpertainingtocreatingcompositesishowexpensesare
treated.Unlikemutualfunds,asdiscussedinchapter6,moststand-alone
separateaccountscannotoffsetincomewithexpenses.Therefore,theywill
havelowerafter-taxreturnswhencomparedwithmutualfundandtrust
portfolios,whereincomemaybeoffsetwithexpenses.Toaccommodate
thesedifferences,itisrecommendedthattheafter-taxreturnsbeadjusted
forthetaxbenefitoftheoffset.Forexample,ifamutualfundisbeing
placedinacompositeofequity-strategyseparateaccountsforindividu-
alinvestorsanditchargestheindustryaverage1.5percentfee,itwould
bepropertoincreasetheannualafter-taxreturnsofthemutualfundby
approximately by 0.23 percent (1.5% fee × 15% tax rate applicable to
qualifieddividends),orthefirmmightdecidetomaintaintheaccounts
asseparatecomposites.Insuchcases,adisclosureshouldbemadestating
whytheafter-taxreturnwouldbedifferentifthestrategywereheldina
stand-aloneseparateaccountarrangement.
The list of items to consider certainly need not be limited to those
listed here and in other AIMR documents.The key is not to limit the
compositestosomepreconceivednumberbutrathertocomeupwiththe
numberofcompositesnecessarytoallowpractitionerstoeffectivelycom-
municatetheresultsoftheirtaxableaccountsaccordingtotheirunique
circumstanceswithclients,prospects,andinterestedthirdparties.
Therearethreemainpointsthatshouldbeunderstoodwiththerevi-
sionstotheAIMRafter-taxreportingstandards.Previously,applicationof
theclients’maximumfederaltaxonordinaryincome,currently35per-
cent,wasmandatorywhencalculatingafter-taxreturns.Therevisedafter-
tax standards favor the application of the clients’ “anticipated” tax rate.
Thiswasdoneforseveralreasons.First,formoststrategiesitissimplypart
ofaprofessional’sdutytoascertainfromtheclientwhattypesandlevelof
taxationneedtobeconsideredinordertomakesoundinvestmentdeci-
sions.Second,asmentionedearlier,afixedincomemanagermayelectto
84 After-TaxReportingandMeasuresofTaxEfficiency
purchaseataxablebondiftheinitialafter-taxyieldtomaturityisgreater
thanthereturnfromatax-exemptbondofsimilareffectivematurity.In
theseinstances,applyingthemaximumfederaltaxratefortheclienttype
wouldresultinafter-taxreturnsthatwouldnotreflectthemanager’sability
toaddvalue.Third,firmsthatwerecalculatingafter-taxreturnsdiscovered
that their performance measurement professionals were actually calcu-
lating and maintaining two separate after-tax returns for each account,
andtheamountofworkrequiredtodothiswassimplyoverwhelming.
After-taxreturnsusingthemaximumfederaltaxratewerebeingusedfor
compositepurposes,yetclientswereprovidedinformationusingthepre-
ferred“anticipated”taxrates,whichweremoreinlinewiththeiractual
experience.Sincethereisadeductionatthefederallevelforthepayment
ofstateandlocaltaxes,theanticipatedtaxrateislessthanorequaltothe
sumwhenmorethanonerateisconsidered.Theformulatocalculatethe
anticipatedtaxrateis:
TRanticipated=TRfederal+(TRstate×[1–TRfederal])
+(TRlocal×[1–TRfederal]),
whereTRstandsfortaxrate.Iftheclientissubjecttoa35percentfed-
eraltaxrate,10percentstatetaxrate,anda2percentlocaltaxrate,then
theanticipatedtaxrateisequalto42.8percentasshownbelow:
35%+(10%×[1–35%])+(2%×[1–35%]),or
35%+(10%×0.65)+(2%×0.65),or
35%+6.5%+1.3%=42.8%
Theseratesshouldbemaintainedforeachclientportfoliointhecom-
posite.Inreality,theclient’sactualtaxratewillbeacombinationofthe
anticipatedtaxratesforordinaryincome,short-termcapitalgains,quali-
fieddividends,andlong-termcapitalgains.Tocomeupwiththismore
precise weighted rate would be extremely time-consuming. Besides, the
taxinformationforseparateaccountsislot-specific.Therefore,useofthe
anticipatedtaxratebasedontherateofordinaryincomeatleastgivesthe
reviewerofthecompositeinformationaframeworkastohowinvestment
decisionsmayhavebeenaffectedbytheleveloftaxation.Therearelegiti-
matecases,likewraprelationships,wheretheclientdoesnothaveaccess
tothisinformation.Intheseinstances,usingthemaximumfederaltaxis
acceptableandshouldbeencouraged.
Advocatesofusingthemaximumfederalratesclaimthatuseofthe
anticipatedtaxdoesnotfacilitatecomparingafter-taxresultsofmultiple
managers.Thisimpliesalevelofaccuracythatissimplynotobtainableor
SeparateAccountAfter-TaxReporting 85
reasonable,asadditionalinformationisrequiredtomakesounddecisions.
Evenbefore-taxreportingisanestimateofperformance,butthecaseisfar
moresowithafter-taxresults.
Thesecondkeyfeatureoftherevisedafter-taxstandardsisthatAIMR
institutedaspecificmethodforthetreatmentoftaxes.Thislendsitselfto
aformofbranding,andundertheGlobalInvestmentPerformanceStan-
dards(GIPS)afirmcanputonaclient’squarterlyperformancereportthat
“the after-tax returns have been calculated in a manner consistent with
theAIMRafter-taxreportingstandards,”orwordstothiseffect.Thisis
notablebecausemanyfirmsviewthequarterlyperformancereportastheir
mostimportantcommunicationtool.Whilefirmsmayonlyusethepre-
liquidationafter-taxreturnsforcompositeconstruction,thefirm’sclients
arelikelytoaskforboth.Therefore,firmsshouldlookforthiscapability
whenselectingsoftwarevendors.
The third key element of the AIMR after-tax reporting standards is
thattheSubcommitteewascarefultoensuretheywereconsistentwiththe
SECstandardsformutualfunds,exceptwheremodificationwaswarrant-
ed.TheonemajordifferenceisthattheSECstandardsrequirereporting
of returns after taxes on distributions and sale of fund shares—known
as the post-liquidation calculation methodology—whereas the AIMR
standard does not.The post-liquidation methodology does in fact pro-
vide extremely meaningful information for a single separate account or
individualmutualfund.UnliketheSEC’safter-taxstandards,whichal-
low individual investors to make better-informed investment decisions
onspecificfunds,theAIMRstandardswereoriginallydevelopedwithan
emphasis presenting results from a composite of accounts managed ac-
cording to a distinct style, such as domestic large-capitalization growth
equityportfolios.Withperformancecomposites,accountsarecontinually
beingaddedordropped.Unfortunately,theflowofaccountinformation
incompositesdistortspost-liquidationafter-taxreturnstothepointthey
cannotbereliedontoproviderelevantinformation.Ifthecompositele-
gitimatelyconsistsofonlyoneaccount,afirmcouldcertainlyprovidethis
additionalinformationifitmightbehelpfultoprospects.Thisdoesnot
meanothermethodsofcalculatingafter-taxreturnsshouldbeignored,but
ifsupplementalinformationisprovideditshouldbemarkedassuchand
thepre-liquidationreturnsmustbeshownprominently.Onesuchcaseis
afixedincomepractitionerthatappliesthe“full-liquidation”method,in
whichthecompletetaximpactiscalculatedfortheunitofmeasurement,
currently monthly. This method is more appropriate for fixed income
portfolios and usually results in the most conservative after-tax return.
Sincepropertyandcasualtyinsurancecompaniestypicallyhaveamajority
oftheirassetsallocatedtofixedincome,theiradviserswilloftensupport
86 After-TaxReportingandMeasuresofTaxEfficiency
use of the full-liquidation methodology. However, this fails to account
forthebenefitofcompoundingtax-freebyextendingtheholdingperiod,
whichisextremelyimportantwithequityportfolios.Readersdesiringto
readmoreaboutvariousafter-taxcalculationmethodologiesshouldrefer
toLeeN.Price(1995).10
InboththeSECandAIMRafter-taxreportingstandards,thetaxim-
pactisaccountedforwhenthetaxableeventtakesplace,ratherthanat
the end of a period. A system that utilizes the client’s data from Form
1040andend-of-yearcustodialrecordsmayinfactprovideextremelyac-
curateafter-taxreturninformation,butitisinconsistentwiththeAIMR
standard.TherationalebehindtheAIMRafter-taxstandardsistocapture
theportfoliomanagerorfirm’sdecisiontotaketheclient’staxprofileinto
account at the time of the transaction, versus establishing an extremely
accurateaccountingreport.Ifthelatterwastheobjective,thenahigh-net-
worthindividualaccountthathasataxableeventinJanuarywouldnot,
inmanycases,seeanafter-taxreturnuntilperhapstwenty-oneormore
monthslater,asmanyfamiliesdonotfinalizetheirtaxesuntilthefollow-
ingfall.Applicationofthisrationalealsomakesitmucheasierforthefirm
whenaretroactivetaxbilloccurs,whichhappenedin2003.Eventhough
thebillwaspassednearmidyear,thelowertaxrateonqualifieddividends
of15percentwasretroactivetothebeginningoftheyear.Applyingthis
approachagainensuredthattheafter-taxreturnscapturedhowportfolio
managerswereaccountingfortaxes,asuntilthebillwaspassedtheyhad
tooperateundertheassumptionthattheexistinghigherrateonordinary
incomewouldapply.Moreover,performance-measurementprofessionals
werenotburdenedwiththetaskofrecalculatingsixmonthsofprevious
returnsforaccountssubjecttothechangeinthetaxcode.
Significant cash flows require attention with tax-exempt accounts,
but even more so with taxable accounts. Constructing composites that
takeintoaccountthevariousfactorsnotedabovewillgiveprospectsmore
meaningfulinformation,butequallyimportant,portfoliomanagerscan
applytheinformationmoreeffectivelyintheday-to-daymanagementof
theirtaxableaccountsintheirquesttoproducesuperiorresults.
Thekeytoafter-taxperformanceisthatitisanartform,ratherthan
ascience.Itissimplyfoolishtothinkyoucancompareonereturnagainst
anotherandcometoavalidconclusionwithoutanalyzingadditionalin-
formationaffectingday-to-daytaxmanagement.Thetax-awarepractitio-
nerneedstobecognizantofthemarketenvironmentinwhichtheportfo-
liomanagerwasoperatingtounderstandhowtaxconsequenceshavebeen
managedandtodrawmeaningfulconclusions.
FIGURES7.2,7.3,and7.4,courtesyofParametricPortfolioAssociates,
showhowafirmcandistinguishitselfthroughafter-taxreporting.These
SeparateAccountAfter-TaxReporting 87
FIGURE7.2 PortfolioPerformance—IncomeStatement
ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport
FOURTH YEARSINCEINCEPTION(10/23/1998)
QUARTER TODATE CUMULATIVE ANNUALIZED
PretaxPerformance
Portfolio 11.7% 28.2% 13.3% 2.4%
Source:ParametricPortfolioAssociates
After-TaxPerformance
Portfolio 11.6% 29.4% 23.4% 4.1%
Benchmark 12.1% 28.4% 8.5% 1.6%
exhibitsarepartofthequarterlycommuniquéthatParametricsendseach
ofitsseparateaccountclients.ThePortfolioPerformancesectionofthe
communiquéstartswithpretaxandafter-taxcomparativeresultsagainst
anappropriatebenchmarkforthecurrentquarter,year-to-date,andsince
inceptionoftheaccount(Figure7.2).Thiscanbeviewedastheincome
statementofthereport.Inthecolumnlabeled“yeartodate,”youcansee
thattheportfoliolaggedtheperformanceoftheS&P500by0.5percent
beforetaxes,butitoutperformedonanafter-taxbasisby1.0percent.This
highlights the potential of a tax-loss harvesting strategy, which is para-
mounttothesuccessofParametricandotherfirmsfocusedonthisniche
of the market. Note that the “since inception” annualized value-added
from the process is +2.5 percent (4.1 percent after-tax return for Para-
metricascomparedto1.6percentfortheS&P500).Thisexampleisfor
periodsendingDecember31,2003.ItshouldbenotedthatParametricis
oneofthefewfirmsthatattemptstocalculatetheactualafter-taxreturn
foracomparativebenchmarkportfolioofsecurities.Todothisproperly
requires running benchmark portfolios for the different inception dates
forallaccountsundermanagement.
ThePortfolioValuesectionhighlightsthebalancesheetoftheaccount
fromataxaccountingperspective(Figure7.3onthefollowingpage).As
shown,theportfoliohaslessthan0.2percentinunrealizedlosses.This
tellstheclienttwothings.First,Parametrichasbeendiligentintax-loss
harvesting.Second,unlesssomeoftheholdingsfallsignificantlyinprice
88 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE7.3 PortfolioValue—BalanceSheet
ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport
AT12/21/03
MarketValue $3,366,382
CostBasis $2,283,892
Source:ParametricPortfolioAssociates
UnrealizedGains
ShortTerm $152,440
LongTerm $934,995
UnrealizedLosses
ShortTerm $660
LongTerm $4,286
FIGURE7.4 I ncomeandRealizedGains—CashFlow
Statement
ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport
Source:ParametricPortfolioAssociates
INVESTMENTFLOWS FOURTHQUARTER YEARTODATE CUMULATIONS
during the months ahead there will be less opportunity to add value
throughtax-lossharvestinginsubsequentperiods.
TheIncomeandRealizedGainssectionofthecommuniquéservesas
thecashflowstatementofthereport(Figure7.4).TheParametricformat
addressesthethreekeyareasessentialtotaxplanningforacommonstock
portfolio:dividendincomeandnetrealizedshort-andlong-termcapital
gains.Bytrackingthe“yeartodate”column,membersofthequalified
triumvirateservingtheclientareabletomakebetter-informeddecisions
astohowthenetlossescanbemosteffectivelyutilized.Additionalinfor-
mationcanbeprovidedtohighlightthecriticalportfoliocharacteristics
thatreflecttheparticulartypeofstrategy.ForafirmlikeParametricthat
SeparateAccountAfter-TaxReporting 89
hopestoreducetrackingerrortoadefinedbenchmark,itemssuchasthe
numberofsecuritiesintheportfolioandsectorweightingsareimportant.
Otherfirmsmaywishtofocusoncharacteristicssuchasdividendyield
andvaluationmetricstoemphasizeaparticularstyleororientation.To
developaclientperformancereportofthisqualityrequiresasignificant
commitmentofresourcesonthepartofthefirm,butlikeGratrywith
itsafter-taxcompositeinformation,Parametricthoughtitwasworththe
effort to highlight the value of its process and demonstrate its distinc-
tive competence with the one document that is most important to its
clients.
After-tax returns should be a source of pride for a firm.Therefore,
firmsthatunderstandthevalue-addedpropositionfromtax-awareinvest-
mentmanagementaretheonesmostlikelytoprovideafter-taxreturns.
Serviceprovidersrespondingtotheneedsoffirmscanbesegmentedinto
thefollowingcategories:
❑ Portfolioaccountingstand-alonesystems
—IDS
—Osprey
—Shaw
—Sungard
❑ Separateaccountsupplementalsystems
—iKindi
—Meradia
—PricePerformanceSystems
❑ Systemsdevelopmentandsupport
—AccountingfirmswithAIMRauditingpractices
—CutterAssociates
—Meradia
—Osprey
—TowerGroup
Theseareproviderstheauthorisawareofasofthesummerof2005.
Thelistdoesnotrepresentanendorsementofanyfirm.Theremaycer-
tainlybeotherwell-qualifiedprovidersavailable,andadditionalfirmsare
likelytooffersimilarservicesinthefuture.
Stand-alonesystemsarethecalculationandreportingengineforthe
assetmanagementfirm.Supplementalsystemsworkinconjunctionwith
information provided from the stand-alone system or custodial reports.
Price Performance Systems offers an equity-oriented product, whereas
iKindihasundertakenthechallengingtaskofprovidingtheabilitytocal-
culateafter-taxreturnsforfixedincome,takingintoaccountamortization
andaccretionofpremiumsanddiscounts.
90 After-TaxReportingandMeasuresofTaxEfficiency
Therearevariousprovidersofsystemssupport.Thekeytoestablishing
anafter-taxreportingcapabilityistoensureallkeydecisionmakersarein-
cludedintheprocess.Iftheplanningisdonewithcare,thefirmwillmost
likelyavoidcostlymistakesandsolutionsthatdonotsatisfytheneedsof
clients and investment professionals. Any firm considering entering the
realmoftaxableaccountinvestingtodaywouldbefoolishtoentertaina
proposalfromasoftwarevendorthatdoesnotalreadyofferanafter-tax
reporting capability consistent with the AIMR provisions. It is difficult
enoughtobecomeAIMRcompliantwithbefore-taxreturnsandhaving
torecalculatehistoricalreturnsorreconstructcomposites,buttodosofor
after-taxreturnsmaybealmostaninsurmountabletask,especiallywith
fixedincomeaccounts.
Asmentionedinchapter6,firmsdesiringtoincludeafter-taxbench-
marksreturnsintheircompositedisplaysareencouragedtoutilizeafter-
taxreturnsfromanappropriateindex-orientedmutualorexchange-traded
fund.Meaningfulofferingsarenowavailablefortraditionalassetclasses—
with the exception of municipal bonds, for which a competing mutual
fundproductofsimilardurationandqualityshouldbesufficient.Another
alterativeistouseataxablebondmutualfundandjustapplytheaverage
historicalspreadbetweenitandamunicipalbondbenchmark.Depending
on the average historical term (cash equivalents, short, intermediate, or
long)thespreadtobeappliedmayrangefrom70percentforshorter-term
benchmarksto85percentforlonger-termbenchmarks.Forexample,let’s
sayyourmunicipalbondproductisintermediatetermandafteranalyzing
thespreadbetweenappropriateLehmanbondindicesyoudecidetomul-
tiplyreturnsoftheBarclaysGovernment/CreditETFby0.80.Althoughit
willnottrackthemunicipalbondmarketperfectly,clientswillappreciate
thatyouareattemptingtomeasureandcommunicatetheimportanceof
taxesoninvestmentreturns!
Thechallengesofcreatinganafter-taxreportingcapabilityaremagni-
fiedforconsultingfirms,especiallythosewithhigh-net-worthclients.Un-
fortunately,thisnichehasbeenservedbyproviderswithpension-consult-
ingsoftwarethatdoesnotconsidertaxes.Ifthesystemcalculatesreturns
bysecuritypositionversustransactioninformationitneedstobereplaced
byonethatcanprovideanafter-taxreportingcapabilityconsistentwith
theAIMRmethodology.Tax-lotaccountingandtransaction-basedinfor-
mation are simply a must, and there are no shortcuts or alternatives to
them.Thetypicalsourceofinformationisthecustodialstatement.The
propertyandcasualtyinsuranceconsultingindustryisabletoobtainthe
sameinformationfromasmallnumberofprovidersofstatutoryinforma-
tion.11Thismakestheprocessmuchmoreefficient.Therefore,consulting
firmsingeneralcanbenefitiftheylimittheirclientstoaselectfewsources
SeparateAccountAfter-TaxReporting 91
of account information. Efficient data feeds are critical so that the rec-
onciliationprocessfocusesonexceptionsratherthaneverypieceofdata.
Also,havingalltheinformationinonedatabaselendsitselftotheuseof
third-partyproviderstoachieveconsistentpricing,portfoliocharacteris-
tics,etcetera.Oncethecalculationsaremade,acustomreportwritercan
createaproducttorespondtovariousclientneeds.Onewaytosimplify
theentireprocessistoestablishanindustryHTMLformatforsecurity
transactioninformation,anideathatwasproposedtotheauthorbyJay
WhippleIII,thefounderofSecurityAPLandOsprey,well-knownpro-
vidersofportfolioaccountingsoftwareandsolutions.Thiswouldalleviate
thechallengesofapplyingvariousaccountingconventionsandmatching
saleswithspecifictaxlots.
Atthisjuncture,firmsarestillspendinginordinateamountsoftime
and effort choosing a portfolio accounting system to calculate after-tax
returns.Firmsembarkingonthisdecisionshouldreadarticlespreparedby
DouglasS.RogersandLeeN.Price(2002),JohnD.Simpson(2003),and
DouglasS.Rogers(2000,2003).12IfthefirmdesiresanAIMR-compliant
solution,thesystemmustincludethesecriticalelements:
❑ TheabilitytoincorporatetheimpactoftaxesasoutlinedbyAIMR
forthemodifiedDietz,dailyvaluation,ormodifiedBAImethods
❑ Tax-lot accounting that captures the amount and date of every
transaction
❑ Theimpactofeachandeverytransaction
❑ Maintenanceoftheinformation,includingsuchitemsastheamor-
tizationandaccretionoffixedincomesecuritiespurchasedatalevel
otherthanpar
❑ Informationthatcapturesthetaxparametersofthetypesoftaxable
clientsthatwillbeenteredintothesystem
❑ Abilitytodistinguishbetweenvarioustypesofsecurities,suchas
taxablebondsversustax-exemptbondsorgovernmentbondsex-
emptfromstatetaxesversusothers
❑ Theabilityofthesoftwareprovidertokeepupwithchangesinthe
taxcodefortheclienttypeyouareservicing
Thereisone“lastfrontier”intheareaofafter-taxanalysisandreport-
ingthathasyettobesolved:after-taxperformanceattribution.Utilizing
current attribution software on taxable accounts is almost a useless, and
insomecasesadetrimental,exercise,becausenoneoftheexistingsystems
takeintoaccountthecapitalgain/losspositionofasecurity.Forexample,a
particularsecuritythataportfolioownedmayhavelaggedtheperformance
ofitspeersinthesameindustry,andtheindustryinturnmayhavealso
lagged the overall performance of the benchmark.Therefore, one might
92 After-TaxReportingandMeasuresofTaxEfficiency
havenaivelyconcludedthatthemanager’ssecurityselectionandsectoral-
locationwasnegativefortheperiod.However,thesecuritymayhavehada
substantialshort-termunrealizedcapitalgainposition,andsellingtheposi-
tionwouldhavebeendetrimentaltotheclient.Resolvingthisquandary
can potentially integrate attribution with the portfolio decision-making
process.Bydoingthisproperly,theperformancemeasurementprofessional
would become part of a forward-looking value-added proposition rather
thanjustprovidingbackward-lookinginformationtoexplainpastevents
andactivity.13
SinceLeePricefirstrespondedtoclients’requestsintheearly1990s,
substantialprogresshasbeenmadetomastertheartofafter-taxreport-
ing.Wenowhaveacceptedafter-taxreportingcalculationmethodologies
andstandardsthatenablebothtaxablemutualfundinvestorsandseparate
accountinvestorstomakebetter-informedinvestmentdecisions.Fortu-
nately,thereareaselectgroupofsoftwareprovidersthatprovedthatthe
standardscanbesuccessfullyimplemented,giventhedesireandresources.
It takes a meaningful commitment of resources to achieve an after-tax
reportingcapability,butevensmallboutiquefirmshaveaccomplishedit.
Therefore,thereisnolongeravalidexcuseforinvestmentmanagersnot
toofferthiscapability.Firmsthatembraceafter-taxreportinginitiallywill
mostlikelybethosethatwillbenefitbycommunicatingtheirresultsac-
cordingtoanacceptedformat,allowingotherstoevaluateandconfirm
theirvalue-addedpropositioninwaysneverbeforepossible.
ChapterNotes
1. Muchofthediscussiononseparateaccountafter-taxreportinghasbeentaken
directlyorsummarizedfromtheauthor’sarticlewithSeanW.Egan,“Evaluating
andClassifyingTaxableAccountManagers,”JournalofWealthManagement(Fall
2004):49–62.
2. ThefirstAIMRSubcommitteeforAfter-TaxReportingconsistedofco-chairs
LeeN.PriceandRobertE.PruyneandScottR.Abernethy,MichaelS.Caccesse,
Robert H. Jeffrey, Catherine M. O’Connor, John R. O’Toole, and Douglas S.
Rogers.
3. Association for Investment Management and Research, AIMR Performance
PresentationStandardsHandbook,2ded.(Charlottesville,Va.:AIMR,1997).
4. TheAIMRSubcommitteeforAfter-TaxReportingreconstitutedin2000was
chairedbyDouglasS.Rogers.MembersincludedJenniferP.Cahill,ThomasF.
Drumm,PaulJ.Jungquist,SeanS.Keogh,DanielW.Koors,DavidA.Krause,
JamesPoterba,NeilE.Riddles,DavidM.Stein,RonaldJ.Surz,andCeciliaS.
Wong.LeeN.Priceservedasanobserver.
SeparateAccountAfter-TaxReporting 93
MeasuresofTaxEfficiency
Acitizencanhardlydistinguishbetweenataxandafine,except
thatthefineisgenerallymuchlighter.
—G.K.Chesterton
T
herearefourkeycalculationsthatpractitionersmayencounter
for measuring the tax efficiency of the portfolio management
process:
❑ Accountant’sratio=$amountoflong-termcapitalgainsrealized/
$amountoftotalcapitalgainsrealized
❑ Captureratio=Rat/Rbt,whereRequalsthereturnafter-taxand
Rbtequalsthereturnbefore-tax
❑ Relativewealthmeasure1=([Rat–Rbt]/[1+Rbt])×1,000
❑ Morningstartax-costratio2=(1–[(1+Rat)/(1+Rbt)])×100
Thischapterexaminesthecharacteristicsofeachandhowtheycanbe
appliedtoallowinvestorsandadviserstomakebettertax-awaredecisions.3
Accountant’sratio:Thisratioisappliedtoseeiftheportfolioman-
ager is taking advantage of the lower tax on long- versus short-term
capitalgains.Thedifferencebetweenthetwotaxratesiscurrently20
percent.Obviously,thehigherthepercentageoftheaccountant’sratio
thebetter,withtheidealbeing100percent.Theratioisbestusedfor
discussionswithinthefirm,asithasseveralweaknesses.First,thereis
nodirectlinkagebetweenthismeasureandtheactualafter-taxreturns.
Second,itdoesnottakeintoaccounttheoffsettingofrealizedgainsand
95
96 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE8.1 ChallengeswiththeCaptureRatio
RETURN
BEFORE-TAX AFTER-TAX CAPTURERATIO
Source:DouglasS.Rogers
2.0% 1.0% 50.0%
–1.0% 1.0% –100.0%
–8.0% –6.0% 75.0%
losses.Third,itcan’tdifferentiatebetween“good”and“bad”turnover,
aswediscussedinchapter3.However,evenwithitsweaknesses,some
firms have found it useful to communicate to their clients a commit-
menttotax-awareprinciples.
Captureratio:Thismeasureiscertainlytheeasiesttounderstandand
waswidelyacceptedbytheconsultingcommunityalmostwithoutques-
tionuntil2000.Whenthebefore-taxreturnis10percentandtheafter-tax
returnis8percent,themanagerhas“captured”80percentofthebefore-
taxreturn.Itssimplicityiswhatmakesthecaptureratiosoattractivewhen
communicatingtaxefficiency.Unfortunately,theusefulnessofthecapture
ratio diminishes when returns are other than the ideal upward-sloping,
smoothshape—orwhatiscalledthe“hockeystickmarket”—andwhen
themagnitudeofreturnsdeviatessignificantlyfromaverageannualhis-
toricalreturns.
ThefirsttworowsinFIGURE8.1makesense,buttheresultsinthelast
threerowsaredifficulttoexplaintoclientsandhavelittleornorelevance.
Relativewealthmeasure:Therelativewealthmeasurewasdeveloped
bymembersoftheAIMRSubcommitteeforAfter-TaxReporting.Their
effortwasindirectresponsetothefrustrationwiththeweaknessofthe
capture ratio. An equation was proposed and simplified to the current
form.Ratherthancallingitaratio,theSubcommitteedecidedtolabelit
moreappropriatelyasameasure.Therelativewealthmeasureisarange
bound by a rough estimate of the maximum tax rate applicable to the
client portfolio. For example, if the client is subject to the 35 percent
federalmaximumtaxrateonordinaryincomeandtheportfoliorealizeda
maximumamountofshort-termcapitalgains,therelativewealthmeasure
isroughly–35,butmorepreciselyitis–31.8.Ontheotherhand,ifthe
MeasuresofTaxEfficiency 97
FIGURE8.2 C omparisonofRelativeWealthMeasureand
Tax-CostRatio
AIMRSUBCOMMITTEE MORNINGSTAR
RETURN RELATIVEWEALTH TAX-COST
BEFORE-TAX AFTER-TAX MEASURE RATIO
portfolioharvestedthemaximumamountoflosses,themeasurewouldbe
+35,or+31.8tobeexact.Ifthereisnonettaxliabilityorcredit,thenthe
measureis0.
Thebeautyoftherelativewealthmeasureisthatitdeliversreasonable
resultsregardlessofthedirectionormagnitudeofthemarket.Therefore,
itovercomesthemajorshortcomingofthecaptureratioandhasservedto
advancetheunderstandingoftaxefficiency.However,itisabitchalleng-
ingtoexplaintoclientswhentheyencounteritforthefirsttime.
Morningstartax-costratio:Thisratiowascreatedaftertherelative
wealthmeasureandprovidesameaningfulimprovementoverotherratios
andmeasures.Asshowninthefourexamplesin FIGURE8.2,theMorn-
ingstartax-costratioisaderivationoftheAIMRsubcommittee’srelative
wealthmeasure.
Theseriesofnumbersisthesameineachcalculation.Thedifferences
aretheplacementofthedecimalpointandwhethertheresultispositive
or negative. As you can see, the relative wealth measure has a negative
signwhentheresultisdetrimentaltothetaxpayer,whereasthetax-cost
ratio is positive. Morningstar intended the ratio to be a “percentage of
an investor’s assets that are lost to taxes,” or the difference between the
before-taxandafter-taxreturn.4Thus,thepositivesignoftheoutputof
theequationmakessense.Thismethodologyiseasiertoexplaintoclients
and,therefore,wellsuitedtomoreretail-orientedmutualfundinvestors.
DonPhillipssharedastoryaboutreceivingacallfromadisgruntledinves-
torwhenMorningstarlaunchedthetax-costratio.Theinvestor’sconcern
wasthatourcountrywasinapension-fundingcrisisandfuturemarket
returnswouldmostlikelybelowerthaninthelate1990s.Nowthatthe
98 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE8.3 I nformationRequiredtoAnalyzeAfter-TaxCapability
Source:Morningstar,DouglasS.Rogers
RETURNS UNREALIZED
BEFORE-TAX AFTER-TAX TAX-COST CAPITAL
MUTUALFUND DISTRIBUTIONS DIST&SALE RATIO GAINS
mutualfundinvestorshavethisinformation,theconcernedindividualfelt
itwouldonlyheightentheawarenessofthemagnitudeoftheproblem.5
Fortunately, for the rest of investors who do wish to be informed, the
educationalvalueofthetax-costratiohasbeenextremelypowerful,and
mutualfundinvestorsnowhaveareliablewayofanalyzingtheimpactof
taxesonbefore-taxreturns.
The problem with all the ratios and measures adopted thus far is
that none of them have been able to find a way to account fairly for
theimpactoftheinternalunrealizedcapitalgainsposition.Therefore,
toanalyzemanagersproperly,itisessentialtoincorporatebefore-and
after-taxreturns,ameasureoftaxefficiency,andthepercentageofun-
realizedcapitalgains.
Thetwolarge-capvaluefundsin FIGURE 8.3havesimilaroutstand-
ingbefore-taxperformanceforthefiveyearsendingJune30,2004.6The
Dodge & Cox Stock Fund has been the more tax-efficient of the two
funds,asevidentbythelowertax-costratio.Therefore,youwouldexpect
theafter-taxperformanceoftheDodge&CoxStockFundtobesuperior
to the PIMCO PEA Value A Fund. In this case, the difference is 0.84
percentannuallywhenonlytaxesondistributionsareaccountedfor.Since
PIMCO PEA Value A has 6 percent less capital gains outstanding, the
differenceinafter-taxperformancenarrowsto0.80percentusingthesale-
of-fund-sharesmethodology.
Anotherpieceofinformationthatcanbevaluablewhentryingtoan-
ticipatefuturetaxefficiencyisthetrendinthefund’snetpurchaseand
redemptionactivity,asshowninFIGURE8.4fortheDodge&CoxStock
FundandPIMCOPEAValueAFund.Thisiscalculatedbymultiplying
thebeginningyear-endassetvalue(row2)bythefund’stotalrateofre-
turn(row3)plus1fortheyear(row4).Thensubtractthisresult(row5)
fromthecurrentend-of-yearassets(row1)tofindthenetpurchaseand
redemptionactivity(row6).
MeasuresofTaxEfficiency 99
FIGURE8.4 EstimatingPurchaseandRedemptionActivity
ThisquickcalculationshouldhaveraisedaflagfortheDodge&Cox
Fund. Upon further investigation you would have discovered that this
fundisclosedtonewinvestors.Asdiscussedinchapter6,themostad-
vantageouspositionforashareholdertobeinisthatofanearlyinvestor
inafundthatiscontinuinggrow,asthecapitalgainsaredistributedtoa
greaternumberofinvestors.Sincethereisnocashflowfromnewinves-
tors,existingtaxableshareholdersshouldanticipateexperiencingahigher-
than-normalperiodofgainsrealizationuntilthefundreopens.Thiscaseis
certainlynotofthemagnitudeachievedduringthespringof2000,when
growthfundshad50percentunrealizedcapitalgainspositionsandsales
andnetredemptionactivityresultedincapitalgainsdistributionsequaling
15to20percentoffundassets.
Thequestiontax-awarepractitionersshouldaskis:Whatarereasonable
measuresoftaxefficiencyfortax-awareproductsorportfolios?FIGURE8.5
providesreasonablemeasuresoftaxefficiencyforbothseparateaccountand
mutualfundproducts.Theratiosandmeasurescanchangesignificantly,
dependingonthemarketenvironment.Theinformationprovidediswhat
shouldbeexpectedwithaveragehistoricalreturnsoveraten-yearperiod.As
wewillseeinchapter9,year-to-yeartaxefficiencycanswingdramatically.
Whatisimportantisthatthepractitionerbefamiliarwiththestrengths
andweaknessesofeachtax-efficiencymeasureandknowwhenandhow
toapplythem.Therelativewealthmeasure,eventhoughabitcomplex,
isbestsuitedforseparateaccounts,whereasthetax-costratioworksquite
wellwhenreturnsafterdistributionsarereportedformutualfunds.With
thesemeasuresandtechniques,investorsandinvestmentprofessionalscan
analyzeafter-taxresultsmoreeffectivelythaneverbefore.
100 After-TaxReportingandMeasuresofTaxEfficiency
FIGURE8.5 E fficiencyRatiosandMeasuresforTax-Aware
Products
SEPARATEACCOUNT MUTUALFUND
CAPTURE RELATIVEWEALTH CAPTURE TAX-COST
ASSETCLASS RATIO MEASURE RATIO RATIO
Source:Morningstar
Tax-AwareMunicipalBond 105% 4.5 99% 0.09
ChapterNotes
Tax-AwarePortfolio
Management
Incaseyoudidn’tknow,ethanolismadebymixingcornwithyour
taxdollars.
—PaulA.Gigot
101
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CHAPTER9
OutperformingtheIndexFund
I’m putting all my money in taxes—it’s the only sure thing to
goup.
—Anonymous
T
hus far, we have demonstrated through various studies and ex-
amplesthatitisdifficulttooutperformanindexfundonanafter-
taxbasis.Weshouldnote,however,thatnotallindexfundsare
createdequal,norhavetheyallbeentax-efficientwithlowfees.Forex-
ample,in1997theGalaxyIISmallCompanyIndexFundandMainStay
InstitutionalEAFEIndexFundhadcapitalgainsdistributionsequalto
34.4percentand25.4percentoftheirassets,respectively,andsomeindex
fundschargefeesclosetothoseofactivelymanagedproducts.1Chapter
3 described how Charles Schwab funded two working papers by John
ShovenandJoelDicksonofStanfordUniversitytosupporttheSchwab
1000IndexFund,whichsinceitsinceptionhasnevermadeacapitalgains
distribution.Thepurposeofthefirstworkingpaperwastodemonstrate
thecomparativevalueofatax-awareproduct,whereasthepurposeofthe
secondwastoexplaintechniquesthatcouldbeemployedtoachievethe
loftygoalofmanagingafundwithoutcapitalgainsdistributions.Shoven
and Dickson identified the following principles as critical to avoiding
capitalgainsdistributions:
1 When you have to take gains, sell the highest-cost-basis shares
first.
2 Realizecapitallossestooffsetfuturecapitalgainliabilities.
103
104 Tax-AwarePortfolioManagement
3 Establish rules to overcome limitations created by the wash sale
rule.
The first element was enhanced through the application of high in,
firstout(HIFO)accounting,versusfirstin,firstout(FIFO)oraverage
costaccounting.DicksonandShovenrecognizedthatabuy-and-holdap-
proach to portfolio management would not be sufficient to obtain the
desired goal.Therefore, they determined it was necessary to take losses
when they were available and noted that as early as 1983, George M.
ConstantinidesoftheUniversityofChicagodemonstratedthatsecurities
withgreaterpricevolatilityoffermorepotentialforthe“tax-lossharvest-
ing”trade.2Lastly,thewashsalerulecreatedachallenge,becausetoget
creditforalossyouhadtoensureyoudidnotpurchasethesamesecurity
againwithinthirtydays.Ifflowscomeintothefundandcertainsecurities
cannotbepurchased,thenthecharacteristicsoftheportfoliomightdeviate
fromtheactualindex.Therefore,ruleshadtobeestablishedforwhena
securityshouldbesold,howmuchofthepositiontosell,andwhatthe
minimumindexweighttoholdis.Bymodelingthisprocess,theydiscov-
eredtheycouldpotentiallyaddanother0.85to0.95percentinincremen-
talreturn,ortaxalpha,beyondthebefore-taxreturnsoftheindex.3
Launchedin1991,theSchwab1000IndexFundwasalreadybuilding
anenviablerecordofachievementwhenDicksonandShovenbegantheir
research.Atthebeginningoftheirsecondworkingpaper,theyacknowl-
edgedthecontributionofGeorgeU.“Gus”Sauter,chiefinvestmentofficer
atVanguardInvestmentsfor“providinguswithkeydataandinsightinto
themanagementofVanguard’s500IndexFund.”Soitisnocoincidence
thatVanguardfounderJackBogletooknoteoftheirconclusions.Forat
leasteightyearspriortothattimeBoglehadbeenencouragedonmorethan
oneoccasionbyTadJeffreytorunatax-awarefundsimilartotheWindsor
IIFund,buthejustcouldn’tbeconvinceditcouldbedonesuccessfully
overalongperiodoftimewithanactiveapproach.4SinceBoglehadhis
heartandsoultiedtopassiveinvesting,thiswascertainlynosurprise.Itwas
theworkofDicksonandShovenin1993thatfinallyconvincedhimthat
hispositiononapplyinganindex-basedportfoliowastheproperapproach
andthattheprocesscouldbedonewithoutharmingVanguard’sreputa-
tion.Shortlythereafter,inSeptemberof1994,Vanguardlaunchedaseries
oftax-managedfunds.WiththesuccessofGoogle,onehastowonderifthe
StanfordteamofDicksonandShovennowlookbackandwishtheyhad
personallycashedinonthepracticalvalueof“AStockIndexMutualFund
WithoutNetCapitalGainsRealization”ratherthansharingtheirfindings
withthepublic.InDickson’scase,hewouldsoonputhisknowledgetouse:
aftercompletinghisdoctorate,hespentashortstintattheFederalReserve
OutperformingtheIndexFund 105
analyzingthemutualfundindustry,andthenBoglemadeoneofhismany
astutebusinessdecisionsbyhiringhimtoassistGusSauterwithoperation
ofVanguard’sindexandtax-managedfunds.5
By adhering to and building on the three principles outlined by
Dickson and Shoven, the Schwab 1000 Index Fund and VanguardTax-
Managed Funds collectively boast well over a half century of operating
withoutdistributingcapitalgains.AsBoglehassaid,“theyhavebeenout-
standingfortheirshareholders,butamarketingdisappointment.”6These
are certainly the products that should have virtually eliminated high-cost
variable-annuityproducts.TheSchwabandVanguardtax-managedprod-
uctsofferatax-deferralmechanismsimilartoavariableannuitybutwith
significantlylesscostanddailyliquidity.Moreimportant,ifheldmorethan
ayear,theappreciatedamountofthetax-managedproductsaretaxedatthe
federalrateforlong-termcapitalgainsratherthanthemuchhigherordinary
incometaxrateforvariableannuities.Sowhy,insomeyears,aremorethan
$50billionofvariableannuitiesissued?Forthesimplereasonthatannuities
are“sold”toinvestorswhodonotrealizethereisavastlysuperioralterna-
tive,whereastax-managedproductsare“bought”mostlybyself-educated
tax-awareinvestors.Onceagain,thekeyiseducation,becauseifinvestors
understood the tax ramifications of various investment alternatives, they
wouldlikelymakequitedifferentpurchasedecisions.
Tax-managedmutualfundsmayhaveredemptionfeesthatarewaived
afteradesignatedperiod.Thisfeatureisintendedtoattractonlythosein-
vestorswithlongtimehorizonsortodeterotherswhofrequentlyredeem
shares.TheVanguardtax-managedseriesemploysa2percentredemption
thefirstyearand1percentforthenextfouryears.Boglebelievesthatal-
thoughthefeaturewasneededandperhapsaheadofitstime,ithasbeen
detrimentaltothegrowthoftheproducts,asheknowstherearesizable
amountsoftaxableassetsintheirS&P500IndexFundeventhoughthe
Tax-ManagedGrowth&IncomeFundhasmorepotentialtoachievesu-
periorafter-taxreturns.
AtthetimeDicksonandShovenwereworkingontheirpapersthere
emergedanothertax-efficientproduct:theexchange-tradedfund(ETF).
ThelargestandmostrecognizableETFistheStandard&Poor’sDeposi-
tory Receipt (SPDR), which appeared in January 1993. However, the
ideaoftradingaportfolioasasharebeganwithindexparticipationshares
(IPS),whichbegantradingontheAmericanandPhiladelphiastockex-
changesin1989.Theseproductswereoriginallydesignedforinstitutions
thatsoughtavehiclewithintradayliquiditytoincreaseordecreasesignifi-
cantmarketexposureinacost-effectivemanner.Likesomanyitemsin
tax-awareinvesting,theinnovationrequiredacatalysttoattractsufficient
attention.Thismarketwasprettymuchdormantuntilinvestorsembraced
106 Tax-AwarePortfolioManagement
FIGURE9.1 WorldwideETFGrowth
$250,000 300
250
200,000
Assets in USD Millions
200
Source:MorganStanleyResearchandBloomberg
150,000
Number of ETFs
150
100,000
100
50,000
50
0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Mar.’04
10
Assets in USD Millions $811 $1,122 $2,302 $5,258 $8,234 $17,596 $39,605 $74,337 $104,800 $141,621 $212,016 $229,308
Number of ETFs 3 3 4 21 21 31 33 92 202 280 282 32
FIGURE9.2 CreationofaniShare
BrokerageAccount
Cash Cash
Exchange
iShares
Investor Capital
Market
(buyer) Markets
Makers
iShares Securities
BasketofSecurities iSharesCreationUnits
Source:BarclaysGlobalInvestors
AlthoughiSharesmaybebought
andsoldontheexchangethrough iSharesFund
anybrokerageaccount,iSharesare (Trademarkof
notindividuallyredeemablefromthe BarclaysGlobal
Fund.InvestorsmayacquireiShares, FundAdvisors)
andtenderiSharesforredemption,
throughtheFundinCreationUnit
aggregationsonly.
Figure9.2Rogers
FIGURE9.3 TraditionalMutualFundProcess
Source:BarclaysGlobalInvestors
CustomerService
Cash Cash
Investor Capital
Fund
(buyer) Markets
SharesofFund Securities
fundbuysandsellssecuritiestosatisfydailynetpurchaseandredemption
activity(see FIGURE9.3).Ifthesecurityissoldatalevelotherthanthe
Figure9.3Rogers
currentcostorbookvalue,thenataxableeventoccurs.Therefore,from
ataxstandpoint,theopen-endmutualfundisverysusceptibletodaily
shareholderpurchaseandredemptionactivity.
Whenanauthorizedparticipantredeemsshares,itdoesnotcauseatax-
ableeventforotherETFshareholders,becausethereissimplyanexchange
ofsecuritiesfortheETFshares.Afterward,theauthorizedparticipantcan
dowhateverhedesireswiththebasketofsecurities,butagainithasno
taximpactontheETF.Betteryet,whenacreationunitisredeemed,the
manageroftheETFdoesnothavetogivebacktheoriginalshares.Since
108 Tax-AwarePortfolioManagement
hecanchoosewhichsharestodistributethroughtheapplicationofspe-
cificlotidentificationaccounting,hewillmostlikelydistributetheshares
with the lowest cost basis.This causes the average cost of the securities
comprising the portfolio of the ETF to trend upward over time. In es-
sence,thein-kindtransferisasubstituteforthetax-lossharvestingtrade,
thatis,theETFmanagerlowerstheamountofembeddedcapitalgainsin
thefundthroughthein-kindtransfer,whereasthemutualfundmanager
takeslosseswhenavailabletooffsetgains.
Likeindexfunds,ETFshaveverylowexpenseratios.Unlessthebuyer
isanauthorizedparticipant,ETFsarepurchasedinthesecondarymar-
ketthroughabroker,whoreceivesacommission.SinceETFsaretraded
intraday,theunderlyingsecuritiesneedtobesomewhatliquid.Although
therearemorethan100ETFsavailabletoinvestorsandnewETFsare
being launched almost weekly, the structure is not suitable for all asset
classes.Unfortunately,asaresultofchallengeswithliquidityandpricing,
noneoftheprovidershavebeenwillingtoundertakeamunicipalbond
ETF,eventhoughthereistremendousdemandforsuchaproduct.
SomeadvisersarefansofETFs,whileothersprefertax-managedopen-
endmutualfunds.Unfortunately,neitherETFsnortax-managedfunds
aretherightchoiceorperfectsolutionforallsituations.Therefore,tax-
awareadvisersneedtobeawareofthetaxconsequencesofeachsothat
theycanoffertheirclientssageadvice.
FIGURE9.4buildsonaschematicutilizedbyGaryGastineauinThe
Exchange-TradedFundsManualtocompareatypicalmutualfund,ETF,
andaholder,whichisaportfolioofstocks.8Theevaluationsystemofthe
figureisthesame,butitislimitedtoacomparisonofatax-managedand
exchange-traded funds. The fields have been expanded and subdivided
intothreemajorareas:taxefficiency,operational,andestate.
Taxefficiency:Bothtax-managedmutualfundsandETFsbenefitthe
taxableinvestorbytakingadvantageofspecific-lot-identificationaccount-
ingandoffsettingfundexpenseswithtaxableincome.Thekeydifference
inhowtax-managedmutualfundsandETFsattempttoachievetaxef-
ficiency is their reliance on the internal tax-loss harvesting trade versus
the in-kind transfer. Both types of funds can sell depreciated securities,
harvesttheloss,andapplyitagainstgainsinthefuture.However,ETFs
typicallyachievebettertaxefficiencyfromexchanginglow-cost-basisfor
high-cost-basisshares.PerhapsthegreatestadvantageETFshaveovertax-
managedfundsishowthein-kindtransfercanhandleitemslikeindexre-
constitution,deferralofshort-termgains,andstocksacquiredinmergers.
Withtheseadvantages,ETFsofferamoretax-efficientsolutionfortaxable
investorswhowanttoobtainexposuretosmall-andmiddle-capitalization
domesticequities.
OutperformingtheIndexFund 109
FIGURE9.4 C omparingTax-ManagedandExchange-Traded
Funds
TAX-MANAGED EXCHANGE-TRADED
TaxEfficiency
AbilitytoDeductExpenses + +
SpecificLotIdentificationor
HIFOAccounting + +
ApplyTax-LossHarvestingTrade + +
TaxBenefitFromIn-KindTransferofShares – +
TaxConsequencesofIndexReconstitution – +
DeferralofShort-TermGains – +
TaxImpactofStocksAcquired
forCashinMergers – +
Operational
IntradayLiquidity – +
AdditionalCommissionCost + –
Bid/AskSpread + 0
LowFee +/0 +/0
RedemptionFee +/– +
ShareholderContributions + 0
ShareholderWithdrawals – +
DiversificationRules – –
Estate
GiftAppreciatedSharestoCharity 0 0
Source:GaryGastineau,DouglasS.Rogers
Step-UpofBasisatDeath + +
+ Best
0 OK
– Worst
110 Tax-AwarePortfolioManagement
Operational:TheETFcanbeboughtandsoldintraday,butunless
investorsareauthorizedparticipantscreatingandredeemingETFshares,
they must pay a broker’s commission on the transactions.The investor
maypayaslightpremiumforthisadditionalliquidityintermsofabid/ask
spread,butthesedifferencesaresmallwithhigh-volumeproducts.Mu-
tualfundshareholdersbenefitwhentheyinvestearlyinafundandfuture
capitalgainsaredistributedacrossagreaternumberofinvestors.However,
ETFinvestorsbenefitwithredemptionswhenthemanagerexchangesout
oflow-costbasisshares.Bothtax-managedfundsandETFsofferinvestors
reasonableorlowfees,withsomeETFschargingfeeslessthan0.10per-
centannually.ETFstypicallydonothaveredemptionfees.Redemption
feescanbebothapositiveandnegativefortheinvestorinatax-managed
fund.Thenegativesideisinvestorsmayhavetopaythemiftheyredeem
their shares earlier than anticipated. However, redemption fees assist in
drivingawayhotmoneythatleadstocapitalgainsgeneration.Also,the
redemptionfeesareleftinthefund,whichcanboostfundperformance.
ETFsarenotimmunetocapitalgainsdistributions.Therearetimeswhen
they simply have to sell a security and cannot avoid taking a gain. For
example,country-specificfundsmaynotbeabletoavoidacapitalgains
distributionifacertainholdingexceedsthelimitsetbyvariousregulatory
diversificationrulesandhastobesold.Perhapsthebest-knownexamples
aretheiSharesMSCICanadaandSwedenETFs,whicheachhaddistri-
butionsofmorethan18percentofassetsin2000.9IntheCanadaETF,
Nortelbecamemorethan25percentofthecapitalizationoftheportfolio.
AsNortelcontinuedtoincreaseinsizerelativetootherstocksintheCan-
adaportfolio,themanagerwasforcedtosell.Fortunately,thissituation
is primarily limited to the country-specific funds, but it highlights that
advisersneedtobeinformedofhowgainscanbegeneratedwithETFsso
theycanavoidpotentiallyembarrassingsituationswiththeirclients.
Estate: Tax-managed funds and ETFs are pretty much equal when
itcomestocharitablegivingandtakingadvantageofthestep-upincost
basisatdeath.
The information in Figure 9.4 enables advisers to check a client’s
personalsituationofbeforerecommendingatax-managedorexchange-
tradedfund.Unlesstheyaredealingwiththesamesizeandtypeofclient
withidenticalcircumstances,oneproductmaybemoresuitableinsome
instancesthantheother.Additionally,managersoftheseproductsareal-
wayslookingforwaystorefinetheirprocessesandenhanceperformance.
Therefore, it is recommended advisers maintain a similar checklist that
incorporatesthemostrecentdevelopments.
FIGURE 9.5showstenyearsofbefore-andafter-taxperformancefor
theVanguardTax-ManagedGrowthandIncomeFund,ETFSPDR,and
OutperformingtheIndexFund 111
FIGURE9.5 B efore-andAfter-TaxReturnsofSimilarTax-
ManagedandExchange-TradedFunds
(Forthe10-YearPeriodEndingDecember31,2004)
Source:MorningstarPrincipia,January2005
AFTER-TAX
EXCHANGE-TRADED DISTRIBUTIONS&
ORMUTUALFUND BEFORE-TAX DISTRIBUTIONS SALEOFSHARES
Vanguard500IndexFund.Thesethreefundswerechosenforthiscom-
parisonexercisebecausetheyallusetheS&P500stockindextoconstruct
theunderlyingportfolioofstocks.
From this limited amount of information come three conclusions.
First, it is readily apparent that the differences in performance between
the three funds are extremely small. Second, each of the funds has an
extraordinarilyhighleveloftaxefficiency,astheMorningstarten-yeartax-
costratiosrangefromonly0.52to0.63.Therefore,allofthemanagers
ofthefundshavedoneanoutstandingjobofexecutingtheirstrategyina
tax-awaremanner.
Overextendedperiodsoftime,therearetwokeyfactorsthatdictate
whetherthemutualfundorETFformatisbetterformanagingtheunreal-
izedgainposition.Manageableredemptionactivitybenefitstheremain-
ing shareholders of the exchange-traded fund, whereas reasonable price
volatilityofindividualsecuritiesbenefitsthetax-managedmutualfund.
Extremesineithercasemayresultinacascadeofredemptionactivitythat
could force the sale or distribution of shares, with a meaningful capital
gaindistributiontofollow.
Theresultsshownthusfarareallnetoffees,whichiscustomarywith
mutual and exchange-traded funds. Now let’s examine the results on a
grossoffeebasistotheactualreturnoftheS&P500(seeFIGURE9.6).
Notethatallthreefundshaveachievedgrossbefore-taxreturnsclose
totheS&P500stockindex.Twoofthefundshaveactuallyexceededthe
resultsofthebenchmarkbyasmallmargin.Manypractitionerscallfunds
andaccountsofthisnature“passive”investmentsorportfolios.Therefore,
thethirdandperhapstheprimaryteachingpointofthisexerciseisthat
tax-aware investing is anything but passive! In fact, there may be more
112 Tax-AwarePortfolioManagement
FIGURE9.6 B efore-andAfter-TaxReturnsofSimilarTax-
ManagedandExchange-TradedFunds
(Forthe10-YearPeriodEndingDecember31,2004)
Source:MorningstarPrincipia,January2005
EXCHANGE-TRADED GROSS
ORMUTUALFUND BEFORE-TAX STATEDFEE BEFORE-TAX
tradingactivityintheseportfoliosthaninthetypical“actively”managed
fund.Thedifferencehereisthatitisinformedtradingactivitythatworks
tothebenefitofthetaxableinvestor.
Thereareanumberoftechniquesthatarevaluableinmanagingindex-
basedportfolios.Theseinclude:
❑ Cost-efficienttradingthatincludeselectroniccrossingnetworks
❑ Purchasingderivativeswhentheyareinitiallycheaperthantheun-
derlyingstocks
❑ Pledgingsecuritiesoftheportfolioforsecuritylending
❑ Purchasingstocksbeforetheyareaddedtotheindex
❑ Takingadvantageofanimbalanceinaparticularsecurity
Anything the manager can do that leads to superior results without
takingonundueriskshouldbeencouraged.
ThelastpointisthatETFshavelaggedtheperformanceoftheirmu-
tualfundtax-managedpeerswithsimilarportfoliosbyaveryslightmargin
beforetaxbuthavedonequitewellaftertax.Oneofthereasonsforthe
minordifferentialinbefore-taxreturnsoftheSPDRTrustSeries1isthat
ithasnotbeenallowedtoreinvestthedividendsitreceivesfromitsport-
folioholdings:thecashmustbeheldinamoneymarketfund.Addition-
ally,sharescannotbeputoutforsecuritieslending.EarlyETFs,likethe
SPDR,wereregisteredasunittrusts,whereasnewerETFsareregistered
asopen-endmutualfundsanddonotfacethisdisadvantage.Thisweak-
nessisknownandhasbeensharedwiththeSEC.Inthemeantime,some
brokerage houses have established cost-effective dividend reinvestment
planstominimizethisimpact.10Hopefully,apositiveresolutiontothis
OutperformingtheIndexFund 113
challengewillbeprovidedsoon.Anotherfeaturethatmayhavebenefited
tax-managedfundsduringthisperiodistheredemptionfee.Whilemost
investorsintax-managedproductsplantostaywithafundforfiveyearsor
more,unforeseenpersonaleventscanoccurthatforcethemtosellshares.
Also,redemptionactivityintheVanguardTax-ManagedFundsincreased
during the bear market of 2000 to 2001, but it was still far below the
industry average. Investors that redeemed shares during their first year
would have received 98 percent of their net asset value, and those that
wereintheone-to-five-yearrangereceived99percent.Thedollarsofthe
1to2percentredemptionfeesremainedwiththefundandhadasmall
butfavorableimpactonperformance.
Dotheresultsofthesethreefundsmeantax-awareinvestorsshould
notownETFs?Absolutelynot:ETFsareaninnovativesolutionthattax-
awareinvestorscanaddtotheirarsenalofweapons,andtherearemany
caseswheretheyinfactoffertheoptimaltax-efficientsolution.Moreover,
ithasonlybeensinceabout2000thatthemanagersofETFshavecome
tofullyrecognizehowimportantthetaxadvantageofthein-kindtransfer
istotheirtaxableinvestors.Nowinvestorsandadvisersneedtodetermine
whenitisbesttoapplythem.Barclayshasbeenextremelyproactiveinthe
marketbyofferinginvestmentseminarsthatemphasizegeneraleducation
onETFsratherthanemphasizinghowtheirproductsmaybesuperiorto
thecompetition.Asaresult,moreadvisersarebeginningtounderstand
thetaxbenefitsofETFsandapplyingthemininnovativeways.Mostim-
portant,onceinvestorsbecomecomfortableusingtax-efficientproducts
andseethefavorableresultwhentheirtaxesaredue,theyarereluctantto
reverttousinglesstax-efficientmutualfundsandseparateaccountprod-
uctsandmanagers.
Mutualfundsthatincludetermssuchas“tax-managed,”“tax-aware,”or
“tax-efficient”intheirtitlesarerequiredtoincludeafter-taxreturnsintheir
advertisingmaterials,whereasitisoptionalforothers.11However,thisdoes
notguaranteeaninvestorwillreceiveatax-efficientoutcome.Therearetwo
noteworthyhistoricalexamplesofshareholderswho,unfortunately,didnot
receivetax-efficientoutcomes.12ThefirstexampleinvolvestheBernstein
Tax-ManagedInternationalFund.Thisinitiallysuccessfulfundattracteda
meaningfulamountofassetsanddevelopedasubstantialunrealizedcapital
gainsposition.Thenthepricesforinternationalstocksbegantofall,and
alongwiththisdevelopmentcameshareholderredemptions.Althoughthe
managerattemptedtominimizethecapitalgainsdistributions,therewas
onlysuchmuchhecoulddo.Eventuallyhewasforcedtosellshareswith
embeddedgains.Thisexamplehighlightshowshareholderactivitybeyond
the control of the manager can influence the after-tax returns of share-
holderswhoremaininthefund.TheotherinstanceistheStandishSmall
114 Tax-AwarePortfolioManagement
CapitalizationTax-ManagedEquityFund.Inthiscase,theteammanaging
the fund sold large positions in technology and biotechnology shares in
thespringof2000,andsoonthereafterdepartedforanotheremployer.13
Standish’scompliancepersonnelwerenaturallyconcernedthattherewould
besignificantredemptionsasaresultofthedepartureandthatnotdistrib-
utingthecapitalgainswouldbeunfairtoshareholdersthatremainedin
thefund.Theydecidedtoannounceacapitalgaindistributionratherthan
towaitandseeiftherestofthefiscalyearwouldofferthepotentialtosell
somesharesatlossestoreducethemagnitudeofthedistribution.Withthe
marketdeclinein2000,thedistributioncametomorethan19percentof
thefund’sassetvalueatyear-end.14Thesetwoexampleshavebeenpretty
muchforgottenbyinvestors,butatthetimetheydrewalotofnegative
attentiontotheemergingnicheoftax-awaremutualfunds.Theseexamples
arementionedasillustrationsofthepotentialchallengesindeliveringona
tax-awaregoal,despitewhataparticularfundtitlemayimply.
Itwillbeinterestingtomonitorhowindex,tax-managed,andexchange-
traded funds will manage the reconstruction of the S&P 500, MidCap
400,SmallCap600,andREITCompositeindicesforfullfloatadjustment.
Previously,Standard&Poor’sderivedthepercentagefortheallocationby
takingintoaccountthetotalsharesoutstandingversustheavailablefloat
inthemarketplace.Thesepercentagescandiffersignificantlyifacontrol-
lingfamilyoracompany’streasuryfunctionisholdingasignificantstake.
Therefore,theamountofsharesofaparticularcompanyavailabletoinves-
torsasmeasuredbytheoutstandingfloatcanbequitedifferentthanwhat
was previously portrayed by index funds. Standard & Poor’s announced
the methodology and analysis of the adjustment for float on September
28,2004,thusgivingmarketparticipantsknowledgeofwhatwilleventu-
allytakeplaceandwhen.TheS&Pplanisfortheindicestobehalffloat-
adjustedonMarch18,2005.Theexamplegivenintheannouncementis:
“acompanywithan80%floatfactorwillbeadjustedtoa90%factor—half
wayfrom100%to80%.”OnSeptember16,2005,allS&Pindicesareto
befullyfloat-adjusted.15Forsomestocks,theshiftwillbedramatic,such
asWal-MartStores,whichadjustedtoahalf-floatfactorof0.80onMarch
18, 2005, and was scheduled to adjust to a full float factor of 0.60 on
September16,2005(seeFIGURE9.7).16
Thisprocedurewillresultinareductionintheoutstandingfloatofap-
proximately20percentofthestocksintheS&P500.Toavoidgenerating
substantialcapitalgainsfromthisexerciseisgoingtotakecarefulplanning
andcoordinationonthepartofthefundmanagers.
Managers of exchange-traded and tax-managed funds realize today
morethaneverhowimportantmaintainingtheirreputationsandrecords
for tax efficiency are to future success. Evolving risk-management tools
OutperformingtheIndexFund 115
FIGURE9.7 Standard&Poor’sFreeFloatSchedule
S&P500HalfFloat
S&P500FullFloat
Source:Standard&Poor’s
Figure9.7Rogers
allowmanagerstostress-testportfoliostodeterminethepotentialforgains
inadversemarkets.Asaresult,managersarebetterpreparedforchallenging
situationsthaneverbefore.Althoughitwouldbefoolishtosayinvestors
seekingatax-efficientfundsolutionwillnotencounteranotherinstance
ofasizablecapitalgainsdistribution,theexperiencesofthepastandthe
growingbodyofknowledgepertainingtotax-awareinvestingshouldresult
inattractivefundproductsthathaveahighprobabilityofoutperforming
theunderlyingindexofsecuritiesonanafter-taxbasis.
ChapterNotes
1. AaronLucchetti,“IndexFundsAren’tAlwaysTaxEfficient,”WallStreetJournal,
July28,2000.
2. GeorgeM.Constantinides,“CapitalMarketEquilibriumWithPersonalTax,”
Econometrica51,611–636.
3. JoelM.DicksonandJohnB.Shoven,“AStockIndexMutualFundWithout
NetCapitalGainsRealizations,”NBERWorkingPaperNo.4717,April1994,
1–26.
4. RobertH.JeffreytoJohnC.Bogle,May29,1985,andJuly6,1990.
5. JoelDickson,indiscussionwithauthor,September21,2004.
6. JackBogle,indiscussionwithauthor,September2,2004.
116 Tax-AwarePortfolioManagement
7. “MeetingInvestmentChallengesWithETFs,”ForbesSpecialAdvertisingSec-
tion,http://www.federalreserve.gov/releases(accessedOctober30,2004).
8. Gary L. Gastineau, The Exchange-Traded Funds Manual (New York: John
Wiley&Sons,2002).
9. Dawn Smith, “An Education in ETFs,” http://www.smartmoney.com (ac-
cessedOctober30,2004).
10. Karen Damato, “For Index Funds, the Devil Is in the Detail,” Wall Street
Journal,September7,2004.
11. Securities and Exchange Commission, “Final Rule: Disclosure of Mutual
FundAfter-TaxReturns(S7-09-00),”newsrelease,April16,2001,11.
12. DannyHakim,“InGloom,aBeacon:Tax-SavingsFunds,”NewYorkTimes,
February25,2001.
13. AaronLucchetti,“StandishFundPayouttoCarryTaxBite,”WallStreetJour-
nal,August22,2000.
14. DannyHakim,“InGloom,aBeacon:Tax-SavingsFunds,”NewYorkTimes,
February25,2001.
15. Standard&Poor’s,“Standard&Poor’sAnnouncesFloatAdjustmentSched-
uleforS&P500andAffiliatedIndices,”http://www.standardandpoors.com(ac-
cessedSeptember15,2004).
16. Standard&Poor’s,“S&P500InvestableWeightFactors,”newsrelease,Sep-
tember17,2004;Standard&Poor’s,“Standard&Poor’sAnnouncesFloatAd-
justmentScheduleforS&P500andAffiliatedSchedules,”newsrelease,August
12,2004.
CHAPTER10
QuantitativeTax-Aware
PortfolioManagementand
ConcentratedStock
Taxissuesarefun.Gettingtolovethemmaytakeabitofeffort,
butthesameistrueforBeethoven’sstringofquartets,andthinkof
howmuchpleasuretheygiveifonedoesmaketheeffort.
—PeterL.Faber
I
nthischapter,weintroducetheconceptofthequantitativetax-aware
(QTA)portfoliostrategyandcompareitwithothermethodsofdi-
versifyingaconcentratedstockposition.TheQTAinvestmentstrat-
egyissimilartowhatatax-managedmutualfundmanagermayemploy
withtax-lossharvesting.Unlikelossesrealizedinmutualfunds,lossesin
separateaccountscanbeusedtooffsetaclient’sgainsinotherportfolios
andarenotsubjecttotheeight-yearcarryforwardlimitationthatapplies
tomutualfundlosses.Therefore,thisstrategyisideallysuitedforcom-
biningwithtax-inefficient,high-alpha-generatingstrategiesorforuseas
a tax-efficient mechanism to transition concentrated stock positions to
diversifiedportfolios.Asaresult,tax-inefficientactivemanagementstrat-
egiesshouldbereviewedinconjunctionwithotherconcentrated-stock
diversificationstrategiessuchasexchangefunds,collars,andprepaidvari-
ableforwards.
FIGURE10.1illustratestheimpactoftax-lossharvestingovertimewith
a portfolio funded all in cash. It shows a First Quadrant Monte Carlo
simulation of 500 observations, taking into account an average annual
yieldof1.44percentandtotalreturnof7.92percentwith15percentan-
nualstockvolatilityanda35percentmarginaltaxrate.Individualstock
volatilitywas31percent.Obviously,theresultsmaychangewithdifferent
117
118 Tax-AwarePortfolioManagement
What’s It Worth to the Taxable Investor?” Journal of Wealth Management
Source: Robert D. Arnott, Andrew L. Berkin, and Jia Ye, “Loss Harvesting:
FIGURE10.1 PortfolioValueAlphas
10%
9%
75thPercentile
8% Median
7% 25thPercentile
6%
Alpha
5%
4%
3%
(Spring2001):10–18.
2%
1%
0%
0 50 100 150 200 250 300 350
Months
assumptions,buttheparametersappliedhereareverytypicalofwhatone
wouldapplytoday.
The key point is the tax alpha is far greater at the inception of the
relationship than when the Rogers/TaxAwareFig.10.1
portfolio becomes seasoned. However, even
aftertwenty-fiveyears,therearestillopportunitiesforlossesthatproduce
ataxalphaofabout0.5percentayear.1Unfortunately,therewillalways
besurpriseslikeEnronandMCI,butatleasttax-lossharvestingextracts
economicvaluefromdeterioratingsituations.Atcurrentlevelsoftaxes,
theestimatedaverageannualalphaforthefirsttenyearsisapproximately
1.3percent,whereasithadbeenabout1.5percentbeforethelong-term
capitalgainstaxwasreducedfrom20percentto15percentandtaxon
qualifieddividendsfrom38.6percentto15percent.
Separateaccountportfoliosthatemphasizetax-lossharvestinghavebeen
aroundforonlyaboutadozenyears.In1992,ParametricPortfolioAssoci-
atesreceivedacallfromCTCConsultinginPortland,Oregon.CTChad
alargefamilyclientintheNorthwestforaboutadecade,andbothCTC
andtheclienthadbecomedisgruntledwiththelackofattentiontheirac-
tiveequitymanagerswerepayingtotheimpactoftaxes.Parametricwasin
thecustomindexbusiness,butuntilthistimeithadnottakenonataxable
account.The inquiry caught the attention of the firm’s chief investment
officer,MarkEngland,andheassignedportfoliomanagerBrianLangstraat
toassisthimwiththisspecialproject.Theylistenedcarefullytocomments
fromtheclientandCTCconsultantsRalphRittenourandNancyJacob.
Parametric first ran the strategies with a typical before-tax approach
accordingtovalueorgrowthmandatesbycapitalization.Thetaxableturn-
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 119
overinlarge-capitalizationstockindiceswasrunninglessthan5percent
ayearandwasattributedprimarilytomergersandacquisitionsthatwere
consummated by a cash transaction rather than an exchange of shares.
Therefore,theindexapproachbyitselfwasavastimprovementoverthe
client’s previous managers’ tax efficiency, or lack thereof. Parametric was
beginningtoanalyzehowitcouldaddvaluebyapplyingotherthantradi-
tionalapproacheswhenthearticlesbyJeffreyandArnottandDicksonand
Shovenin1993caughtitsattentionand,moreimportant,thatofother
CTCclients.In1995,Parametricbeganmakingtax-lossharvestingtrades,
andoneclientsoonturnedintothree.MarkEnglandretired,andthings
really picked up when Parametric hired David Stein as chief investment
officerin1996.Parametricsoonfoundthatitsearlyleadinthisnewniche
would have an overwhelming impact on the future of its business. Less
thanfiveyearslater,itfoundthatdemandforitsapproachwouldnecessi-
tatethatitabandonthelow-margin,tax-exempt,indexingcommoditytype
ofbusinessforretirementplans,foundations,andendowmentsandfocus
itsattentiononthehighlycustomizedtaxableaccountbusiness,whereits
uniqueapproachofferedclientsatruevalued-addedproposition.
Parametricwastheearlyleaderinwhatsomerefertoaspassiveinvest-
ing,butismoreappropriatelydesignatedasquantitativetax-awareinvest-
ing(QTA).Thepassivenomenclatureofthisnichecomesfromtheearly
portfolioshavingbeenmanagedaccordingtothetraditionalformofindex
investing.Obviously,advocatesoftheefficientmarkethypothesisbelieve
thisisreasonenoughtoemployapassiveratherthananactiveapproach
toinvesting.However,shortlyafterhissuccessfularticlewithTadJeffrey
waspublished,RobArnottbroughtFirstQuadrantintothedebate.His-
torically,FirstQuadranthadmanagedportfoliosusingsophisticatedmath-
ematical modeling—known as the quantitative, or “quant,” approach to
investing—initsefforttoprovideclientswithabefore-taxalpha,whichit
hassuccessfullydoneovertime.Therefore,theindustrysoonhadofferings
thatprovidednotonlyatax-advantagedapproachbutalsotheoptionto
closelytrackadesignatedindexortopotentiallyachieveincrementalreturn
onabefore-taxbasis,aswell.Moreover,asmentionedinchapter9about
tax-managedandexchange-tradedfunds,theportfoliomanagementtech-
niquesandtradingofthesestrategiesisanythingbutpassive.
SohowdoQTAstrategieswork?Thefollowingisalistofkeyelements
thattheadviserandtheclientshouldunderstand:
❑ Benchmarkselection
❑ Clientcriteria
❑ Custodian
❑ Fees
❑ Trackingerror
120 Tax-AwarePortfolioManagement
Benchmarkselection:ThefirststepintheQTAprocessistoselectthe
appropriateequitybenchmark.Today,almostanyequitybenchmarkinthe
worldcanbefollowed,aslongasthemanagercanreceivetheunderlying
percentageallocationstoeachsecurity.Forlarge-capitalizationcoretype
indices, the process is pretty straightforward.When attempting to have
aportfoliomanagedforaparticularstyle,itisimportanttounderstand
howtheindexproviderconstructsitsstylebenchmarks.Forexample,the
Russell style benchmarks have a 30 percent overlap, whereas the Barra
indiceshavenone.ThemanagerwilllikelysteeryoutowardtheRussellin-
dices,sincetheyprovideagreaternumberofsecuritiestoworkwith.The
MorganStanleyCapitalInternational(MSCI)indices,nowemployedby
Vanguard,utilize“bufferzones”forchangesincapitalizationassignment.
Forexample,ifthereare500stocksintheindexanda100stockbuffer
applies,thestockwouldhavetodropbelow600beforeitistakenoutof
theindex,orastockwouldhavetoreach400beforeitisincluded.This
featureisdesirableforsomeoneinterestedinasmall-ormid-capportfolio,
asittonesdowntheamountofreconstitutionthatgeneratesgains.Asa
generalrule,QTAportfoliosaretypicallymoreadvantageouswithvalue-
styleandlarge-capportfolios.Growthindexportfoliosarenaturallymore
tax-efficient,astopperformersstayintheindex.Astockisremovedfrom
thegrowthindexbecauseitsrelativevaluationhasfallen.Therefore,the
amountofappreciationmaybeinsignificant,oritmayeventransitionat
aloss.Ontheotherhand,whenastockshiftsfromthevalueindextothe
growthindex,itcanonlydosobyasignificantimprovementinrelative
valuation,whichislikelytoresultinsubstantialgainsrealization.
Clientcriteria:Therearecriticalclientfactorsthatthemanagerneeds
to know before he can attempt to provide an optimal solution. Obvi-
ously,thetaxprofileoftheclientortaxableentityisessential.Informing
themanagerofthemagnitudeandtimingofanticipatedcashflowsand
withdrawalswillallowhimtobettergaugetheleveloftaxefficiency.The
managermaysuggesttheflowsbereceivedjustpriortoanticipatedrecon-
stitution dates, as that will give him greater flexibility in shifting funds
towardincreasingsectorandindustryallocations.Iftheportfolioperiodi-
callyreceivesacontributionofcash,thenahigherleveloftaxefficiency
canbeperpetuatedthanshowninFigure10.1.Also,ifdividendsaretobe
reinvested,thatallowsforabitmoreflexibilityinrebalancingtheportfo-
lio.Thesizeoftheportfoliodictateswhetherodd(lessthan100shares)
orround(100-shareincrements)arepurchased.SincetheQTAmanager
typicallybatchestrades,oddlottransactionsarenotaproblem.
Portfolioconstruction:Todaythereareaboutahalf-dozensignificant
playersinthisspace.Theyarelistedhereinalphabeticalordertoavoid
theappearanceofapersonalpreference:AperioGroup,FirstQuadrant,
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 121
M&IBank,NorthernTrustGlobalInvestments,ParametricPortfolioAs-
sociates,StateStreetGlobalAdvisors,andU.S.TrustCorporation.These
firmsallhaveexcellentwaysofservingthetaxableinvestorandattempt
todifferentiatethemselvesbytheirslightlydifferentapproaches,thecli-
ents they serve, and their product design. For example, Parametric has
anoutstandingreportingcapabilityandservesanarrayofvariousclient
types,NorthernTrusttypicallyholdsagreaternumberofsecuritiesinthe
portfoliotoemphasizereductionintrackingerror,FirstQuadrantaims
toachieveabefore-taxalpha,M&IBankisknownforahigher-yielding
product,andU.S.TrustCorporationfocusesmoreoncustomsolutionsin
conjunctionwithothersecuritiesandderivatives.Plus,someofthefirms
aresubadviserstomutualfundsandvariousmanagerplatforms.
Twosituationsthatinvestorsoftenfailtotakeintoaccountarethatthe
managerdoesnotalwaystakealosswhenitmayappearobviousfromthe
accountstatementtodosoandthatthemanagermayactuallytakesome
gains.Bothoftheseactionsaretakentoreducethereturnorperformance
trackingerroroftheaccount.Investorsshouldavoidattemptingtoover-
ridethemanager’smethodologybydirectinglossesifpossible.Thosewho
intend to do this may be better off working with a broker rather than
with one of the managers mentioned above, who employ sophisticated
approaches.
Custodian:Forthesestrategiestobeeffective,thecustodianplaysa
majorrole.Iftheaccountsizeissmall($3millionorless),theclientwishes
toreplicatetheS&P500with250holdings,andtradingturnoveraverages
15to35percentayear,thentherearegoingtobenumerousindividual
transactions.Thecostoftheaveragecommissionandsettlementcharges
dictateshowfarthesecurityhastofallinpricebeforeitiseconomicalto
conductthetrade.Somecustodiansaremorecost-effectivewithQTAac-
counts.Therefore,aclientmayfinditeconomicallybeneficialtohouse
thequantitativetax-awareportfoliowithonecustodianorplatformand
theremainderofassetswithanother.Intheinstanceswherethismayoc-
cur,theclientshouldseekreferencesfromtheQTAmanagerofthosewho
haveestablishedasimilararrangement.
Fees:OneoftheadvantagesofQTAportfoliostrategiesisfeesaretypi-
callyhalfthoseofactivemanagers,dependingonthesizeoftheaccount,
butdon’texpectthemtobesimilarlow-feeindexedportfolios.Again,these
arereallyactiveratherthanpassivestrategies.Itisimportantthattheadviser
understandcompletelynotonlythemanagementfeebutalsothecustodial,
commission,andsettlementfeesandcharges.Youmayencounterasitua-
tionwheretheentirefeeisbundled.SinceM&IBank,NorthernTrust,State
Street, and U.S.Trust Corporation have well-known custodial platforms,
theycanoftenbeverycompetitiveintheirpricing,butthisnicheshould
122 Tax-AwarePortfolioManagement
notbelookedatasacommoditybusiness,asthereturnsnetoffeesand
taxescanbemeaningfullydifferent.
Trackingerror:Trackingerroristhedifferencebetweenthereturnsofa
portfolioanditsbenchmarkindex.Itismeasuredbythestandarddeviation
ofthedifferenceinreturnsbetweentheclientportfolioandthebenchmark.
ThereareseveralfactorsthatcancontributetotrackingerrorfortheQTA
portfolio.First,themanagermustdeterminetheoptimalnumberofstocks
toholdintheportfolio.Forexample,aQTAportfoliothatisintendedto
mirrortheS&P500willtypicallyholdone-halfoftheunderlyingsecurities
oftheindex.Determiningthenumberofsecuritiesisanartratherthana
matteroffollowingascientificrule.Sincethesuccessofthestrategyistax-
driventhroughtheapplicationoftax-lossharvesting,portfoliomanagers
mustensurethethirty-daywashsaleruleisnotviolated.Therefore,they
mustmakesuretherearesecuritiessimilarinnatureorsubstitutecandi-
datesthatarenotownedandavailableforpurchase.Thetrickformanag-
ersistoensurethesecuritiestheyselectforinvestmentwillsatisfactorily
representeachofthesectors,industries,andotherportfoliocharacteristics
theydeemimportant.FIGURE10.2isanexampleofthecharacteristicsthat
Parametricincludesinitsquarterlyreporttofacilitateahealthydialogue
witheachclient.
Modelingoranalyzingtheportfolioisusuallydonethroughasophis-
ticated risk-management software solution provided by Axioma, Barra,
ITG,orNorthfield.Todistinguishthemselvesinthemarketplace,QTA
firmswillcustomizethesolutionasaresultoftheirinternalresearchor
work in consultation with other knowledgeable individuals. They are
alsointerestedinminimizingthedifferencesinmodernportfoliostatis-
tics,suchasbeta(amountofmarketrisktheportfolioissubjectto)and
R-squared(amountofreturnthatcanbeexplainedbythebenchmark),
betweentheclient’scustomportfolioandthedesignatedbenchmark.The
firmsmayapplyvariousruleswhenconstructingaportfolio.Forexample,
theymayavoidsecuritieswithinsufficienttradingvolume,astheymake
itdifficultifnotimpossibletoexecutetax-lossharvesting.Whenrulesof
thisnatureareestablished,theymayonlyinfluenceasmallamountofthe
overallcapitalizationoftheindex,buttheycanhaveasignificantimpact
onperformance.Forexample,manyoftheseless-liquidsecuritiespriced
under$5asharehadstellarperformancesduring2003,butiftheywere
notheldbythemanager,thebefore-taxreturnoftheportfoliocouldhave
fallenshortofthebenchmarkby1percentormore.
Themanagerhastobeextremelycarefultoavoidexcessivetracking
errorwithtax-lossharvesting.Thiscanhappenwhenasecurityissoldfor
alossanditbehavesquitedifferentlyinpricethanthesubstitutesecurity.
This is especially so with the top holdings in the benchmark. General
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 123
FIGURE10.2 PortfolioCharacteristicsandFiveLargestHoldings
ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport
PORTFOLIO BENCHMARK
FIGURE10.3 GeneralElectricStockPrice
▲
Split
Source:Bloomberg
ElectricCo.(GE)waslistedintheParametricreportasthelargesthold-
ingintheportfolio.Thefive-yearhistoricalpricechartforGEwaspulled
from the Bloomberg Professional Service to show how this can happen
(seeFIGURE10.3).Let’senvisionaQTAportfolioisbegunafterGEshares
splitinthemiddleof2000.Laterthatyear,thepriceofthesecuritybegan
tofall,andsometimein2001itwouldhavebecomeacandidatefortax-
lossharvesting.ButnotethatfourdifferenttimesbetweenMarch2001
andJanuary2003whenthestockdroppeditquicklyreboundedinprice.
IftheentireholdingofGEwassoldduringthesetimesandthereplace-
ment lagged the upward price movement, the portfolio tracking error
wouldhavebeensignificant.Toprotectagainstthistypeofadverseaction,
the portfolio manager typically only sells a portion of a large holding.
Therefore,thedifferencesovertimearelikelytoaveragethemselvesout,
andnoonetransactionshouldprovetobedetrimental.Thiscouldbetrue
especiallyifanentireholdingwassoldforalossandthenthecompanywas
acquiredthroughamergerandthetake-outpricewassubstantiallyhigher.
AsDavidSteinofParametricsays,“Youcangiveamanasword,butthat
doesn’tmakehimaswordsman.”Furthermore,ifheisn’ttrainedintheuse
ofthesword,hemayendupcuttinghisownthroat.
To avoid excessive tracking error, the portfolio manager periodically
runsanoptimizationinaworkstation-typeenvironment.Theleveloftax-
lossharvestingisoftendictatedbytheamountofprojectedtrackingerror
themanagerpredeterminesasaninputvariable.Theoutputwillsuggest
whichstocksandhowmuchofeachtosell.Itwillalsosuggestreplace-
mentorpurchasecandidatesandtheappropriatenumberofshares.Then
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 125
theportfoliomanagerreviewseachsuggestiontodetermineafinaltrade
recommendation.Hemayvoidaparticulartradeandreruntheoptimiza-
tionifheisaware,forexample,thataparticularstockmaybesubjecttoa
corporateaction.Again,thesimulationwillprovidehimwithaprojected
trackingerror,andwhenheissatisfiedthetradeswillbeconsummated.
Sincetheinceptiondateinfluencestheinitialcostbasis,itisconceivable
thatafirmcouldhavenotwoportfolioswiththesameholdingsevenif
theyaremanagedtotrackthesamebenchmark.
ForQTAfirmswithalargenumberofaccounts,ordersarebatched
beforeapredesignatedcutofftime.Variousformsoftradingareemployed
toachieve“bestexecution”onbehalfoftheirclients.Thismayinvolvein-
teractionwithnumerousbroker-dealersandtheuseofelectroniccrossing
networks.SinceQTAstrategiesaretechnology-driven,theirfirmsnatu-
rallyembracethelatestsolutionstoenhancetradingsystems.Asaresult,
thecostoftradingisonlypenniesashareonaverage.
WiththeexceptionofFirstQuadrant,whichattemptstoachievea
before-taxreturngreaterthanthebenchmark,positivetrackingerror—or
areturnhigherthanthebenchmark—isasignthemanagerhasaweak-
ness in its risk-control management system, and in the future it could
justaslikelyexperiencenegativetrackingerror.Theimportanceofthe
before-taxtrackingerroroftheaccountcannotbeunderstated,forthe
simplereasonthatifthemanagercannotdeliverthebefore-taxreturn,
then you may actually better off with a tax-managed mutual fund or
exchange-tradedfund.
In a similar fashion to what we did in chapter 9, we now compare
thecharacteristicsofaQTAseparateaccountportfoliotoatax-managed
mutualfundandETF(seeFIGURE10.4).Theminimumaccountsizefor
QTAstrategiesreplicatingtheS&P500typicallybeginsat$500,000.
Taxefficiency:ThemajoradvantageoftheQTAstrategyistheabil-
itytopassthroughlosses.Additionally,individualinvestorscanusethe
lossesindefinitely.Inmostcases,specificlotidentificationandhighin,
first out accounting are available, but there are still custodians that do
notofferthisvalue-addedfeature.Inamutualfund,theshort-termgains
arelumpedtogetherwithordinaryincome.Thisshouldnotbeanissue
withseparateaccountreporting,sinceonlyiftheclientandhisadviser
makeaspecialrequestshouldtheQTAmanagergeneratenetshort-term
capitalgains.
Operational:WheretheQTAstrategystandsoutinthisareaisthat
theholdingsarenotsubjecttoregulatorydiversificationrules.Ifsode-
sired,theclientcanobtainatrulycustomizedportfolio,whichisgaining
inpopularitywithindividualslookingforsociallyresponsibleinvestment
restrictions.
126 Tax-AwarePortfolioManagement
FIGURE10.4 ComparingTax-ManagedFunds,Exchange-TradedFunds,
andQuantitativeTax-AwareSeparateAccountStrategies
TaxEfficiency
AbilitytoDeductExpenses + + +/–
SpecificIdentificationorHIFOAccounting + + +/–
ApplyTax-LossHarvestingTrade + + +
TaxBenefitFromIn-KindTransferofShares – + –
TaxConsequencesofIndexReconstitution – + O
DeferralofShort-TermGains – + –
TaxImpactofStocksAcquiredfor
CashinMergers – + –
AccrueLossesIndefinitely O O +
Pass-ThroughLosses – – +
Pass-ThroughofShort-TermGains – – +
Operational
IntradayLiquidity – + O
AdditionalCommissionCost + – –
Bid/AskSpread + O –
LowFee +/O +/O O
RedemptionFee +/– + +
ShareholderContributions + O O
ShareholderWithdrawals – + O
DiversificationRules – – +
AbilitytoManageaCustomPortfolio – – +
Estate
GiftAppreciatedSharestoCharity O O +
Step-UpofBasisatDeath + + +
ManagementValueAdded
ElectronicCrossingNetworks + +/+ +
PurchasingDerivatives + +/N/A +/–
OvernightLending O + –
PurchasingStocksPriortoBeingAdded
totheIndex + + +
ImbalanceinaParticularSecurity + + +
Source:GaryGastineau,DouglasS.Rogers
CostofPurchasingandSellingSecurities – + –
AdjustPortfolioforChangeinLifeStyle – – +
+ Best
0 OK
– Worst
ingthetax-lossharvestingenginewhenyouhaveaclientinapersistent
netoperatinglossposition.Inthissituation,youcanconsistentlyharvest
gains!Thebeautyofthisexerciseisthatyoudon’thavetoworryabout
the wash sale rule, and you are constantly raising the cost basis of the
portfolio.
QTAstrategiesarenowenteringanothereraofsophistication.Since
theinvestingpublichasbecomecomfortablewiththem,opportunitiesto
expandtheirusefulnessarebeingexploredinextremelyinnovativeways.
One rapidly growing use is the “overlay” application that is becoming
moreprevalentwithwrapproviders,whichwillbecoveredingreaterde-
128 Tax-AwarePortfolioManagement
tailinchapter19.Sincetaxratesarehistoricallylow,firmsareconduct-
ingresearchonwhetheritmakessensetosellsecuritiesthathaveprofits
toreplenishtheportfolio.Perhapsthemostinterestingmethodincludes
combiningtax-lossharvestingwithleverage,whichhasbeendonebyLot-
soff Capital Management.To do this successfully requires sophisticated
riskmodelingandclosecoordinationwithaprimebrokertohandlethe
borrowingoffundsproperly.
Sincetheirinception,QTAstrategieshavebeeneffectivelyemployed
toreduceconcentratedstockpositions.Ideally,theclientshouldhavea
significantamountofcash,equalingonetotwotimesthesizeoftheinitial
QTA portfolio.The process is quite simple. A QTA portfolio is set up
andthenperiodically,usuallymonthly,theprofessionalcoordinatingthe
effortdeterminesthedollaramountoflossesthatcanbetakenandsellsa
correspondingofamountoftheconcentratedstockposition.Again,the
objective is to offset gains with losses, taking the various provisions for
short- and long-term gains and losses into account.When the stock of
theconcentratedpositionissoldatagain,thecashfromthesettlementof
thetransactionistransferredtotheQTAportfolio.Thisrefreshesthecost
basisoftheportfolio,enhancingtheopportunitytoharvestlossesinfuture
periods.Theprocesscontinuesuntilsufficientlosseshavebeentakento
eliminatetheconcentratedstockposition.
FirstQuadrantandLotsoff,inconjunctionwithTwenty-FirstSecurities,
have conducted creative derivations of this strategy. One such derivation
involvesamarket-neutralstrategywhilealsoborrowingandtakinglosseson
theshortposition.Themanagersmayalsobetryingtoachieveapositiveal-
phaforboththelongandshortportionsoftheportfolio.Since,onaverage,
themarketsappreciateby5percentormoreannually,thereisgreaterop-
portunityforlosses.Ofcourse,thenetbenefitoftheshortpositionisinflu-
encedbythecostofborrowing.Amarket-neutralstrategyobviouslymakes
riskmanagementoftheportfoliofarmorecomplicated.Totakethesimplest
casepossible,considerthatwithalong-onlyS&P500portfolio,youwould
holdapproximately250securitiesandusetheremainderasareservefortax-
lossharvesting.Whentheportfolioisbothlongandshort,youneedtohave
approximately125securitieslongandanother125short,with250securi-
tiesagainservingasthetax-lossharvestingreserve.Thisprocesscanexpedite
transitioningaconcentratedpositionusingalong-onlyQTAstrategy,which
takesapproximatelysevenyears,toaleveragedlongandshortQTAstrategy,
whichtakestwoyearsorless.Obviously,thisprocessisfarmorecomplicated
thanthelong-onlyQTAstrategy,butifitisdonecorrectlytherewardsare
obvious.
QTA strategies are often compared with other diversification strate-
gies.Abriefdiscussionofeachalternativefollows,alongwithappropriate
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 129
questionstoassistadvisersorownersofconcentratedpositionsindeter-
miningwhichstrategyisbestsuitedfortheirspecificsituation.
Exchangefunds:Anexchangefundisapartnershipinwhichthepart-
nerseachcontributehighlyappreciatedstockinordertoachievediversi-
ficationanddeferthetaxliability.EatonVanceoffereditsfirstexchange
fundin1961and,asofthespringof2004,hasapproximately$16billion
assetsinthisniche.2Otherprovidersincludetheinvestmentbanks,since
theyoftentakecompaniespublicandtheirclientsareseekingawayto
diversifytheirconcentratedstockriskwithoutpayingcapitalgainstaxes.
The investor retains his cost basis in the exchange fund shares, so this
shouldbeconsideredataxdeferralratherthanataxminimizationoption.
Toqualifyforatax-freeexchange,theinvestor’sstockmustremaininthe
fund for at least seven years. For the fund to satisfy regulatory require-
ments, at least 20 percent of assets must be maintained in “qualifying
assets,”whicharetypicallyrealestateinvestments.Theinvestormayhold
shareslongerthansevenyears,andsomefundshavealmostaperpetual
inclination.Aninvestorwhoredeemssharesmaybegivenaselectgroup
orbasketofstocksoraproratadistributionofsharesheldbythefund.
The portfolio construction process may exclude certain types of stocks,
depending on the manager’s acceptance criteria.Therefore, the investor
mayhavetocheckwithseveralproviderstodetermineiftheywillaccept
theconcentratedholding.Aswithallportfolios,thereisinvestmentrisk
and a component of active management.Therefore, the exchange fund
mayachieveareturndifferentfromthemostcommonstockbenchmarks.
InthecaseofEatonVance,itmanagesitsexchangefundsinconjunction
withitsTax-ManagedGrowthFund,whichhasahistoryofneverhaving
distributedanycapitalgains.3Investorsandtheiradvisersneedtounder-
standthevariousprovisionsofthefundtheyareconsidering,astheremay
beearly-withdrawalpenaltiesoradversetaxconsequencesiftheseven-year
holdingperiodcannotbesatisfied.Feesonexchangefundstypicallyrun
about 1 percent or slightly less annually.The exchange fund may offer
estateplanadvantages.Iftheinvestmentintheexchangefundisintended
to be a gift, it is likely a meaningful discount to the face value for tax
purposescanbeachieved.Fromtimetotime,exchangefundshavecome
under the scrutiny of legislators and regulators. Most recently, it is the
SECtryingtodetermineifcorporateinsiderswereusingthemtoreduce
theirexposurewithoutsendingasignaltoinvestors.4
Collars:Therearemanywaysofconstructingcollarswithderivatives,
butthemostcommonisthecashlesscollar.Bysellingcallsandpurchas-
ingputoptions,theinvestorcanbracketboththeupsideanddownsideof
futurereturns.Inthiscase,theproceedsfromthecallareusedtooffsetthe
costoftheput.Thetradeisdoneinconjunctionwiththestock.Settle-
130 Tax-AwarePortfolioManagement
mentcanbedoneeitherbyphysicallydeliveringstockorincash.Physical
settlementrequiresactuallysellingtheinvestor’sstockposition,whereas
withcashsettlementcashisdeliveredandtheinvestorretainscontrolof
thestock.Whetherthestockclosesabovethestrikepriceofthecallor
below the strike of the put will dictate whether stock or cash must be
delivered.Ifthestockclosesbetweenthetwostrikepricesandtheoptions
expireworthless,theinvestorcanagainreviewhisvariousalternatives.
Prepaidvariableforwards:Thisstrategyisbestsuitedforaninves-
torthatplaceshighpriorityonprotectingagainstadropinthepriceof
the concentrated stock and has a need for immediate liquidity. In this
strategy,aninvestorsellsavariableamountofhisconcentratedstockata
futuredateforcash.Theinvestorreceivesapredeterminedamountofcash
forthefuturesale.Theactualamountofsharestheinvestorwillhaveto
deliverinthefutureisdeterminedbyanagreed-uponformulathatadjusts
forthechangeinthepriceofthestock.Thisallowstheinvestortoreceive
a known range of outcomes with some potential for appreciation.The
proceedsfromtheprepaidvariableforwardcanalsobeplacedinaQTA
portfoliotoreducethetaximpact.
Saleofthestock:Oneshouldnotignoretheoptionofsimplyselling
thestock.Withthelong-termcapitalgainstaxatitslowestlevelduring
thepost–WorldWarIIeraandlargegovernmentdeficitslooming,many
investorsbelieveitisonlyamatteroftimebeforetherateisincreasedfor
wealthyindividuals.Therefore,simplysellingthepositionandpayinga15
percenttaxhaircutisaviableoptiontoconsider.
Factorsthatinvestorsshouldconsiderwhenselectingadiversification
strategyinclude:
1 Does the strategy have the potential to save tax dollars, or is it
purelyadeferralmechanism?
2 Isthereanimmediateneedforcash?
3 Can the investor accept limited upside and some downside for
reducingoreliminatingtheriskofaconcentratedposition?
4 Howfarintothefuturecanthetransactionbeextended?
5 Willthecapitalgainsgeneratedbesubjecttothemorefavorable
ratesforlong-termtransactions?
6 Istheconcentratedstockaviablecandidateforthestrategiesbeing
considered?
7 Howwilldividendsbetreated?
8 Willtherebeanimpactonvotingrights,andisthisimportantto
theinvestor?
9 Whataretheinitialandannualcostsforthestrategy?
10Canthestrategybeunwound,andatwhatcost?
11Isthestockrestrictedwhilemaintainedinaparticularstrategy?
QuantitativeTax-AwarePortfolioManagementandConcentratedStock 131
12Iftheinvestorisanemployee,officer,ordirectorofapubliccorpo-
ration,shoulda10b5-1planbeconsidered?
13Havethestrategiesbeinganalyzedbeenchallengedbyregulators
inthepast,andisthislikelytohappeninthefuture?Ifso,whatis
thedownsidewithanadverseruling,andistheinvestorwillingto
endurepotentialadverseconsequences?
14Howattractiveisthestrategywhentakingintoaccounttheageof
theclientandthestep-upinbasisatdeath?
Inlessthantenyears,QTAstrategieshaveestablishedthemselvesas
acompellingalternativetoless-tax-efficienttraditionallymanagedstock
portfolios.Additionally,theirapplicationtoconcentratedstockpositions
nowprovidesamethodtoachievediversificationandpayminimalcapital
gainstaxratherthanjustdeferringit.ThenextgenerationofQTAstrate-
gies will certainly continue to enhance risk control through the use of
derivatives.However,thegreatestadvancementinperformancewillcome
from incorporating short sales and leverage in the mix, which are skills
more closely aligned with hedge fund practitioners. Will the asset class
managers and banks that have thus far dominated the QTA methodol-
ogylandscapefulfillthisneed,orwillanewsetofprovidersemergewho
aremorewillingtotakeahigherlevelofriskanddemandapremiumfor
theirservices?Regardlessofwhowillsatisfythisdemand,QTAmanagers
willbecomeapermanentpartofthetaxable-accountsolution,barringa
changeinthetaxcodethatwouldeliminatethebenefitsoftax-losshar-
vesting.
ChapterNotes
1. RobertD.Arnott,AndrewL.Berkin,andJiaYe,“LossHarvesting:What’sIt
WorthtotheTaxableInvestor?”JournalofWealthManagement(Spring2001):
10–18.
2. EatonVanceinternalmarketingpresentation,August2004.
3. MorningstarPrincipia,June30,2004.
4. RandallSmith,“SECLooksatHowInsidersUseExchangeFunds,”WallStreet
Journal,September7,2004.
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CHAPTER11
PracticesofEliteTax-Aware
EquityActiveManagers
Myfatherhasagreatexpression:‘Thecapital-gainstaxhascreated
moremillionairesthananyothergovernmentpolicy.’Thecapital-
gains tax tends to make investors hold longer. That is almost
alwaystherightdecision.
—ChrisDavis
T
hat statement by Chris Davis has more truth than most inves-
tors would like to admit.There are times when the best thing
the investor can do to maximize after-tax returns is simply not
to sell positions with substantial unrealized capital gains. FIGURE 11.1,
byParametricPortfolioAssociates,highlightsthefutureperformancethe
managerorinvestormustachievetobreakevenandovercometheem-
beddedcapitalgainhurdle.1
The table shows the additional return the manager must achieve, de-
pendingonthepercentageofcostrelativetothemarketvalueofthesecurity
thatwillbesoldandoverwhattimeperiodinyears.Thisadditionalreturn
iswhatallmanagersstriveforandisknownastheiralpha.Forexample,if
amanagerplanstosellasecuritywherethecostbasisis50percentofthe
marketvalue,itwouldrequireapretaxalpha,oradditionalannualreturn,of
3.5percentforthreeyearsjusttocoverpayingthetaxesonthesaletobreak
even.Thistablewaspreparedbeforethetaxonlong-termcapitalgainswas
loweredfrom20percentto15percent,butthemessageisclear.Managing
portfolioswithoutconsideringgainsrealizationmakesitextremelydifficult
forlow-alpha-generatingstrategiestobecompetitiveonanafter-taxbasis.
Unfortunately,therearefewactivemanagerswhoincorporatethistypeof
analysiswitheachbuyandselldecisionfortheirtaxableinvestors.
133
134 Tax-AwarePortfolioManagement
FIGURE11.1 T axAlphaRequired(PerYearforHoldingTime
toJustifyaSaleatGivenCostBasis)
COSTBASIS
0 10% 20% 30% 40%
Activeportfoliomanagementcanoutperformpassiveinvestingonan
after-taxbasis,butitisanextremelylow-probabilitybetwhenrelyingon
traditional methods. At this juncture, nontraditional methods are those
thatincorporatetheimpactoftaxesintheportfolioconstructionprocess
andtradingpracticesthatarenotpartofthetax-exemptaccountindustry.
Thehopeisthatthesetax-awaremethodswillbecometraditionalprac-
tices in the years to come, but they are currently only being employed
astutelybyapproximately2percentofpractitionersin2005.Itisabelief
oftheauthorthatmanagerswhoemploythesetax-awaremethodshavea
greaterthan50percentchanceofoutperformingpassivemanagementon
anafter-taxbasis,whichishigherthanthesuccessrateofmostmanagers
beforetax.Thisisbecausetax-awaremethodshaveamuchhigherprob-
abilityofcreatingalphathanthetraditionalmethodsofsectorallocation
andsecurityselection.
Impressiveafter-taxreturnsthatarebothlong-termandconsistentdo
nothappenbychance.Tax-awareinvestmentmanagementistrulyanart
formthatthusfarhasonlybeenmasteredbyasmallnicheofelitetax-
awarepractitioners.2Theyarethemostproactivetowardestablishingand
enhancing their tax management capabilities and the ones most serious
aboutmaximizingtheirafter-taxreturns.Theyallocatesignificantresourc-
es toward creating, monitoring, and maintaining their tax-management
process,whichshowstheircommitmentandwillingnesstobesuccessful
in this area.To facilitate an understanding of what it takes to become
anelitemanager,wewillexamineaprogressivelistofelements.Theten
elements may change with revisions to the tax code—for example, the
PracticesofEliteTax-AwareEquityActiveManagers 135
COSTBASIS
50% 60% 70% 80% 90% 100%
Source:ParametricPortfolioAssociates
5.3 4.2 3.1 2.0 1.0 0.0
3.5 2.8 2.0 1.3 0.7 0.0
2.6 2.1 1.5 1.0 0.5 0.0
2.1 1.6 1.2 0.8 0.4 0.0
amountoftaxableincomeinanequityportfolioisnotasimportantnow
asitwasbefore2003.
ElementsoftheHierarchy
ofTax-AwareInvesting
(EquityPortfolioManagement)
1 Maintaininglowturnover
2 Extendingtheholdingperiodbeyondayearandmonitoringthe
levelofshort-versuslong-termcapitalgains
3 Adjustingtheleveloftaxableincome,whenappropriate
4 Tax-lossharvestingasanend-of-yeardrill
5 Incorporatingtax-lotaccountingindecisionmaking
6 Applying specific lot identification or high in, first out (HIFO)
versusaveragecostorfirstin,firstout(FIFO)accounting
7 Havingqualifiedprofessionalsservetaxableaccounts
8 Tax-loss harvesting opportunistically throughout the year, with
knowledgeofthewashsalerule
9 H avinganalystsandportfoliomanagerswhofocusonlyontaxableac-
countsandincorporatetaximplicationsineachbuyandselldecision
10Beingcommittedtoafter-taxperformancestandardsandreporting
The truly elite practitioners have mastered all ten elements shown
above.Thefollowingdiscussionhighlightstheimportanceofeach.
136 Tax-AwarePortfolioManagement
1Maintaininglowturnover:Thisisthefirststeporelement.Low
turnoverisnice,butinmostcasesisnothingmorethanwhatcomesout
ofthebasicsecurityselectionprocess.Alltoooften,ithasnothingtodo
withattemptingtoenhancetheafter-taxreturnsoftheportfoliostrategy.
Moreover,lowturnoverbyitselfdoesnotleadtoacceptablelevelsoftax
efficiencyunlessitiskeptbelow5percentannually.Manyvaluemanag-
erswillstatetheirstrategyistax-efficientbecausetheyhaveturnoverof
20percentayearorless.However,asnotedinpreviouschapters,thisoften
resultsintax-costratioswellabove1.5percentannually.
2Extendingtheholdingperiodbeyondayearandmonitoringthe
levelofshort-versuslong-termcapitalgains:Thiselementisveryba-
sic,butithasameaningfulimpactonafter-taxperformance.Ifamanager
candelaysellingasecurityforseveraldaysorevenamonthsothatitben-
efitsfromthelowertaxrateonlong-termcapitalgains,thedelayshouldbe
encouraged.Thistypeofactivitycanbemonitoredinternallybyuseofthe
accountant’s ratio, as discussed in chapter 8. Human experience should
bebroughtintoplay,becauseifthepriceislikelytofallmorethanthe
amountofthetaxbenefit,thesecurityshouldbesold.Itisimportantto
remembertheprocessshouldbeorientedtomaximizingafter-taxreturns
ratherthanminimizingthepaymentoftaxdollars.
3Adjustingtheleveloftaxableincome,whenappropriate:With
thechangeinthetaxcodein2003,thisfeatureisnolongerasimportantas
itwaspreviously,buttherearestillsomesituationswhereitapplies.More-
over,thelowerrateonqualifieddividendsisscheduledtobephasedoutin
2009unlessadditionaltaxlegislationisenacted.Equityportfoliomanagers
needtobecarefulwhentheypurchasesharesofrealestateinvestmenttrusts
(REITs)andforeignsecurities,whichmaynotproducequalifieddividends.
SinceREITspayamuchhigherlevelofincomethanmostothersectorsof
themarket,taxable-accountmanagersshouldincorporatethisdifferential
intheirdecision-makingprocess.Oneprovisionofthetaxactof2003that
mustrememberedisthatsharesmustheldsixtydaysoutofthe121-day
periodthatbegansixtydaysbeforetheex-dividenddatefordividendsto
qualifyforthepreferentialtaxtreatment.
4Tax-lossharvestingasanend-of-yeardrill:Therearethreecom-
mon ways to execute tax-loss harvesting trades. If conducted properly,
thesetradescanaddtremendousvalue.However,asexplainedbelow,two
ofthethreemethodsmayyieldlessthandesirableresults.
a. Thefirstmethodiswhatisreferredtoasthe“naked”trade.In
thiscase,themanagersellsthesecurityorfundandthengoesto
cashforatleastthirtydaystoavoidviolatingthewashsalerule.
Typically the same security or fund is repurchased at that time.
Thisleavestheinvestorunexposedtothedesiredsecurity,sector,
PracticesofEliteTax-AwareEquityActiveManagers 137
orassetclass,thustheterm“naked.”Thisprocedureistantamount
tomarkettimingandshouldbeavoidedwheneverpossible.Don’t
besurprisedifyouencounterasituationwheretheclientdirects
thistypeofactivityandtheassetmanagementfirmrespondswitha
formbythecomplianceofficerthattheclienthastosign,relieving
thefirmofanyresponsibilityforthetradebeforeanylossescanbe
taken.Additionally,onceittakesthelosses,itwillattempttoleave
the proceeds in cash.This is a telltale sign the firm is incapable
ofadequatelyservingtaxableaccounts,contrarytotheirclaimsin
marketingpresentationsandthelike.
b. The second method is known as the “double-down” trade, a
phrasefromthegameofblackjack.Amanageremploysthistactic
whenasecuritydropsinpricebyameaningful amount and the
managerstillbelievesinthefundamentalmeritsofthesecurity.As
inblackjack,toexecutethistrade,amanagerdoublestheposition
size by purchasing an amount of shares equal to those presently
owned.Themanagerdoesthisbecauseheexpectsthesecurityto
reboundinpricesothattheoriginalpurchasepricecanbereached
orexceeded.Oncethisoccurs,theoriginaltaxlotissoldtoavoid
payingtaxes.Thisstrategyrepresentsmoreofavalueproposition
thanatax-managementtechnique.Itlacksatax-managementpro-
spectivebecauseevenifsuccessful,ataxlossisnevertaken—itonly
delaysataxpayment.Moreover,whentheremainingtaxlotissold,
themanagerincursagreatertaxliabilityfortheclient,asthepo-
sition carries a much lower cost basis than the original position.
Althoughthisstrategycanbeaneffectivetradingstrategy,itserves
more to increase individual position risk and falls into a “value
trap”andonlyincreasestheclient’staxliability.Thisisafavorite
toolofvalue-orientedmanagersandisasigntheyhavenotgiven
serious consideration to tax efficiency. Like the naked trade, the
double-downtradeistobeavoided.
c. Thepreferredmethodforexecutingatax-lossharvestingtrade
incorporatesa“pair-wise”transactionbysellingonesecurityand
purchasinganotherthatissomewhatsimilarorcorrelated.Correla-
tionismeasuredinmanydifferentways,includingbutnotlimited
to buying a security in the same sector or industry, with a simi-
larbeta,orinfluencedbysimilareconomicfactors.Anexampleof
suchatradewouldbeaninternationalmanagersellingINGGroep,
N.V.,theworld’slargestinsurer,foralossandtemporarilyreplac-
ingitwithAXAGroup,theworld’ssecondlargestinsurer.Theidea
isthatamanagerisabletorealizealossfortaxpurposeswithout
losing(inthisexample)theglobalinsuranceexposure.Ofcourse,
138 Tax-AwarePortfolioManagement
nootherinsurancecompanystockwillbeaperfectmatch,soin-
dividualcompanyriskwillneverbeentirelyeliminated.Therewill
alwaysbetheopportunitycostifINGappreciatesonfirm-specific
news that would not necessarily affect AXA.This trade is much
strongerthanthetwomentionedpreviously,asitallowstheman-
agertorecognizetherealizedloss,maintaintheportfolio’sexposure
andriskprofile,andreturntotheoriginalsecurityafterthirtydays.
Thismethodoftax-lossharvestingcanleadtosignificanttaxalpha
withnewaccountsfundedwithcash,especiallythoseinafalling
marketenvironment.Managersopposedtopair-wisetradingmay
grousethattheycannotfindsuitablereplacementsecurities.The
evolutionofexchange-tradedfundsformajormarkets,countries,
andsectorsinvalidatesthisargument.Forexample,expandingon
thepreviousexamplewithING,themanagerhasseveralotherop-
tions available through ETFs. Instead of using AXA, which the
manager might not like for a particular reason, he could use a
Netherlands index fund, MSCI Europe, Australasia, and the Far
East(EAFE)fund,oraglobalfinancial-sectorETF,dependingon
whatmarketexposuresofINGheistryingtoreplicate.Someman-
agerswillevenuseopen-endmutualfundsoroptionsorfuturesto
harvestthetaxloss,astheyunderstandthisisoneareawherethey
canaddtremendousvaluetowardafter-taxperformance.
Thetax-lossharvestingtradeisparamounttotax-awareinvesting.If
equitymanagersignorethisbasicexercise,theyshouldnotbeconsidered
forhire,unlesstheycanconsistentlydeliveranalphaofatleast3percent
ayearonabefore-taxbasis.
5Incorporating tax-lot accounting in decision making: Surpris-
ingly,in2005youwillfindsomemanagersandcustodiansthatdonot
havethiscapability.Tax-lotaccountingistheessentialelementthaten-
ablesmanagerstomaketradingdecisionsbasedonthecostbasisortax
lotsofindividualsecurityholdings.Wheneveramanagerbuysasecurity,
thepriceofthatsecurityisrecordedintotheportfolioaccountingsystem.
Ifamanagerbuysthesamesecurityinseveraldifferentlotsovertime,the
systemwillbeabletorecordthepurchasepriceanddateofeachtransac-
tion.Thebenefitcomesatthetimeofsale,whenthemanagercanusethe
tax-lotaccountingsystemtoidentifythemostadvantageoustaxlotorlots
tosellsoastominimizerealizedgainswhenconductingapartialsaleof
theoverallposition.
6ApplyingspecificlotidentificationorHIFOversusaveragecost
orFIFOaccounting:AsDicksonandShovenadvancedasearlyas1994,
theaccountingconventionemployedhasameaningfulinfluenceonafter-
PracticesofEliteTax-AwareEquityActiveManagers 139
taxresults.Thisfeatureisoperationalinnature.Whenitispresent,this
elementisaclearsignatax-awareculturepermeatesthroughoutthefirm.
7Havingqualifiedprofessionalsservetaxableaccounts:Thedeg-
radationoftheaccount-servicingfunctionisoneofthekeyreasonswhy
tax-aware investing is having difficulty gaining ground. Unfortunately,
with the asset management industry changing from a boutique culture
to an asset-gathering one, highly qualified servicing positions necessary
to maintain a tax-aware relationship have been eliminated in droves.
Many relationships have been terminated, because the economics of an
assetgathereraredifferentthanthoseofaboutiquefirm.Boutiquefirms
typicallystartwithafewentrepreneurs.Afterasuccessfulstarttheypay
offtheirinitialdebtandachieveacomfortableexistence.Theygrowby
providing a distinctive service. However, there comes a time when the
foundersofthefirmwouldliketocashinontheirsuccessandtypically
selltoanassetgatherer,whichpaysapremiumforthehighlyprofitable
operation.Unfortunately,onlythroughrapidgrowthandcostcuttingwill
theacquisitionbesuccessful,asitnowhasatremendousdebtloadoran
extremelyhighgoalforreturnoncapital.Sofollowingthetransaction,the
service positions are often eliminated or turned into sales or marketing
jobs.Nowindividualsarecompensatedbygatheringassetsratherthanby
satisfyingtheneedsoftherelationship.Additionally,oftenapersonfrom
atax-exemptaccountbackgroundisassignedtherelationship.Asaresult,
it is only a matter of time before the taxable client looks elsewhere for
service.
Thelackofservicingisalsoamajorconcerninopen-architecturesys-
tems,whichinsomeinstancesarenothingmorethanglorifiedwrapsitua-
tions.Whiletheyprovideaccesstoanaccountstrategyatareasonablefee,
theydonotguaranteeameaningfulrelationshipbyaqualifiedservicing
professional. All too often, the open-architecture system is a crutch for
minimallyqualifiedsalesandservicingprofessionalswhoareonlycapable
ofpresentingprospectsandclientswithsuperficialperformancerecords.
Openarchitecture,oraccesstomultiplefirms,isavalue-addedproposi-
tion when the servicing function can take the unique circumstances of
theclientandallocateassetstomanagersinatax-awaremanner,whichis
coveredindetailinotherchapters.
Tax-awareinvestingisaboutprocessfirstandlong-termrelationships
servicedbyknowledgeableindividuals,butaccomplishingthisrequiresed-
ucatedandexperiencedprofessionals.Youknowyouhaveawinnerwhen
youhearafirmperiodicallypullsinallitsservicingprofessionalsforan
internalconferenceatleastannuallytohearaboutthelatestintax,estate,
orregulatoryissues.Fortunately,therearestillfirms,bothlargeandsmall,
thatarecommittedtoprovidingtheirclientswiththistypeofvalue-added
140 Tax-AwarePortfolioManagement
expertise.Thekeypointhereisthatfirmsmayhaveexcellenttax-aware
products,buttheyhavelessvalueunlessqualifiedindividualscaninteract
withthetaxableclients.
8Tax-lossharvestingopportunisticallythroughouttheyear,with
knowledgeofthewashsalerule:Atthislevelintheprogressionoftax-
aware elements, we are getting to the point where active management
canofferatruevalue-addedpropositionaboveandbeyondwhatcanbe
achieved through passive investing.This can be stated because doing it
requiresadherencetoallthepreviouselements.Continuoustax-losshar-
vestingrequiresameaningfulcommitmentbythefirmintermsofsystems
technologyandtrading.Codingofaccountsforvariousfeaturesallowsthis
tobedoneinvolume.However,itrequiresclosecoordinationbetweenthe
investment,servicing,operational,andperhapseventhecompliancefunc-
tionsofthefirm.
Thesemanagersneedtohavesystemsinplacetomonitorwashsales
rulestoensuretheydonotrepurchaseasecuritywithinthirtydaysafterthe
sale.IRSPublication550states:“Youcannotdeductlosseswhenyousellor
tradestockofsecuritiesatalossandwithin30daysbeforethesaleyou:
—Buysubstantiallyidenticalstockorsecurities.
—Acquiresubstantiallyidenticalstockorsecuritiesinafullytax-
abletrade,or
—Acquireacontractoroptiontobuysubstantiallyidenticalstock
orsecurities.”3
Thequestionmosttaxableinvestorshaveis,Whatconstitutesasub-
stantiallyidenticalsecurity?Unfortunately,theInternalRevenueService
hasnotprovidedaprecisedefinitionoftheterm.4Thetax-exemptfixed
incomecommunitywasoneoffirstnichestoapplythistrade,andhere
ishowtheyapproachit.Wewilldemonstrateaswapthatwouldbecon-
sideredanacceptabletradewithintheindustry,usingfictitiousmunicipal
bonds.Atthebeginningof1994,theportfolioholdsaNewYorkSewer
municipalbondwitha6.0percentcoupondueMay15,2014.Thebond
waspurchasedatpar.Asyoumayrecall,therewasageneralincreaseinthe
levelofinterestratesacrosstheyieldcurveofapproximately2percentin
1994.Sincethebondhasadurationofapproximately10years,itfallsin
priceby20percent.Youdecidetosellthesecuritytoharvestthelossand
wishtopurchaseanotherbondwithoutcausingamajordisruptiontothe
characteristicsoftheportfolio.YounoticeanIllinoisGeneralObligation
municipal bond available for purchase with a 5.0 percent coupon due
September15,2013.Inthisexample,thereareseveralitemsthatshowthe
bondsarenotidentical:differentissuer,sectorortypeofcredit,coupon,
andmaturity.Thebondsmayhavesimilarbutnotidenticalexpectedprice
PracticesofEliteTax-AwareEquityActiveManagers 141
movementtochangesininterestrates,soyoudecidetomoveforwardwith
thetrade.Aswediscoveredoverthepastfiveyears,therewillalwaysbea
fewindividualswhowillpushtheenvelopeonaccountingissues—eventhe
washsalerule.Forexample,theywillownamutualfundthatreplicates
theS&P500stockindex,sellitataloss,andpurchaseanETFthatholds
theexactsamestocksaccordingtothesameallocationscheme.Whilethe
twovehiclesmayhavesomewhatdifferentliquiditycharacteristics,they
haveanR-squared(percentageofreturnexplainedbyanotherbenchmark
orsecurity)ofalmostexactly1,or100percent.Inthiscase,youshould
notbesurprisedifsomeoneeventuallyquestionsthetrade.Tobeonsafe
groundwhenconductingatax-lossharvestingtrade,youshouldanalyze
ifthereisameaningfulamountofcapitalatriskwhenyoucomparethe
pastreturnpatternsofthesaleandpurchasecandidates.Ifso,thenyouare
probablysafe.Thethreeconsequencesofawashsaleare:
—Youarenotallowedtoclaimthelossonyoursale.
—Your disallowed loss is added to the basis of the replacement
stock.
—Your holding period for the replacement stock includes the
holdingperiodofthestockyousold.
Managerswholooktoharvesttradesonlyattheendoftheyearare
severelylimitingthenumberofavailabletax-lossharvestingopportunities
theycanexploit.Forinstance,ifaninvestmentmanagerconductsalltax-
lossharvestingtradesattheendofyear,hemayhavemissedopportunities
inthebeginningoftheyear,asin2003whenthemarketdroppedand
thenrebounded.Wheninterviewingfirms,itisparamounttounderstand
howoftentheyreviewaccountsfortax-lossharvesting.Ifitisonlydone
quarterlyorso,theywillbeunabletoextractthetruenaturallyoccurring
additionalvaluecreatedbymarketvolatility.
Notallaccountsneedorcantakeadvantageoftax-lossharvesting.For
example,youmayhaveclientswhoareinanetoperatinglosspositionand
thereforehavetheluxuryofneedingtoharvestgains.Insuchcases,the
tax-lossharvestingenginecanbereversed,andyoudon’thavetoworry
aboutthewashsalerule.Betteryet,whentheclientgetsoutofthenetop-
eratinglossposture,hisportfoliowillhaveacostbasiscloseorequaltothe
marketvalueoftheportfolioandhecaneasilystarttakinglosses.Thisis
justanotherexampleofhowknowledgeoftax-awareinvesting—orinthis
case,“tax-gainharvesting”andthewashsalerule—canbenefittheclient.
9Havinganalystsandportfoliomanagerswhofocusonlyontax-
ableaccountsandincorporatetaximplicationsineachbuyandsell
decision:Wearenowgettingtothepinnacleoftax-awareinvestingfor
equitymanagers.Thesemanagersandtheirfirmsunderstandthattaxable-
142 Tax-AwarePortfolioManagement
accountinvestingshouldserveasadistinctseparatebusinessunitandthey
treatitassuch.Theygotheextradistancetomodeltheimpactofevery
potentialsaleintheirinvestmentdecisions.Incertainsituations,theim-
pactofsellingsecuritieswithlargeunrealizedgainscanbesignificant.As
Figure11.1shows,itmighttakeseveralyearsormoreforthenewsecurity
(thepurchasecandidate)torecapturethecostsofpayingthecapitalgains
tax.Thesemanagersaddressthisissuebyusingoptimizersandperforming
break-even analysis to determine the tax impact of every potential sale.
Usingassumptionsthatareoftencustomizedtothespecificsofeachtax-
able client’s portfolio, the manager considers all tax implications before
makingasale.Whattheprocessentailsis:
—Calculatingthedollaramountofthecapitalgainthatislikelyto
berealized.
—Determining how much of the price per share of the security
considered for purchase must be adjusted upward for the tax
impactofthepotentialsale.
—Recalculatingtheprojectedreturnofthesecuritybeingconsid-
eredforpurchasewiththeupward-adjustedprice.
—Iftheprojectedreturnofthesecuritybeingconsideredforpur-
chasedoesnotclearlyexceedtheprojectedreturnofthesecurity
held,calculatingabreak-evenpointinyears.
Ifthespreadinprojectedreturnisstillclearlyinfavorofthebuycandi-
date,followthroughwiththetrade.Ifnot,thenhumanexperiencecomes
backintoplayandyouhavetoask,“Howmuchconvictiondowehavein
ourprojectedreturns?”Somefirmstaketheprocessabitfurtherwhenthe
projectedreturnofthesecuritybeingconsideredforpurchaseisgreater
thanthatofthesellcandidate:Theycalculateabreak-evenperiodinyears.
Then they compare the break-even period with their historical average
holdingperiod,whichistypicallyderivedfromtheaverageturnoverrate.
Ifthebreak-evenperiodisgreaterthanhalftheaverageholdingperiod,the
tradeiswithdrawn.Forexample,ifthehistoricalturnoverrateofastrat-
egyis25percent,thefirmassumesanaveragehistoricalholdingperiodof
fouryears.Iftheanalystcalculatesabreak-evenperiodofthreeyearsfor
aparticularbuycandidate,thatsecuritywouldmostlikelybeeliminated
from further consideration for the immediate future. Other candidates
areconsidered,orthetradeisputonholduntilthereisamorefavorable
marketenvironmentandthetransactionhassuperioreconomicvalue.
Aportfoliomanagerwhousesthisstrategyandhaspresentedthevalue
of its methodology at public conferences is Joanne Howard of Rosen-
bergCapitalManagement(RCM).5Thesecuritybreak-evenanalysisby
Howardandherassociatesstartsbyanalyzingthetaxcostofsellingthe
PracticesofEliteTax-AwareEquityActiveManagers 143
FIGURE11.2SecurityBreak-EvenAnalysis
CURRENTINVESTMENT NEWINVESTMENT
600,000
500,000 OldInvestment
NewInvestment
Source:JoanneHoward/RosenbergCapitalManagement
400,000
Pretaxreturns($)
300,000
200,000
100,000
0
1 2 3 4 5
Years
Rogers/TaxAwareFig.11.2
144 Tax-AwarePortfolioManagement
returns,asbothofferusefulinformation,dependingontheneedsofthe
client.Moreover,iffirmshavegonetothisextremetopositionthemselves
aselitepractitioners,theyshouldattempttobrandtheirreport.Examples
ofaclientreportbyParametricPortfolioAssociatesandasampleAIMR-
compliantafter-taxcompositereportaregiveninchapter7.
Inyearstocome,furtherelementsmaybeaddedtothelist.Beecher
Investorshasputinplaceoneofthemoreinnovativeinitiatives.Thisis
afirmthattrulyendorsestax-awareinvestingprinciples,somuchsothat
it has instituted fees based on its after-tax results. If a manager cannot
outperformanETFortax-managedfund—whicharereadilyavailableal-
ternatives—onanafter-taxbasis,thenhowcanitjustifychargingafee?
Itcan’t,sowhyshouldn’ttaxableclientsinsistonpayingforresultsbased
onafter-taxresults?Thisisanareayouwilllikelyhearmoreaboutinthe
futureandhopefullywillbecomemorecommonsothatitcanbeaddedto
thelistoftax-awareelementsinthefuture.
There are three additional factors managers need to consider in the
managementofinternationalequityportfolios.Thefirstisthatnotallfor-
eignstocksproducequalifieddividends,andU.S.domiciledaccountsand
funds are subject to dividend withholding taxes. Second, foreign stocks
mustbeheldsixteendaysfortheinvestortoclaimacreditforthewith-
holding taxes.The third factor involves additional taxes from currency
overlaymanagement.Ifpossible,internationalmanagersemployingcur-
rencyhedgingshouldbepositionedintax-exemptentities,sincethepro-
cess is inherently tax-inefficient. Unless the manager can demonstrate a
meaningfulalphathroughamethodicalprocessofcurrencymanagement,
taxableaccountsarebetteroffemphasizingmanagersthatomitthisfacet
ofinternationalorforeignsecuritymanagement.
Anothermethodthatisgainingacceptanceismanagingbytaxablecli-
entobjectivesversustax-exemptconsultantdemands.Inthepast,manag-
ers were criticized if they did not transition accounts quickly to model
portfolios that resulted in minimal return dispersion between accounts.
Now taxable-account managers are taking the time to properly analyze
thereturnpotentialofeachsecuritytheyinheritinconjunctionwiththe
costbasis.Thisisamajorchangefromthemindlessprocessofimmedi-
atelysellingallholdingsthatdonotconformtothenewmodelportfolio,
regardlessoftheircostbasis.Iftheunrealizedcapitalgainsaresubstantial,
tax-awaremanagersmaytakemonthsoryearsbeforeeliminatingtheposi-
tionandwilltrytodosowhentherearelossesavailabletominimizethe
taximpact.Also,evenwhenstartingwithcashportfolios,somemanagers
areonlyfundingaportionoftheirtaxableportfolio,astheydonotwant
to subject new clients to rapid trading when some positions are on the
146 Tax-AwarePortfolioManagement
FIGURE11.3 B efore-FeeandTaxAlphafortheTenYearsEnding
December31,2003
PERCENTILERANKFROM“TOP”
ASSETCLASS 10% 25% 50% N BENCHMARK
Source:PlanSponsorNetwork,SeanWhite
Large-CapGrowth 5.29 4.06 2.32 179 Russell1000Growth
Small-CapValue 5.86 3.76 1.59 31 Russell2000Value
Small-CapGrowth 11.38 9.64 6.93 116 Russell2000Growth
International 6.88 4.11 2.03 227 MSCIEAFE
MunicipalBonds 0.82 0.42 0.17 66 LehmanBrothers
Municipal
cuspassellcandidatesandwillbeeliminatedinthemonthsahead.Each
ofthesepracticesservestheclient’sobjectivesratherthancateringtothe
whims of tax-exempt account consultants. Further insistence by clients
andtheiradvisersofmanagingbyclientobjectivewillultimatelyleadto
enhancedwealthcreation.
Wehavediscussedthechancesthatactivemanagerswilloutperform
passiveportfolios.Toaddressthisissue,weextractalpha-statisticinforma-
tionfromthePSNmanagerdatabase(seeFIGURE11.3).6
First,weneedtodeterminetheappropriatebefore-taxandbefore-fee
hurdle for an equity manager to be competitive. We create the hurdle
by determining what is required to outperform the appropriate bench-
mark,thatis,theQTAmanager’sexpectedreturn.AQTAmanagershould
outperformthebenchmarkonanafter-taxbasisby1.3percentperyear
withnormalmarketvolatilityandunderthecurrentprovisionsofthetax
code.(Theoutperformancewas1.5percentunderthetaxcodepriorto
2003,whentaxratesonordinaryincomeandcapitalgainswerehigher.)
Takingintoaccountthattheaveragemanagernotadheringtotax-aware
methodswilllikelyachieveatax-costratioof1.3percent,orloseanequal
percentagethatthetax-lossharvestingfirmwillgain,resultsinareturn
differential due taxes of 2.6 percent (1.3% + 1.3%).The difference in
fees,anotherformoftax,foractivelymanagedseparateaccountscanvary
significantlybutisusuallyinarangeof0.5to1percent,dependingonthe
PracticesofEliteTax-AwareEquityActiveManagers 147
assetclassandsizeoftheassignment.Usingamid-rangeof0.75percent
anda0.35percentannualfeeforQTAmanagerscreatesafeedifferential
of0.4percent.Addingthefeedifferentialof0.4percenttotheafter-tax
performancedifferentialof2.6percentresultsinahurdleof3.0percent.
Again,thisisthealpha,ortheamountbywhichanequitymanagerneeds
tooutperformasuitablepassivebenchmarkbeforeheshouldbeconsid-
eredaseriouscandidatetoservetaxableaccounts.Readerscanadjustthe
threeinputvariablestoaccommodatetheirownoutlookfortaxefficiency
andfees,butthisapproachmakesthesearchprocessasimplertask,as
it eliminates many firms that simply do not have a process in place to
achievethistypeofresultinthefuture.Asshownforthetenyearsend-
ing December 31, 2003, managers had to be in the top 10 percent of
activecoreandvaluemanagerstooutperformthe3.0percenthurdle,or
bogey.Theinformationsuggeststhatmanagersinless-efficientsmall-cap
andinternationalmarketsdohaveachancetoachieveattractivereturns
onafter-taxbasis,butisthisinformationrepresentativeoftheactualex-
perience investors encountered? Unfortunately, manager databases have
extremesurvivorbias:managersthatgooutofbusinessorstopsubmitting
dataareexcluded.Additionally,marketersrarelysubmitdatatoamanager
databaseunlessthemanager’sinitialperformanceisatleastinthetophalf
ofmanagers.Also,wedon’tknowhowmanyofthemanagersshownare
closedtonewbusiness,whichiscommonwithsmall-capmanagers.With
theexceptionofsmall-capgrowth,noneoftheequityclassesrepresented
demonstrateameaningfulchanceofoutperformingonanafter-taxbasis.
Forthereasonsmentioned,thelikelihoodthatthosemanagerswhodid
outperformthe3.0percenthurdle,willrepeatinthefutureisfarlessthan
theinformationabovesuggests.
By applying the nontraditional tax-aware elements discussed above,
eliteequitymanagerscaninfactachievecompellingafter-taxresults.As
theybecomemorecomfortableandcompetentintheprocessofexecuting
theelements,theydiscoverahighprobabilityofsuccess.Forequityman-
agers,thealternativetoatax-awareportfolioisaconcentratedportfolioof
twentysecuritieswithgreateremphasisonalphageneration.Thosewho
emphasizeconcentratedportfoliosalongwiththetax-awareelementsare
being sought out by the most discriminating taxable-account investors
andadvisers.Whileelitemanagerswhoembracethetax-awareelements
are emerging, they are still in short supply. If taxable investors wish to
ensuretherearelargenumbersofmanagerswhocanservetheirtaxable-
accountneeds,theyhavealignthemselveswithadviserswhocanidentify
managerswithcredibleprocessesandbecomelessdependentonhistorical
recordsofperformance.Furthermore,asTadJeffreysuggests,long-term
investorsmaybebetteroffignoringtheconceptsofbenchmarkingand
148 Tax-AwarePortfolioManagement
trackingerrorandfocusonfactorsmorerelevanttobottom-lineafter-tax
results.7Asimilarissuethatinvestorsmustgrapplewithistheapproach
ofsomemanagerswhomakelargeshiftstocashequivalentswhenthey
believeopportunitiesfromstocksarelessattractive.Theactionbyitself
istax-inefficient,disruptstheoverallassetallocationplan,andshouldbe
avoidedunlessthemanagercanclearlydisplaythatoverlongperiodsof
time he has produced sufficient alpha to justify the process. Hopefully,
theemphasisonprocessandonputtingtaxableclientneedsfirstwillulti-
matelyprovethatcompellingresultscanbeachievedonbothabefore-and
after-taxbasis.
ChapterNotes
1. ParametricPortfolioAssociates,“ParametriconTaxes&Investing”(internal
marketingpresentation),Fall2001,2.
2. Muchofthediscussiononthepracticesofelitepractitionershasbeentaken
directlyorsummarizedfromtheauthor’sarticlewithSeanW.Egan,“Evaluating
andClassifyingTaxableAccountManagers,”JournalofWealthManagement(Fall
2004):49–62.
3. IRSPublication550,InvestmentIncomeandExpenses(2003),http://www.irs
.gov/publications/p550/ch04.html(accessedNovember5,2004).
4. Fairmark PressTax Guide for Investors, http://www.fairmark.com (accessed
November5,2004).
5. NewYorkSocietyofSecurityAnalystsPrivateWealthConference,NewYork,
NewYork,July2001.
6. InformationcompiledbySeanWhiteofCTCConsultingfromthePSN(Plan
SponsorNetwork)database,April2003.
7. RobertH.Jeffrey,“Tax-EfficientInvestingIsEasierSaidThanDone,”Journal
ofWealthManagement(Summer2001):9–15.
CHAPTER12
PracticesofEliteTax-Aware
FixedIncomeActiveManagers
A fool and his money are soon parted. It takes creative tax laws
fortherest.
—BobThaves
(“Frank&Ernest”)
T
hus far, we have focused on equity portfolios. However, all the
tax-awareelementspresentedhaveapplicationswithfixedincome
portfoliosaswell.Sincefixedincomemanagementisquantitative
in nature, it truly lends itself to tax-aware management. With taxable
accounts,after-taxhistoricalresultsforbondsaretypicallyabouthalfor
evenlessofwhattheyareforequities.
“BondManagementforTaxableInvestors,” which R. B. “Guy” Da-
vidsonIIIwrotein1999,stillstandsastheseminalarticlepertainingto
tax-aware fixed income management.1 In the article, Davidson outlines
thevalueoftax-lossharvestingforbondinvestors.Aswithequityportfo-
lios,healsoshowshowtheopportunityfortax-lossharvestingwithbond
portfoliosdissipatesovertime.Whenshort-termlossesoffsetshort-term
gainsandlong-termlossesoffsetlong-termgains,hedemonstrateshow
tax-lossharvestingcanaddatleast0.5percentand0.8percentannually
forperiodsuptotenyearsforten-andtwenty-yearmaturities,respectively
tothevalueoffixedincomeportfolios.Inaddition,headdressestheoften-
ignoredsubjectoftakingprofitswithtaxablebonds.Whenthereisadrop
ininterestrates,asweexperiencedfrom1981to2003,manyhigh-yield
bonds are priced at a significant premium to par value. Depending on
theoutstandinglifeormaturityofthebond,thereisabenefitinselling
149
150 Tax-AwarePortfolioManagement
thepremiumbondwitha10percent-pluscoupon,payingthelong-term
capitalgainstax,andthenreinvestingtheproceedsinanotherhigh-yield
bondwithamuchlowercouponatparvalue.Thisisfavorabletothetax-
ableinvestor,sincethetaxonincomefromthecouponofthebondfor
investorsinthehighesttaxbracketisnowmorethantwicetherateofthe
taxonlong-termcapitalgains.AsDavidsonpointsout,thereisalimitto
thebenefitofthistransaction,astherearefewerproceedstoreinvestafter
taxesarepaid.Whenthestudywasconductedin1999,thisopportunity
peakedwithten-yearmaturities.
Bondinvestingisconsideredtobeagameofinches,ascomparedwith
feetoryardsinstockinvesting.Dependingonthelevelofinterestrates,the
differencebetweenagreatfixedincomemanagerandagoodormediocre
managermayonlybe0.25to0.75percentannually.Additionally,astheav-
eragecouponofbondsoutstandingcontinuestofall,itbecomesmoredif-
ficultforbondmanagerstoachieveattractiveabsolutereturns.Therefore,
inalow-interest-rateenvironment,theenlightenedorelitetax-awarefixed
incomemanagerbecomesevenmorevaluabletohisclients.Thischapter
willaddressthekeycharacteristicsoftax-awarefixedincomemanagers.
TheHierarchyofTax-AwareInvesting
(SupplementalElementsforFixedIncomePortfolios)
1 Knowsthataladderofmaturitiesisnotatax-awaresolution
2 Iswillingtoenhanceafter-taxincomebutnottocausedetrimental
consequences
3 Understandstheimpactofpremiumsanddiscounts
4 Avoidsphantom-incomesituations,ifpossible
5 Purchasesout-of-statemunicipalbondswhentheyoffersuperior
after-taxreturns
6 Purchasestaxablebondswhentheyoffersuperiorafter-taxreturns
7 Takesadvantageofgoodthingshappeningtomunicipalbonds
8 Understandsthatportfolioshavinglongeffectivematuritiesoffer
thegreatestpotential
9 Canmanagebondportfoliossuccessfullyforvarioustypesoftax
ableentities
10 Understandshowtooptimizeportfoliosforthealternativemini-
mumtax
Eachelementwillbeexaminedtoprovideanunderstandinghowthe
elitefixedincomemanagersextractvaluefromthebondmarketsonan
after-taxbasis.
PracticesofEliteTax-AwareFixedIncomeActiveManagers 151
1 Knowsthataladderofmaturitiesisnotatax-awaresolution:
Iftheobjectiveistomaximizeafter-taxtotalreturn,aladderofmunicipal
or tax-exempt bonds represents a willingness to accept mediocrity. Un-
fortunately,toomanyindividualsacceptthembecausetheyareinformed
bondladdersarenotsubjecttopricevolatilityasarefixedincomemutual
funds.Allbondportfoliosaresubjecttopricesensitivityfromchangesin
thegenerallevelofinterestrates!Moreimportant,bondladdersrepresent
amissedopportunitycostfortax-awareinvestorsthatinsomecasescan
exceedasmuchas1percentormoreinreturneachyear.UntiltheSECre-
quiresbrokerstodisclosethefullcostoftradingfixedincomesecurities,as
theydowithequities,bondladderswillunfortunatelycontinuetoflour-
ishasinvestorswillremainunawareofthetruecostsofconstructingand
maintainingthem.Ifyounaivelypurchasemunicipalortax-exemptbonds
and hold them to maturity, you forgo tax-aware opportunities. As with
equities,oneofthebestwaystoaddincrementalvalueisthroughtax-loss
harvesting.Unlikethecasewithequities,doingthiseffectivelywithbonds
requires sizable, liquid positions that can be exchanged at a reasonable
bid/askspread.Moreover,therearenuanceswiththetaxcodethatmake
tax-lossharvestingmorecomplexforbonds,ascomparedwithequities.
Theadvocatesofladderscannotcompeteinthisarenafortwoprimary
reasons.First,unlessamanagertradesaccordingtobest-executionprovi-
sionsandpassesthecompletesavingsontotheircustomers,itisdifficult
toconductthetax-lossharvestingtradewithbondaccounts.Second,as
yougothroughtheadditionalelementsoftax-awarefixedincomeinvest-
ing,youcometotheconclusionthattheexperienceandskillsetnecessary
toachieveoptimalfixedincomeresultsrestswithalimitednumberofelite
managers.
This discussion is oriented toward investors with sufficient assets to
fundalargeseparateaccountandthoseprofessionalsthatmanagethem.
However, most individuals think of a fixed income mutual fund as an
alternativetoabondladder.Itisdifficulttojustifyfixedincomemutual
funds when the average intermediate national municipal bond category
hasatwelve-monthSECyieldof3.4percentandtheaverageexpenseratio
is1.03percent,accordingtoMorningstar.2Thismeansthefeesconsume
almostaquarteroftheyield!Thisdifficultyismagnifiedevenmorewith
moneymarketfunds,someofwhichhavehadtowaivetheirfeestoavoid
havingnoyield.Feesmatterwithfixedincomefundsandoverthelong
haulareamajorcontributortosuccessorlackthereof.Feesaloneshould
eliminatethemajorityoffixedincomemutualfundsfromconsideration.
For example, cost-competitive funds have expense ratios of 0.2 percent
orless,whereastheaveragefundhasafeeslightlygreaterthan1percent.
Thisdifferenceof0.8percentaloneiswhatdifferentiatesafixedincome
152 Tax-AwarePortfolioManagement
managerwhoismedianperformerfromoneinthetopquintile.Ifyouare
withafundgroupwithmultiplefundofferings,youcanconductthetax-
lossharvestingwithaphonecall,whichisasignificantadvantageoverthe
ladder.Ifyoutakeadvantageofthisopportunity,itcanmorethancover
theexpenseratio.
2 Iswillingtoenhanceafter-taxincomebutnottocausedetri-
mental consequences:Taxable-bond management is different than the
total-return-focused environment of tax-exempt account management.
Withtaxableaccounts,itisnecessarytobalanceboththeabilitytogener-
atemeaningfulincomeonanafter-taxbasisandpriceappreciation.Estab-
lishedfixedincomefirms,likeStandishMellon,devotesignificantresourc-
estodeterminedailyhowtheycanachievethehighestafter-taxreturns
fortheircustomerswithoutsubjectingthemtorisksthatmayjeopardize
principal. These firms employ state-of-the-art systems and experienced
professionalswiththeexpertiseandexperiencetoconstructportfoliosthat
generatemoreincomethanamarketproxyandthentodelivermorepro-
tection or appreciation, depending on their outlook for changes in the
outlookforinterestrates,shapeoftheyieldcurve,andrelativevalueof
varioussectorstheydeemmostcompelling.Theirobjectiveistodeliver
consistent,above-benchmarkresultswithouttakingonunnecessaryrisk.
Theyshouldbeexpectedtoaddvalue,butthereisalimitastowhatcan
beaccomplishedwithinthisframework.Fishermenhaveasayingthatyou
can’tcatchaten-poundbassifthepondisonlycapableproducingabass
thatweighsfivepounds.Thisissotruewithfixedincomeportfolios,as
theamountofupsideislimited,andinvestorsalltoooftenhaveanunre-
alisticexpectation.Whenbondyieldsarelow,youcan’texpectmanagers
toadd1percentinperformanceunlesstheyaretakingonadditionalrisk.
Foramanagerwhoiscontrollingrisk,asinthecaseofStandishMellon,
themostinvestorsshouldexpecttoreceiveinincrementalreturnisap-
proximately10percentofthecurrentyieldtomaturityofthebenchmark
portfolio.Therefore,ifmunicipalbondsyield4percent,anactiveman-
agershouldbeabletoproduceareturnof4.4percentbeforefees.There
aretoomanyexamplesofhowinvestorshavelostnot1or2percentbut
25percentormoreoftheirinvestmentorprincipalfrombondmanagers’
reachingfortoomuchyield.Ifadditionalincomeisbeingachievedbe-
yondwhatisachievedbyamethodologythatStandishandothersemploy,
youhavetoask,“WhatistheadditionalriskIamtaking,andamIbeing
compensatedforit?”
Additionalincomeoryieldcanbeachievedthroughemphasizingcer-
taintypesofsecuritiesorbyemployingleverage.Atthesecuritylevel,the
marketoffersadditionalincomeforabondthatiscallableorisoflesser
creditquality.Callriskarisesfromnotparticipatinginmarketapprecia-
PracticesofEliteTax-AwareFixedIncomeActiveManagers 153
FIGURE12.1 A fter-TaxReturnsofHigh-Yieldvs.Municipal
BondFundsCategoryAveragesfromMorningstar
Principia(ForPeriodsEnding6-30-2003)
ONDISTRIBUTIONS
ONDISTRIBUTIONS ANDSALEOFSHARES
MORNINGSTARCATEGORY 5YEARS 10YEARS 5YEARS 10YEARS 15YEARS
tion opportunities when interest rates fall or bonds are taken from you
bytheissuerwhenyouhavepurchasedthematapricegreaterthanpar.
Creditriskreferstotheissuer’sabilitytopayinterestandrepayprincipal
asscheduled.Whatmanyinvestorsfailtorealizeisthathighyielddoes
notnecessarilyresultinhighafter-taxreturns.Forthepasttwodecades,
taxable high-yield corporate bonds have been issued with coupons near
10percent,buttheaverageannualreturnaftertaxesondistributionsand
saleoffundsharesforhigh-yieldbondfundshasbeenapaltry2.08per-
centand3.48percentfortenandfifteenyears(see FIGURE12.1).Thisis
evenafterfavorabledouble-digitreturnsin2003.
Asthefigureshows,municipalbondshavehadvastlysuperiorresults,
ascomparedwithhigh-yieldcorporatebondsonanafter-taxbasisforthe
simplereasonthatyouhavetoconsiderdefaultsaswellasincomeoryield.
Onewaytomitigateriskisthroughdiversification.However,amajordif-
ferencebetweentheequityandbondmarketsisthatdiversificationtypi-
callybenefitsstockportfolios,butitcanbedetrimentaltohigh-yieldbond
portfoliosbecausecertainsectorsarenotoriousfortheirhistoryofpersis-
tent high default rates. High-yield managers who have been successful
mostlikelyrunconcentratedportfoliostoavoidweaksectors.Moreover,
equitiestradeonformalexchangesandforthemostpartareliquid.U.S.
Treasuriesareliquid,buthistoryhasshownthatyield-orientedbondsec-
torsgothroughperiodsofilliquiditythatcanlastaquarterormore.
Manyclosed-endfixedincomemutualbondfundsemployone-third
orsoinleveragetoboosttheirincomegeneration.Leveragingcanalsobe
combinedwithpurchasinglonger-termmunicipalbondinstrumentsand
154 Tax-AwarePortfolioManagement
shorting short-term taxable bond instruments. It is not uncommon for
someofthesebetstobemagnifiedeighttotentimesbyhedgefundsusing
leveragetoachievetax-exemptincomethatmayexceedayieldof10per-
centannually.Thismayallbefineforashortperiod,butthemanagermay
notbeabletosustainthestrategythroughaperiodofilliquidity,which
canhappeneveryfiveyearsorsointhefixedincomemarkets.
When reporting yields to taxable investors, you should refrain from
quotingthemonagrossyieldbasis.
grossyield=tax-exemptbondyieldtomaturity/(1–taxrate)
netyield=taxablebondyieldtomaturity×(1–taxrate)
Todemonstratethecalculation,let’sassumewehaveatax-exemptor
municipalbondwithayieldtomaturityof4.0percentandtheinvestoris
subjecttothemaximumfederaltaxrateonordinaryincomeof35percent.
Inthiscase,thebondhasagrossyieldof6.15percent(4%/[1–35%]).
Ifataxablebondhasayieldtomaturityof6.0percent,itwouldhavea
netyieldof3.9percent(6%×[1–35%]).Unfortunately,thepracticeof
quotingagrossyieldinmutualfundadvertisinggivesafalseimpression.If
youcompoundgrossyieldsandthenreducetheamountbyanappropriate
percentageoftax,youobtainagreateranswerthanifyoucompoundthe
after-taxyields.FirmsconformingtotheAIMRafter-taxreportingstan-
dardsmustreportportfoliocharacteristicsonanetratherthangrosstax
basis.Thestatement“Youcan’teatgrossyields”isoftenusedtohighlight
thisissueandcertainlystrikesachordwithtax-awareinvestors.
3 Understands the impact of premiums and discounts:Whena
bondisfirstissueditprobablyofferstheleastvaluetoinvestors,asthere
is great demand for bonds priced at par value. Retail investors like par
bondsbecausetheirmechanicsaresimpletounderstand.Tax-awarebond
managersmostoftengotothesecondarymarkettohuntforvalue,but
thismeansthebondmostlikelyisatapriceotherthanpar.Mostoften,
tax-awaremunicipalbondmanagerspurchasebondsatapremiumtopar,
because of a relatively obscure provision of the tax code known as the
deminimisrule.Priorto1993,whenyoupurchasedabondatadiscount
andhelditmorethanayear,theaccretionoftheprincipalwastaxedat
therateforlong-termcapitalgains.Sincethen,ifyouexceedthedemi-
nimisamount,theaccretionistaxedatthemuchhigherrateforordinary
income.Iftheamountisdeminimis,whichisdefinedasthemarketdis-
countbeinglessthan0.25percentofthefacevalueofthebondmultiplied
bythecompletenumberofyearstomaturity,thenthelong-termcapital
gainratestillapplies.Forexample,ifyoupurchaseabondwitharemain-
inglifeoftenyearstomaturityat98,thediscountisconsideredtobede
PracticesofEliteTax-AwareFixedIncomeActiveManagers 155
minimis.However,ifyoupurchasedthebondatapriceof97.5orbelow,
theaccretionissubjecttotheordinaryincomerate.Thisfeatureisespe-
ciallyimportantwheninvestorsanticipateconductingatax-lossharvesting
tradewhenbondpricespeakoryieldstrough,astheydidinthesummer
of2003.Followingperiodslikethis,youwanttoholdaportfolioofbonds
purchasedatapremiumratherthanatparvalueoratadiscount,because
whenratesgraduallyincrease,themarketpricesinanadditionaldiscount
whenthebondstrendtowardthelevelatwhichdeminimistaxprovisions
takehold.Thiscausesdeeper-discountbondstoacceleratedownwardin
price.Moreover,itbringsintoquestiontheviabilityofthetax-lossharvest-
ingtrade,becauseyouaremostlikelytakingalossatthelong-termcapital
gainsrateandyoudonotwanttopurchaseareplacementbondthatwill
haveaccretionsubjecttotheordinaryincometaxrate.Doesthismeanyou
shouldtotallyignorediscountbonds?Notnecessarily,astherehavebeen
timeswhendeep-discountbondsbecamesooversoldthatastutetax-aware
investors could extract compelling returns from them even after paying
theoneroustaxontheannualaccretionamount.
Ifatax-exemptbondispricedatapremium,noamortizationisal-
lowed.However,thereductioninbasismustbeaccountedforwhenthe
bondissold.Thisfeatureneedstobecarefullyconsideredwhenanalyzing
abondonanafter-taxtotalreturnbasis.Fortaxablebondspurchasedata
premium,theinvestorcanelecttoamortizethebonduntilmaturityornot
amortizeandincludeitaspartofthecostbasis.Thishasoftencausedcon-
fusionfortaxableinvestorswhopurchasecertainGovernmentNational
MortgageAssociation(GNMA)mutualbondfunds.Ifthefundelected
nottoamortizehigh-couponbondspurchasedatapremium,itpaidout
ahighlevelofincomeovertimeandthepriceofthefundgraduallyfell
toadjustforthetreatmentofthepremium.Inthiscase,thereisnofree
lunch!Thisarrangementmakeslittlesenseforaninvestorinahightax
bracket,asheendsuppayingtaxonthehighlevelofincomethatisnot
offsetbytheamortizedamountattheordinaryincomerate,andthenif
heholdsthefundmorethanayearandsellsit(mostlikelyataloss),he
onlygetsacreditatthelong-termcapitalgainsrate.Thisresultwasquite
prevalentwithfundsinthe1980s,whenbondscouldstillbepurchased
inthemarketplacewith10percentpluscoupons.Thekeytothiselement
isthatbondmanagersneedtobeawareofhowinvestorsevaluatebonds
fortaxnuancesandbeabletotakeadvantageofpricingdiscrepanciesand
dislocationinthemarketwhentheycanaddvaluefortheirclients.
4 Avoidsphantom-income situations,ifpossible:Oneitemthat
perplexesindividualsisthepaymentoftaxonphantomincomecreatedby
strippedTreasuryzero-couponbonds.Thesebondscanbeidealforfund-
ingspecificcashflowrequirements,asthezero-couponstructureavoids
156 Tax-AwarePortfolioManagement
reinvestment risk. In this case, the total rate of return of the bond will
equal the yield to maturity, because semiannual coupon income is not
reinvestedatdifferentyieldandpricelevels.Unfortunately,eventhough
thezero-couponTreasurydoesnotdistributeincome,investorsmustpay
taxontheamountofannualaccretion,orphantomincome.Thisproblem
alsooccurswithTreasuryinflation-protectionsecurities(TIPS).Theseare
Treasurybondsthatareissuedalower-than-marketcouponandtheirprin-
cipalamountisincreasedmonthlybythepercentageincreaseintherate
ofinflation,asmeasuredbytheconsumerpriceindex.Therearetwoways
thiscanbeovercome.First,ChristineToddofStandishMellonnotesthat
the phantom-income tax does not apply to the zero-coupon municipal
bondsintheirportfolios.Second,Barclayshas developed an innovative
solutionwiththeirTIPSiShareexchange-tradedfundofdistributingthe
amountofprincipaleachmonthratherthanaccretingit.Nowindividual
investorsdesiringtoinvestinTIPshaveasufficientflowoffundstocover
taxpayments.Therearenowmunicipalinflation-protectedsecurities,or
MIPS.Inthese,theprincipalamountisfixed,butthesemiannualcoupon
isadjustedforinflation.Atthisjuncture,bondmanagershavesomecon-
cernswiththeseissuesbecausethereislimitedvolumeavailableandthe
semiannualcouponpaymentsystemmissessomeoftheseasonalinflation
patternsthatareprevalentwithTIPS.3
5 Purchases out-of-state municipal bonds when they offer su-
periorafter-taxreturns.Tax-awaremunicipalbondmanagersthinkof
maximumafter-taxversuspayingnotaxandarenotwedtopurchasing
bondssolelyfromtheclient’sstateofresidence.Thereissomuchdemand
forthebondsofhigh-taxstateslikeCalifornia,Massachusetts,Minnesota,
andNewYorkthatlocalinvestorsoftenpayapremiumforthem.When
themarketgetsfrothy,theastuteinvestorwilllooktootherstates,where
demandislower.Thiswillusuallytakethemanagertolow-taxstatesor
oneofthesixstateswherelocalinvestorsmuststillpaytaxesonmunicipal
bondincomefrombondsissuedfromtheirstateofresidence.Tomake
mattersmorecomplex,therearestateslikeWisconsinwhereonlyapor-
tion of municipal bonds are exempt from both federal and state taxes.
Withcomplexityoftencomesopportunity.Therefore,managerscanof-
tenpurchasemunicipalbondsatlevelscheapenoughthattheystilloffer
compellingvalueafterpaymentofastatetaxontheirincome.Notonly
doesthispracticeservetoachievehigherafter-taxreturns,italsoleadsto
amorediversifiedportfoliowithlesssensitivitytostate-specificeconomic
orpoliticalrisk.WhiletheeconomicoutputofNewYorkorCaliforniais
largerthanthatofmanycountries,theybothhavehadtheirfairshareof
budgetaryconcernsoverthepasttwodecades,whichhaveputseverepric-
ingpressureontheirbonds.
PracticesofEliteTax-AwareFixedIncomeActiveManagers 157
FIGURE12.2 After-TaxYieldComparison
Before-TaxYieldtoMaturity
TAX-EXEMPT U.S. GOVERNMENT A-RATED
MUNICIPAL TREASURY AGENCY CORPORATE
After-TaxYieldtoMaturity
FEDERAL TAX-EXEMPT U.S. GOVERNMENT A-RATED
TAXRATE MUNICIPAL TREASURY AGENCY CORPORATE
FederalHomeLoanBank,andSallieMaearealsoexemptfromstatetax.
SincetheseagencyissuesofferapickupinyieldoverU.S.Treasuriesand
areveryliquid,theyareoftenemphasizedbymanagerswhoincorporate
the“crossover”trade(crossingoverfromtax-exempttotaxablebondsand
back again to achieve the highest potential after-tax returns) as part of
theoverallstrategytoenhanceafter-taxreturns.Onthesurface,thetrade
appearstobequitesimple.Youjustselectthebondofferingthehighest
potentialafter-taxreturn.Toillustratetheopportunityforvalue,FIGURE
12.2showsbefore-andafter-taxyieldsforatax-exemptmunicipal,U.S.
Treasury,governmentagency,andcorporatebondatthedifferentbreak
pointsinthefederalmarginaltaxrates.
In reality, bond prices and yields change daily, and firms that apply
thecrossovertradeinasophisticatedmannerincorporatestatetaxratesas
well.Toachieveafter-taxtotalreturnsforcomparativepurposes,thefirm
mayincorporateaninterestrateforecastortakeintoaccountinformation
derived from the shape of the theoretical spot rate curve to determine
the impact of price movement over a defined time horizon.Tax-aware
municipalbondmanagersincorporatethisinformationalongwithother
informationbeforemakingbuyandselldecisions.Onefirmthatempha-
sizesthistypeofstrategytoachieveitsvalue-addedpropositionisM.D.
Sass.Throughelectronicapplicationsitcanmonitorthecurrentafter-tax
potentialofeverybondinitsinventory.Itreceivesbidsonitsholdings
frommorethan200professionalsacrossthecountryhavingaccesstoits
inventory.This is especially advantageous for its performance; as men-
tioned earlier, the retail side of the business will often pay a premium
forin-statebonds.Youmayask,“Dotax-exemptinvestorseverpurchase
municipalbonds?”Astutetax-exemptbondmanagersdo,especiallywhen
theyieldsapproach100percentofTreasuryyields.Thesemanagersrealize
thattaxableinvestorswillcomebackintothemarketwhentheyrealize
howcheapmunicipalbondsare,withpricemovementsuperiortothatof
equalmaturityTreasuries.
7 Takesadvantageofgoodthingshappeningtomunicipalbonds:
AnotherelementthatpeoplemissthatMichaelBrilleyofSitInvestment
Associatesshareswithhisclientsandprospectsis“Goodthingshappento
municipalbonds!”Unliketaxablebonds,withwhichthebestthingthat
canhappenisperhapsacreditupgrade,municipalbondscanbepre-re-
fundedorescrowedtomaturity.Whenratesfall,theissuermayestablish
anescrowaccountandfundtheremainingcashflowsfromtheproceeds
ofU.S.governmentbonds.Whenthisoccurs,thebondsareupgradedto
AAA,causinganimmediateimprovementinprice.Also,thebondsmay
becomesubjecttoapremiumparcall,wherethebondswillbetakenout
atlevels two tothreepointsabove par. Corporate sinking-fund bonds,
PracticesofEliteTax-AwareFixedIncomeActiveManagers 159
whicharebecomingincreasinglyrare,aretheonlytaxableissuesthatex-
hibitsimilarfavorablefeatures.Anastutemoneymanagerwantstofocus
on bonds that are likely to have these favorable actions happen rather
than purchasing those bonds where the favorable actions have already
occurred.
8 Understands that portfolios having long effective maturities
offer the greatest potential: Most bond professionals think of achiev-
ing compelling returns as the ability to produce superior risk-adjusted
returns.Thatisfineifyoulimityourselftotheconfinesofatradingdesk.
Whatisignoredtoalargeextentwithtaxablebondportfoliosistheneed
tomatchthehorizonofclientassetswiththeirliabilities,whichismore
ofaretirement-planconcept.Foranindividualstartingacareer,thereis
aneedforasafetynetandarisk-adjustedreturnorientationmakessense.
However,ifahigh-net-worthfamilyhasarespectableestateplan,itcan
beconsideredtobeaperpetualorganization.Therefore,portfolioshaving
alongermaturityordurationmakesense,especiallyifyoucantakead-
vantageofthetax-lossharvestingtradewithmoreliquidsecurities.This
does not mean you should immediately plunge into longer maturities
wheninterestratesarenearhistoricallows.However,overtime,asop-
portunitiespresentthemselves,high-net-worthfamiliesespeciallywould
befinanciallybetteroffextendingtheaveragelifeoftheirtaxablebond
portfolios.Thisisespeciallytruewithmunicipalbonds,astheyareless
susceptibletoFederalReserveactivity.UnlikeTreasuries,whereshorter-
maturity issues offer greater yields than longer-term bonds, municipal
bonds do not experience yield-curve inversions. The municipal bond
yieldcurvemaintainsitshumpedshapewithapeakinyieldtypicallyin
thefifteen-totwenty-five-yearmaturityrange.Therefore,investorscan
takeadvantageofthehigher,persistentleveloftax-exemptincomefrom
thisportionoftheyieldcurveandgainsomeappreciationinpricewhen
theirindividualbonds“rolldowntheyieldcurve”withtime.
9 Can manage bond portfolios successfully for various types of
taxableentities:Thepropertyandcasualtyinsuranceindustrypresents
adifferentsetofchallengesforthetaxable-accountbondmanager.There
arethreedistinguishingfactors.First,municipalbondincomeissubject
toa15percenthaircut—meaningitistaxedatarateof5.25percent
(35%×15%).Second,thepropertyandcasualtyinsuranceindustryis
subjecttostatutoryreportingrequirements.Untilamanagercandem-
onstrate competence with this additional layer of complexity, compa-
nies and their advisers are usually unwilling to take them on. Third,
the insurance company may, from time to time, tap the portfolio for
profitswhentheyareavailable.Therefore,whenamanagertakesagain,
hemayinfactbeworkinginthebestinterestsofthecorporation.This
160 Tax-AwarePortfolioManagement
thoughtprocesscanbequitedifferentthantheprocesswhereamanager
maywishtotakelossesanddelaytakinggainsforhigh-net-worthfam-
ilyportfolios.Also,theprovisionsofvarioustaxcodesthatapplytothe
different types of taxable account entities generally have a far greater
impact on the day-to-day management of fixed income portfolios, as
compared with equity portfolios. While everyone should know about
the tax ramifications of trading a particular client portfolio, the fixed
incomeprofessionalnavigatingthesevarioustypesofmarketssuccess-
fullysoonfindshimselfalmostataxexpertoneach.Perhapsthatiswhy
bondmanagerswhostartedtheircareersoriginallyasaccountantsfind
thisnichesorewarding.
10UnderstandshowtooptimizeportfoliosfortheAMT:Thebond
managerneedstoexercisecautionwithcrossovertradingwhentheclient
issubjecttotheAMT.4TheAMTisoftenreferredtoevenbyaccountants
as“theonetaxaccountantsdonotunderstand.”Anaccountanttypically
thinks of minimizing the tax bite of a client, not necessarily being tax-
awarewhenitcomestoinvestments.Thisisagainacaseofoptimizing
theamountofdollarsofnetorafter-taxincome,ascomparedwithpay-
ingtheleastamountoftaxes.Itisessentialthatthetaxable-accountfixed
incomemanagermastersanunderstandingoftheAMT,asoftentimeshe
willbetheonewhoinitiatesandcarriestheconversationasapartofor
whenworkingwiththemembersofthequalifiedtriumvirateoftax-aware
serviceproviders(seechapter5).TheAMTcameaboutin1986andisa
formoftheflattaxthatSteveForbessupportedinhiscampaignforthe
presidency.FIGURE12.3liststheitemsthatmostoftencauseanindividual
tobesubjecttotheAMT.5
Line42ofForm1040requirestaxpayerstocalculatetheirAMTac-
cording to Form 6251. AMT income, or AMTI as it is referred to, is
calculated by starting with adjusted gross income and adding back cer-
tain preference items. For married couples having more than $175,000
FIGURE12.3 ItemsCausingtheAlternativeMinimumTax
Exemptions InterestonSecondMortgages
StateandLocalTaxes MiscellaneousItemizedDeductions
Source:FairmarkPress
MedicalExpenses IncentiveStockOptions
Long-TermCapitalGains TaxShelters
PracticesofEliteTax-AwareFixedIncomeActiveManagers 161
in AMTI, multiply by 28 percent and then subtract $3,500 to achieve
theAMTtax.Forcoupleshavinglessthan$175,000inAMTI,simply
multiplyby26percent.IftheAMTisgreaterthantheregulartaxdollar
amount,theAMTapplies.Moreandmoreindividualsarefindingthem-
selvespayingtheAMT,especiallysincethemaximumfederaltaxratehas
beenloweredfrom39.6percentto35.0percent.
Theincomefromasubsetoftax-exemptormunicipalbondsknownas
privateactivitybondsissubjecttotheAMT.Amunicipalsecurityisclassi-
fiedasaprivateactivitybondifmorethan10percentoftheprivatebusi-
nessactivityoftheissueorloanstonongovernmentalborrowersexceeds
5percentoftheproceeds.AsFIGURE12.4,providedbyStandishMellon,
shows,privateactivitybondsoffergreateryieldsthansimilar-maturitytax-
exemptbonds.
The yield differential in this chart is shown in basis points. A basis
pointis1/100thof1percent.Thetrendsince2002makessense.Since
more investors are becoming subject to the AMT, there is less demand
forprivateactivitymunicipalbonds.ForclientsnotsubjecttotheAMT,
privateactivitybondsprovideasmallboostintax-exemptincomegen-
eration and should be considered. A municipal bond manager can be
tax-efficientbyavoidingprivateactivitybondsforclientssubjecttothe
AMT. However, this simplistic approach typically does not provide an
optimaltax-awaresolution.
FIGURE12.4 H istoricalYieldDifferentialBetweenTen-Year-
MaturityInsuredandAMTMunicipalBonds
40
32
BasisPoints
24
16
8
Source:StandishMellon
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Rogers/TaxAwareFig.12.4
162 Tax-AwarePortfolioManagement
FIGURE12.5 C alculatingtheRegularandAlternative
MinimumTax(MarriedCoupleWithAMTI
GreaterThan$175,000)
REGULARTAX ALTERNATIVEMINIMUMTAX
OtherIncome $1,000,000
AdustedGrossIncome $1,000,000
OtherItemizedDeductions $400,000
TaxableIncome $600,000 $600,000
PreferenceItems $300,000
AMTIncome(AMTI) $900,000
Source:ThomasLawrence,DouglasS.Rogers
TaxRate 35% AMTTaxRate 28%
Tax $210,000 AMTTax $248,500
(AMTIx28%)–$3,500
AnoptimalapproachforclientssubjecttotheAMTrequiresmodel-
ingtheallocationtotax-exemptversustaxablebonds.Adjustmentofthe
allocationbetweenthetwotypesofbondscanmeaningfullyincreasethe
client’s net after-tax income, which is the tax-aware approach.To start
theprocess,weselectyieldsonrepresentativehigh-gradetax-exemptand
government agency bonds that have effective maturities similar to the
portfolio’s.Forthisexample,thebondportfoliois$30millionandthe
yieldonanappropriatemunicipalbondis3percent,whereasthetaxable
bondisofferingayield4.5percent.Nextweconstructaspreadsheetthat
includestheitemsnecessarytoestimatetaxesandnetincomeforthein-
vestoratboththeregulartaxrateof35percentandtheAMTrateof28
percent,asshowninFIGURE12.5.
Inthefigure,westartwiththeamountoftaxablesecurityincomefrom
thebondportfolioandaddtoitotherincometocalculatetheadjusted
grossincome.Intheexample,thereis$0oftaxablesecurityincome,be-
causetheportfoliohasa100percentallocationtomunicipalbonds.We
adjustthisamountfortheallocationtotaxablebonds(seeFIGURE12.6).
PracticesofEliteTax-AwareFixedIncomeActiveManagers 163
FIGURE12.6 A djustingtheMixofTax-Exemptvs.TaxableBonds
toOptimizeNetIncome
Thenwesubtractitemizeddeductionstocalculatetheamountoftaxable
income.Tocomputetheregulartaxdue,wesimplymultiplybytheclient’s
taxrate,inthiscase35percent.Last,wesubtractthetaxfromthetaxable
andtax-exemptincometocalculatethenetorafter-taxincome.
FortheAMTcalculation,webeginwiththetaxableincome,addback
thepreferenceitems,andthenmultiplybytheAMTrate.Sincethisclient
ismarriedandsubjecttothe28percentrate,wesubtractanother$3,500
to achieve the dollar amount of the potential AMT.The greater of the
regulartaxorAMTamountapplies.Inthisexample,theAMTamount
of$248,500isgreater,sotheindividualwouldhavetopaynoadditional
taxwitha100percenttax-exemptbondportfolioandwouldfeelquite
content.Moreoftenthannot,hisadviserswouldsay,“Itisunfortunate
thatyouhavetopaytheAMT,butaslongasyoudon’tholdprivateac-
tivitybonds,youhavedonetherightthingbecauseyouminimizedyour
taxliability.”Iftheinvestortakesthistax-efficientadvice,hemissesthe
opportunitytoenhancehisnettaxableincomebyapproximately$30,000
annually.Thiscanbeaccomplishedbyholdingaportfolioofslightlyless
164 Tax-AwarePortfolioManagement
than60percentintax-exemptbondsandtheremainderintaxablebonds.
Wecometothisconclusionthroughaniterativeprocessbyadjustingthe
mixofbondsin10percentincrementsandrecalculatingthetaxandnet
income,asshowninFigure12.6.Theshadedareainthelastcolumnhigh-
lightshowgraduallyaddingtaxablebondstothemixincreasesafter-tax
netincome.Whiletheinvestor’staxishigher,soishisnetincome.
Holdinganymorethanapproximately40percentintaxablebonds
pushes the client out of the AMT and provides no benefit. When the
clientholdslessthan60percentintax-exemptbonds,thereeventually
comesapointwheretheAMTnolongerapplies,hepaysanincreasingly
higheramountoftaxes,andhisnettaxableincomecontinuestodrop,as
highlightedinthefourthcolumn.Therefore,itisextremelynaivefora
managertosay,“Taxablebondsareabargainrelativetomunicipals,so
let’smovethewholeportfoliointhatdirection.”AsFigure12.6shows,
the municipal bond manager that works in a trading-room vacuum
withouttakingtheclient’suniquetaxprofileintoaccountshouldbeap-
proachedwithahighdegreeofcaution.Thistypeofmodelingdoesnot
requireasophisticatedapproachbut,unfortunately,isalltoorare.Each
taxableclientisdifferent,andthepractitionerdoingthistypeofanalysis
shouldconsiderexpandingtheentriesunderadjustedgrossitems,item-
izeddeductions,andpreferenceitemstogainabetterunderstandingof
theinteractionbetweenthekeyvariables.Thisexerciseshouldfacilitate
ahealthydialogueandmaycausetheclient’saccountanttosuggestaddi-
tionalrecommendationspertainingtoincomegenerationandpreference
itemsthatcanbeextremelyvaluableinthewealthcreationprocess.
Couplingmunicipalbondswithothersecuritiescanproduceinterest-
ing tax-advantaged products. For years, firms like PIMCO and Metro-
politanWesthavecombinedshort-durationbondtradingwithfuturesto
createbenchmark-plus-equityreturns.Thesametypeofstructurecanbe
done with municipal bonds in lieu of taxable short-duration bonds. As
uniquecombinationssuchasthesebecomemoreprevalent,wearelikely
touncoveradditionalelementsoftaxablefixedincomeinvestingthatwill
continue to allow competent tax-aware bond managers to outperform
ladderedportfolios,afterfees,byameaningfulmargin.Besides,theone
serviceaninvestorshouldpayafeeforiscreditanalysisaimedatavoiding
potentialdefaultsituations.
Wehaveshownthatactivefixedincomeportfoliomanagementmakes
sensefortaxableaccountswhentax-awareelementsareemployed,butat
whatassetsize?Toanswerthis,wemustasktwoquestions.First,whatis
theminimumnumberofbondsnecessarytoachieveadiversifiedportfo-
lio?Mostpractitionerswouldanswertwenty,astheydonotwanttohave
anymorethana5percentexposuretoanyonecredit-sensitiveissuer.The
PracticesofEliteTax-AwareFixedIncomeActiveManagers 165
numbercouldbesmallerifsomeofthesecuritiesarefull-faith-and-credit
obligationsoftheU.S.government.Second,whatisthesmallestsizeof
bondtradethatcanbeconductedwithareasonableamountofliquidity?
The answer varies according to the sector, but $250,000 is the mini-
mumdollarpositiontoefficientlyconductthetax-lossharvestingtrade.
Therefore,investorsshouldshyawayfromactivelymanagedportfoliosof
lessthan$5million(20securities×$250,000persecurity)insize.For
amountsunderthisthreshold,fixedincomemutualfundsserveavalu-
ablepurpose.Besides,withamutualfundyoucanconductthetax-loss
harvestingtradewithasimplephonecallortwo.
For taxable-bond managers, establishing the hurdle is a different
process and the spread is narrower. Fees are similar for bond managers
whetherornottheyconducttax-lossharvesting.Inanycase,youshould
realizethetax-lossharvestingtradealoneallowstheinvestortoobtainthe
manager’sexpertiseforlessthancost,butthisisonlytrueforintermedi-
ate-andlong-maturityportfolios.Ifthemanagerdoesnotofferanyofthe
tax-awareelements,heneedstohaveanalphaof+0.5percentannuallyto
becompetitive.AsFigure11.3highlights,thisperformanceisinthetop
25percent.Aswithequities,fixedincomemanagerswhodonotapplythe
tax-awareelementsareatameaningfuldisadvantagetothosethatdo.
ChapterNotes
1. R.B.DavidsonIII,“BondManagementforTaxableInvestors,”AIMRConfer-
enceProceedings,InvestmentCounselingforPrivateClients,no.2(1999):59–68.
2. MorningstarPrincipia,June30,2004.
3. ChristineToddofStandishMellon,indiscussionwiththeauthor,November
10,2004.
4. The author is extremely grateful for the input received from family office
executiveThomasLawrenceforhiscommentspertainingtothealternativemini-
mumtax.
5. “TopTenThingsThatCauseAMTLiability,”FairmarkPressTaxGuidefor
Investors,http://www.fairmark.com/amt/topten.htm,accessedJuly30,2004.
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CHAPTER13
TheHedgeFundDilemma
Thosethatcandoagoodtradedon’twrangleovertaxes.
—OldChineseProverb
T
here is no other place in the market today where the Chinese
proverb above is more applicable than in the rapidly growing
hedgefundarena,whereassetswillsoonexceed$1trillion.Inves-
torsinvestinhedgefundsfortwoprimaryreasons:tolowertheriskof
theirexistingholdingsortoseeksuperiorresultsfromothersourcesof
return.Fortaxableinvestors,especiallyhigh-net-worthindividuals,these
arecertainlyworthwhileobjectivestopursue,butiftheresultsaren’tthere
aftertaxesarepaid,evenso-calledgoodtradesarenotworththeeffort.
Bytheirverynature,mosthedgefundswillbenotoriouslytax-inef-
ficient.Doesthismeanthatinvestorsshouldignorethem?Absolutelynot,
butiftaxableinvestorswishtopursuehedgefunds,theyshouldhavean
appreciationofthetax-awareopportunitiesthatareavailable.Thereisno
singlesolutionthatissuitableforallsituations.Therefore,itisparamount
that taxable investors and their advisers align themselves with qualified
individualswhospecializeinunderstandingandsharinghowtonegoti-
atetheserelativelyunchartedwaters.Thekeyistoseekindependentand
objectiveadvicethatisnotalignedwithaparticularproductorstrategy.
Forexample,withouttheeducationtheauthorhasreceivedoverthepast
severalyearsfromBobGordonandTomBoczarofTwenty-FirstSecuri-
ties,thischapterwouldhavebeendifficult,ifnotimpossible,toprepare.
167
168 Tax-AwarePortfolioManagement
Thefirstthinginvestorsneedtounderstandisthathedgefundsutilize
partnershipaccounting.Thetaxstrategiesofthepartnershipoutlinedinthe
fund’sprivateplacementmemorandumshouldbecarefullyreviewed.The
resultsofthepartnershipflowthroughtotheinvestorsandarereportedon
ScheduleK-1.Therearecertaintaxapplicationsofpartnershipaccounting
thatbothtax-exemptandtaxableinvestorsneedtobeawareof.
Sincehedgefundsoftenemployleverage,theycangenerateunrelated
businesstaxableincome(UBTI).Thisisofparticularconcerntocertain
trusts,charitableorganizations,andretirementplans,asUBTIcancause
allincomereceivedbytheentitytobetaxable.Investorsconcernedabout
UBTIinvestintheoffshoreoffering,versustheonshoreoffering.Offshore
hedgefundsarestructuredascorporations,andgeneratedividendincome
notsubjecttothetaxonUBTI.
Sincehedgefundsarepartnerships,onetechniquethatcanbeem-
ployed to lower the tax bite of the fund is to make an asset-in-kind
distributionofassets,aswasdiscussedwithexchange-tradedfunds.In
thecaseofanETF,thistypicallyinvolvesalargebasketofliquidsecuri-
ties. However, there have been instances with hedge funds where the
distribution consisted of low-cost-basis securities that were extremely
illiquid.Itisonethingtoreceiveanarrayofliquidstocks,butitisquite
anothertoreceiveobscureprivateplacementsordistressed-debtissues
withlargebid/askspreadswherethereisnoorderlyexchange.Therefore,
itisimportantforinvestorsandadviserstoinvestigatehowthehedge
fund has executed past distributions, especially in challenging market
environments.
Perhapsthegreatesttaxissuecurrentlyofconcerntotaxableinvestors
isthedeductibilityofhedgefundexpenses.Hedgefundschargeafeeas
apercentageofassetsmanagedandaperformancefeebasedonresults
aboveapredesignatedhurdlerate.Atypicalfeearrangementis1percent
ofassetsand20percentoftheprofitsabovethereturnofabenchmark
likeT-bills.Hedgefundsoffunds,whichmanageabasketorportfolio
of individual hedge funds, typically further charge 1 percent of assets
and 10 percent of profits.Therefore, if a hedge fund or fund of funds
achievesagrossreturnintheneighborhoodof15percent,thefeescan
easilybe5percentormore.Likemutualfunds,hedgefundsreporttheir
returnsnetofallfees.However,ifthesefeesarenottax-deductibleatthe
hedgefundlevelandtheinvestorexperiencesanetreturnof10percent,
hemayenduppayingtaxonareturnofapproximately15percent.This
isachallengewithafundoffunds,becauseahedgefundneedstoclaim
traderstatustobeabletooffsetthefeesagainstexpenses.1Otherwise,ina
partnership,expensescannotbeoffsetagainstincomeandarelistedsepa-
ratelyontheK-1asamiscellaneousitem.Mostinvestorscannotusethese
TheHedgeFundDilemma 169
miscellaneousdeductions,astheydonotexceedthethresholdpercentage
ofadjustedgrossincomeneedtoqualifyforadeduction.Recentrulings
ondaytraderssuggestthatthesefeesarenotdeductibleforcertainhedge
funds.Asthisbookgoestopress,thisistheoneissuetostayabreastof,as
itcouldhaveasignificantimpactonhowtaxableinvestorsallocatetheir
hedgefunddollarsinthefuture.Moreover,ithighlightstheimportance
of knowing the various approaches to enhancing the tax efficiency of
hedgefundinvesting.
Factorsthatinvestorsandadviserscanexploretoenhancetheafter-tax
returnsofhedgefundsare:
1 Taxefficiencyofexistinghedgefunds
2 Significantownership
3 Favorabletransactions
4 Allocationfavoringhedgefundsthatofferthepotentialforhigher
after-taxreturns
5 Placementofassetsinindividualretirementaccounts
6 Investmentinanoffshorefund
7 Privateplacementlifeinsurance(PPLI)policies
8 Sharesofstockinacompanywhoseinvestmentportfolioconsists
of,orwhoseprofitsaretiedto,hedgefunds
9 Hedgefundderivativeproducts
10Derivativesonhedgefundindices
Separatelyorcombined,thesetentax-awarefacetsofhedgefundin-
vestingcanservetoenhancethewealthoftaxableinvestors.
1 Taxefficiencyofexistinghedgefunds:ScheduleK-1canbeana-
lyzed to determine the relatively efficiency of various hedge funds.The
keytothisprocessisyouneedseveralyearsofhistorybeforeyoucandraw
meaningfulconclusions,whichisnotalwayspossiblewithhedgefunds.
Segregatinginformationbythetaxnatureofeachitemcanprovevaluable.
Ifyouservethehigh-net-worthindividualmarket,youarelikelytohave
clients,especiallythosepayingthealternativeminimumtax,whomaynot
beabletotakeadvantageofcertaindeductions.
2 Significantownership:Perhapsthebestwaytodetermineifthe
hedgefundislikelytobetax-efficientistointerviewtheseniorprofession-
alsinvolvedanddeterminehowmuchoftheirpersonalwealthisinvested
inthefund.Amanagerwhohasasignificantpersonalstakeinafundis
likelytohaveadistinctlydifferentapproachtowardtaxconsequencesthan
another manager with a minimal commitment.Tax-aware hedge funds
mayapplysomeofthesamemeasuresastraditionalmanagershighlighted
in chapters 11 and 12, but the nature of hedge fund trading will most
likelycausethemtofocusontheelementsofitem3.
170 Tax-AwarePortfolioManagement
3 Favorabletransactions:Thefollowingtransactionsareexamples
of how tax savings can be achieved in the daily management of hedge
fundsthatTwenty-FirstSecuritieshassharedwiththepublic.2
a. Equitylong/shortfundsneedtobesixty-onedaysonthelong
sideandforty-sixdaysontheshortsideforthequalifieddividend
to be taxed at 15 percent and the expense to be deducted at 35
percent.
b. Whencashispartofamerger,holdingthetargetstockforat
leastsixty-onedayswillcausetheamounttobetaxedatthemore
favorablerateforqualifieddividends.
c. Constructive-sale rules do not apply to fixed income transac-
tions.Therefore, a trade that is short against the box, where you
shortthesameappreciatedsecurity,candeferthegain.Thistrade
alonehastremendouspotentialfordistressed-debtspecialists,who
oftenachievesizableprofitsfrombondsthatappreciatesignificantly
inpriceafterbeingpurchasedforpenniesonthedollar.
d. Anothertradethathaswideapplicationistheuseofabroad-
basedlistedoptionthatqualifiesforfavorabletaxtreatmentunder
Section1256.Ifyouaregoingtoholdanindexproductforless
thanayear,itmakessensetouseaqualifiedSection1256contract,
becauseitissubjecttoablendedcapitalgainstaxrateof60percent
long-termand40percentshort-term,oramaximumfederaltax
equivalentof23percent.Whenheldatyear-end,thesecontracts
are marked to market and the cost basis is adjusted accordingly.
Therefore,short-termtradingwithaSection1256contractinlieu
ofusinganindexfundorETFcansaveone-thirdintaxdollars.
Thesearesimplyasampleoftradesthatcanleadtotaxsavings.The
tax-awarehedgefundmanagersworkcloselywithtaxexpertswhospecial-
izeinthisnichesotheycankeepabreastoftax-minimizationstrategies.
Thehedgefundmanagersmustanalyzethetaximplicationsofthetrades
thatcharacterizetheircorecompetencyandestablishprocedurestotake
advantageofcertaintechniqueswhentheymakeeconomicsense.
4 Allocation favoring hedge funds that offer the potential for
higherafter-taxreturns:Generallyspeaking,nondirectionalhedgefund
strategiesthatemphasizeconsistentabsolutereturnshavelowerafter-tax
returnsthandirectionalhedgefundstrategies.Therefore,whenstrategies
areputthroughaportfoliooptimizationprocess,itonlymakessensethat
taxable accounts will rely on directional strategies more than tax-exempt
charitable organizations and retirement plans will. This is why advisers
servingtaxableaccountstypicallyrecommendahigherallocationtoequity
long/shortfunds,ascomparedwiththevariousarbitrage-relatedstrategies.
TheHedgeFundDilemma 171
FirmsplanningtoenterthePPLIarenaareseekingtheexpertiseofin-
dividualssuchasLeslieGiordaniofGiordani,Schurig,Beckett&Tackett,
whospecializesinthisarea.Thisisanexampleofhowregulatoryknowl-
edgeplaysakeyroleeveninindividualinvestorsituations.Skepticsbelieve
theinsurancecompanieswillnotbeabletoattracttop-notchhedgefunds,
whichwouldnotwanttobecomecaptivetoasingledistributionchannel
orclientwheretheirfeestructuremaybebroughtintoquestioninfuture
years.Iftheseproductscanbelaunchedwithoutoutlandishfees,theben-
efitsfromtaxefficiencywillmakethemanextremelycompetitivetax-aware
172 Tax-AwarePortfolioManagement
alternativethatwilldemandseriousconsideration.Asaresult,adviserswill
beforcedtodeterminewhichinsurancecompaniesofferthemostadvanta-
geousproductsinresponsetoinquiriesbytheirtax-awareclients.
8 Sharesofstockinacompanywhoseinvestmentportfolioconsists
of,orwhoseprofitsaretiedto,hedgefunds:Oneinnovativewaytoap-
proachthisprocessistostartanoffshoreinsurancecompany.Inlieuof
traditionalassets,thecompanywouldutilizehedgefundsfortheinvest-
mentportfolio.Obviously,ithastobedonewheretheuseofhedgefunds
wouldsatisfyrisk-basedcapitalstandardsorsimilarprovisions.Whileyou
cannot remove the company-specific risk, this is a way to achieve indi-
rect exposure to hedge funds in a tax-aware manner. Another example
ofhowinvestorscangainexposuretohedge fundsis purchasingshares
of a company like Man Group, an enterprise that derives profits from
themanagementofalternativeinvestments.Thesearelessthanperfectly
correlatedplaysonhedgefunds,buttheydodemonstrateinsightful,tax-
awarethinking.
9 Hedgefundderivativeproducts:Playingoffinvestors’fearsfollow-
ingthreedownyearsinarowintheequitymarkets(2000to2002),it
should be no surprise Wall Street has responded with costly principal-
protected notes. From a tax viewpoint, they are less than a satisfactory
solution,becausetheytypicallycombineafinancialderivativewithaU.S.
Treasurystripsecurity.Therefore,theyaresubjecttothephantomtaxon
accretedincomedescribedinchapter12.ThenextstepbytheStreetwas
toofferacalloptiononahedgefundoffunds.Thisproducthasreceived
a lackluster response, because the premium charged for the tax-deferral
mechanismis20to25percent,andmanybelievethestructurewillrun
afouloftheconstructive-salerules.Anotherwaytolookatthisofferingis
whywouldaninvestorpaysuchahighpremiumforanoptiononahedge
fundoffundswith5to7percentannualvolatility?Inthisscenario,the
probabilityofachievinganegativereturnoverfiveorsevenyearsisnear
zero.Boththeaccountingprovisionsandthecostofthetaxdeferralorop-
tionneedtobetightenedupbeforethesestructuresbecomemoreaccept-
edbyastuteadvisers.BruceTavelandhisquantitativespecialistsatU.S.
TrustCorporationhaveconstructedanalternativeworthconsideringthat
producesasimilaroutcome.TheycombineaQTAstrategyhighlighted
inchapter10withvariouscallandputoptionstotrulyaddressboththe
client’staxesandinvestmentneeds.
10Derivativesonhedgefundindices:Forinvestorsthatarelooking
fortaxefficiencyandliquidity,thisisprobablythemostpromisingalterna-
tivetoday.Therearenowinvestablehedgefundindicesavailabletoinves-
tors.Asaresult,dealersareofferinginvestorssyntheticexposurethrough
theuseofderivatives.Structurednotesarenowbeingofferedwithweekly
TheHedgeFundDilemma 173
liquidityinamountsaslittleas$50,000.Unlikecalloptions,taxexperts
believethenotescanbeofferedwithouttriggeringtheconstructive-sale
rulesthatconvertthereturnstreamintoordinaryincome.Therefore,if
heldmorethanayear,theywillbesubjecttothemorefavorablerateon
long-termcapitalgains.AsTomBoczarandMarkFichtenbaumpointout
in their article, “Making Hedge Fund Investing MoreTax-Efficient,” a
hedgefundoffundswouldhavetoproducea4.8percentannualalphato
matchthereturnonaseven-yearnoteandtheunderlyingindexproduc-
inga10percentreturn.5Evenifthefund-of-fundsinvestorcoulddeduct
expenses, the alpha hurdle is 3.3 percent.There will be skeptics of this
strategy,especiallythosewhoquestionthereturnsofahedgefundindex
forvariousreasons.However,asinthecaseofHedgeFundResearch,these
areinvestableindiceswithunderlyingmanagers.Willthebestmanagers
bepartoftheirprograms,andwilltheirreturnsdivergesignificantlyfrom
the actual overall market, which nobody has yet been able to measure
becauseofallthedifficultiesinobtainingmeaningfulhedgefundperfor-
mance?Onlytimewilltell,butwhatwedoknowisthatovercominga3or
4percentalphainanyassetclassisanextremelyarduoustaskoveraseven-
yearperiod,especiallyforhedgefundcategoriesthathavemoreuniform
returns,suchasconvertiblearbitrage.
Thischapterexplainedvariousoptionsavailabletohedgefundmanag-
ers,advisers,andinvestorstolowerthetaximpactofthistax-inefficient
niche of investing. With the rapid growth expected for hedge fund in-
vestinginthedecadeahead,therewillbenewandinnovativetax-aware
approachesworthconsideration.Inthemeantime,investorsareapplying
tax-aware solutions first to those niches of hedge fund investing where
the alpha, or incremental return is limited, which follows the trend of
traditionalassets.Therefore,weshouldanticipatethecontinualevolution
of“optimal,”“coreandsatellite,”or“hubandspoke”tax-awarecustom
hedgefundcombinationstomatchtheclient’staxprofileandtolerance
forrisk.
ChapterNotes
1. Robert N. Gordon, “Taxing Phantom Hedge Fund Profits: Here’s How to
MakeSureYourClientsPayTaxesonWhatTheyMake,”OnWallStreet,August
1,2004,http://www.keepmedia.com(accessedNovember13,2004).
2. Robert N. Gordon, “Making Hedge Funds MoreTax-Efficient,” Journal of
WealthManagement(Summer2004):75–80.
3. Twenty-FirstSecuritiesCorporation,Newsletter(Summer2004).
174 Tax-AwarePortfolioManagement
4. LeslieC.GiordaniandAmyP.Jetel,InvestinginHedgeFundsThroughPrivate
PlacementLifeInsurance,”JournalofInvestmentConsulting(Winter2003/2004):
77–82.
5. ThomasJ.BoczarandMarkFichtenbaum,“MakingHedgeFundInvesting
MoreTax-Efficient,”Monitor(July/August2004):31–35.
CHAPTER14
AmendingtheSearchProcessfor
Tax-AwareManagerSelection
Ican’tmakeadamnthingoutofthistaxproblem.Ilistentoone
sideandtheyseemright—andthenIlistentotalkfromtheother
side and they seem just as right, and here I am where I started.
God,whatajob!
—WarrenG.Harding
T
hebesttoolfortryingtogetagraspofthevariousnuancesofhow
afirmorportfoliomanager,especiallyonewhotakeshisfiduciary
responsibilityseriously,considerstheimpactoftaxeswhenmak-
inginvestmentdecisionsistheformalmanagerquestionnaire.Aquestion-
naire—orrequestforproposal(RFP),asitisformallyreferredto—should
notbeissueduntilthesponsor,consultant,oradviserhashadtheoppor-
tunitytodetermineashortlistofcandidatesafterconductingtelephone
orone-on-oneinterviews.Ifquestionsarethoughtoutinadvance,much
oftheinformationrequiredtomakeinformeddecisionscanbeobtained
earlyonintheprocessandshouldberecordedinanorganizedmanner
forfuturereference.Constructinganefficientquestionnaireisanartform
that requires experience to master. It is an extremely important part of
the search process, as by the vary nature of your questions you will be
establishingtheexpectationsfortheinvestmentmanager.Therefore,you
shouldattempttotailoryourquestionnaireaccordingtothemagnitude
andcomplexityoftherelationship.Alsorememberthatthequestionnaire
representsyourorganizationandclient.Oneofthehighestcompliments
youcanreceiveiswhenamanagercallstoclarifyanissueandstates,“After
reviewingyourquestionnaireInowknowwhyyourfirmhassuchanout-
standingreputationinthetax-awareinvestmentmanagementarena!”
175
176 Tax-AwarePortfolioManagement
Thequestionsyoulistshouldbeorientedtowardthespecificasset
class the search is focused on.This chapter offers a detailed question-
naireforadomesticequitymanagersearch.Thequestionsrelateonlyto
thoseareaswheretaxescomeintoplay,astherearenumerousoutstand-
ingsamplequestionnairesfortax-exemptaccountsthatcanbeobtained
fromotherbooksandwebsites.Sothinkofeachquestionofferedasa
supplementtotheprocessforatax-exemptaccount.Thequestionnaire
was developed to cover in detail the various types of taxable accounts
practitionersmightservesothatitwouldbeofvaluetoallreaders.The
questionsareorganizedaccordingtotopicalareasandlistedinalogi-
calprogression.Donotthinkthatyouneedtouseeveryquestion;the
completelistofquestionsismostlikelyfarmorethanwhatisrequired,
basedonthemagnitudeandcomplexityoftheclientsituation.However,
tax-awareinvestingisemergingasanartininvesting,andprofessionals
often interpret terms quite differently. Unless you craft questions that
are consistent with your manager-evaluation process, you will receive
responsesthatwillforceyoutospendaninordinateamountoftimefol-
lowinguptotrytogetattheactualcruxofthemanager’sprocess.Thisis
especiallytruewithhowmanagersaddressthewashsaleruleandexecute
tax-lossharvestingtrades.Quitesimply,usethefollowingasasourceof
questionsthatcanbecherry-pickedtofocusontheneedsofthespecific
assignment.
SupplementalTax-RelatedQuestionsfora
DomesticEquityManagerSearchQuestionnaire
Organization
1 Howmanytaxableaccountsandassetsdoyoumanage?Pleasepro-
videbreakdownsfortaxableandtax-exemptassetsforthefirmoverall
andforeachstrategyyouemploy.
2 What types of taxable accounts do you manage? (Check all that
apply.)
a. Individualsandfamilies
b. Corporatefunds
c. Nucleardecommissioningtrusts
d. Propertyandcasualtyinsurancecompanies
e. Medical retirement trusts or nonprofit voluntary employee
benefitassociations(VEBAs)
f. Settlementtrusts
g. Other(pleasedescribe)
AmendingtheSearchProcessforTax-AwareManagerSelection 177
3 Whatistheaveragesizeofyourtaxableaccountsineachcategory
listedabove?
4 Whataretheproductsyourfirmrecommendstotaxableinvestors
andaretheylistedinthe_________reportingdatabase(s)?
5 Pleaselistthenamesandtheprimaryresponsibilitiesofallinvest-
mentprofessionals(portfoliomanagers,analysts,servicingpersonnel,
traders,etc.)thatwillbeinvolvedinthemanagementofthistaxable
accountstrategy.Pleasealsolistthenumberofyearstheyhaveserved
taxableaccounts,thetypesoftaxableaccounts,thetimespentontax-
able versus tax-exempt accounts, and their unique taxable account
qualifications,ifany.
6 Whomdoesyourfirmutilizeforsecuritytaxexpertise,asitper-
tainstotax-awareinvesting?
7 Doesyourcompensationstructureincludeincentivesformaximiz-
ingtheclient’safter-taxreturn?
8 Whatisyournormalfeeschedule,andareyouwillingtoaccepta
performance-orientedfeearrangementbasedonafter-taxreturns?
Philosophy
1 Explainindetailyourfirm’sapproachtotaxableaccountmanage-
mentandwhyitislikelytoproducecompellingafter-taxresultsfor
thisparticularportfoliostrategyinthefuture.
2 What percentage of overall assets do you typically recommend a
clientallocatetothisstrategy?
3 Doyourecommendthisstrategyasaprimaryallocationfortheas-
setclass,orisitmosteffectivewhencoupledwithotherstrategiesthat
maybedifferentinthenumberofsecuritiesheld,style(value,core,
growth),capitalization(large,mid,small,micro),sector(technology,
healthcare,etc.),country,overlay,orotherconsiderations?
4 Ifotherstrategiesarebeneficial,doyouhaveinternalofferingsyou
recommendtocomplementthisstrategy,ordoyouseektheservicesof
otherfirms(pleasenamethem)?
InvestmentMethodology
1 Doesthetaxableaccountstrategymodifyanexistingstrategyforthe
impactoftaxeswithinthefirm,orhastheproductbeendevelopedand
managedsinceinceptionsolelyfortaxableaccounts(explainindetail)?
2 Do you include the effective tax rate (consideration of federal,
state,local,andothertaxrates)inyourmanagementforeachseparate
accountrelationship?
3 Istaxefficiencyimprovedthroughanalysisofthetaximpactaspart
ofbuyandselldecisions,orisitbestdescribedasanoverlayprocess?
178 Tax-AwarePortfolioManagement
4 Pleaseaddressthefollowingelementsoftax-awareinvestingwitha
detaileddescriptionofhowyouattempttoaddvaluewitheach:
a. Extendingtheholdingperiod
b. Dependingontheleveloftaxonincomeandlong-termcapital
gainsthatareineffect,incomeversuslong-termcapitalgains
orientation
c. Timehorizonandstep-upincostbasisatthetimeofdeath
d. Tradingactivity
5 Whenlossesarepresentintheportfolio,doyouwaitforinstruc-
tionbytheclientordoyouattempttoproactivelyharvestthem?
6 Howofteniseachportfolioreviewedforpotentialtax-lossharvest-
ingopportunities,andhowcantheclientauditthisprocess?
7 Ifyouharvestalossatyourowndiscretionoratthedirectionofthe
client,doyoueverallowtheproceedstobeincashuntilitisinvested
atleastthirtydays?Ifso,pleaseexplainwhenandwhy.
8 Doyouever“doubledown”onasecuritypositionbypurchasing
additionalsharesratherthenharvestingthelosswhenitfallssubstan-
tiallyinprice?Ifso,pleasedescribewhenyouwoulddothisandhow
youmightattempttominimizethetaxconsequences.
9 If you harvest losses and invest in something other than cash,
whattypeofsecuritiesdoyouuse(e.g.,stocks,bonds,mutualfunds,
exchange-tradedfunds,derivatives,etc.)?Explainthechallengeswith
futurepricemovementandtaxconsequencesofeach.
10Doyouuseanyanalyticaltoolsorsoftwareprogramsthatcalculate
the tax consequences of a buy-and-sell decision before it is actually
conducted?Ifso,weretheydevelopedinternallyorexternally,andhow
doyouadjustthemforaparticularclient’staxprofileandforchanges
inthetaxcode?
11Forconcentratedpositions,doyouassistintheanalysisoftax-loss
harvestingstrategiestograduallyreducetheposition,exchangefunds,
prepay forwards, collars, etc.? If so, what are your capabilities, and
whatdoyouchargefortheseservices?Willyoumonitorandmakean
ongoingrecommendationfortheconcentratedstockposition(s)?
12Doyouhavetaxableandtax-exemptaccountsusingthesameprod-
ucts/strategiesyouoffer?Ifso,howdoyoutreatthemdifferently?
13Canyourunthisstrategyaccordingtosociallyresponsiblecrite-
ria?Ifyouhaveexperienceinthisarea,ifasked,whichcriteriawould
you recommend a client consider and why? From your experience
withsociallyresponsibleaccountsforthisstrategy,doesmanagingthe
accounts by applying the designated social criteria cause returns to
differfromthestandardbenchmarkorindex?
AmendingtheSearchProcessforTax-AwareManagerSelection 179
14Howmuchalphadoyouderivefromthetraditionalmeasures(sec-
torallocation,securityselection,etc.),andhowmuchtaxalpha,ifany,
doyoubelieveisreasonable?(Explainindetailandhighlightwithnu-
mericalexamples,ifpossible.)Howwouldyoudemonstratethevalue
added (net of tax and fee alpha) against an appropriate benchmark,
mutualfund,orexchange-tradedfundonanafter-taxbasisoveranex-
tendedperiodwhentaxesandfeesareaccountedforbyutilizingboth
thepre-andpost-liquidationafter-returncalculationmethodologies?
15Describeyourriskmanagementprocessandcriteria,asappliedto
taxmanagement.
16Whatdoesyourfirmdointhisstrategythatyoubelievetrulydis-
tinguishesyouintaxableaccountmanagement(notwhatyoudodif-
ferentlyfromyourtax-exemptaccountmanagement)?
17Ifyouknowthemandateistomaximizeafter-taxperformance,is
thereanythingyouwoulddomodifytoyourexistingstrategy?
Operations
1 Doyouraccount-openingproceduresincorporateapplyinginfor-
mationpertainingtotheclient’staxprofileandreconcilingsecuritytax
lotsbeforetradingisallowedtobegin?
2 Whoisresponsibleforthisprocess,andhowdoesthisindividual
maintainqualitycontrol?
3 Doesyourportfolioaccountingsystemhaveatax-lotaccounting
capability?
4 How often do you reconcile tax-lot positions with the custo-
dian(s)?
5 Whatisyourdefaultaccountingconvention?
6 Can your portfolio accounting system maintain accounting con-
ventionsotherthanaveragecostorfirstin,firstout(e.g.,highin,first
out;specificlotidentification)?
7 Whodoyoubelievearethebestcustodiansfortaxableaccountcli-
entrelationshipsandwhy?
Trading
1 Doyouuseanytrade-processingsystemsorsoftwarethatoffersa
distinctadvantagewithtaxableaccounts?Ifso,wasitdevelopedinter-
nallyorexternally,andhowdoyouadjustitforaparticularclient’stax
profileandfuturechangesinthetaxcode?
2 Doyouattempttoharvestlossesdependingonwhetheritisadvan-
tageousforaspecificaccountorforthecompositeoftaxableaccounts
withinthesamestrategy?
3 Doyouattempttoharvestlossesaccordingtoeachofthevarious
180 Tax-AwarePortfolioManagement
platformsyoumanage(separateaccounts,wrapaccounts,commingled
funds,mutualfunds,etc.)orbysomeothermethod?Pleaseaddress
howyouprioritizetheprocessandhowyouhandlethechallengeof
potentiallybuyingasecurityforsomeaccounts,whilesellingthesame
securitytoharvestlossesinothers.
After-TaxReporting
1 If your firm claims compliance with AIMR standards, were you
abletosatisfytheafter-taxstandardsfortaxableseparateaccountsand
compositesinJanuaryof2005?Ifnot,whendoyouexpecttobecom-
pliantwiththeAIMRafter-taxreportingstandards?
2 Whatsystemsandprovidersareyouutilizingtosupplyyourclients
withafter-taxreturns?
3 Canyousupplyanindividualclientwithbothpre-andpost-liqui-
dationafter-taxreturns?
4 Ifyourfirmmaintainsafter-taxreportingcompositeinformation,
pleasedescribethethoughtprocessthefirmgoesthroughtodetermine
howaparticularaccountisassignedtoacompositebyaddressingthe
following:
a. Amountoftimeanaccountiswiththefirmbeforeitisentered
intoacomposite
b. Minimumaccountsize
c. Accountswithsubstantialcashflows
d. Accountsinheritedwithsubstantialunrealizedcapitalgainsor
low-cost-basisconcentratedpositions
e. Typeoftaxableentity(individual,propertyandcasualtyinsur-
ancecompany,nucleardecommissioningtrust,medicalretire-
menttrust,settlementtrust,etc.)
f. Vintageyearofinceptionofaccounts
g. Clients’taxdomicile
h. Clients’taxprofilewaswhatleveloftaxation(15percentvs.35
percent)
5 Pleaseattachasamplereporthighlightinghowyoupresentclients
withafter-taxreturns.
6 What is your approach toward after-tax benchmarks, and which
primaryandsecondarybenchmarksdoyoubelievearebestsuitedfor
thisstrategy?
7 Ifyoucannotprovideafter-taxreportingconsistentwiththeAIMR
standardspleasecompletethefollowingtableforarepresentativeac-
count.Pleaseattachcustodialstatementsthatwereusedtocomplete
thetable.
AmendingtheSearchProcessforTax-AwareManagerSelection 181
FIGURE14.1 TemplateforEstimatingAccountAfter-TaxReturn
1 %Before-TaxReturn
2 $BeginningMarketValue
3 $EndingMarketValue
4 $Contributions
5 $Withdrawals
6 $TaxableIncome
7 $QualifiedDividends
8 $Short-TermGains
9 $Long-TermGains
10 $EstimatedTotalTax
11 %AdjustmenttoReturn
(10/[(2+3–4+5)/2])
Source:DouglasS.Rogers
12 %After-TaxReturn
(1–11)
Pleaselisttheanticipatedtaxratesthatwereappliedinrow10forthe
calculationoftheestimatedtotaltax:
Taxableincome __._percent
Qualifieddividends __._percent
Short-termcapitalgains __._percent
Long-termcapitalgains __._percent
AccountServicing
1 Doesyourfirmcreateforeachtaxableaccountaninvestmentpolicy
statementorsimilardocumentthatincorporatestheuniquetaxprofile
oftheclient?Areyouwillingtomeetwithotheradvisersinitially,and
asrequiredinthefuture,togainanunderstandingoftheclient’stax
182 Tax-AwarePortfolioManagement
profile?Ifso,whoisresponsiblefortheprocesswiththispotentialrela-
tionshipandwhatarehisorherqualificationswithtaxableaccounts?
2 How are adjustments made to the investment policy statement
whentheclient’staxprofilechanges?
3 Howdoestheaccount-servicingprofessionalensurethatanalysts,
portfoliomanagers,andtradersareincorporatingtheclient’staxpro-
fileinthedecision-makingprocess?
4 Howdotheclientsandtheiradvisersreceiveinformationthrough-
outtheyearpertainingtorealizedcapitalgainsandlosses(bothshort-
andlong-term)andunrealizedpositionsbothattheportfolioandse-
curitylevel?
5 Willyouapproachtheclientwithrecommendationswithregardto
tax-awareinvestinginaproactivemanner,orwillyouonlyreacttothe
client’sdirection?
6Doyouofferadditionalservicesthatmaybebeneficialtothetax-
ableinvestorbeyondtax-awareinvestmentservices,suchasthefol-
lowing:
a. Accountingservices
i. Preparationoftaxfilings
ii. Form1099-DIVandForm1040ScheduleBandDprepa-
ration
iii.Preparation of statutory reports, e.g., Schedule D for a
propertyandcasualtyinsurancecompany
iv. Partnershipaccounting
b. Legalassistance
i. Assistancewithregulatorymatters
ii. Estateplanning
iii.Trustpowers,fiduciaryservices,andexecutorservices
c. Custodyofassets
d. Familyorback-officeassistance
i. Goalsettingandgenerationalissues
ii. Bill-payingandpayrollservices
iii.Conciergeservices
e. Consultingorfinancial-planningservices
7 Willyouallowtheclienttoconductasitevisit?
8 Willyouprovidetheclientwithatleasttwotaxableaccountrefer-
ences,oneofwhichhasterminatedtherelationshipwithyourfirm?
Oversight
1 Who has oversight responsibility beyond the assigned portfolio
managertoensurethefirmisdoingwhatisnecessarytomaximizethe
client’safter-taxreturn?
AmendingtheSearchProcessforTax-AwareManagerSelection 183
2 Whatchecksandbalancesdoesthefirmhaveinplacetoensurethe
thirty-daywashsaleruleisnotviolated?
3 Whatisyourphilosophytowardvariabilityofafter-taxreturnsfor
taxableaccounts?
4 Ifapplicable,whatdoyouconsidertobeanacceptablelevelofvari-
abilityofreturnsforyourbefore-andafter-taxcompositereturnsfor
thesamestrategy?
5 Isthereadifferenceinthetimeframeforinvestingatax-exempt
versustaxableaccountforthesamestrategywhenyoustartwithall
cashequivalents?Ifso,pleasedescribeyourprocessindetail.
6 Isthereadifferenceinthetimeframeforinvestingatax-exempt
versustaxableaccountforthesamestrategywhenyouinheritaportfo-
lioofexistingsecuritiesthathasanunrealizedcapitalgainsposition?If
so,pleasedescribeyourprocessindetail.
7 Isthereadifferenceinthetimeframeforinvestingatax-exempt
versustaxableaccountforthesamestrategywhenyouinheritaport-
folioofconcentratedpositionsoflow-cost-basissecurities?Ifso,please
describeyourprocessindetail.
WhenyouissueaquestionnaireorRFP,berespectfulofthetimeand
effortrequiredoftheinvestmentmanagementfirmtocompletethedocu-
ment.Dependingonthesizeandstructureofthefirm,theremayormay
notbesufficientresourcesinplacetoreturnapolishedproductinseveral
weeks, but this type of quick turnaround should not be expected. It is
best to allow firms approximately two months to complete a tax-aware
questionnaire for two primary reasons. First, tax-aware investing is still
arelativelynewniche,andthequestionnaireprovokesmorethoughtful
answersthanthestandard,cookie-cutterresponsesgiventothetraditional
tax-exemptaccountquestionnaire.Second,withboutiquefirms,don’tbe
surprisedifagoodnumberofthequestionswillbecompletedbythein-
vestmentprofessionalsratherthanbythemarketingstaff.Crafteachques-
tiontoelicitaspecificresponse,andmakesureyouareavailabletoanswer
anyquestionsthemanagermighthave.
Unfortunately,whentax-awareinvestingcameintovogueduringthe
latterhalfofthe1990s,thereweretoomanyinstancesofmarketinghype,
withlittleornounderlyingtax-awareprinciplesbeingappliedinthedaily
managementofthestrategy.Withtheethicalchallengeswehaveendured
insocietyingeneraloverthepastdecade,itissimplyagoodbusinessprac-
ticetoinsistthatthefirm’scomplianceofficeroraseniorprofessionalsign
offontheresponse,indicatingithasbeenreviewedbyothersoutsidethe
marketingdepartment,beforesubmittingittoyou.Youmayevenwishto
tailoroneorseveralquestionsinamannerthatwillallowyoutodetermine
184 Tax-AwarePortfolioManagement
iftheprospectissimplytellingyouwhatyouwanttohearratherthanhow
thefirmphilosophicallygoesaboutexecutingatax-awareprocess.Inone
instanceintheauthor’spast,aninvestmentmanagementfirmeventook
someofthequestionsandincludedtheminfuturemarketingmaterials,
notrealizingitwassignalingitreallydidnotunderstandthetaxramifica-
tionsofvarioustradingstrategiesonafter-taxtotalreturns.Obviousflags
thatyoushouldlookforintheresponsetoaquestionnaireare:
❑ Incompleteanswers,indicatingthefirmdoesnottakethepotential
assignmentseriously
❑ Referencesonlytothetax-exemptaccountphilosophy,withoutad-
dressingtheimplicationsoftaxes
❑ Firmsthathavelittleornotaxableassetsandinvestmentprofes-
sionalswhospendmostoftheirtimeontax-exemptaccounts
❑ Reference to “team approach” typically means standardization,
whichisfinefortax-exemptaccounts,whereasmanagingtaxableac-
countseffectivelyrequiresahighlevelofpersonalattentiondevotedto
eachrelationship
❑ Immediatetransitioningofaccountstothefirm’smodelportfolio
withoutconsideringsubstantialembeddedunrealizedcapitalgains
❑ Inexperiencedservicingpersonnelwhoprovideonlysalessupport,
ascomparedwithexperiencedprofessionalswhoplayanintegralrole
indevelopinginvestmentpolicyandthelike
❑ Firmsthatconstructperformancecompositesthatdonotsegregate
taxableandtax-exemptaccountswithinthesamestrategy
As addressed in chapter 3, achieving compelling after-tax results re-
quirestime.Forseasonedaccountswithhighlevelsofunrealizedcapital
gains,theperiodfollowingtheassignmentofanewportfoliomanagercan
beextremelycostlytotheclient.Therefore,thestabilityoftheorganiza-
tionanditsinvestmentprofessionalsisparamountwithtaxableaccounts.
Sincemanyinvestmentmanagementfirmshavebeensoldoverthepast
decadeandothersaregoingthroughculturalchange,thoseresponsiblefor
taxableaccountsmaywishtoincludespecialportfoliolock-upprovisions
intheircontracts.Thisisanotherreasoninsupportofpassiveorquantita-
tivetax-awarestrategies,whichreduceoreliminatethepotentiallycostly
humanfactor,fortaxableaccounts.
Thequestionsofferedaboveneedtobemodifiedforsearchesofasset
classesotherthandomesticequities.Itwouldbetoovoluminoustoin-
cludeaseparatequestionnaireforeachassetclass.Therefore,thefollowing
questionshavebeenpurposelylimitedtofixedincomeandinternational
equitytaxableaccountsandareintendedtosupplementthosealreadypre-
sentedforadomesticequitymanagersearch.
AmendingtheSearchProcessforTax-AwareManagerSelection 185
SupplementalTax-RelatedQuestionsfora
FixedIncomeTaxableAccountManager
SearchQuestionnaire
1 Pleaseexplainindetailthefirm’sphilosophyformanagingfixed
incometaxableaccountportfolios.Besuretoaddressifyourobjec-
tiveisto
a. maximizeafter-taxtotalreturnorpayaslittletaxaspossible
b. managetheportfoliointhecontextofanisolatedsingleaccount
or consider the interaction of multiple classes/portfolios and
theiroveralltaxramifications
c. manage the portfolio for the best risk-adjusted return or the
maximumafter-taxlong-termsolution
2 Forthemunicipalbondportionofthetaxableaccountportfolio
strategy:
a. Doyoupurchasebondsoutsidethestateoftaxdomicile?Ifso,
doyousetminimumormaximumportfolioallocationstoin-
orout-of-statebonds?
b. Do you favor any particular bond structures (premiums, dis-
counts,callable,zero-coupon,etc.)astheyrelatetotheimpact
onafter-taxreturns?Ifso,pleaseexplainindetail.
c. Whatisyourapproachtomunicipalbondssubjecttooriginal
issuediscount(OID)andthedeminimisrule?
d. Whatisyourapproachtobondssubjecttothealternativemini-
mumtax(AMT)?
3 Doesyourfirmbelieveithassufficientinternalexpertisetoassist
clients and their advisers with issues pertaining to the AMT? If so,
whoistheindividualmostqualifiedtoaddressthissubjectandwhat
arehisorherqualifications?Ifnot,whomdoyougotoforthistypeof
expertise?
4 Whatistheuniverseofsecuritiesforyourfixedincomestrategyfor
taxableaccounts?
5 Ifyouincludetaxablebondsinthemix,whatistheprocessyou
employtodeterminewhentheyareappropriatefortaxableaccounts,
andwhoisresponsibleforthisprocess?
6 Areanylimitsimposedontheuseoftaxablebonds?
7 Ifyoupurchasetaxablebonds,doyourelyonyourmunicipalbond
teamtomakeindividualsecuritybuyandselldecisionsoronyourtax-
exemptaccountbondteam?
8 Does your portfolio accounting system handle amortization and
186 Tax-AwarePortfolioManagement
accretionofbondspurchasedatapremiumordiscounttoparvaluein
conjunctionwithprovisionsofthetaxcodeappropriateforthetypes
ofclientsthatyouserve?Whataccountingmethodforamortization
andaccretiondoyouapplyandwhy?
9 Given the way you manage fixed income portfolios for taxable
accounts,doyouenvisionthatthestrategy’safter-taxreturnwillbe
greaterthantheafter-taxreturnoveraten-yearperiodofseveralinter-
estratecycles?Explainindetailwhyorwhynot.
10Knowing that unlike the U.S.Treasury yield curve, the munici-
pal bond yield curve has rarely inverted, how would you manage a
fixedincometaxableaccountportfoliodifferentlyfromyourexisting
strategyifyouknewthetimehorizonwasatleastthirtyyearsandthe
objectivewastomaximizelong-termafter-taxperformance?
Withfixedincomesearches,beextracarefulinyourcommunication
andaddtheterms“fixedincome”or“accounts”afterthewords“taxable”
or “tax-exempt.” This will avoid possible confusion, because managers
tendtothinkintermsofthetypeofbond,whereasclientstendtothink
ofthetypeoftheaccount.Obviously,usingthephrase“municipalbonds”
eliminatespotentialconfusion.
SupplementalTax-RelatedQuestionsfora
InternationalEquityTaxableAccountManager
SearchQuestionnaire
1 DoyoupurchaseprimarilyAmericandepositaryreceipts(ADRs)
or“ordinary”sharesissuedinforeigncountries?
2 Howdoesyourfirmhandlewithholdingoftaxesondividendsof
foreigncompanyshares?
3 Iscurrencymanagementpartofyourprocess?Ifso,isitdoneany
differentlybetweentax-exemptandtaxableaccountstoaccountforthe
impactoftaxpayments,andhaveyouanalyzedtheimpactonafter-tax
returns?
Questionnairesarequitehelpful,butremembertheyarejustoneof
thetoolsrequiredtoanalyzeamanager’spotentialforachievingcompel-
lingafter-taxreturns.Forseparateaccountinvesting,thereissimplyno
excusefornotconductingasitevisit.Iftheinitialinterviewsandques-
tionnairehavebeendoneproperly,thesitevisitshouldbeprimarilyan
exerciseinconfirmingwhatyoubelievetobetrue.Arrangeyourvisitin
advance,andshareacopyofyourchecklistwithyourhost.Makesure
you have the opportunity to speak with individuals from all pertinent
AmendingtheSearchProcessforTax-AwareManagerSelection 187
areasofthefirm.Priortoyourarrivalyoushouldcarefullycraftseveral
questionsthatyouplantoaskofeverydepartment.Ifthereisatax-aware
processinplace,expecteveryoneyoumeettoknowhowthesubjectim-
pactstheirareaofexpertise.Itiseye-openingwhenyoureceiveaques-
tionnairebackthatappearstoindicatethefirmconsiderstaxesinmaking
investmentdecisions,yetwhenyouinterviewananalystduringyoursite
visityouhear,“Idon’tknowwhatthemarketingpeopletoldyou,butwe
don’tlookattheimpactoftaxeswhenrecommendingstocks.”Another
curiosityiswheninitsresponsetothequestionnairethefirmhighlightsa
particularsystemthatassistsinmakingtax-awaredecisions,andyoufind
duringthesitevisitthatalthoughthefirmdoeshavethesystem,noneof
theportfoliomanagersareactuallyusingit.Itwillbecomeobviousafter
youhavereceivedseveralquestionnairesandvisitedthefinaliststhatthe
elitetax-awarepractitionerswillprovideconsistentanswerstoyourques-
tionsandfeelhonoredtorolloutandsharetheirdistinctiveapproachto
tax-awareinvesting.
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PARTFOUR
ChallengingTraditional
AssetAllocation
Methods
Don’ttaxyou.Don’ttaxme.
Taxthefellowbehindthetree.
—RussellB.Long
189
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CHAPTER15
ChallengesWithTraditional
InvestmentPolicyDevelopment
Thinkingisonethingnoonehaseverbeenabletotax.
—CharlesF.Kettering
W
iththegreatbullmarketofthelatterhalfofthe1990s,many
less-than-idealpracticespersistedandunfortunatelyhavebe-
comealmostaccepteddoctrine.Thehighreturnsduringthis
period simply masked the lack of capability of the average adviser to
serve taxable investors.These shortcomings start with the creation of
theinvestmentpolicystatement.Firmscanmaketremendousstridesin
overcomingthesinsofthepastwhenservingtaxable-accountrelation-
shipsbyadoptingthefollowingtax-awareprocedures:
1 Listingtheclient’sassetsbythetaxcharacteristicsoftheinvesting
entity
2 Obtainingandreconcilingthecostbasiswithcustodialandman-
agerstatementsofeachtaxlotforeachsecurityandfundheldby
theclient
3 Addressingwiththeclientwhatisrequiredtoachieveanoptimal,
tax-awareinvestmentsolution,versususingquestionnairesfocused
ontheclient’spersonalitytraits
4 Including and revising the investment policy statement for the
client’scurrentandprojectedtaxrates
5 Applying after-tax return and standard deviations in the asset al-
locationprocessbasedonreasonableassumptions,versushistorical,
before-taxassumptions
191
192 ChallengingTraditionalAssetAllocationMethods
6 Applying an asset allocation tool that is different than the firm’s
standardsolutiontoaddressanuniqueclientsituation
7 Avoidingtheuseof“cookie-cutter”assetallocationoptionsbased
onhistoricalriskprofiles
8 Ensuring 401(k) presentations include the need to incorporate
fundsoutsidetheemployer’splaninthedecision-makingprocess
foroptimaltax-awarepositioning
9 Reviewing the magnitude of a manager’s unrealized capital gains
positionbeforeterminatingthemanager
10Establishingappropriateminimumandmaximumallocationrang-
esaroundthestrategictargetallocationpercentagethatincorporate
abalancebetweenriskmanagementandtaxefficiency
Unfortunately,manyinexperiencedpractitionersfallshortinoneor
moreoftheseprocedures.Alltoofrequently,thecosttotheclientisso
greatthatitfarexceedsthefeetheadviserchargesorthevalueadded.With
item10,youdon’twanttobesotax-sensitivethatyoufailtomaintain
theoverallriskprofileofthemixandavoiddecliningmarkets,butatthe
sametimeyoudon’twanttobeadjustingallocationstoassetclassesand
managers/fundssofrequentlythatyougenerateexcessiveandunnecessary
short-termgains.Thischapteraddresseswhatcanbedoneduringthecon-
structionoftheinvestmentpolicystatementtoovercometheseshortfalls
and provide the client with a meaningful tax-aware solution. Elements
mentionedabovenotdirectlyinvolvedwiththecreationoftheinvestment
policystatementlistedaboveareaddressedinotherchapters.
Theinvestmentpolicystatementservestodriveinvestmentdecisions
in accordance with the desires of the client. Because of the importance
ofitsrole,thepolicystatementneedstoincludekeyelementsofthetax-
awareprocessthatarenotpartofthetax-exemptaccountprocessutilized
forpensionplansandcharitableorganizationstobeeffectivefortaxable
investors. The investment management process includes the following
standardsteps:
1 Analyzeexistingholdingsandneeds
2 Developtheinvestmentpolicystatement
3 Presenttax-awareallocationandpositioningsolutionsforconsid-
eration
4 Selectmanagersandimplement
5 Monitorandreviseholdings
Youcaneasilytellpeoplewhodonothaveaworkingknowledgeof
taxable accounts when they reverse steps 2 and 3, which represents the
procedureusedtomanagetax-exemptaccounts.Withtaxableaccounts,
ChallengesWithTraditionalInvestmentPolicyDevelopment 193
FIGURE15.1 C lientAssetInventorySheet
(PersonalTaxableAssets)
CashEquivalents
Tax-ExemptorMunicipalFixedIncome
DomesticLargeEquities
Source:DouglasS.Rogers
DomesticSmall-/Mid-CapEquities
InternationalEquities
RealEstate(REITs)
194 ChallengingTraditionalAssetAllocationMethods
FIGURE15.2 SampleHoldingsReport
Source:DouglasS.Rogers
6/1/2003 400 $26.75 $10,700.00
CompanyB 3/23/04 300 $34.75 $10,425.00
8/23/02 250 $57.25 $14,312.50
spreadsheetratherthanapreprintedformisrecommended,asspacecan
beexpandedorcontractedtoaccommodateallentrieswithease.Tosave
time,anorganizationshouldconstructtheformusingnomenclaturecon-
sistent with that used in all functional areas of the firm. For example,
domesticstockscanbecategorizedinvariousacceptablewaysbycapital-
izationand/orstyle,butitshouldbedoneconsistentlytoavoidconfusing
theclientbyhavingonenomenclaturefortheinitialquestionnaire,asset
allocation,andpolicystatementandyetanotherinthereportingpackage.
Consistencywiththedeliverablesshowsthatafirmhasawell-thought-out
processandpaysattentiontoqualitycontrol.
Oneofthebiggestmistakesanadviserorclientcanmakeistoallow
tradingtobeginwithanewmanagerbeforeestablishingthecorrectcost
basis of each security with the custodian. A complete reconciliation of
eachandeverytaxlotshouldbeconductedanddiscrepanciesresolvedbe-
foretradingisallowedtobegin.Ifthisisnotdone,someonewillhaveto
spendaninordinateoftimetoresolvethesituationlater.Thecustodian’s
statementshouldserveastherecordofchoicewiththemanager’sreport
serving as a backup, but this is not always the case.There are still in-
stancestodaywherecustodiansdonothavetax-lotaccounting.Without
accuratetax-lotaccountinginformationitisdifficult,ifnotimpossible,
fortheadvisertomakesagerecommendationsthatwilllowertheclient’s
taxbite.
FIGURE15.2representsthetypeofinformationthatisrequiredforeach
tax lot. Before entertaining new managers for hire, a solid understand-
ingofthepotentialtaxconsequencesofterminatinganexistingmanager
ChallengesWithTraditionalInvestmentPolicyDevelopment 195
FIGURE15.3 Risk
GAINREQUIRED
LOSS TORECOUPLOSS
10% 11%
25% 33%
Source:DouglasS.Rogers
50% 100%
75% 300%
90% 900%
needstobeestablished.Iftheexistingmanagerhasasubstantialunrealized
capitalgainsposition,itmaytakeanexcessiveamountoftime,ifever,to
breakevenorgetaheadwiththenewmanager.Thisisthesametypeof
analysis that is conducted by elite tax-aware equity and bond managers
beforetheysellanexistingsecurityposition(seeFIGURE11.2).
Determininganappropriateriskprofileisthemostcriticalelementof
theprocess,asitdrivestheremainderofthesolution.Itisalsotheelement
thatrequiresthemosteducationandexperiencetodoproperly.Unfor-
tunately,untilclientsexperienceabearmarket,theytrulydonotknow
whattheirthresholdisforriskorthepainoflossofwealth.Theadviser
shouldhighlightatleasttwoconcepts:First,ittakesfarmoretorecoup
aloss,as FIGURE15.3demonstrates,thanmanybelieve.Whileitiseasy
toplay“Mondaymorningquarterback”andpointtotheInternetstock
bubble,themarketenvironmentof2000to2002doesprovideinvestors
withsomelevelofsobrietytowardrisk.Gainandlossarenotsymmetri-
cal.AsFigure15.3shows,ifyoulose90percentofyourassets,ittakesa
900percentgaintobreakeven!Whereasthelosscanoccurquickly,a900
percentreturntypicallyonlycomesaboutbycompoundingresultsover
severaldecadesormore.
Second, investors fail to realize that with greater volatility, you need
morereturntoachievetheresultsofmoreconsistentperformers.InFIGURE
15.4,therearetworeturnseries:AandB.Bothachieveanaveragereturn
of 10 percent over five years. However, look at the difference in dollars
betweenseriesAandBattheendofthefifthyear.SeriesBendsupwith
$506less.Thisiscapturedinthegeometricreturn,whichwillalwaysbe
lessthanorequaltotheaveragereturn.Themorevolatilethereturnseries,
thegreaterthegeometricreturnwillbebelowthearithmeticreturn.
196 ChallengingTraditionalAssetAllocationMethods
FIGURE15.4 TheImpactofVolatilityonCompoundReturns
Source:DouglasS.Rogers
AverageorArithmeticReturn 10.0% 10.0%
GeometricReturn 9.8% 9.1%
FIGURE15.5 P rofileMixReturnandRiskInformation
(forthe25yearsEnding2003)
all-fixed-income mix combines bonds and cash equivalents. In the four
primaryprofilemixes,theequityandfixedincomecomponentsareadjust-
edbyincrementsof15percentstartingwith80percentequitiesforanag-
gressivemix.Theresultsinthefigurearederivedfromthequarterlyreturn
history of the S&P 500 stock, Russell 2000 stock, MSCI EAFE stock,
LehmanBrothersAggregatebond,andCitigroupthree-monthTreasury-
billindices.Thekeyhereistoemphasizethemeasurementsofriskforeach
profilemixwiththeobjectiveoftheclientidentifyingacomfortzonewith
onerepresentativeprofileandinitiallevelofstandarddeviationtobegin
themoredetailedanalysistofollow.
Forthosemorecomfortablewithstatisticalmeasures,thestandardde-
viationstatisticandSharperatioworkwell.TheSharperatiomeasuresthe
amountofincrementalreturnabovearisk-freerateofreturn(U.S.Trea-
surybills)comparedwiththeamountofrisktaken([returnofportfolio
–risk-freerate]/standarddeviation).ItwasoriginallycreatedbyWilliam
F.Sharpe,thewinnerofthe1990NobelPrizeinEconomics,ashebelieves
investorsshouldonlytakeonriskiftheyareamplyrewardedbeyonda
guaranteed rate of return. As Figure 15.5 depicts, from the perspective
ofrewardperunitofrisk,theallfixedincomemixistheleastattractive
(0.39Sharperatio).Theallfixedincomeprofilemixhasa40percentcash
equivalentscomponent,soalowSharperatioisexpected.Fixedincome
securitiesandcashequivalentsarenotasvolatileasotherassetclasses,but
theyarelikelytoproducejustaslightpremiumoverthegeneralrateof
inflationoverthelongterm.Addingequitiestothemixdoesimprovethe
198 ChallengingTraditionalAssetAllocationMethods
trade-off between risk and return, and it is interesting to find the risk-
aversemixwouldhavebeentheoptimalmix(0.55Sharperatio)forthe
trulyrisk-sensitiveinvestor.
StandarddeviationandSharperatioinformationisniceforanalyzing
risk-adjustedreturns,butitdoesnothitattherealpainofpotentiallylos-
ingmoney.Forthisrequirement,thelow-yearreturn,drawdown(greatest
peaktotrough),andnumberofdown years are more vivid.The draw-
downstatisticisverycommonlyusedinalternative-investmentanalysis,
andisgainingawiderfollowing.Usingseveraldifferentmeasuresjustin-
creasesthechancethatatleastonewillresonatewiththeclient,whichis
theultimategoaloftheeducationportionoftheexercise.
One must be careful with risk analysis based on historical returns,
becausethetimeframeislimited.Unfortunately,meaningfulbenchmark
informationreflectiveofspecificassetclassesisonlyavailablebeginning
in the late 1970s.This challenge becomes even greater whenTIPS or
alternativeinvestmentsareincludedasspecificassetclasses.Fortunately,
theexperiencesof2000to2002forstocks,1994and1999forbonds,
1998forhedgefunds,andvintageyear1999forprivateequity/venture
capitalallowinvestorstogaininsightintothepotentialpainofatumultu-
ousmarketenvironment.Educationpertainingtoriskprofilingisimpor-
tantbecauseitsetsthetoneforallactivitiestofollow.Additionally,many
advisersdonothavesufficientexperiencewith alternative investments,
anduntilrecentlyyoungprofessionalshavenotmanagedthroughtough
marketenvironments.
Advisersoftenusequestionnairestohelpensureaconsistentapproach
isusedacrossthepracticewitheachclientandtofulfillcompliancere-
quirements.Questionnairescanbeexcellenttoolsiftheyservetoeducate
theclientandestablishreasonableexpectations,buttheycanbeacrutch
for firms that do not have qualified practitioners capable of communi-
catingeffectivelywithsophisticatedclients. Moreover, the ultra-affluent
oftenfindquestionnairesinsulting,especiallythosethatfocusonperson-
alitytraits.Thesetypesofquestionnairesmaybeabletotelliftheclientis
perhapsconservativeoraggressivebynature,buttheytypicallyofferlittle
morethanentertainmentvalue.Theobviousexampleisaninvestorwhois
conservativebynature.Anadviserfollowingthisconceptwilloftenpres-
entamixsoconservativethepotentialreturnswillbeinsufficientforthe
investortomaintainarespectablelifestyleduringretirementaftertaking
inflation, investment expenses, and taxes into account. Likewise, entre-
preneursmostoftentakeanaggressivepostureintheirbusinessdealings,
butafteramassingtheirhard-earnedfortunestheyaremostoftenseeking
topreservetheirwealth.Regardlessofwhattypeofquestionnaireisused,
anexperiencedprofessionalstillneedstostepinandbeabletocoachthe
ChallengesWithTraditionalInvestmentPolicyDevelopment 199
clients and at times protect them from the characteristics of their own
personality.
Organizationsshouldprovidesufficienteducationfortheirstafftoen-
surethatinexperiencedindividualsdonotusequestionnairesasacrutch
when attempting to solve taxable-account scenarios with mechanical,
cookie-cutter solutions solely for operational efficiency and compliance
purposes.Theseshortcutsaretypicaloffinancialplannersofferingsolu-
tionsbasedonwhattheclientorsponsoriswillingtopay.Withthesetypes
ofsolutionsyouonlygetwhatyoupayfor.Fortunately,therearequalified
practitioners within the financial planning and consulting communities
thatrefusetofallintothistrapanddoapplyaknowledgeableskillsetto
achievefavorableresultsfortheirclientsforareasonablefee.
Thefollowingisanoutlinethatcanbeusedtocreateaninvestment
policystatementthatwillincorporatethekeyelementsoftax-awarein-
vesting.
ElementsofaTax-AwareInvestment
PolicyStatement
1 Purposeormission:Outlineinsimpletermswhatistobeaccom-
plished.
2 Background
a. Source of wealth: Describe the source with the objective of
showing respect—for example, corporate source of funds, family
wealth,currentemployment,oraconcentratedstockposition.
b. Evolutionoftheprocess:Listkeyeventsandteachingpoints.
c. Education:Addresstheexperienceoftheindividualsinvolved
intheprocessandhoweducationwillproceedinthefuture.Also,
highlightlicensingorcertificationrequirements,ifany,toservein
certaincapacities.
3 Responsibilities
a. Client:Besuretodescribetheroleoftheclient,dependingon
whetheritisadiscretionaryornondiscretionaryplatform.
b. Adviser/consultant: Outline the specific services to be ren-
dered—forexample,riskprofiling,investmentpolicydevelopment,
assetallocation/location,managersearch,andmonitoring.Discuss
interactionwiththeothermembersofthequalifiedtriumvirate.
c. Accountant: Mention how reports will be presented and the
processforinteractingwithothermembersofthequalifiedtrium-
virate.
d. Estateattorney/trustee:Outlineauthorityandhowrecommen-
dationsaretobepresentedaspartofthequalifiedtriumvirate.
200 ChallengingTraditionalAssetAllocationMethods
There is no perfect length or amount of detail for the investment
policy statement. A firm may wish to have a lengthy document that it
keepsonfileandanexecutivesummarythatisincludedinthequarterly
reportingmaterials.Itisagoodpracticetostarteachmeetingbyasking
ifthereisanyneedtoconsiderrevisingthepolicystatement.Thus,the
documentshouldbedynamic,ratherthanstatic.Changescanbemade
intheoriginaldocumentorbylistingtheminanappendix.Appendices
shouldprovidetheflexibilitytorespondtoadditionalrequirementsand
detailwhenrequired.Formutualfundsandpartnerships,thereisaformal
documentforeachinvestmentstrategy.Thisisnotthecaseforseparate
accountmanagers.Ratherthanhaveeachadviserinthefirmcraftindi-
vidualinvestmentcriteriaforeachmanagerposition,thisprocessshould
becentralizedwithintheresearchstafftoachieveconsistencyandkeepthe
criteriawheretheycanbeeasilyaccessed.Thiswillsaveagreatdealoftime
andagainhighlightthefirm’sorganizationandattentiontodetail.
Thetypeofoptimizationtooluseddependsontheamountofassets
andtypeofsituationyouaremodeling.Forexample,amean-variance
optimizationmaybequitesuitableforanultra-high-net-worthfamily.
Withthistool,thepractitionercansharewiththefamilytherangeof
possibleoutcomesovervarioustimehorizonsandtheprobabilityofnot
meetingadesiredreturnobjective.Thevalueoftheoutputcanbeen-
hancedwithmethodslikeMonteCarlosimulation,whereasmanyasa
thousand iterations are modeled to provide a feel for likely outcomes.
These types of solutions are becoming more prevalent as the cost of
computermemorydrops.
Ifthereturngoalisnotmet,thefamilymayhavetoadjustitsstyle
of living or philanthropic activity. Another tool that incorporates asset/
liabilitymatchingismoreappropriateforcriticalfundingissues,suchas
foreducation.Inthiscase,ifthereturngoalisnotmet,theconsequences
arelikelytobefarmoresevere.Therefore,ratherthannaivelyapplyinga
givensoftwarepackage,theadvisershouldfirstaskwhattoolismostap-
propriateforthenatureofthetaxable-accountscenario.
In the example of the high-net-worth family, the policy statement
shouldattempttoidentifyasuitablelevelofriskasmeasuredbythestan-
darddeviationofreturns,whereaseducationfundingismoreorientedto
achievingadesiredrateofreturn.Thecurrentyieldtomaturityofagov-
ernment-sponsoredzero-couponbondwithamaturitydateequaltothe
timewhenfundswillbeneededeliminatesreinvestmentriskandprovides
aguaranteedprincipalamount.Therefore,oneormoreyieldsfromzero-
couponbondscanbeenteredintoaprogramorspreadsheettodetermine
theleveloffundingrequired.
Oneareathatisoftenoverlookedistheimpactofrebalancingtomain-
ChallengesWithTraditionalInvestmentPolicyDevelopment 203
tainthedesiredstrategictargetallocationontheafter-taxreturnsoftaxable
accounts.Aminimumandmaximumpercentageallocationisestablished
foreachassetclassinanefforttoadheretoabuylow,sellhighapproachand
controltheriskofthemixintheprocess.Quiteoften,practitionerssimply
pullapercentageoutoftheairtoestablishtherangeswithoutapplyingany
serious thought to the process.The magnitude of the ranges for taxable
accountsshouldstrikeabalancebetweenmaintainingaprudentriskprofile
andavoidingexcessivemovementofassetsthatwillleadtosubstantialcapi-
talgainsrealization,especiallygainsthatareshort-terminnature.Ifone
assetclassdropsfarbelowitscost,youmaywanttoselltheexistingposition
andharvesttheloss.Inthemeantime,theproceedsfromthesaleshouldbe
heldinasuitablealternativeforthirtydaystoavoidviolatingthewashsale
rule.Exchange-tradedfundssatisfythisneedwell.Thenthisamount,along
withtheadditionalfundsrequiredtoachievethestrategictargetallocation,
canbeinvestedinthelong-termstrategyofchoice.
As Jeffrey Horvitz points out in his article, “The Implications of
RebalancingtheInvestmentPortfoliofortheTaxableInvestor,”thereisno
perfectmethodforestablishingoptimalrangesortriggerpointsfortaking
action.1However,healsooffersamethodemployedbytax-awarepracti-
tionersthatcanreducepotentiallyfrivolousrebalancingbytakingintoac-
counttheprojectedvolatilityofeachassetclass.Toaccomplishthis,deter-
mineasuitablemultipleofthestandarddeviationandthenmultiplyitby
thestrategictargetallocationpercentage—forexample,1,1.5,or2times
thestandarddeviationofeachassetclass.Thisisoneareaoftax-awarein-
vestingthatwouldbenefitfromadditionalresearch.Unfortunately,there
isnoformulaavailabletodeterminetheoptimalfactorthatwilltakeinto
accountvariablessuchastheinvestor’staxprofileandthetimehorizon.To
demonstratehowthiscanbedone,FIGURE15.6wascreatedbytakingthe
after-taxstandarddeviationassumptionsfromchapter16andapplyinga
factorof1.5toachievethe+/–factororpercentagethatisappliedtothe
strategictargetallocationtoachievetheminimumandmaximumpermis-
siblepercentageallocations.
The one exception where you might not apply the methodology of
Figure15.6iswithcashequivalents,becausetheremaybeagenuineneed
tomaintainaliquidityreserve,10percentinthefigure.Sointhisexample,
10percentisenteredastheminimumrangeforcashequivalents.
Althoughagreatdealhasbeenwrittenaboutpayoutordistribution
policyforcharitableorganizations,thissubjectmatterislessunderstood
withhigh-net-worthfamilies.Thechallengewithhigh-net-worthfamilies
is that members of the family grow exponentially with each successive
generation,whilethegrowthinassetsislinear.Therefore,sometimeafter
theoriginalfortunehasbeenachieved,unlessfamilymemberscontinueto
204 ChallengingTraditionalAssetAllocationMethods
FIGURE15.6 C reatingthePermissibleRangeforEachAsset
Class(1.5+StandardDeviation)
AFTER-TAX STRATEGIC
STANDARD TARGET +/– MINIMUM MAXIMUM
ASSETCLASS DEVIATION ALLOCATION FACTOR RANGE RANGE
Source:DouglasS.Rogers
CashEquivalents 0.5% 10.0% 1.0% 10.0% 11.0%
100.0%
beeconomicallyproductive,theywillsoonsignificantlydilutetheamount
offundsavailabletomembersofsuccessivegenerations.Toillustratethis
concept,wewilluseanamountequaltothecurrentannualestateexclu-
sionof$2millionastheinitialamountofcorpus.Thefundsareinvested
inabalancedmixof65percentlarge-capdomesticstocksand35percent
fixedincomesecurities.Thehistorical10.4percentgrossreturnforlarge
companystocksisappliedtodomesticstocks,and80percentofthehis-
torical5.4percentreturnforintermediategovernmentsisusedtoachieve
areturnof4.3percentfortax-exemptbonds.2Thenweapplytheaverage
feeandtax-costratiofortherespectiveMorningstarcategorytoachieve
net returns of 7.8 percent for common stocks and 3.2 percent for tax-
exempt bonds.This results in a blended rate (net of fees and taxes) of
6.2percent.Applyingthehistoricalrateofinflationof3percentleavesa
realreturnofonly3.2percent.Therefore,historically,ifafamilyinvested
inatypicalmixofmutualfundsandachievedaveragereturns,distribu-
tionshadtobe3.2percentorlesseachyeartomaintainrealgrowthin
assets.Thisestimateisconservative,becausefeespaidtotheadviser,estate
attorney,andaccountantarenotincluded.
FIGURE15.7wascreatedusingdistributionratesof3,2,and1percent
annuallyinrealterms.Theavailableamountperfamilymemberfallspre-
cipitouslywiththegrowthinthenumberofindividualswitheachsuccessive
generation(thirtyyears).Itisnowonderyouhearstoriesaboutwell-known
wealthyfamilieswherecurrentgenerationsreceiveonlyapittanceinannual
ChallengesWithTraditionalInvestmentPolicyDevelopment 205
financialsupportascomparedwithearliergenerations,especiallyifthose
earliergenerationshadlavishlifestyles.Byapplyinghistoricalassumptions
andaveragefeeandtax-costratioinformationfromMorningstar,youfind
youwillneedtodistributesomewherelessthan1percentofassetsannually
ifyouwantfuturegenerationstobenefitequally.Theonlywaystoimprove
onthisscenarioaretohopeforlowerinflation,haveamoreaggressiveasset
mix,achievehigherreturns,paylowerfees,and/orlowerthetaxbite.Con-
trollinginflationisoutsidethecontrolofadvisersandinvestors.However,
byutilizingafter-taxassumptionsintheassetallocationprocess,allocating
asset classes and managers/funds according to the characteristics of each
entity, tax-aware equity manager positioning, and identifying tax-aware
managers/funds,thetaxableinvestorcanimproveperformanceby1.3to
2.5percentannually,dependingonthestructureoftherelationship.3
Tax-awaremanagersachievetheexposuretotheunderlyingassetclass
andattempttocreatealphabycombiningtheirtraditionalpracticesand
tax-awaremethodsthatlessenthetaxbiteorturnthestrategyintoanet-
loss generator. Fees and taxes can both be controlled by tax-aware prac-
titioners and their clients. For this exercise, fees and taxes amounted to
2.2 percent annually.This percentage can be reduced to as little as 0.6
percentbyusinglower-costtax-efficientmutualfundsorexchange-traded
funds,foranimprovementinnetannualperformanceof1.6percentalone!
Therefore,combiningthesesavingswiththeotherthreeelementsoftax-
awareinvestingcaneasilyproduceresultsthatareconsistentwiththeclaim
ofa2.5percentannualenhancementinperformancemadebymanytax-
awarepractitioners.Ithasonlybeentenyearsorsosincethesefeatureshave
beguntoreceivetheattentiontheydeserve.Thebottomlineis,iffamilies
wishtomaintaintheirfinancialdynasties,theyneedtotakeseriouslyatax-
awareapproachtoinvesting.
Managingatrustwasrelativelysimpleinthepast,whenallyouhadto
dowaspayoutincome.Previously,trustshavehadtwotypesofbeneficia-
ries:incomeandprincipal.Oftentheirinterestswerenotaligned,aswhen
onebenefitsitisusuallytothedetrimentoftheother.TheUniformPrin-
cipalandIncomeAct(UPIA)allowsgreaterflexibilitywithtrustdistribu-
tions.Perhapsthisactcameaboutbecauseincomebeneficiarieswerecom-
plainingaboutlowerdistributionsasaresultofloweryields.Fortunately,
morestatesareamendingtheirrulestoallowforaportionofgainstobe
allocatedaswell.Thischangeinmethodologyissimilartothedistribution
orspendingpoliciescharitableorganizationsadopt.Theonlydifference
is the distributions are taxable to the beneficiary. Therefore, the UPIA
heightenstheimportanceofthetrusteeormembersofthequalifiedtri-
umvirate,asnowtheyareinvestingfortotalreturnwithtaximplications.
Thetrusteenowneedstodeterminewhatlevelofdistributionisjust.As
206 ChallengingTraditionalAssetAllocationMethods
FIGURE15.7 H owtheLevelofDistributionAffects
theWealthofFutureGenerations
NO.OF 3%DISTRIBUTION
PEOPLE ANNUAL $DISTRIBUTION
GENERATION LIVING DISTRIBUTION PERMEMBER
$60,000
1 2 $60,114 $30,057
2 4 $63,516 $15,879
3 8 $67,238 $8,405
4 16 $71,178 $4,449
5 32 $75,349 $2,355
6 64 $79,764 $1,246
7 128 $84,438 $660
8 256 $89,386 $349
9 512 $94,624 $185
10 1024 $100,169 $98
aresult,wealthyfamiliesarenowtakingthetimeandefforttoconduct
elaborateafter-taxassetallocationandcashflowexercisestodeterminea
payoutratiothatwillbeequitabletoboththeincomebeneficiariesandthe
remaindermen.Atleastforthebeneficiariesinvolvedintheprocess,itisto
theirbenefitthatthequalifiedtriumvirateadherestoatax-awareprocess,
becauseiftheyhavetopaytaxesontheprincipaldistributionsitismuch
more favorable to account for them at the long-term capital gains rate
thanattheshort-termrate.Thisprocessjusthighlightshowimportantit
istobeabletoworkwithmembersofthequalifiedtriumviratewhocan
comprehendandapplythevariousfacetsoftax-awareinvesting.
Theinvestmentindustryhasevolvedtoapointwheretax-awarecon-
ceptscannowbeappliedinamoresystematicanduniformmanner.How-
ever,todosorequiresaplan,andthereisnobetterplacetoarticulatewhat
is required than in the investment policy statement.Therefore, putting
forththeeffortduringthecreationoftheinvestmentpolicystatementwill
drivetheremainingtaskstoensureatax-awareapproachcanbeachieved.
ChallengesWithTraditionalInvestmentPolicyDevelopment 207
2%DISTRIBUTION 1%DISTRIBUTION
SPENDING $DISTRIBUTION SPENDING $DISTRIBUTION
DISTRIBUTION PERMEMBER DISTRIBUTION PERMEMBER
$40,000 $20,000
$40,476 $20,238 $20,438 $10,219
$57,041 $14,260 $38,307 $9,577
$81,342 $10,168 $73,373 $9,172
$115,996 $7,250 $140,535 $8,783
$165,414 $5,169 $269,177 $8,412
$235,884 $3,686 $515,573 $8,056
$336,378 $2,628 $987,511 $7,715
Source:DouglasS.Rogers
$479,684 $1,874 $1,891,445 $7,388
$684,042 $1,336 $3,622,812 $7,076
$975,463 $953 $6,939,014 $6,776
ChapterNotes
1. JeffreyE.Horvitz,“TheImplicationsofRebalancingtheInvestmentPortfolio
fortheTaxableInvestor,”JournalofWealthManagement(Fall2002):49–53.
2. IbbotsonAssociates,Stocks,Bonds,BillsandInflation2003Yearbook(Chicago:
IbbotsonAssociates,2003).
3. J. Richard Joyner, “Tax-Efficient Investing: Can It Add 250 Basis Points
to Returns?” Journal of Investment Consulting vol. 67, no. 1 (Summer 2003):
82–89.
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CHAPTER16
DevelopingAfter-TaxAssetClass
Assumptions
[American tax laws] are constantly changing as our elected rep-
resentativesseeknewwaystoensurethatwhatevertaxadvicewe
receiveisincorrect.
—DaveBarry
A
t the Association for Investment Management and Research
(AIMR,nowtheCFAInstitute)conventionin2003,economist
PeterL.Bernsteinsharedfourkeypointsthathethoughtrep-
resented inflection points in the investment management industry.”1
Bernsteinbroughttotheforefrontpracticesthathavebeenacceptedin
investmentpolicydevelopmentalmostwithoutquestionforthebetter
part of thirty years.While bear markets are painful, the experience of
2000to2003broughtoutmanyoftheillsthatBernsteinandothershad
beenquestioningforsometime.Hisproclamationregardingthe“death
ofthepolicyportfolio”couldnothavebeenbettertimed,asitplayedto
amore-than-receptiveaudience.
Following a thought process to similar Bernstein’s, William Jahnke,
inhisnoteworthyarticle,“DeathtothePolicyPortfolio,”appropriately
attackstheinvestmentconsultingcommunityforitsmisrepresentationof
studiespertainingtotherandommarkethypothesisandtheimpactofas-
setallocationonfuturereturns.2Jahnkehighlights,“Thereisnothingin
Markowitzmean-varianceoptimizationorinSharpe’scapitalassetspric-
ingmodeltoindicatethattherandom-walkmodelsuggeststhathistorical
returnsshouldbeusedinforecasting.”Additionally,clientshavebeentold
foryearsthatthestatictargetallocationdictatesmorethan90percentof
209
210 ChallengingTraditionalAssetAllocationMethods
futurereturns,asaresultofthefindingspresentedin“Determinantsof
PortfolioPerformance,”byBrinson,Hood&Beebower(BHB).3While
assetallocationisimportant,asJahnkepointsout,properinterpretation
oftheresultssuggestsstatictargetallocationexplainsabout50percentof
thefuturereturnoveraten-yearhorizon.Thisestimateisfortax-exempt
accounts,sowhentaxesareincluded,thepercentagethatshouldbeattrib-
utedtostaticallocationshouldbeevenless.Thedifferencebetweenthe
BHBstudyandJahnke’sanalysisishowtheR2measurementisapplied.
RonaldSurz,DaleStevens,andMarkWimerhavepointedoutthat
whiletheBHBstudyhasbeenmisinterpreted,amuchsimplerapproach
providesvaluableinsight.4Theybelievethefocusshouldbeonthemag-
nitudeofthedifferenceinthereturnoftheactualportfoliomixandthe
investmentpolicyweightedbenchmarkreturn.Anexampleofanactual
return of 9.01 percent versus a policy return of 10.11 percent demon-
stratesthattheinvestmentpolicyportfoliorepresents112percent(10.11
/ 9.01) of the performance. Since the policy portfolio return is a com-
binationofpassiveportfolios,theactualportfoliomixreturnisaresult
ofthethreeprimaryeffects:sponsor,manager,andcosteffects.Fortax-
exemptandtaxableaccounts,thefirsttwoeffectsarethesame.However,
fortaxableaccounts,thetaximpactisanadditionalcostthatrangesfrom
–0.5to–2.5percent.Ifweappliedthemid-rangeof–1.5percenttothe
exampleabove,thepolicyportfoliowouldexplain135percent(10.11/
[9.10 – 1.50]).What this meaningful, simplistic approach highlights is
how difficult itis fortaxableaccounts tooutperform the passive policy
portfolio.However,thetaskisnotinsurmountable,andinfact,informed
taxableseparateaccountpractitionerscanachieveabetterratiothantheir
tax-exempt account peers. What follows in chapters 16 through 18 are
solutionstocommonmistakesmadewithtaxableportfoliosandsolutions
tonarrowthegaporexceedthereturnofthepassivepolicyportfolio.
Unfortunately,thereisanaiveaudiencetodaythatstillbelievesusing
historicalreturnstocalculateastatictargetmixwithoutstrategicadjust-
mentsisthepropermethodforallocatingclientfunds.Whenmarketsare
tradingatvaluationlevelssubstantiallydifferentfromhistoricalaverages,
usinghistoricalassumptionsleadstoanill-advisedsolution.Inthespring
of2000,adviserswhoutilizedhistoricalreturnsweresubjectingtheircli-
entstothegreatestequityexposureeveratpreciselythewrongtime,be-
causeoftherobustreturnsofthe1980sand1990s.Reversionbacktothe
normormeanisapowerfulforce,andwhenthingsgetoutoflinethere
isanaturalperiodofcorrection.Whiletheexacttimingofthesepoints
is difficult to predict, these long-term events are anything but random.
Thisisevidentbythe–0.85correlationbetweenreturnsofa60percent
equity/40percentfixedincomemixcalculatedbyRobArnottwhencom-
DevelopingAfter-TaxAssetClassAssumptions 211
paringthepreviousandfollowingten-yearperiods.5
Thestrategicingredientorelementthatincorporateshowtheworldis
likelytochangeoftengetsconfusedwithtacticalallocationorquicktim-
ingmechanisms.Strategicrevisionsaremadegraduallyandmethodically.
Liketaxes,financialmarketsandtheelementsthatinfluencethemchange
overtime.Historyisrifewithexamplesofmilitaryleadersfailingtoadjust
for change while their conquerors applied one or more strategic initia-
tivestodefeatthem.Tosimplyacceptadefeatistattitudeandclingtoa
portfolioallocationthatnolongerrepresentsrealitymakeslittlesense,but
ithappensalltoooften.Unlesshistoricalreturnsarerepresentativeofthe
future,usinghistoricalreturnsissimplyasigntheadviserorfirmsimply
isunwillingtodevotethetimeandenergynecessaryordoesnothavethe
intellectualcapitaltojustifyitsfee.
YogiBerraoftheNewYorkYankees,theholderoftenWorldSeries
rings, supposedly said among other things, “Predicting is very difficult,
especiallywhenitinvolvesthefuture.”Forecastingisdifficultbutitshould
not be neglected, and when done in a rationale, systematic manner it
servestheclients’bestinterests.Fortaxableaccounts,forecastingshould
alsoincludetheexpectationforchangesinthetaxcode.Remember,Berra
alsosaid,“Itain’tover’tilit’sover!”TheuseofYogiBerraasanexample
isintentional.Theanswersclientsreceivefromadvisers,afterbeingsub-
jectedtoreturnsofportfolioscreatedfromhistoricalreturnassumptions
duringthelastbearmarket,havehadthemtwistingtheirnecksandshak-
ingtheirandheadsjustliketheAFLACduckafterasessionwithBerraat
thebarbershop!
Threeprimaryinputassumptionsarerequiredforeachassetclassin
order to conduct a mean-variance allocation optimization exercise: the
projected return, the standard deviation of returns, and the correlation
coefficientbetweeneachassetclass.Modifyingbefore-taxassumptionsto
convertthemtonet-of-tax-and-feeassumptionsatfirstappearssomewhat
difficult,butitcanbedonewithrelativeeaseifasystematicapproachis
taken.Specificstepsrequiredinclude:
1 Identifysuitableassetclasses.
2 Determinethebefore-taxassetclassreturnassumptionstoinclude
theappreciationandincomecomponentsofreturn.
3 Calculatetheclient’santicipatedtaxprofile.
4 For the appreciation component of return, estimate the capital
gainsrealizationrateforeachassetclassandthepercentagesubject
toshort-versuslong-termcapitalgainstreatment.
5 Fortheincomecomponentofreturn,identifytheportionofin-
comethatistaxable,isaqualifieddividend,oristax-exempt.
6 Applyanappropriatefeeschedule.
212 ChallengingTraditionalAssetAllocationMethods
7 Adjustthebefore-taxstandard-deviationassumptionsfortheim-
pactoftaxes.
Thepurposeofthischapteristoprovidethemostbasicapproachto
determiningafter-taxassetclassassumptions,sothatitwillapplytothe
widestaudiencepossible.Thus,ifareader’scurrentassetallocationsoft-
warepackagedoesnotincorporatetheimpactoftaxes,asimplespread-
sheetcanbecreatedandmodifiedasappropriatetocreatethenecessary
inputvariables.
The assumptions are not intended to be static, as this would be as
faultyasapplyinghistoricalassumptions.Itisfrequentlyasked,“Howof-
tenshouldassetclassassumptionsberevised?”Theyshouldbeformally
reviewedonanannualbasis,asmostprofessionalcertificationprograms
includethisprovisionintheircodeofethicsorsimilardocuments.How-
ever,keyeconomicandpoliticaleventsshouldinstigatemorefrequentre-
view.TheeconomicimpactoftheeventsofSeptember11,2001,andthe
effectsofthecutsindividendandcapitalgainstaxratesin2003arejust
twoexamplesofeventsthatshouldhavecausedpractitionerstogobackto
thedrawingboardandreviewtheirassumptions.Manyfirmssatisfythis
requirement with a quarterly review of asset-class assumptions by their
investmentpolicycommittee.Theassumptionsshouldalsobemodified
when clients go through a major change in their tax profile, especially
thosethatarecreepingintothealternativeminimumtaxzone.
1 Identifysuitableassetclasses:First,youneedtodeterminethe
permissibleassetclassestheclientwishestoconsiderorthelistthefirm
desirestomaintainforgeneralpurposes.Theapprovedlistshouldbede-
terminedduringinitialcommunicationwhenobtainingtheinformation
necessarytoconstructthepolicystatement.Thereisafinelinebetween
offeringeducationandtakingdiscretionovertheassets.Advisersneedto
becarefulthattheydonotexceedtheauthorityinherentintheirparticular
typeofplatform.Theadvisermaybeastrongadvocateoftheemerging
markets,buttheclientmaybeunwillingtotoleratethevolatilityofthe
assetclass.Asaresult,thediscussionshouldfocusonthesesevenprimary
assetclassesandinflation:
1. Domesticequity
2. Internationalequity
3. Tax-exemptfixedincome
4. Realestate(REITs)andotherhardassets
5. Hedgefunds
6. Privateequity/venturecapital
7. Cashequivalents
8. Inflation
DevelopingAfter-TaxAssetClassAssumptions 213
Most firms maintain a more extensive list of asset class assumptions
drivenbythenatureoftheirclients.Also,refinementscanbemadewithin
thebroaderassetclasses.Forexample,taxablebondsmaybeincludedand
domesticequitycanbefurtherdelineatedintolarge-andsmall/mid-cap
components.
2 Determinethebefore-taxassetclassreturnassumptionstoin-
cludetheappreciationandincomecomponentsofreturn:Whende-
terminingassetclassassumptions,itisbesttofamiliarizeyourselfwiththe
followingelements:
❑ Historical returns, standard deviations, and correlation coeffi-
cients
❑ Therealreturnpremiumforeachassetclassinexcessofthehistori-
calrateofinflation(3percent)
❑ Economic,demographic,andpoliticaltrendsthatarelikelytohave
ameaningfulimpactonfuturereturns
❑ Projectedcorporateearnings
❑ Relativevaluationofeachassetclass
❑ Projectedrateofinflation
Afirmcangoaboutestablishingassetclassassumptionsbyvariousac-
ceptedmethodsthatincorporatevaluationtechniquesinabuilding-block
method.The key is to employ a method the firm can support and its
servicingpersonnelcaneasilyexplaintoclients.Theimportanceofestab-
lishingassumptionsissuchthatfirmsgenerallyrallythebestintellectual
resources to provide meaningful input into the process. For the sake of
brevity,hereisaverysimplemethodtodemonstratehowthiscanbedone
evenwitha“backoftheenvelope”approach.
To start the process, calculate the difference between the yield-
to-maturity of a U.S.Treasury bond and the real yield of an infla-
tion-protectionecurityofsimilarmaturity.AsofNovember2004,the
differentialsuggestsinflationof2.6percentoverthenexttenyears,as
comparedwiththe3percentaveragesince1926.6Thoughitissimple,
thismethodutilizesinformationfromthoseinthemarketwhoarecom-
mittingsignificantcapitalbasedontheiroutlookforinflationandfuture
interestratelevels.
Theinflationassumptioncanbeappliedtoachieveaprojectedyield-
to-maturity for a municipal bond of similar maturity, for instance, five
years. First, take the inflation assumption and add to it an appropriate
premiumabovetherateofinflation.Historically,thismeasurehasbeen
approximately2.4percent.Thissuggeststhefive-yearTreasuryislikelyto
yield5percent(2.6%+2.4%)inthefuture.Sincehigh-grademunicipal
bondstypicallytradeatayieldof80percentofTreasuries,weachievea
214 ChallengingTraditionalAssetAllocationMethods
yieldestimateof4percent(5%×0.80).Withthecurrentyield-to-matu-
rityforintermediate-maturitybondsat3percent,theaveragebondinthe
marketistradingatasignificantpremiumtoparvalueat108.45andasof
December31,2004,hadanaveragecouponof5.75percent.7Whenthe
averagebondinthemarketistradingatameaningfuldifferentialfrompar
(100)thebond’stotalreturnprojectionshouldincludeanappreciationor
depreciationcomponentofreturn.Thisisespeciallytrueforadviserswho
relyontheirassetclassassumptionsforclientincomeprojections.Forex-
ample,atthebeginningof2005,iftheclientelectedtoreceiveallincome
thenthecurrentpayoutwouldbeequaltothecurrentaveragecouponof
5.75percent,butwithbondstradingwellabovepartherewouldbemean-
ingfulerosionofprincipal.Thistypeofexerciseisespeciallyimportantfor
high-yieldcorporatebondafter-taxassumptions,asthetaxconsequences
ofpremiumsanddefaultsshouldalsobetakenintoconsideration.
Onemethodofaddressingtheseconcernsistocalculatetheaverage
yield-to-maturityandamountofamortizationoraccretionofthepremi-
umordiscountofthebenchmarkfixedincomeportfoliooverthetime
horizonoftheassetclassassumptions,forexample,tenyears.Tomakethese
calculations,wemustalsoknowtheremaininglifeormaturityoftheaver-
FIGURE16.1 EstimatingtheAverageCoupon
agebondinthebenchmarkportfolio,whichinthiscaseis6.76years.
InFIGURE16.1,theyield-to-maturity(YTM)foreachyearistheav-
erageversusthebeginningorendingYTM.Bytakingintoaccountthe
gradualadjustmentinthebenchmark’saveragecoupon,wecanestimate
theaveragecouponflow(4.20percent).Nextwecalculatetheannualad-
justmentinprice.Intheexample,bondsarepricedatapremiumtopar
value,sotheaverageannualamortizationwilloffsettheaveragecoupon
amountjustcalculatedtoachieveanestimateofaveragetotalreturn(see
FIGURE16.2).
Whenwesumtheaveragecoupon(4.20percent)andimpactofamor-
tizationforbondstradingatapremiumtoparvalue(–0.81percent),we
reachanestimatedannualtotalreturnof3.39percent.
JeremySiegelpointsoutthatonaverage,stockshavehistoricallytraded
at14.8timesearnings,andwhenyoutaketheinverseofthisnumberyou
comeupwith6.8percent,whichisclosetotherealreturnpremiumfor
domesticstocks.8AsofNovember2004,theprice-to-earningsratiobased
onoperatingearningsisapproximately18($1,185/$65.75).Therefore,
thecurrentestimateoftherealreturnpremiumfordomesticstocksis5.5
percentbythisapproach.Sinceourestimateforinflationis2.6percent,
FIGURE16.2 CalculatingAnnualChangeinPricePremium
FIGURE16.3 ComponentsofReturn
Source:DouglasS.Rogers
PrivateEquity/VentureCapital 13.0% 13.0% 0.0%
CashEquivalents 2.4% 0.0% 2.4%
Inflation 2.6%
thenominalreturnestimatefordomesticcommonstocksis8.1percent.
Returnsfortheremainingassetclassescanbederivedbasedontheircur-
rentvaluationrelativetothesetwoprimaryassetclasses.Forexample,at
thisjuncture,REITsarepricedatanevenhigherpremiumthandomestic
equitiesandshouldbeawardedanappropriatediscount.FIGURE16.3lists
theassumptionsthatwillbeemployedthroughouttheremainderofthe
chapter.
Thekeyistoeducateclientsandmanagetheexpectationofwhatthe
futureislikelytobringandhowbesttopositiontheiroverallmixofassets.
Alongwiththetotalreturn,theappreciationandincomecomponentsof
return are given in Figure 16.3.This is necessary, because our tax code
hasdifferenttaxratesthatapplytothevarioustypesofappreciationand
income.Aswasshownwithtax-exemptincome,theincomecomponent
shouldrepresenttheaverageoftheperiodratherthanwhatiscurrently
availableinthemarket.Thereisnosingletimeperiodfortheanalysisthat
isperfect.Thisexerciseassumesaten-yearprojection.Thetimehorizon
oftheanalysisshouldbeestablishedaccordingtotheneedsoftheclient.
Anappropriatetimehorizonforanucleardecommissioningtrustmaybe
twenty-fivetofortyyears,whereasforaretireeitmaybemuchshorter.
3Calculate the client’s anticipated tax profile: Before we begin
analyzing the impact of taxes on the before-tax return assumptions, we
needtodeveloptheanticipatedtaxrateprofileoftheclient.Inthisex-
ample,ourclientissubjecttothemaximumfederaltaxrates(35percent),
DevelopingAfter-TaxAssetClassAssumptions 217
a5percentstatetax,anda1percentlocaltax.Usingtheformulaforan-
ticipatedtaxratesfromchapter7,weobtainthefollowingrates:
Ordinaryincomeandshort-termcapitalgains 38.9%
Qualifieddividends 20.1%
Long-termcapitalgains 18.9%
Thesetaxratesareappliedwhenappropriatetoachievetheafter-tax
returns.Theexampleshowstaxratesfor2004.However,tobeconsistent
with the method used to determine asset class assumptions, it is also a
worthwhile exercise to consider applying a forward-looking element to
theclient’saverageprojectedtaxprofile.Forexample,asofthiswriting,
ordinaryincome,stockdividend,andcapitalgainstaxratesareatthelow-
estlevelseverinthepost–WorldWarIIera.However,withlargebudget
deficits,manybelievetaxlevelswillrevertbacktothe39.6percentrateon
ordinaryincomeand20percentrateoncapitalgainsforwealthyindividu-
als.Therefore,youcoulduseblendedratesforthefederaltaxonordinary
incomeof37.3percent([35%+39.6%]/2)onordinaryincome,17.5
percentonlong-termcapitalgains([15%+20%]/2)and27.3percent
([15%+39.6%]/2)oncommonstockdividends,ifsodesired.Similar
analysiscanbeappliedtostateandlocaltaxratesaswell.
4Fortheappreciationcomponentofreturn,estimatethecapital
gainsrealizationrateforeachassetclassandthepercentagesubject
toshort-versuslong-termcapitalgainstreatment:Fortheapprecia-
tioncomponentofreturn,therearetwofactorsthatinfluencetheimpact
oftaxes.Firstisthecapitalgainsrealizationrate(CGRR).Forthisexercise
only,theCGRRisdefinedasthepercentageoftheappreciationcompo-
nentofreturnthatgeneratesataxableevent.Thisshouldnotbeconfused
withtheportfolioturnoverrate,whichisbestsuitedformeasuringtrans-
action or commission costs versus tax implications. The CGRR might
alsobecalledthenettaxableturnover,andsomepractitionerscallitthe
effectiveturnover.Thenextstepistotakeintoaccountthepercentageof
short-versuslong-termcapitalgains.Fromthisinformation,thetaxim-
pactfortheappreciationcomponentofreturncanbecalculatedforeach
assetclass,asFIGURE16.4shows.
TheCGRRisshownherepurposelyasanegativevalue.Thenegative
signisappropriateifthemanagersbeingconsideredhaveafter-taxreturns
lowerthantheirbefore-taxreturns,whichistypicallythecase.However,
quantitativetax-awareequitymanagersdiscussedinchapter10andmu-
nicipalbondmanagerswhoemphasizetax-lossharvestingdogeneratepre-
liquidationafter-taxreturnsgreaterthantheirbefore-taxreturns.When
employingthesetypesoftax-awaremanagers,theCGRRpercentagecan
beapositiveentryashighas+5percentto+15percent,dependingonthe
218 ChallengingTraditionalAssetAllocationMethods
FIGURE16.4 E stimatingtheTaxImpactoftheAppreciation
ComponentofReturn
Source:DouglasS.Rogers
PrivateEquity/
VentureCapital 13.0% –0% 0% 100% –0.2%
CashEquivalents 0.0%–100% 100% 0% 0.0%
timehorizonoftheexercise.Asdiscussedinchapter11,tax-lossharvesting
ismostproductiveduringtheearlyyearsofanaccountrelationshipthat
isfundedwithcash.Therefore,thelongerthetimehorizon,thelowerthe
percentageshouldbeforthispositivecontributiontotheportfoliomix.
Somefirmsevenlistthesemanagersasseparateassetclassestodetermine
anappropriateequity“coreandsatellite”allocation.
5 For the income component of return, identify the portion of
incomethatistaxable,isaqualifieddividend,oristax-exempt:The
taxcalculationfortheincomecomponentofreturnisrelativelystraight-
forwardbutsubjecttothreedifferenttaxrates,asshowninFIGURE16.5.
If the client is also subject to the alternative minimum tax, additional
adjustmentsmaybenecessary.
TheareathatisleastspecificisthepercentageofREITandinterna-
tionalstockdividendseligibleforqualifieddividendtaxtreatmentatthe
morefavorable15percentrate.Coordinatingwithmanagersandcalling
companytreasurersaresometimesnecessarytoacquirethisinformation.
6 Apply an appropriate fee schedule: Now that the tax conse-
quencesfrombothcomponentsofreturnarecalculated,feescanbein-
cludedtoderivethereturnsaftertaxesandfeesforeachassetclass(see
FIGURE16.6).
Thefeeestimatesshownaboveareforseparateaccountmanagers,and
forpartnershipsinthecaseofhedgefundsandprivateequity/venturecap-
ital.Inthisexample,aconservativeapproachwastakenbyassumingthe
DevelopingAfter-TaxAssetClassAssumptions 219
FIGURE16.5 E stimatingtheTaxImpactoftheIncome
ComponentofReturn
PrivateEquity/
VentureCapital 0.0% 0% 100% 0% 0.0%
CashEquivalents 2.4% 100% 0% 0% –0.9%
feeswerenotdeductiblefortaxpurposes.Whenusingmutualfundsand
modeling for certain trust structures, fees may be offset against income
andshouldbeaccountedforappropriatelyintheprocess.Inthecaseof
mutualfunds,youcanforgothefeeanalysisandsimplyconducttheexer-
cisenetoffees,whichisthemethodforreportingmutualfundbefore-and
after-taxreturns.
Eachestimateshouldberepresentativeofthetypesofseparateaccount
managers, funds, and partnerships the client is likely to hold.You may
wishtoapplyauniformfeeforeachassetclass—say,forexample,ifyou
arecharginganall-infeearrangementthatwouldberepresentativeofa
wrapprovider,whichonaverageis1.75percent. If a consultant is em-
ployed,youmayalsowishtoaddthatfeetothemanagerfeeforeachasset
class.
Oneareathatisabitchallengingisestimatingfeesforhedgefunds
andprivateequity/venturecapitalpartnerships.Thetypicalstructureof1
percentofassetsand20percentofprofitsaboveahurdleratecausesasub-
stantialdifferencebetweengrossandnetresultsevenbeforeconsidering
theimpactoftaxes,andtheadditional1percentofassetsand10percent
ofprofitschargedbyafundoffundsonlyaddstothecomplexityofthe
calculation.
7 Adjustthebefore-taxstandarddeviationassumptionsforthe
impactoftaxes:Manyfirmsstarttheprocessbytakinghistoricalstandard
220 ChallengingTraditionalAssetAllocationMethods
FIGURE16.6 ReturnAssumptionsAfterFeesandTaxes
RETURNAFTER
BEFORE-TAX AFTER-TAX FEESAND
ASSETCLASS RETURN TOTALTAX RETURN FEES TAXES
Source:DouglasS.Rogers
PrivateEquity/
VentureCapital 13.0% –0.2% 12.8% 2.90% 10.1%
CashEquivalents 2.4% –0.9% 1.5% 0.20% 2.2%
deviationsandadjustingthemslightlyfortrendsinthemarket.Forexam-
ple,mostrecently,domesticstockreturnshavebeenlessvolatilethantheir
historicalaverage.Iftheadviserbelievesthiswillbeapersistenttrend,then
anappropriateadjustmentisinorder.Withafter-taxreturns,itisassumed
thattaxesarepaidquarterly,sincethistypeofanalysistypicallyappliesto
clients filing quarterly estimated taxes.Therefore, you can review quar-
terlyreturnsandfocusonthevariationintheappreciationcomponentof
returntocomeupwithareasonableadjustmentfactor.After-taxstandard
deviationsarelowerthantheirbefore-taxcounterparts,becausewithap-
preciation,taxesarepaidonrealizedgainsandcreditsaccumulatefrom
realizedlosses.Thisleadstoasmoother,less volatile return stream. For
equitiesthereisabouta10percenthaircut,orreductioninvolatility.With
taxablebondsandsomehedgefundstrategies,thetaxhaircutapproaches
thetaxrate,sincethemajorityofthereturnistaxable(seeFIGURE16.7).
Last,tohavealltheinformationnecessarytoconducttheoptimiza-
tionexercise,correlationcoefficientsbetweentheassetclassesarerequired
(see FIGURE 16.8).Thisistheoneareawheretherereallyisnoneedto
make an adjustment, because the tax impact causes only minute differ-
encesbetweenbefore-andafter-taxassumptions.Asaresult,mostfirms
thatuseafter-taxassumptionssimplyrelyontheirbefore-taxcorrelation
coefficientassumptions.
DevelopingAfter-TaxAssetClassAssumptions 221
FIGURE16.7 S tandardDeviationAssumptionsAfter
FeesandTaxes
PrivateEquity/
VentureCapital 32.0% 95% 30.4%
CashEquivalents 0.5% 95% 0.5%
Aswithanyoptimization,reasonableconstraintsmustbeputinplace
foreachassetclasstopreventa“cornersolution.”Acornersolutionoccurs
when the optimizer selects a preponderance of one or two asset classes
thatsimplydonotrepresentaprudentrecommendation.Thiscaneasily
happenwhenhedgefundsareincludedinthemix,becauseoftheirlow
volatilityandcorrelationswithotherassetclasses.Alwaysrememberthat
theexerciseshouldbebasedonwhatisreasonable,asthisisanartform
ratherthananexactscience.
Onceyouruntheoptimizationwithafter-taxassetallocationassump-
tions, you are likely to face three outcomes. First, since after-tax return
andstandarddeviationassumptionsarelowerthantheirbefore-taxcoun-
terparts,youshouldexpecttheefficientfrontiertoslopedownandtothe
left(seeFIGURE16.9).
Second, the after-tax portfolio will shift from tax-inefficient hedge
funds to more tax-efficient private equity/venture capital, as compared
withthenormalbefore-taxmix.Thisiswhyconsultantsinthehigh-net-
wortharenaoftenrecommendahigherpercentageoftax-inefficientnon-
directionalstrategiesinfoundationsandlesstax-onerouslong/shortequity
strategiesfortheirfamilies’taxableaccounthedgefundrequirements.
If you adhere to the concept of speaking to clients in terms of be-
fore-taxvolatilityorstandarddeviation,theoptimalafter-taxsolutionwill
222 ChallengingTraditionalAssetAllocationMethods
FIGURE16.8 CorrelationCoefficients
AssetClass 1 2 3 4 5 6 7
Source:DouglasS.Rogers
5 HedgeFunds 1.00 0.52 –0.20
7 CashEquivalents 1.00
mostlikelyincludemoreequityandfewerbondsthanthebefore-taxmix.
Thisoccursbecauseyouattempttotargetthesamelevelofriskbyapply-
ingless-volatileafter-taxstandarddeviationassumptions,asFigure16.7
indicates.Therefore,thirdandlast,whenyoucompareefficientmixesfor
theafter-taxandbefore-taxsolutions,theafter-taxefficientmixgenerates
asuperiorsolutiononanafter-taxreturnbasisfortheequivalentlevelof
risk.Theamountofthevalueaddedtypicallyrangesfrom0percentto
perhapsashighas0.7percent,dependingonthereturnassumptionsand
themixofpermissibleassetclasses.
Whenproperlyapplied,useofafter-taxassumptionsintheassetclass
optimizationprocessisoneofthefourkeyelementsintheconsultative
processthatcanleadtosuperiorafter-taxresults.Thediscussionherewas
purposelymaintainedatabasiclevelsothatwhenpractitionersencounter
sophisticatedallocationsoftwareincorporatingtaxes,theywillbefamiliar
enoughwiththeapproachandterminologytomakeinformeddecisions.
More important, software applications have their strengths and limita-
tions,andtax-awarepractitionersneedtohavetheexperiencetoensure
quantitative tools are being properly employed to the benefit of clients
withtaxableaccounts.
DevelopingAfter-TaxAssetClassAssumptions 223
FIGURE16.9 ShiftintheEfficientFrontierforTaxesandFees
FrontierBeforeTaxesandFees
ReturnPercent
Source:DouglasS.Rogers
EfficientFrontierAfterTaxesandFees
Risk(StandardDeviation)Percent
ChapterNotes
1. PeterL.Bernstein,“Overview:AFifthPointofInflection,”PointsofInflection:
Rogers/TaxAwareFig.16.9
NewDirectionsforPortfolioManagement,CFAInstituteConferenceProceedings,
2004,1–5.
2. William Jahnke, “Death to the Policy Portfolio,” in The Investment Think
Tank:Theory,StrategyandPracticeforAdvisers,editedbyHaroldEvenskyand
DeenaB.Katz(Princeton,NJ:BloombergPress,2004),17–37.
3. GaryL.Brinson,RandolphHood,andGaryL.Beebower,“Determinantsof
PortfolioPerformance,”FinancialAnalystJournal(July/August1986).
4. RonaldJ.Surz,DaleStevens,andMarkWimer,“TheImportanceofInvest-
mentPolicy,”JournalofInvesting(Winter1999):1–6.
5. RobertD.Arnott,“Editor’sCorner,”FinancialAnalystsJournal(September/
October2004):6–9.
6. IbbotsonAssociates,Stocks,Bonds,BillsandInflation2003Yearbook(Chicago:
IbbotsonAssociates,2003).
7. WeightedaverageofLehmanMunicipalBondone-,three-,five-,seven-,and
ten-yearindexinformation.
8. JeremyJ.Siegel,“TheLong-RunEquityRiskPremium,”PointsofInflection:
NewDirectionsforPortfolioManagement,CFAInstituteConferenceProceedings,
2004,53–62.
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CHAPTER17
WhytheStyleBoxHurts
TaxableInvestors
Because of the income tax, a penny saved is more than a penny
earned.
—JefferyL.Yablon
T
heschematicthatweinvestmentprofessionalsareintroducedto
during our formative years categorizes equity managers accord-
ingtotheaveragemarketcapitalizationofcommonstocksinthe
modelportfolioandthestylemethodologyemployedtoselectthem.1Em-
ployingmultipleequitymanagersfortaxableclientsaccordingtothispro-
cessleadstonothingmorethan“overpricedentertainment,”assuggested
byDavidSteinofParametricPortfolioAssociates.2Unfortunately,trading
by portfolio managers to maintain capitalization and style purity leads
to premature and unnecessary realization of capital gains. Additionally,
whenanexcessivenumberofmanagersareemployed,themanagerstend
tocomeinatthehighendoftheirindividualfeeschedulesratherthan
allowingaccesstosliding-scalevolumediscountswhenjustafewmanag-
ersareutilized.Fortaxableaccounts,whenitcomestodeterminingthe
optimalnumberofequitymanagers,theruleofthumbis“Lessisbetter
thanmore!”
Concreteguidelinesforsegmentingcommonstocksaccordingtomarket
capitalization do not exist; more precisely, they differ from provider to
provider.Themeanandmedianmarketcapitalizationcanbequitediffer-
ent.Forexample,theS&P500stockindexcurrentlyhasameanmarket
capitalizationof$90billion,ascomparedwithamedianof$10billion.
225
226 ChallengingTraditionalAssetAllocationMethods
FIGURE17.1 T raditionalEquityManagerStyle/Capitalization
Grid
Large
Middle
Source:DouglasS.Rogers
Small
ThemeanmarketcapitalizationintheRussell1000,MidCap,and2000
Figure17.1Rogers
indicesare$80.2billion,$6.2billion,and$0.9billion,respectivelyfor
the large-, middle-, and small-capitalization segments of the domestic
stockmarket.Thesevaluescanshiftdramatically,dependingontheav-
erageprice-to-earningsratioofstocksandinvestmentbankingactivity.3
Corporatetransactionsinvolvinginitialpublicofferings,companiesgoing
private,mergers,andtakeoversinfluencethecompositionofthevarious
marketindices.
Attemptingtocategorizeandbenchmarkmanagersaccordingtotheir
purchaseandsalemethodologycanbechallenging,asmanagersmayem-
ployeclecticapproaches.Managersselectingstockswithagrowthorien-
tationtypicallyseekcompanieswithsuperiorearningsgrowthandcor-
respondinglyhighprice-to-earnings(P/E)orprice-to-book(P/B)ratios.
Ontheotherhand,valuemanagersattempttoidentifystocksthatare
trading at a discount to others and typically have a lower P/E or P/B
multiple than the overall market. A “core” or a “blend” strategy sim-
plycombineselementsofboththevalueandgrowthstock-selection
methodologies.
FIGURE17.1illustratesthetraditionalequitystyle/capitalizationgrid.
Overtheyears,thetax-exempt-accountconsultingindustryhasem-
phasized style/capitalization purity to create a high degree of focus and
specialization, as there is an accepted belief this eliminates overlap and
createsthemostpotentialforsuperiorreturns.Itistakensoseriouslythat
managersareoftenterminatediftheydrifttoofarawayfromtheirper-
WhytheStyleBoxHurtsTaxableInvestors 227
ceivedcategory.Whilethismaybenefittax-exemptaccountinvestors,it
workstothedetrimentofthetaxableinvestor.
Thefrictionalcoststotaxableinvestorscomeinthreeways.Thefirst
costassociatedwithmaintainingstylepurityisthecostoftrading.The
othertwocostsarefarmoresignificantandinvolvethepaymentoftaxes
onrealizedcapitalgains.Thisoccurswhenasecuritymustbesold,be-
causeachangeinpricecausestheP/EorP/Bratioorthecapitalization
ofasecuritytobeinconsistentwiththemanager’sstyleorcapitalization
designation.
Tohighlightthecostofrigidstyleadherence,wewillinvestigatethe
capital gains realization history of several Vanguard index funds.The
fundsusedinthisexerciseareintendedtodemonstrateteachingpoints
andnottosuggestarecommendationfororagainsttheirpurchaseinthe
future.Sinceweareapplyinginformationfrommutualfunds,thecosts
presentedshouldbeconsideredasthemostconservativewaytoestimate
whatinvestorsonaveragearelikelytoexperience.Withtheexception
ofredemptionactivity,theonlytimestocksintheportfolioaresoldis
whentheindexisadjusted,or“reconstituted.”Thereisanotherevent
thatcancauseataxabletransaction:themergeroftwofirmsconducted
on a cash basis, versus an exchange of shares.Therefore, the costs in-
volvedareinmostcasesfarlowerthanwouldbethecaseifactiveman-
agerswereemployed.Mutualfundcapitalgainsgenerationinformation
istakenfromMorningstarPrincipiatohighlighthoweasilythistypeof
analysiscanbedone.4
First,wewillexaminetheimpactthatadherencetomarketcapitaliza-
tionparametershasongeneratingcapitalgainsandtaxes.Thechallenge
occurs when the sponsor reconstitutes the indices and eliminates the
mostsuccessfulstocksinsmall-andmid-capportfolios.Tomaintainthe
integrityoftheindexportfolio,themanagersellsstocks,whichusually
resultsinsubstantialgains.Whensmall-andmid-capstocksriserapidly
incapitalization,aswithtechnologyissuesduringthelatterhalfofthe
1990s,theindiceshavethepotentialtoproduceshort-termcapitalgains
thataretaxedatthehigherratesforordinaryincome.Thischallengeis
not a factor with large-cap portfolios, as there is no need to remove a
long-termconsistentgrowthstock,suchasGeneralElectric.Therefore,
weshouldexpectbothsmall-andmid-capindexportfoliostogenerate
meaningfulcapitalgainsinordertomaintaindesiredmarketcapitaliza-
tioncriteria.ThecostofthisphenomenonisshowninFIGURE17.2using
informationtakenfromMorningstarInvestmentDetailReportsforthe
Vanguard500,Mid-Cap,andSmall-Capindexfunds.Allcapitalgains
distributionshavebeenadjustedtoreflecta$100investmentatthebe-
ginningoftheyear.
228 ChallengingTraditionalAssetAllocationMethods
FIGURE17.2 ImpactofCapitalizationonCapitalGains
RealizationDistributionper$100Investment
Source:Morningstar,DouglasS.Rogers
500Index/S&P500Index $0.88 $0.00 $0.00 $0.00 $0.00 $0.18
Mid-CapIndex/S&P
MidCap400Index $8.71 $8.68 $2.05 $1.10 $0.00 $4.11
Small-CapIndex/
Russell2000Index $9.81 $12.80 $0.00 $0.00 $0.00 $4.52
FIGURE17.3 eightedBlendCapitalGainsRealizationVersus
W
TotalMarketDistributionper$100Investment
Source:Morningstar,DouglasS.Rogers
70%Large/20%Middle/
10%Small/S&P500,
S&P400&Russell2000 $3.34 $3.02 $0.41 $0.22 $0.00 $1.40
100%TotalMarket
StockMarketIndex/
Wilshire5000Index $1.29 $0.42 $0.00 $0.00 $0.00 $0.34
Fiveyearsofinformationisshown,astheVanguardMid-CapIndex
FundbeganinMay1998.Moreimportant,usinganaverageofthefive
yearsgivesamoreaccurateportrayalofwhattoexpectinanyoneyear,as
thebullmarketuptothespringof2000hadamuchgreaterimpacton
capital gains generation when compared with the bear market that fol-
lowed.Asexpected,adherencetomarketcapitalizationparametershasa
tremendoustaximpactwithsmall-andmid-capindexportfolios.Froma
taxstandpointalone,itisreasonabletolumpsmallandmiddlecapitaliza-
tion together to create a small/middle-capitalization category. A typical
equityallocation—orinthiscase,afundallocation—of70percent500
Index,20percentMid-CapIndex,and10percentSmall-CapIndexwith
the resulting capital gains is compared with the VanguardTotal Stock
WhytheStyleBoxHurtsTaxableInvestors 229
FIGURE17.4 ImpactofStyleonCapitalGains
RealizationDistributionper$100Investment
Value/S&P500/
BarraValueIndex $8.71 $4.28 $4.29 $0.00 $0.00 $3.45
Growth/S&P500/
BarraGrowthIndex $3.28 $0.00 $0.00 $0.00 $0.00 $0.66
Source:Morningstar,DouglasS.Rogers
Small-CapValue/
S&PSmallCap600/
BarraValueIndex $5.72 $5.92 $5.70 $2.62 $0.00 $3.99
Small-CapGrowth/
S&PSmallCap600/
BarraGrowthIndex $0.00 $5.01 $0.00 $0.00 $0.00 $1.00
MarketIndexFund,whichattemptstoreplicatetheoveralldomesticeq-
uitymarket(seeFIGURE17.3).
Thecapitalgainsdistributionofthetraditionalblendthatconsultants
andadvisersfortax-exemptaccountsusetoconstructclientportfoliosre-
sultsinmorethanfourtimestheamountofcapitalgainsgenerationthat
holdingthemarketportfolio,asrepresentedbytheVanguardTotalStock
MarketIndexFund!Itshouldbenotedthatthetwoexamplesrepresenta
best-casescenario,becausetheprimarysourceofcapitalgainsrealization
isfromtradingactivityconductedasaresultofreconstitutingtheunderly-
ingindexofthefunds.Withactivemanagement,thecomparativeresults
wouldmostlikelybefarmoredramatic,sincemanagerswouldhavead-
ditionaltradingactivitywhensellinglessattractivestocksforthosethey
believewilloffersuperiorreturnsinthefuture.
Thesecondfactorpertainstothetradingactivityrequiredtomaintain
aparticularbuy-and-sellstockmethodologyorstylethatresultsinundesir-
ablecapitalgainsandtaxes.Inthefollowingexample,wewillanalyzeresults
fromVanguard’svalueandgrowthstyleindexfunds(seeFIGURE17.4).
Cautionshouldbetakenincomparingtheresultsofthestyleindices
bycapitalization,becausethelarge-capfunds(1992)werecreatedsixyears
beforethesmall-capseries(1998).Therefore,theyhadmoretimetoac-
cumulateanunrealizedcapitalgainposition.However,whatthefundsdo
showisthatbuy-and-holdgrowthismoretax-efficientwhenmeasuredby
230 ChallengingTraditionalAssetAllocationMethods
thedollaramountofcapitalgainsgeneratedbyafactorofapproximately
4to1.Forthisperiodofanalysis,Vanguardemployedtheindexinforma-
tionfromS&P500/Barra,butithasrecentlyswitchedtoanewmethod-
ologycreatedbyMorganStanleyCapitalInternational.5Barracategorizes
stocks as being value or growth according to their relative P/B ratio, as
studieshavedemonstratedthatthismeasureismorestablethantheP/E
ratio.6Whenindicesarereconstituted,stockssoldfromavalueindexport-
folioarelikelytohaveappreciatedsignificantly,causingtherealizationof
meaningfuldollaramountsofcapitalgains.Fromataxview,evenwith
index funds, the value-stock selection methodology represents more of
atradingstrategyratherthanabuy-and-holdpropositionthatwillallow
capitalgainstocompoundtax-freeuntilrealized.Ontheotherhand,a
stockremovedfromagrowthindexislikelytohavebeenexperiencinga
decliningpriceandmayhaveminimalappreciation,orpossiblyevenbe
soldataloss.Whenlossesoccurwithtaxableaccounts,orinthisexample
anindexfundportfolio,theyoffereconomicvaluebecausetheywillulti-
matelybeusedtooffsetaportionofrealizedcapitalgains.
Anotherfactorthathascontributedtolowertaxefficiencyforvalue-
oriented portfolios is that dividends were taxed at the ordinary income
ratebefore2003.
FIGURE17.5showsthatthevaluestyleconsistentlyhasahigherpayout
FIGURE17.5 IncomeofStyleofBenchmarkStyleFunds
Distributionper$100Investment
Value/S&P500/
BarraValueIndex $1.60 $1.57 $1.40 $1.69 $2.53 $1.76 $0.23
Growth/S&P500/
BarraGrowthIndex $0.73 $0.33 $0.62 $0.87 $0.90 $0.69 $0.23
Source:Morningstar,DouglasS.Rogers
Small-CapValue/
S&PSmallCap600/
BarraValueIndex $0.80 $0.95 $0.73 $0.87 $2.35 $1.14 $0.27
Small-CapGrowth/
S&PSmallCap600/
BarraGrowthIndex $0.42 $0.00 $0.18 $0.28 $0.00 $0.18 $0.27
WhytheStyleBoxHurtsTaxableInvestors 231
individends,asexpected.Using2002asanexample,forevery$100in-
vested,aninvestorsubjecttothemaximumfederaltaxrate(38.6percent)
wouldhavepaid$0.65($1.69×38.6%)intaxesfordividendsdistributed
fromtheValueIndexFund,ascomparedwith$0.34($0.87×38.6%)for
theGrowthIndexFund.Manyseparateaccountinvestorscannotoffset
feesagainsttaxableincomewhenfilingtheirtaxreturn.Therefore,togain
anaccurateportrayalofthetaximpactofdividendsfromtheinformation
inFigure17.5,theyneedtoaddbackthefeetofindthegrossdividend
yield.Sointhelastcolumn,thefeeorcostper$100investedisshownfor
eachVanguard fund. During this five-year period, the expenses for any
ofthefundsshowndidnotvarybyanymorethan$0.01.Aseparateac-
countmirroringtheVanguardValueFundwouldhavehadagrossyieldof
$1.92($1.69+$0.23).Therefore,forseparateaccountsholdingtheindex
portfolio,thedifferenceintaxpaymentsforthevalueandgrowthstyles
wouldbe$0.74($1.92×38.6%)and$0.42($1.10×38.6%),respectively.
Asyoucansee,ifthefeeforseparateaccountmanagementwasnotsub-
stantiallylower,themutualfundformatmayofferthetaxableinvestor
an advantage from a tax standpoint, but the separate account format
doeshaveanadvantageofprotectinginvestorsfromtheadverseimpactof
shareholderredemptionactivity.
Combining the impact of portfolio rebalancing and dividend yield
dampens the value style’s after-tax returns.7Therefore, growth-oriented
indexportfoliosareinherentlymoretax-efficientthanthosewithavalue
orientation.Anexceptiontothisgeneralruleiscorporateaccounts,which
benefitfromtheexclusionof70percentoftheirdividendincomefrom
taxation.Inthesecases,stocksthatpayhigherdividends,likepreferreds,
mayoffersuperiorafter-taxreturns.
Thedilemmawiththetraditionalstylematrixcanbesolvedinoneof
twoways.Thefirstmethod,forseparateaccounts,istoemployastruc-
tureotherthanthetraditionalthree-by-threematrix.Thesecondmethod,
whichpertainstomutualfunds,istoutilizeafundvehiclethatisnotvic-
timizedbycapitalizationgainsgenerationfromperiodicreconstitution.
Thereareseveralequityallocationmodelsthatconsultantsandinves-
torswhomanagetaxableassetscanemploytolessenunnecessarycapital
gainsgenerationandpaymentoftaxes.First,let’sexaminemodifications
tothetraditionalthree-by-threematrix.Alogicalevolutionisthe“modi-
fiedtraditional”model.Inthismodel,thecoreandmid-capmanagerposi-
tionsareeliminated.Additionally,small-capmanagersareallowedtohold
theirwinnerslongerbytakingonasmall/mid-capmandate,andlarge-cap
managersareallowedtodipdowninmarketcapitalizationwithperhaps
asmuch20percentofassets.
Theobviousintentionofthemodifiedtraditionalmodelistoreduce
232 ChallengingTraditionalAssetAllocationMethods
capitalization-andstyle-orientedtradingandlessenthedragonafter-tax
performance.However,forlargeportfolioswhereseparateaccountmanag-
ersareemployed,thereisanadditionalbenefit.Areductioninthenumber
ofseparateaccountmanagersfromperhapsninetofourwillmostlikely
leadtoloweroverallmanagementfees,whichisalsoaformoftax.This
processworksbestwithelitetax-awaremanagers,especiallyforthelarge-
capitalizationvalueandgrowthmandates.Oneproceduretheconsultant
orsponsorcanemploywhileservingasthequarterbackoftheprocessisto
suggestatransferofstockthathasrisenincapitalizationfromasmall/mid-
capmanagerforanequaldollaramountofcashfromalarge-capmanager.
Thisassumesthatthelarge-capmanagerfindsthestockofthecompany
in question to be a purchase or long-term hold candidate and has cash
available.Themodifiedtraditionalmodelisappropriateforclientswho
wishtohavetheopportunitytopotentiallyoutperformanindexportfolio
onanafter-taxbasisandarenotcomfortablewithaquantitativetax-aware
approachtoequitymanagement.
A compelling alternative to the modified traditional approach de-
scribed above is the “all-capitalization/style-specific” model (see FIGURE
17.6).Withthismodel,theportfoliomanagerisallowedtoselectstocks
accordingtohisparticularstyle(valueorgrowth)fromacompleteuni-
verseofsecurities,whichmayberepresented,forexample,bytheRus-
sell3000ortheWilshire5000stockindices.Thereareveryfewactive
managersthatofferall-capitalizationvalueorgrowthproducts.Withthe
adoptionofthetraditionalequityallocationmodeloverthepastthirty
yearsorso,firmsgraduallydroppedtheseproductsandfocusedonstyle/
capitalization-specificstrategies.However,withgrowinginterestintax-
awareinvesting,all-capitalization/style-specificportfoliosareexperiencing
arenaissancewithinformedinvestorsandadvisers.Theadvantageofthe
FIGURE17.6 ModificationstotheTraditional3x3Matrix
ModifiedTraditional All-Capitalization/Style-Specific
Large
Middle
WhytheStyleBoxHurtsTaxableInvestors 233
all-capitalization/style-specificmodelisthatitallowsinvestmentanalysts
andportfoliomanagerstotakealong-termapproachtoinvesting,since
theyarenotforcedtosellsmall-andmid-capstocksthathavehadsignifi-
cantappreciationiftheystillbelieveitisbeneficialtoholdthem.Theworst
thing that can happen with the all-capitalization/style-specific model is,
forexample,ifthegrowthmanagersellsacompany’sstockatashort-term
lossand thevalue manager purchases itwithin thirty days, negating the
benefitofthelosssale.Itiscriticalthattheconsultantorsponsorensures
thattimelycommunicationbetweenthetwomanagersismaintainedforall
tradingactivitythatresultsinlosses.Thisisoftendonebyfacsimileor,even
better,bye-mailbeforethetradebeingconsideredisactuallyexecuted.
Thenexttypeofstructureinvolvesusingaquantitativetax-awareport-
folio strategy or coupling it with less tax-efficient products.These strate-
gies,coveredindetailinchapter10,emphasizeconstructingaportfolioto
replicatethebefore-taxperformanceofadesignatedstockindexandthen
actively trading to generate net losses that can offset gains in other port-
folios. It is extremely difficult to manage small portfolios profitably in a
tax-aware manner, since taking taxes into account is likely to result in a
morelabor-intensiveprocess.Thus,theall-capitalization/all-style,or“whole
stock”modelisespeciallybeneficialforseparateaccountassignmentswitha
totalequityallocationfrom$500,000to$3millionorgreater.8Perhapsone
oftheexcitingdevelopmentsonthehorizonfortaxableaccountsisthe
creationoftheall-capitalization/all-styletax-awareglobalequityportfolio
(seeFIGURE17.7).
FIGURE17.7 A ll-Capitalization/All-StyleQuantitative
Tax-AwarePortfolio
Large
Middle
Source:DouglasS.Rogers
Small
Figure17.7Rogers
234 ChallengingTraditionalAssetAllocationMethods
FIGURE17.8 C ombiningAll-Capitalization/All-Style
(QuantitativeTax-AwarePortfolio)
WithModifiedTraditionalPortfolio
Large
Middle
Source:DouglasS.Rogers
Small
Figure17.8Rogers
Astuteadvisersattemptingtomaximizeafter-taxreturnsusethequan-
titative tax-aware approach where the odds of outperforming an index
are the least attractive and selectively place active managers where they
believetheyhavethepotentialtoproduceanalphaof3.0percentorbet-
ter.Therefore, the next logical extension is to combine the quantitative
tax-awareapproachwithsmall-orsmall/mid-capmanagers,asshownin
FIGURE17.8.
ThisexamplerepresentsanS&P500quantitativetax-awarecorewith
small/mid-capvalueandgrowthmanagers,buttherearemanysolutions
that are equally attractive. For example, you could have a Russell 1000
quantitativetax-awarecorewithanactivelymanagedRussell2000core
small-cap portfolio. Additionally, instead of one or two small- or small/
mid-capmanagers,youcouldusethree,dependingontheamountofassets
youareworkingwithandtheminimumaccountsizemanagersarewilling
toaccept.FIGURE17.9,againfromBarclays,showsthepercentageofactive
managerswhohaveunderperformedtheirrespectiveindicesonarespec-
tivebasis.Sinceclosedfundsarenotincludedandthedatasufferfrom
survivorbias,thispictureismorefavorablethanreality.However,itdoes
showwhereitmakesmostsensetomakeyouractivemanagementbets.9
Also,therecanbeaseparateaccountforthequantitativetax-awarecore
andmutualorexchange-tradedfundsforthesmall-capallocation(s).The
keyhereisnottofallintothetrapofthetax-exemptindustryanddrive
somepreconceivedformatornumberofmanagers.Becreativeandsimply
WhytheStyleBoxHurtsTaxableInvestors 235
FIGURE17.9 P ercentofActiveManagersUnderperformingthe
Index(from12/31/93to12/31/03)
Note: Past performance is no guarantee of future results. All total returns reflect 10-year annualized
figures.FundsarecategorizedbyMornigstarobjective.
dowhatmakessensewiththestrategiesandproductsyouhaveavailable!
Takingthisprocesstothelogicalextremeresultsinthe“optimal”tax-
awareequityallocationmodel.Itisthecurrentragewithtax-awareconsul-
tantsandadviserstoday,asitbringstogetherthemostcompellingfeatures
ofvarioustypesofmanagers.Thismodelisalsoknownasthe“core-and-
satellite”or“hub-and-spoke”approachtodomesticequitymanagerposi-
tioning(seeFIGURE17.10).10
FIGURE17.10 O ptimalTax-AwareDomesticEquity
ManagerAllocation
Middle QuantitativeTax-AwareCore
Source:DouglasS.Rogers
Figure17.10Rogers
236 ChallengingTraditionalAssetAllocationMethods
FIGURE17.11 InformationRatio,After-TaxAlpha,andTracking
ErrorbyAllocationtotheTax-ManagedCore
CoreandSatellitePortfolioStructure,”JournalofWealthManagement
Source: Clifford H. Quisenberry, Jr., “Optimal Allocation of Taxable
.50 2.5%
.45
After-TaxAlphaandTrackingError
.40 2.0%
After-TaxInformationRatio
.35
.30 1.5%
.25
After-TaxInformationRatio
.20 1.0%
After-TaxAlpha
.15 TrackingError
(Summer2003):18–26.
.10 0.5%
.05
.00 0.0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
AllocationtoTax-ManagedCore
WhytheStyleBoxHurtsTaxableInvestors 237
componentsforagivenbase-casescenario,CliffordQuisenberryofPara-
metric Portfolio Associates illustrates in FIGURE 17.11 that the after-tax
informationratiopeakedwithapproximately62percentallocatedtothe
quantitativetax-awareportfolio.Inthiscase,theafter-taxinformationis
definedas“theportfolio’safter-taxalphaoverthetrackingerror.”12
Applying the information in the figure suggests allocating approxi-
mately60percenttothecoreand10percenteachtotwosatellitesand
twosmall/mid-orsmall-capitalizationmanagerswouldproduceanattrac-
tiveportfoliomixtodelivercompellingafter-taxresultsthatadequately
represents each of the nine style boxes.Thus, the mix of managers and
fundscaneasilybedonewithfiveorfewermanagers.Insomecases,there
maynotbeasubstantialfeesavings,asconcentratedandhigh-alphaman-
agerstypicallycharge1percentormoreandmayevenapplythetypical
1percentoffeesand20percentofprofitperformancetypicalofhedge
funds.However,thenetresultshouldcreatethepotentialformuchhigher
returnsafterallfeesandtaxes.ThegraphcreatedbyParametricillustrates
oneapproachtodeterminingtheoptimalpercentageforthecorealloca-
tion. Consultants and advisers may wish to create their own propriety
methodtodemonstratetheirfirm’sdistinctivecompetence.
Thekeytodevelopingahigh-performingmixofdomesticequityman-
agers on an after-tax basis is what Jean Brunel refers to as avoiding the
“murkymiddle”(seeFIGURE17.12).13
FIGURE17.12 ovingAwayFromtheMurkyMiddle:ACore-
M
and-SatelliteApproach
Source:JeanL.P.Brunel,“ATax-EfficientPortfolioConstructionModel,”
Tax-efficientcore Highvalue-addedsatellites
JournalofWealthManagement(Fall2001,43-49.
Taxefficiency
Portfolioactivitylevel
Figure17.12Rogers
238 ChallengingTraditionalAssetAllocationMethods
The murky middle consists of the vast majority of equity portfolio
managers, who simply have little or no chance of outperforming the
benchmarkonafter-taxbasis.Therefore,tax-awarepractitionersnaturally
findcomfortinallocatingtotheextremesthatconsistofacoremanager
emphasizingthetax-lossharvestingstrategyononeendoftherangeof
choicesandhigh-alpha-generatingstrategiesontheother.
Thesecondwayinvestorscanreducethetaxdragfromadherenceto
specificdomesticequitystyle-boxallocationsistoseekaninvestmentve-
hiclethatdoesnotsufferfromthereconstitutionoftheindex,asdomutual
fundsandseparateaccountmandates.Fortunately,exchange-tradedfunds
servethispurposewell,especiallythoserecentlydevelopedbyBarclaysin
conjunction with Morningstar.14 As described in chapter 9, the in-kind
transfer allows exchange-traded funds to minimize the tax impact to
investors, and in certain market environments eliminate it altogether.
Sincemostreconstitutionsareannouncedinadvance,portfoliomanagers
ofexchange-tradedfundscanbeginacquiringsharestoensureanorderly
transitionoftheportfoliotothenewallocation.TheMorningstarmeth-
odologyofstyle/capitalizationindexconstructionincorporatesthefactors
listedinFIGURE17.13.
The reason these are listed here is the nine iShare portfolios or ex-
change-tradedfundsareconstructedinawaytominimizetheproblem
withoverlap.Toaddresstheconcernwithoverlap,Morningstarappliesa
methodofcontrolcalled“ownershipzones.”Thisallowsinvestorstocreate
mixesofportfoliosandfundswiththeconfidencethattheywillnotendup
withanundesirablepercentageallocationtooneormorestyle/capitaliza-
tionblocks.Moreover,theycandosowiththeiSharesMorningstarfunds
andindexesinawaythatishighlytax-efficient.Additionally,althougha
FIGURE17.13 iSharesMorningstarIndexMethodology
VALUEFACTORS GROWTHFACTORS
Source:Morningstar,BarclaysGlobalInvestors
brokeragefeeischargedtopurchaseandsellthem,annualfeesrunfrom
only0.2to0.3percentannually,dependingonthespecificproduct.
TheMorningstariSharesindexmethodologyismoreintunewiththe
waythemixofportfolioholdingsfortaxableinvestorsshouldbeconstruct-
ed, as compared with the Russell methodology, where approximately 30
percentoflarge-capstocksareownedbyboththeRussell1000Valueand
theRussell1000Growthindices.Thisisfinewithpensionorcharitable
accountsportfolioswheretaxesarenotaconsideration,asyouoftenfind
relativevalueandgrowth-at-a-reasonable-price(GAARP)stylemanagers
holdingmanyofthesamestocks.However,taxableaccountsshouldavoid
pairingthesetypesofmanagers,astheirtradingoftenviolatesthethirty-
daywashsalerulenegatingthevalueofsellingasecurityataloss,and
whenyoucombinethetwoyoutypicallyhavelittlemorethananexpen-
sivemarketportfolio.Moreover,highalphaismoreoftenassociatedwith
managersthatadheretodeeporextremestyleemphasis.
The core portion of the “optimal” portfolio does not have to be an
index-orientedproducttobeeffective.Therearemanagerswhoattempt
tousethebefore-taxapproachtheyhavemasteredforadecadeormore
and now apply a tax-loss harvesting overlay to their process. Although
theirbefore-taxreturntrackingerrorwillbegreaterthantheirindex-based
peers,thisisnecessaryforthemtocreateadesirablebefore-taxalpha.If
theycansuccessfullyachievebothabefore-taxalphadrivenfromsecurity
allocation and security selection and an after-tax alpha from tax-loss
harvesting,theinvestoristheultimatebeneficiary.Familyofficesareusing
thistypeofapproachtohighlightthatwhattheyofferisuniqueinthe
marketplaceandreallyallowstheirmanagerstofocusonlong-termresults,
rather than being subject to the ridiculous pressures of the tax-exempt
consultingcommunitywhichwantsthemtopigeonholetheminoneof
theninestyle/capitalizationboxes.Moreover,thistypeofapproachand
tax-efficientexchange-tradedfundscanallowthemanagertomigrateto
oroverweighttheportionsofthematrixtheyfeelhavetheopportunityfor
superiorlong-termreturnsbasedonvaluation.Forexample,DonPhillips
ofMorningstarrelatedataBarclaysiSharesconferencethatasofthefall
of2004,small-capvaluehasoutperformedlarge-capgrowthoverthepast
fiveyearsbyperhapsthewidestmargininthemodernhistoryofthemar-
kets.15Thisoutperformancewillnotlastforever.Therefore,ifyouaccept
acontrarian’sapproach,theall-capitalization-and-styletax-awaremanager
cangraduallyshifthisportfoliostyleandcapitalizationtoareaswiththe
greatestreturnpotential.AnotheralternativeisusingMorningstariShares,
sincetheyareextremelypureinstyleandcapitalization,allowingthe
advisertouseaminimalamountofdollarstoachievethedesiredalloca-
tion.Thisisthetypeoftacticalredeploymentofassetsthatcanbeexecuted
240 ChallengingTraditionalAssetAllocationMethods
inatax-awaremannerbasedonsoundprinciplesandjudgment.
Insummary,efficientlyallocatingequitymanagersfortaxableaccounts
initiallyappearstobeamorecomplexprocessthanwithretirementplans
oreleemosynaryorganizationswheretaxesarenotafactor.However,with
experience,itbecomesasimpleandnaturalprocessofdoingwhatisneces-
sarytoachievethehighestafter-taxreturnpossible.Bytakingintoaccount
the following factors, taxable investors benefit by adopting innovative
equityallocationmodelsthatsuittheirclient’sneeds:
❑ Establishingthetotaldollaramountoftheequityallocation
❑ Reducing the number of equity managers employed to minimize
unnecessarycapitalgainsandtaxesbyadoptinganallocationmodel
other than the three-by-three matrix developed for tax-exempt
accounts
❑ Positioningaquantitativeortraditionalmanagerwithafocuson
tax-lossharvestinginthecoreposition
❑ Deployingtraditionalmanagerswheretheyhavethegreatestprob-
abilitytosucceed
❑ Emphasizing concentrated or high-alpha-generating portfolios,
especiallyinefficientmarketniches
Elitepractitionersareembracingandwillcontinuetorefineandoffer
innovativetax-awareequityallocationmodels,becausetheyrepresentan
areaoftheinvestmentmanagementprocessthattrulyhasthecapabilityof
enhancingthetaxableclient’sultimatewealth.
ChapterNotes
1. Muchofthediscussionontax-awareequitymanagerallocationhasbeentaken
directly or summarized from Douglas S. Rogers, “Tax-Aware Equity Manager
Allocation:APractitioner’sPerspective,”JournalofWealthManagement(Winter
2001):39–45.
2. David M. Stein, “Equity Portfolio Structure and Design in the Presence of
Taxes,”JournalofPortfolioManagementvol.4,no.2(Fall2001):37–42.
3. Barrow,Hanley,Mewhinney&Strauss,“Benchmark Review,ThirdQuarter
2004,”listingFactSet,S&P/Barra,andRussellasreferences,September30,2004.
4. MorningstarPrincipia,June30,2004.
5. MorningstarPrincipia,VanguardGrowthIndexFund,June30,2004.
6. Barra,“Overview,”http://www.barra.com(accessedSeptember2001).
7. DouglasS.Rogers,“After-TaxEquityReturnsforNon-QualifiedNuclearDe-
commissioningTrusts,”FinancialAnalystsJournal(July–August1992):70–73.
WhytheStyleBoxHurtsTaxableInvestors 241
8. R. M. Ennis, “The Case for Whole Stock Portfolios,” Journal of Portfolio
Management(Spring2001):17–26.
9. BarclaysGlobalInvestors,TheBasicsofiShares,marketingdocument,March
2004.
10. JeanL.P.Brunel,“AssetLocation:CaseStudyofaCriticalVariable,”Invest-
mentCounselingforPrivateClientsIII,AIMRConferenceProceedings,2001,
18-27;JeanL.P.Brunel,“ATax-EfficientPortfolioConstructionModel,”Journal
ofWealthManagementvol.4,no.2(Fall2001):43–49.
11. E.J.EltonandM.J.Gruber,ModernPortfolioTheoryandInvestmentAnalysis,
3rded.(NewYork:JohnWiley,1987).
12. CliffordH.Quisenberry,Jr.,“OptimalAllocationofTaxableCoreandSatel-
litePortfolioStructure,”JournalofWealthManagement(Summer2003):18–26.
13. JeanL.P.Brunel,“ATax-EfficientPortfolioConstructionModel,”Journalof
WealthManagement(Fall2001,43-49.
14. BarclaysGlobalInvestors,iSharesMorningstarSummary,marketingdocu-
ment,June2004.
15. DonPhillips,“TheNewSchoolofInvestingIsHere,”presentationatBarclays
GlobalInvestorsConference,Chicago,October14,2004.
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CHAPTER18
PositioningAssetsbytheTax
CharacteristicsoftheEntity
Introduce a wise and efficient system of taxation, and life and
energywillpervadethecountry.Withoutsuchasystem,itwillsink
intogeneralandfatalparalysis.
—AtlanticMagazine
P
ositioningassetsbythetaxcharacteristicsoftheentityisacritical
step in the logical progression of managing assets in a tax-aware
manner.Thisstepfollowsderivingafter-taxassetclassassumptions,
discussedinchapter16,andworksintandemwithequitymanagerpo-
sitioning,explainedinchapter17.Oncethisstepiscomplete,managers
andfundscanbeefficientlyassigned,whethertheyaretax-efficientornot.
Thischapterexplainstheprocessatalevelwhereitcanbegraspedbyread-
ersofalldegreesofsophisticationandexperience.
Proficiency at tax-aware location requires an understanding of the
variousentitiesthatinvestorsarelikelytoencounterwhendealingwith
theirpersonalsituationorwhenpractitionersareworkingwithtaxable
clients.Entitiescanbebrokendownintothefollowingmajorcategories
forindividuals:
1 Taxableassets
2 Tax-deferredretirementplans
3 Individualretirementplans
4 Educationplans
5 Insuranceproducts
6 Socialsecuritybenefits
7 Trusts
243
244 ChallengingTraditionalAssetAllocationMethods
Source:CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,2003).
FIGURE18.1 S cheduleY-1:MarriedFilingJointlyandSurviving
Spouse(toNearestDollar)
TAXABLEINCOME
BUTNOT %ON OFTHE
OVER OVER PAY + EXCESS AMOUNTOVER
Mosttaxablecorporatesituationstypicallyapplyasubsetoftheabove
consisting of taxable corporate assets, insurance products, and various
trustsestablishedtoservespecificrequirements.
Asimplefoundationofkeyelementsofthetaxcodeasitappliestoin-
dividualsisalsonecessarytotax-awarepositioningofassets.Thetaxcode,
asitappliestoreturnsonfinancialinstruments,isextremelycomplex.It
takes time and substantial effort for the taxable account practitioner to
obtainalevelofunderstandingsufficienttodealcomfortablywithclient
situations.Thisproblemmanifestsitselfprimarilyfortworeasons.First,
taxratesevolveforindividualsecuritiesandproductsastheyarecreated.
Second,thetaxcodeisorganizedbythecharacteristicsofthetaxpaying
entity—forexample,anindividual,corporation,orpartnership.Plus,tax-
relatedinformationisoftenpresentedintermsthatonlyaccountantsand
attorneysfeelcomfortablewith.Inthischapter,wehighlightafewsimple
conceptsandoutlinethehistoryoftaxesonincomeandcapitalgainsand
theimpactofthemostcommonratesofthepost–WorldWarIIeraonthe
netreturnofinvestments.
Theappendixliststhetopfederalincometaxratesonregularincome
andcapitalgainssince1916.Thetopincomerateisalsooftenreferredto
asthemarginaltaxrate,whichmaydiffersignificantlyfromanindivid-
ual’saveragetaxrate. FIGURE18.1showsthefederaltaxrateschedulefor
marriedcouplesfilingajointreturnforincomeearnedin2004.
Applying the schedule to various levels of taxable income shown in
PositioningAssetsbytheTaxCharacteristicsoftheEntity 245
FIGURE18.2 MarginalVersusAverageTaxRate
FIGURE18.2demonstratesthattheaveragetaxrateistypicallyfarlessthan
themarginal,ortop,taxrate.1
Thedifferencebetweenthemcanbesubstantial,especiallywhenthe
firstincrementonincomeisnottaxed,asisthecasefor2004uptoan
incomelevelof$14,300.Thisconceptisquitesimplebutoftenignored.
Thereasonthispointismadeismoststudiesapplythemaximumfederal
rateineffectfortheyearofthereturntoachieveaworst-casescenario.
Yourowntaxrateortheaveragetaxrateofyourclientsmaydiffersignifi-
cantlyfromthetaxratesappliedinaparticularstudy.Therefore,itmay
benecessarytomodifytheconclusionofaparticularstudytoaccommo-
datethecircumstancesofaspecificsituationifanothertaxrateismore
appropriate.
Oftentimes,thetaxpayerisalsosubjecttostateandlocaltaxes.Taxesby
foreigncountriesmayalsocomeintoplay.Theseadditionaltaxesarealso
importantandshouldbeaccountedforintheanalysisforaspecificcli-
ent.Inadditiontotheneedsofindividuals,taxableaccountmanagement
professionalsmayalsoservetheneedsofvariousformsoftrustsestablished
forthepurposeofestateplanning,propertyandcasualtyinsurancecom-
panies,nucleardecommissioningtrusts,settlementtrusts,andnonprofit
voluntary employee benefit associations (VEBAs). For corporate-related
funds and property and casualty insurance companies, the maximum
federal tax rate of 35 percent is phased in once a certain threshold of
income is received. Short- and long-term capital gains are both subject
246 ChallengingTraditionalAssetAllocationMethods
tothe35percentrate,buttheymaybeeligiblefora“dividends-received
deduction”of70percent.Forpropertyandcasualtyinsurancecompanies,
municipalbondincomeisgenerallytaxedat15percentofthemaximum
federaltaxrate,or5.25percent.Assetsinthequalifiednucleardecom-
missioningtrustaretaxedat20percent,ascomparedwith35percentin
thenonqualifiedtrust.Theareaofestateplanningbringsinanadditional
levelofcomplexity,asanalysisoftaximplicationsmayincludethecom-
ponentsofafter-taxreturnfromeachassetclassbeingconsideredinthe
mix, the tax characteristics of the types of trust being considered, time
horizoncashflowandavailabilityoffunds,andanypotentialvaluation
discountforcontributingassetstothetrust.Withtax-deferredaccounts
andinsuranceproducts,anyreductionintaxableincomefromthecon-
tribution, withdrawal penalties imposed on early withdrawals, the level
oftaxondistributions,andwhetherdistributionswillbetaxabletothe
estateareextremelyimportanttotheanalysis.Anyofthesetopicscould
andhavebeenthesubjectin-deptharticlesbythemselves.Therefore,itis
closetoimpossibleforanyoneinvestmentprofessionaltobecompletely
knowledgeableabouteveryfacetofthetaxcodeandestateplanningand
theimpactofeachonthevarioustypesoftaxableaccounts.However,with
experiencecomestheabilitytoasktherightquestionsandtoknowtoturn
toqualifiedexpertswhenindoubt.
For individuals, estate taxes make the planning process even more
complicated.TheEconomicGrowthandTaxReliefReconciliationActof
2001affectedchild-related,educationandtuition,retirement-plan,and
estate and gift tax provisions of the tax code.The major aspects of the
estateandgifttaxprovisionsareshowninFIGURE18.3.
Theprovisionsshownaboveclearlyhighlighttheimportanceoftax-
awarepractitioners’beingcognizantnotonlyofcurrentprovisionsofthe
taxcodefortheclientstheyservebutalsoofchangeslikelytotakeplace
inthefutureandhowthesemaybeaffectedbytheeconomicandpoliti-
calclimate.
Toestablishanunderstandingofaclient’staxprofileforaparticular
taxableentity,thetax-awarepractitionershouldseekanswerstothefol-
lowingquestionsfromtheclientorhisadvisers.
Generalquestions:
1 Whatarethetypesoftaxableentitiesthatneedtobeanalyzed?
2 Whataretheapplicablesectionsofthetaxcodethataddresseach
specifictypeoftaxableentity?
3 Is this situation subject to any additional statutory or regulatory
guidelines?
4 Intheanalysisofthesituation,shouldtheclient’sorentity’smaxi-
mumoraveragetaxrate(s)beapplied?
PositioningAssetsbytheTaxCharacteristicsoftheEntity 247
FIGURE18.3 E conomicGrowthandTaxReliefReconciliationAct
of2001
5 Isthetaxableentitysubjecttostateandlocalrates?Ifso,whatare
theapplicablerates?
6 Arethereothertaxesthatmustbeconsidered,suchasforeignwith-
holdingtaxes?
7 Whenalltaxcomponentsareconsidered,whatistheentity’seffec-
tivetaxrate?(Thereisusuallyadeductionforstateandlocaltaxes
onfederaltaxreturns.)
Foreachtaxableentityoraccount:
1 Whataretheratesforvarioussourcesofinvestmentincome?
2 Isthereanytypeof“dividends-receivedreduction”(DRD)?
3 Areshort-andlong-termcapitalgainstaxedatdifferentrates?
4 Isthereadefinedinvestmenthorizon,forexample,whentheenti-
ty’slegalstructureisterminated?
5 Do any of the holdings have substantial embedded, unrealized
capitalgains?
6 Does the entity allow for a valuation discount when assets are
contributed?
248 ChallengingTraditionalAssetAllocationMethods
7 W henapplicable,howwilldistributionsbetaxed?
8 Ifthereisashortfallwithintheentity,whatimpactcanthishaveon
therequirementforadditionalcontributionsorthedollaramount
ofdistributions?
9 Whatistheneedforfunds,andhowarewithdrawalslikelytoaffect
potentialcapitalgainsrealization?
10Does the possibility of the alternative minimum tax need to be
considered?
Fortax-deferredaccountsthatarepartoftheclient’soverallholdings:
1 Arecontributionstotheaccountdeductedfromtaxableincome?
2 Willannualcontributionsbemadetotheaccount?Ifso,whatare
thedollaramountsoftheanticipatedcontributions?
3 Arethereanycatch-upprovisions?
4 Arethereanypenaltiesforearlywithdrawals?Ifso,priortowhat
timeorage,andwhatisthepenalty?
5 Canassetsinonetax-deferredaccountberolledoverintoanother
tax-deferredaccount?Ifso,isthereapenaltyassociatedwithun-
dertakingthisexercise,orwhathastobedonetoensureataxable
eventisnottriggered?
6 Atwhatrate(s)arewithdrawalstaxed?
7 Ifyouhavemorethanonemoretax-deferredentityasanoption,
doanyofthemhaveabeneficialestate-planningfeature?Ifso,what
isthevalueofthisbenefit?
nothavetobeafamilyofextremewealthoralargetaxablecorporation
tobenefitfromthiskeystep.Sinceanyonethatearnsincomeiseligibleto
fundanindividualretirementaccount,almosteveryonecanbenefitfrom
thisstepoftax-awareinvestmentmanagement.
Intheexamplethatfollows,wewillstartwithascenarioofanindi-
vidual investor with three entities: a 401(k) plan, an IRA, and taxable
personal assets. Readers may even wish to follow along with their own
personalsituation,astheyarelikelytocomeupwithasolutionthatadds
enoughvaluetopayforthetextmanytimesover.
Theprocedureforpositioningassets/investmentvehicles(funds,sepa-
rateaccounts,partnerships,andsoon)inatax-awaremannerincludesthe
followingsteps:
1 Listexistingfinancialassetsaccordingtotheirentity.
2 Conduct an optimization of all financial assets using after-tax
assumptions.
3 Analyze the projected alpha and tax-cost ratio or relative wealth
measureofeachinvestmentvehiclebeingconsidered:
a. 401(k)
b. IRA
c. Taxableassets
4 Useaniterativeprocessto:
a. Utilizethemostcompellingandtax-inefficientchoicesofthe
401(k).
b. Positiontax-inefficientchoicesnotavailablethroughthe401(k)
intheIRA.
c. Usethepersonaltaxableallocationassetstofundtax-efficient
vehicles,especiallyequities.
FIGURE18.4 SampleClientFinancialAssetsInventory
TAX-DEFERRED
401(K) IRA
ASSETCLASS $AMOUNT % $AMOUNT %
401(k)meeting.Sincetheadviserrecommendedallocatingaccordingto
the investor’s remaining time horizon, the rule of thumb of 100 minus
currentagewasappliedtodeterminetheoverallequityallocationorinthis
case60percent(100–40yearsold).Additionally,theinvestorthoughtit
wasprudenttoplace10percentofassetsincashequivalentsasasafetynet.
Later,a10percentallocationtorealestateinvestmenttrustswasrecom-
mendedforthemix,usingfundsfrompersonaltaxableassets,resultingin
anoverallallocationof35percenttofixedincomeandcashequivalents,
55percenttoequities,and10percenttoREITs.Sincetheinvestorisusing
mutualfunds,allinvestmentsoutsidethe401(k)adheretoareasonable
$2,000minimuminvestment.
Bynotbeingtax-aware,theinvestorhasmissedoutonseveraloppor-
tunitycostsorpotentialsavings.Criticallocationerrorsinthisexample
include:
1 Attemptingtoadheretothesamestrategictargetallocationacross
allentities.
2 Placing a liquidity reserve of cash equivalents in tax-deferred ac-
PositioningAssetsbytheTaxCharacteristicsoftheEntity 251
PERSONAL
TAXABLEASSETS TOTALASSETS
$AMOUNT % $AMOUNT %
Source:DouglasS.Rogers
$10,000 28.6% $ 10,000 10.0%
$35,000 100.0% $100,000 100.0%
countswhenitisnotlikelytobeafactorforatleasttwentyyears.
3 Holding assets that produce high taxable income in taxable per-
sonalfundsratherthanintax-deferredentities.
4 Funding value-oriented equity strategies with personal taxable
assets funds and placing index or buy-and-hold growth-oriented
fundsintax-deferredentities.
Using a total of twenty-one fund positions to achieve the target
5
allocation,whichpresentsanadministrativeorlogisticalchallenge
justtokeepupwiththeflowofinformation.
These types or mistakes are very typical, but costly. Over the past
five years, academic research in this area has confirmed that individual
householdsandinvestorshavenotbeendiligentbyplacinghigh-taxable-
income-generating asset classes and products in tax-deferred accounts.2
Forexample,theinvestorisbetterofffinanciallyholdinganequityindex
fund in a taxable account and taxable bonds in a tax-deferred account
inmostinstances.Partofthereasoninvestorsmayholdahighamount
252 ChallengingTraditionalAssetAllocationMethods
of tax-exempt bonds in their personal taxable assets is due primarily to
precautionaryinvestmentbehavior.Sincetax-deferredinvestmentsarein-
tendedtobelong-terminnature,havingasufficientliquidityreservein
such“sleep-at-night”securitiesandfundsascashequivalentsandshort-
termbondsisunderstandable.
2 Conductanoptimizationofallfinancialassetsusingafter-tax
assumptions:Inchapter16,aprocedureforestimatingafter-taxreturn
assumptionswaspresented.Conductingtheassetallocationoptimization
oranyotherfinancial-planningexerciseonanafter-taxbasisisessential,
otherwisethepractitionerislikelytoachieveinaccurateresultsormislead-
ingconclusionsthatwillbedetrimentaltowealthcreation.Continuing
withtheexamplefromstep1,calculatethebefore-taxstandarddeviation
fortheoverallmix.Thenidentifyanefficientmixusingafter-taxassump-
tionsforthesamelevelofrisk.Thisservesasafocalpointtoensurethe
client’s desired level of risk is maintained. In almost all cases, the new
portfoliowillhaveagreaterallocationtoequitiesandahigherafter-tax
return.Thisexercisecanbedonewithanyassetallocation/optimization
softwarepackagethatallowstheusertoadjustthethreeinputvariables
FIGURE18.5 CriticalInformationforEntityLocation
401(K)
TAX-COST
ASSETCLASS ALPHA RATIO
IRA PERSONALTAXABLEASSETS
TAX-COST TAX-COST UNREALIZED
ALPHA RATIO ALPHA RATIO CAP.GAIN
ratiothanwiththerelativewealthmeasurepresentedinchapter8.
Therearelimitedinvestmentchoicesinmost401(k)plans,andthe
fundselectionsavailablemaynotbeamongthebestintheirrespectivecat-
egories.InFigure18.5,thedomesticlarge-capandsmall/mid-capgrowth
equityfundsarelesscompetitivethansimilaroptionsofferedintheIRA
andpersonaltaxableassetsentities.Thisiscommon,aswecaninvestina
broaderuniverseoffundswiththeIRAandpersonaltaxableassets.Inthis
example,theonlyrestrictionisfundsopentonewinvestmentandthose
willingtoacceptaminimuminvestmentof$2,000orbelow.Often,in-
vestorsarelimitedtotheproductsavailablethroughtheirfundplatform,
suchasSchwaborTDWaterhouse,orinvestalltheirassetswithalarge,
single provider such as Fidelity,T. Rowe Price, or Vanguard. An addi-
tionalrowofinformationwasaddedspecifically,forindex/tax-managed
(TM)/exchange-traded(ETF)funds.Thelastcolumnofinformation,the
percentageofunrealizedcapitalgains,isimportanttoavoidinvestinginto
apotentiallysignificanttaxliability.Ifatax-efficientexchange-traded,in-
dex,ortax-managedfundhasameaningfulunrealizedcapitalgainsposi-
tion,itusuallyisnotamajorconcern.However,thesamecannotbesaid
ofactivelymanagedfundsnotknownforfocusingontaxefficiency.
4 Useaniterativeprocesstopositionthemostcompellingandtax-
inefficientchoicesinthe401(k);tax-inefficientchoicesnotavailable
through the 401(k) in the IRA; and tax-efficient vehicles, especially
equities, in the personal taxable assets: The target allocation, dollar
amountineachentity,andthedesiredliquidityreservearerequiredbefore
startingtheiterativeprocess.Inthisexample,thedesiredallocationis:
Cashequivalents 10%
Intermediatefixedincome 20%
Domesticequities 45%
Large-capcore 10%
Large-capvalue 10%
Large-capgrowth 10%
Small-capvalue 7.5%
Small-capgrowth 7.5%
Internationalequities 15%
Realestate(REITs) 10%
Theclienthasdecidedtheamountoftheliquidityreserveshouldbe
equalto10percentofassets,andthefundsavailableineachentityis50
PositioningAssetsbytheTaxCharacteristicsoftheEntity 255
percenttothe401(k),15percenttotheIRA,and35percenttopersonal
taxableassets,withatotalamountagainof$100,000(see FIGURE18.6).
Theliquidityreserveneedstobesatisfiedbeforetheiterativeprocessbe-
gins.Forsimplicity,wearegoingtoassumeallthepersonaltaxableassets
arebeingheldincashequivalentsandwedonothavetoconsiderembed-
dedunrealizedcapitalgains.Previously,cashequivalentswereassignedin
equalpercentagestoallthreeentities,buttheyshouldn’tbeusedintax-
deferredentitiesbecausetheywouldbesubjecttoa10percentpenaltyif
withdrawnbeforeage59½.Therefore,step1inthetableistoallocate10
percent,or$10,000,tocashequivalentsintaxablepersonalassets.Note
thetax-costratioislistedat0.8percent,whichtakesintoaccountthepro-
jectedreturnfromchapter16fortaxablecashequivalentsandthemaxi-
mumfederaltaxrate.Wecouldjustaswellhavestatedamunicipal-bond
cash-equivalentreturnand0percentforthetax-costratio.Whichtypeof
money-marketfunddoesnothavetobedecideduntiltheimplementa-
tion phase. At this time, we can ascertain if additional taxable income
mightplacetheclientinahighertaxbracketandwhichfundoffersthe
maximumafter-taxreturn.FIGURE18.7(seepage258)differsfromFigure
18.6,inthatithighlightsthestepsinvolvedinthe“worstcase–bottomup”
and“bestcase–topdown”iterativeapproach.Somepeoplearecomfort-
ablewiththetableformatofFigure18.6,whereasothersfindthe“bottom
up/topdown”approachofFigure18.7issimplertoworkwith.Stillothers
startwiththebottomup/topdownapproachandthenlisteachstepin
thetable.Thepointisthereisnothingmagicorsacredhere.Simplydo
whateverworksbestforyouandyourclients.
In step 2, we look for the asset class with the highest potential tax
impact.ThisiseithertaxableintermediatefixedincomeorREITs.Inthis
case,REITshaveahighertax-costratio,sowewillapplythisassetclass
firsttotheIRA,wherewehavethebenefitoftaxdeferralandavailability.
Wenowturntothebestcase–topdownselection.Inthisinstance,the
objective is to place the most tax-efficient equity option in the taxable
personal assets.The analysis in Figure 18.5 shows that the index/TM/
ETFoptionstandsoutwithatax-costratioofonly0.2.Wethusassigna
$10,000allocation,andturnbacktoaworstcase–bottomupselection.
RatherthanassigningaportionofthefixedincomeallocationtotheIRA,
we can assign the entire amount to the 401(k) and save the remaining
$5,000oftheIRAtochoicesthatgeneratehigheralpha,whichmightnot
beavailableotherwise.
Theiterativeprocesscontinuesuntilallfundsareaccountedfor.
When using the iterative tax-aware positioning approach, interna-
tionalequityisquiteoftenthelastassetclasstobeallocated.Thisoccurs
becauseitsrelativetaxefficiencyisbetweenthetax-efficientextremesof
256 ChallengingTraditionalAssetAllocationMethods
FIGURE18.6 IterativeTax-AwareAssetPositioningProcess—
TableFormat
TAX-DEFERRED
401(K)
ASSETCLASS STEP# $AMOUNT %
CashEquivalents 1 0.0%
FixedIncome 4 $20,000 40.0%
DomesticEquity $17,500 35.0%
Index/TM/ETF 3 $ 0 0.0%
Large-CapCore $ 0 0.0%
Large-CapValue 8 $10,000 20.0%
Large-CapGrowth 5 $ 0 0.0%
Small-CapValue 6 $ 7,500 15.0%
Small-CapGrowth 7,9 $ 0 0.0%
InternationalEquity 10,11 $12,500 25.0%
RealEstate(REITs) 2 $ 0 0.0%
Totals $50,000 100.0%
tax-managedfundsandETFsononeendandtax-inefficienttaxablefixed
incomeontheother.Whenthetaxablepersonalassetsarenear50percent,
youshouldinvestigatewhethertheinternationalfundutilizesacurrency
overlay strategy, as that would increase the tax-cost ratio. International
fundsthathedgecurrencypricemovementarebestsuitedfortax-deferred
entities,andthismayinfluenceyourselectionofaparticularfundorfinal
placement.
TheexamplepresentedinFigure18.7isquitesimpleand,withexperi-
ence,canbedoneinlessthanfifteenminutes.Assimpleasitis,position-
ingbythetaxcharacteristicsoftheentitiesandassetclasses/investment
vehiclesprovidesthefollowingmeaningfuladvantages:
1 Itachievestheoveralldesiredallocationandreducesthenumberof
holdingsbyone-halformore—fromtwenty-onetoeleveninthis
instance.
2 Itusesaliquidityreserveonlywhereitmakessense.
PositioningAssetsbytheTaxCharacteristicsoftheEntity 257
TAX-DEFERRED PERSONAL
IRA TAXABLEASSETS TOTALASSETS
$AMOUNT % $AMOUNT % $AMOUNT %
Source:DouglasS.Rogers
$10,000 66.7% 0.0% $10,000 10.0%
$15,000 100.0% $35,000 100.0% $100,000 100.0%
Thissimpleexampleappliestoanyinvestorwitha401(k)plan,IRA,
andpersonaltaxableinvestments.Inthesamplescenario,35percentofthe
assetsaretaxable.Byreadjustingthelocationofthemix,thetaxbitewas
loweredfrom$569to$295foranimprovementof$274eachyear.These
dollaramountswereachievedbytotalingthetaxbite(tax-costratio×dol-
laramountofinvestment)foreachoftheequityandREITpositionsin
258 ChallengingTraditionalAssetAllocationMethods
FIGURE18.7 U singBest-andWorst-CaseApproach
IterativeTax-AwareAsset-PositioningProcess
TAX-COST GAIN
STEP PROCESS $AMOUNT ALPHA RATIO EXPOSURE ENTITY
LiquidityReserve
1 CashEquivalents $10,000 0.0% 0.8% 0.0% PTA
BestCase–TopDown
3 Index/TM/ETF $10,000 0.0% 0.2% -5.0% PTA
5 Large-CapGrowth $10,000 3.0% 1.0% –15.0% PTA
7 Small-CapGrowth $ 5,000 5.0% 1.5% 3.0% PTA
9 Small-CapGrowth $ 2,500 5.0% 1.5% IRA
11 InternationalEquity $ 2,500 4.0% 2.0% IRA
10 InternationalEquity $12,500 4.0% 2.0% 401(k)
8 Large-CapValue $10,000 2.0% 2.0% 401(k)
6 Small-CapValue $ 7,500 4.0% 2.0% 401(k)
Source:DouglasS.Rogers
3 FixedIncome $20,000 0.3% 2.0% 401(k)
2 RealEstate(REITs) $10,000 2.0% 3.0% IRA
WorstCase–BottomUp
thepersonaltaxableassetsfortheinitialandrecommendedsolution.This
isaboostinoverallperformanceof0.27percent($274/$100,000)alone.
Plus,wehavemovedthefixedincomeallocationtothe401(k),wherethe
returnsoftaxablebondscancompoundonatax-deferredbasis.
Thissamethoughtprocessappliesregardlessofthelevelofcomplexity.
You can easily add columns for additional entities, and rows for asset
classessuchashedgefundsandprivateequity.Thisapproachprovidesa
satisfactoryapproachtotax-awarepositioningfor99percentoftheassign-
mentsfinancialplannersandconsultantstakeonforindividualinvestors.
However,forultra-affluentclientswhohavenumeroustrustsacrossthree
ormoregenerations,asystemthathasthecapabilitiesofPORTAXises-
sential to achieve meaningful output for further analysis. PORTAX has
theaddedbenefitofincorporatingthecharacteristicsofeachentityand
cashflowsintothefuture.Spreadsheetscanbeusedtoreplicatethispro-
PositioningAssetsbytheTaxCharacteristicsoftheEntity 259
cessinconjunctionwiththeafter-taxefficientsolutionfromtheoptimiza-
tionsoftware,butitisacumbersomeprocessatbestandsubjecttohuman
errorbecauseofthevolumeofcalculationsinvolved.Whentheanalysis
becomes this complex, coordination with the members of the qualified
triumvirate becomes more critical.The tax characteristics of each trust
shouldbecoordinatedwithboththeaccountantandtheestateattorney.
Moreimportant,iftheestateattorneydoesnotunderstandtheconcept
oftax-awarepositioningofassets,youwillwastealotoftimerunning
asset-locationsimulationsandwillhavedifficultyachievingconsensuson
anoptimalsolution.
Whenaddressingthissubjectforthefirsttime,itishelpfultohavea
financial-planning text for reference.There are about a dozen favorites
usedbycollegeprofessors.Thekeyistofindonethatworkswellforyour
needs. A particularly good one is Practicing Financial Planning for Pro-
fessionals, by Sid Mittra with Jeffrey Kirkman and George Seifert.3 It is
extremelywellorganizedandthorough,whichsavesyoutimewhenthere
isaneedtoaddressasubjectthatyoudonotdealwithonadailybasis.
Sincethisareaofexpertiseissovast,itisdifficulttokeepupwithchanges
drivenbynewandinnovativeinvestmentproductsandtechniquesofeach
nicheoftaxableaccountinvesting,aswellasthecontinualchangesinthe
taxcodeandestate/regulatorymatters.
Toachieveanoptimalsolution,thepractitionermustaddresselements
unique to the type of taxable account investing, such as an individual,
corporatefund,propertyandcasualtyinsurancecompany,nucleardecom-
missioningtrust,medicalretirementtrust,andsoon.Whatfollowsisa
brief discussion of key elements for investing for individuals.This area
waschosentodemonstratewhatisrequiredforthemajorityoftheread-
ingaudience.Forthosepractitionersservinginotherareas,thisdiscussion
shouldserveasanexampleofthecomplexitytheyarelikelytoencounter.
1 Taxableassets:Figure18.1showstheamountoftaxmarriedcou-
plesweresubjecttoin2004,basedontheirlevelofincome.Therearefour
additionalitemsthatarekeyfortax-awarestrategy:gifting,federalestate
exclusionamount,maritaldeduction,andstep-upinbasisatthetimeof
death.
Currently,ahusbandandwifecaneachannuallygiftupto$11,000
freeoftaxtoanyonetheychoose.Separately,duringtheirlifetimes,they
canmakeupto$1millioningiftsfreeoftaxes.Oneimportantstrategy
withgiftingistotransfer$1millioninwealthtootherswheretheincome
andappreciationonthegiftedamountwillbesubjecttoalowertaxrate.
WiththeEconomicGrowthandTaxReliefReconciliationActof2001,
thehighesttaxratesonthegiftandtheestatetaxbecamethesame,asFig-
ure18.3shows.Fortaxyear2004,thetoptaxratewas48percentand
260 ChallengingTraditionalAssetAllocationMethods
willdeclineto45percentfrom2007to2009.Theestatetaxisrepealedin
2010,andthentherepealisreversedin2011withthetaxratesreverting
back to the 2001 level of 55 percent unless Congress takes action.The
exclusion amount for the estate tax is $1.5 million in 2004 and 2005,
increasesto$3.5millionin2009,andrevertsbackto$1millionin2011
if, again, Congress does not take action. Since the estate tax is a major
concern,thereislikelytobemeaningfulchangetotheexistingprovisions
sometimeduringthesecondtermoftheBushadministration.
Theunlimitedmaritaldeductionprovisionofthetaxcodeallowsfor
thetransferofassetsfreeofthegiftandestatetaxtothesurvivingspouse.
Thiscanbeaccomplishedbythespousehavingcontrolofthepropertyor
throughalegalstructure,suchasaqualifiedterminableinterestproperty
(QTIP)trust.
Thestep-upinbasiscurrentlyappliestoappreciatedpropertyorse-
curitiesatthetimeofdeath.Thisfeatureprovidestheflexibilitytoreal-
locate to other asset classes without generating substantial capital gains
tax. Exchange funds are structured to take advantage of the step-up in
basis.Aconcentratedlow-cost-basisstockpositionistransformedintoa
well-diversifiedportfolioofstocks.Thebeneficiaries,therefore,receivein-
dividualstockspositionswherethecostbasisofeachsecurityequalsthe
marketvalue.In2010,theprovisionsofthestep-upinbasisarelimited
to$3millionforthesurvivingspouseandanadditional$1.3millionfor
anybeneficiariesforatotalof$4.3million.Therearemanynuancesofthe
taxcode,butthesearethefourmajorelementsthatapplytoindividual
taxpayersandshouldbetakenintoaccountwithanytypeofanalysisor
planning.
Keyquestionsrelatedtotheclient’spersonalassetsare:
❑ Is the individual making annual gifts and has the exclusion been
utilized?Ifnot,isthereanybenefittodoingthissoonerthanlater?
❑ Whatistheanticipatedsizeofthetaxableestate?
❑ Isitadvantageoustotakeadvantageofthemaritaldeduction,or
shouldaportionofassetsremaininthedecedent’sestate?
❑ Whatarethelikelyestateexclusionamountandtheprojectedrate
oftaxonassetsexceedingthisamount?Haveotherlegalstructures
(trusts)beeninvestigatedtolessenthetaxburden?
❑ Whatistheplanafterthestep-upincostbasis?Willthissuggesta
majorshiftinthefamily’sstrategictargetallocation?
2 Tax-deferredretirementplans:Withtheexceptionoftheultra-
affluent,thesetypesofentitiesoftencomprisethebulkofanindividual’s
financialassets.Theycanbebrokendownintotwobroadcategories:de-
fined-benefitanddefined-contributionplans.
PositioningAssetsbytheTaxCharacteristicsoftheEntity 261
Thedefined-benefitplanisalsoreferredtoasanemployerplan.Inthis
case,thecorporationguaranteescertainbenefitstoqualifiedemployees.
Anappropriateassetmixisdevelopedtakingintoaccountthecharacter-
isticsoftheworkforceandthecostsofbenefitsoffered.Returnsgenerated
bythemixattempttomatchorexceedarate-of-returnobjectiveknown
astheactuarialassumption.Mostrecently,defined-benefitplansoffinan-
ciallyless-than-stablecompanieshavecomeunderpressure,becausethe
actuarialassumptioninsomecasesnolongerreflectsreality.Sinceinterest
ratelevelshavefallendramaticallyandequitieshavebeenathighvalua-
tionranges,assumptionsof8.5percentto9.0percenthaveanextremely
lowprobabilityofbeingachieved.Akeyelementofdefined-benefitplans
isthatfundingcontributionsbythecorporationtotheplan,uptocertain
levels,aredeductiblefromtaxableincomeandtheirappreciationistax-
deferreduntiltheemployeeelectstoreceiveadistribution.Morecommon
today,especiallyforyoungeremployees,aredefined-contributionorindi-
vidualretirementplans.Themostfamiliaristhe401(k)plan,ora403(b)
planforanonprofitorganization.FIGURE18.8showstheamountthatcan
becontributedtoa401(k)bytheemployeewithanadditionalcatch-up
provisionforindividualsagefiftyandolder.4
TherearealsoKeoghplansfortheself-employedthatallowforfund-
ingupto$42,000.Withdefined-contributionplans,theemployeerather
than the corporation is responsible for determining the amount of the
contribution and making specific investment elections. For every dollar
the employee sets aside, there is a reduction in the amount of reported
incomefortaxpurposes.Corporationstypicallymatchaportionofthe
employee’scontributionuptoadesignatedlimit.Thesetwofavorablefea-
turesalmostalwaysmakefundingthe401(k)planessentialandmakethe
planitselfthemostcompellingalternativeofanyentityoption.Astudyby
StephenHoranfoundthe401(k)ispreferredoverthetax-deductibleIRA
aslongastheemployermatchestheemployeecontributions.Additionally,
theindividualisalwaysbetteroffwhendroppingfromthe28percentto
FIGURE18.8 AnnualEmployee401(k)ContributionLimits
*Indexedforinflationafter2006.
262 ChallengingTraditionalAssetAllocationMethods
15percenttaxbracketuponcontributingtothe401(k)foranyinvestment
horizonandforemployeematchingaslowas5percent.5
Other common types of defined-contribution plans include money
purchasepension,profit-sharing,stockbonus,andemployeestockowner-
shipplans.Keyquestionsformodelingretirement-planentitiesinclude:
❑ Whatportionoffundscontributedtotheplan,ifany,arededuct-
iblefromincomefortaxpurposes?
❑ Doestheemployermatchanyoftheemployee’scontribution?Ifso,
whatarethelimitsoftheemployermatching?
❑ For defined-benefit and defined-contribution plans that are the
primary responsibility of the employer, can the asset mix of the
planbedeterminedandincorporatedintheanalysis?
❑ Willdistributionsbesubjecttotaxatanyotherrateotherthanthe
rateforordinaryincome?
❑ Havealltheeligibilityandvestingrequirementsbeensatisfied?If
not,whatistheirimpactandarethereanypenaltiesthatmustbe
considered?
❑ Istheviabilityoftheplaninquestion?
3 Individualretirementplans:Individualretirementplansorac-
counts(IRAs)areeligibletoanyonethathasearnedincome.Individual
contributionlimitsandcatch-upprovisionsareshowninFIGURE18.9.6
TherearetwotypesofIRA:traditionalandRothIRAs.Contributions
canbemadeuptoageseventyforeachtypeofIRA.Theprimaryadvan-
tageoftheRothoverthetraditionalisdistributionsarenottaxed.The
taxableportionofthetraditionalIRAdistributionissubjecttotaxatthe
ordinarytaxrate,buttheinvestormaybeeligibleforafullorpartialde-
ductionforthecontribution.Thedeductionsphaseoutin2005formar-
riedcouplesfilingjointlythathavetaxableincomeof$70,000to$80,000.
FIGURE18.9 AnnualEmployee401(k)ContributionLimits
*Indexedforinflationafter2008.
PositioningAssetsbytheTaxCharacteristicsoftheEntity 263
Therearephase-outprovisionsfortheeligibilitytoparticipateinaRoth
IRA.Formarriedcouples,therangeis$150,000to$160,000.
Investorseligibleforbothshouldtakethetimetoanalyzewhichtype
ofIRAisbestsuitedfortheirpersonalsituation.Individualscanconduct
the analysis themselves, using spreadsheets with present or future value
computations.Fortunately,calculatorsareavailableontheInternettoal-
low investors to determine which IRA is most advantageous for them.
Lookforasitethatwillrequestthefollowinginformation:
❑ Contributionamount(s)
❑ Currentandprojectedageatretirement
❑ Expectedrateofreturnontheinvestmentportfolio
❑ Currentandprojectedmarginaltaxrate
❑ Marital status and eligibility to participate in an employer-spon-
soredretirementplan
Inadditiontotheitemssuggestedaboveforcomparingthetwotypes
ofIRAs,youwillneedthedollaramountdesiredtobeconvertedandthe
portionthatwasnottax-deductible.
Asgeneralrulesofthumb,researchconductedbyStephenHoran,Jef-
freyPeterson,andRobertMcLeodsuggestsconvertingfromatraditional
IRAtoaRothIRAismostadvantageouswhen:7
❑ Theconversioncanbeconductedoptimallybypayingtaxconse-
quenceswithnon-IRAassets.
❑ Thereisalongtimehorizon.
❑ Theexpectedreturnishigh.
❑ Theindividualwillbeinalowertaxbracketatretirement.8
Oneofthekeyelementsoftax-awareinvestingisthenecessitytokeep
accurate records.This is especially true with determining the amount
oftheIRAcontributionthatisdeductible.IRSForm8606shouldbe
filedfornondeductibleIRAs.Anothergoodhabittogetintoistoavoid
mixingrolloverassetswithIRAsfundedthroughannualcontributions
whenchangingemployers.Theaccountingcanconsumeaninordinate
amountoftimeandeffortandcreatearealheadacheinthefuturewhen
youattempttodeterminewhatportionofdistributionsyoualreadypaid
taxeson.
4 Educationplans:Individualshavefourprimaryoptionsforfund-
ing education: 529 savings plans, Coverdell education savings accounts
(education IRAs), UTGM/UTMA custodial accounts, and taxable ac-
counts.Muchoftheliteraturethathasbeenprepareddoesnotcompare
thefirsttwoalternativeswithtax-efficienttax-managedfundsorETFsin
thetaxableaccount.Therefore,caremustbeexercisedinmakingbroad
264 ChallengingTraditionalAssetAllocationMethods
categorizationsof529plansoreducationIRAs,butthereisnodenying
that the benefit of the tax-deferral mechanism is powerful. Moreover,
if earnings are to be taxed it will be at the lower rate of the student.
TheeducationIRAorCoverdelleducationsavingsaccountislimitedto
familieswithadjustedgrossincomeupto$220,000anda$2,000an-
nualcontributionperbeneficiary.The529collegesavingsplansarenot
limited by individual’s adjusted gross income and feature a maximum
contributionperparticipantof$294,000.Asaresult,529plansareex-
tremely popular with parents and grandparents capable of contribut-
ingasubstantialamountoffunds,especiallywhenthecontributionscan
qualifyasgiftsup$22,000annuallyforjointfilers.Additionally,couples
cancontributeupto$100,000onceinfiveyearsandnottriggerthegift
tax.There are also 529 prepaid and independent plans. Some of these
planshaverecentlycomeunderpressureduetoconcernsaboutthefederal
budgetandthelessthanfavorablereturnsfromthefinancialmarketssince
thebeginningof2000.
Earnings of the various plans are tax-deferred. If funds are used for
purposesotherthaneducation,theyaretypicallysubjecttoa10percent
penalty.Likesomanyfacetsoftheindividualtaxcode,529plansare
also subject to sunset provisions in 2010. From an investment view-
point 529 plans and education IRAs make sense if the student is age
ten or less. However,someeducationplansincludecertainrestrictions,
like which academic institutions qualify, that should considered before
investinginthem.
5 Insurance products:Increasingly,themostcontroversialtypeof
investingentityisthedeferredvariable-rateannuityforthesimplereason
thatwiththeevolutionofthetax-efficienttax-managedfundsandETFs,
thereislessandlessreasontoownonewhenusingtraditionalassetclasses
astheunderlyinginvestment.However,sales activityoften exceeds$50
billionannually,becausetheseproductsaresoldtoinvestorswhoareun-
awareofthebetterreturnstheycouldgetfromtax-awarechoices.
There are two aspects that make deferred annuities less competitive
than tax-aware products: fees and taxable distributions being subject to
the ordinary income tax rate. An annuity has several layers of fees. As
mentionedearlier,feesareaformoftax.Annuitieshaveadeathbenefit,
butinterestinglyenough,thecostofthisbenefitgenerallyhaslittletodo
withage.Whenthisfeeiscoupledwiththeunderlyingfundmanagement
fee,totalfeestypicallyequal2percent.Fortunately,thereisaselectgroup
ofdiscountvariable-annuityprovidersthatofferproductswithtotalfees
intherangeof0.4to0.6percent.Thisisavastimprovementoverthe
averagehigh-costalternative,butthisisstilltwotimestoasmuchassix
times higher than the fee for a tax-efficient alternative mutual fund or
PositioningAssetsbytheTaxCharacteristicsoftheEntity 265
ETF.Fundsinvestedinavariableannuitybenefitfromcompoundingon
atax-deferredbasis,butthetaxableportionofthedistributionistaxedat
thehigherrateforordinaryincome.Ifyouhaveanequitymutualfundas
theunderlyingoption,youareinessenceconvertingthelong-termcapi-
talgainsportionofreturnintoordinaryincome,whichmakesnosense.
Whenyouanalyzetax-managedfundsorETFsthathavelittleornocapi-
talgainsgeneration,youconcludethatinmanycasesyouaregettingthe
tax-deferralmechanismofanannuityatafeeof0.2percentannuallyor
lessandtheappreciationistaxedatthemorefavorablerateforlong-term
capitalgains.Additionally,ifthemarketisinitiallyunfavorable,youcan
conducttax-lossharvestingtradeswithfundsheldinpersonaltaxableas-
sets, which you cannot do with an annuity. This feature is not always
relevantifthetax-managedfundhasasteeploaduponthesaleofshares
whenthetradeislikelytobeconsummated,whichwouldmostlikelybe
inthefirstfiveyearsofownership,ifever.
One true benefit of the annuity contract is that in about a third of
thestates,annuitiesareprotectedfromcreditors.Foraphysicianwhose
personalwealthispotentiallysubjecttopatientmalpracticeclaims,this
feature has genuine value.The one exception where the structure may
provebeneficialfordeferredannuitiesiswithhedgefunds.Manyhedge
fundstrategiesachievetheirreturnsthoughactivetradingthatgenerates
ahighamountofshort-termcapitalandgeneratesincomesubjecttothe
higherordinaryincometaxrate.Therefore,thetax-deferralmechanismis
morevaluablethanwhentheinvestmentoptionisanequityindexfund,
forexample,astheinvestmentisalreadyrelativelytax-efficient.
Studiesofvariableannuitiesoftencomparetheresultsachievedbytax-
ablebondsheldinsideandoutsidetheannuity.Theprojectedreturnof
thetaxablebondheldoutsidetheannuityisreducedbyataxhaircutre-
flectingapotentialclient’santicipatedtaxrate.Theproblemwiththistype
ofanalysisistheindividualsconductingthesestudiesoftendonotrealize
isthattax-exemptormunicipalbondsdonotgeneratereturnsequivalent
tothehaircutforthemaximumfederaltaxrate.Typically,anintermedi-
atebondindexwillgeneratereturnsequalto approximately 70 percent
oftheindex,versus60percentaswouldbesuggestedifthefixedincome
marketswereperfectlyefficientonatax-arbitragebasis.Sothemunicipal
bondusuallycarriestheday,unlessabondoflowercreditratingisused
insidetheannuity.
6 SocialSecuritybenefits:Thiselementisusuallyavoided.Itislist-
edherebecausesomefinancialplannersconsiderSocialSecuritybenefits
inthefinancialplanningprocess.SinceSocialSecuritybenefitshavetheir
ownsetoftaxramifications,theycanbetreatedasaseparateentity.Your
eligibilityforfullbenefitsdependsontheyearyouwereborn.Ifdesired,
266 ChallengingTraditionalAssetAllocationMethods
youcanbeginreceivingSocialSecuritybenefitsasearlyasagesixty-two,
butyourbenefitswillbereduced.Also,thereisaformulatodeterminethe
levelofeligibilityifyouelecttoreceivebenefitsatanagebetweensixty-two
andwhenyouarefullyeligible.SinceSocialSecurityispartiallytaxable
income,theremaybeanadvantagetotimingthedistributiondepending
onotherpersonalfactorsifacouple’sincomeisgreaterthan$32,000.Ad-
ditionally,dependinghowclosethecoupleisto$32,000,theplanneror
softwaresolutionmaysuggestagreaterallocationtotax-exemptbonds,
sincetheincomegeneratedisnotincludedinadjustedgrossincomeon
thefederaltaxreturn.
7 Trusts:Trustscanaccommodateavarietyofplanningobjectives.A
trustisverysimplyalegalagreementunderwhichassetsareheldandman-
agedbyonepersonforthebenefitofanother.Thetrusteeistheindividual
responsibleformanagingandadministeringthetrustassetsinaccordance
with the provisions of the legal document.There are different types of
trustsdesignedtosatisfyspecificobjectives.Theyareoftenidentifiedin
terms of their relationship to the trustor’s (also commmonly called the
donor,grantor,orsettlor)life,aslivingortestamentarytrusts.Revocable
livingtrustsaretypicallycreatedtoavoidtheprobateprocess,although
theyhavenoeffectonestatetaxesowed.Anirrevocablelivingtrust,which
cannotbealtered,mayhelpreduceincomeorestatetaxesbytransferring
assetsduringthetrustor’slifetime.Testamentarytrustsarepartofthewill
andbecomeeffectiveuponthetrustor’sdeath.Theirpurposeistocon-
serveortransferwealth.Sinceawillcanbechangedpriortodeath,the
testamentarytrustmaybechanged.Commontypesoftruststheprofes-
sionalservingtaxableaccountsislikelytoencounterinclude:
a. MaritalorQTIPtrust
b. Grantortrust
c. Irrevocablelifeinsurancetrust
d. Charitableleadandremaindertrust
e. Generation-skippingtrust
Othertypesofvehiclesthataresimilarintermsoftheirintendedpur-
posearefamilypartnershipsandprivatefoundations.Inthefamilypart-
nership, members of the family can essentially pool their resources and
gain access to investment vehicles at a reasonable cost that may not be
otherwiseavailable.Privatefoundationsallowfamiliestotransferhighly
appreciatedassetswhileobtainingacreditupto30percentofthetotal
marketvalueofthesecuritiesdonated.
Ifgainsandincomearenotdistributedtothebeneficiaries,thenthe
trustmustapplyataxaccordingtothescheduleinFIGURE18.10.
Sincereachingthehighestfederaltaxcomesquickly,trusteesaregener-
PositioningAssetsbytheTaxCharacteristicsoftheEntity 267
Source:CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,
FIGURE18.10 IncomeTaxRateScheduleforUsebyEstatesand
NongrantorTrusts—2004
TAXABLEINCOME
BUTNOT %ON OFTHE
OVER OVER PAY + EXCESS AMOUNTOVER
$ 0 – $1,950 $ 0 15% $ 0
$1,950 – $4,600 $ 292.50 25% $1,950
$4,600 – $7,000 $ 955.00 28% $4,600
$7,000 – $9,550 $1,617.00 33% $7,000
2003),p.30.
allymotivatedtodistributeincomeandrealizedgainstothebeneficiaries,
wheretheymaybetaxedataratelowerthanifintheyremaininthetrust.
Obviously,investmentvehiclessuchastax-managedfundsandETFsthat
haveahistoryofnotmakingrandomcapitalgainsdistributionscanbe
oftremendousvalue,asitgivesthetrusteegreaterfreedomofchoicein
determiningonhowtomanagedistributionsinatax-efficientmanner.For
example,itismuchmoredesirabletosellaportionofanETFknowing
theproceedswillbesubjecttolong-termcapitalgainstreatmentthanto
reacttoactivemanagersthatmayrandomlydistributegainssubjecttothe
higherrateonshort-termcapitalgains.
Coordinationwithmembersofthequalifiedtriumviratebecomesex-
tremelyimportantwhenattemptingtoestablishpayoutpolicy,especially
when certain charitable trusts are subject to priority of distribution ac-
cording to ordinary income, short-term capital gains, long-term capital
gains,andlastlytax-exemptincome.Thiscoordinationbecomescriticalas
itmaydictatewhetherornotyouconsiderhedgefundsinthemix.Hedge
fundscanservetoreduceoverallvolatilityandenhancetheprobabilityof
achievingatargetreturnobjective,buttheyalsogenerateahighlevelof
ordinaryincomeandshort-termcapitalgainsthatmaybeadversetothe
client’soveralltaxprofile.Trustorestateplanningcanbeextremelycom-
plex.Whentrustsareproperlymanaged,theycantrulyproducefantastic
results for all parties involved. However, when trusts are structured by
takinglibertieswithestate-planningtechniques,thetaxcode,orreason-
ableinvestmentexpectations,theycanproduceresultsthatarelessthan
desirableorevendetrimental.Thefollowingquestionsareprovidedinthe
268 ChallengingTraditionalAssetAllocationMethods
hopethatinvestorsandmembersofthequalifiedtriumviratecanavoid
someofthecommonpitfalls.
❑ Isthetrustpropertyorassetssubjecttothemaritaldeduction?
❑ Areopportunitiesavailablebygiftingbeingutilized?
❑ Isthebestusebeingmadeofthemaritaldeduction?
❑ Howwillthestep-upinbasisbeaccountedfor?
❑ Willthevalueoftrustassetsbeincludedinthedecedent’sestate?
❑ Doestrustincomehavetobedistributedannually?
❑ Is the value of the trust assets included in the surviving spouse’s
estate?
❑ Istheprojectedreturnonthetrust’sassetsrealistic?
❑ Are the philanthropic intentions of the family being satisfied, or
aretheysogenerousthetrustormayhavedifficultymaintaininga
desiredlifestyleinthefuture?
❑ Whatimpactdoesthestructureofthetrusthaveonthepotential
useofspecificassetclasses,styles,andmanagertradingstrategies?
❑ Whenallfees(investment,custody,tax,legal,andsoon)areac-
countedfor,canyoustilljustifythetrust?
❑ Does the trustee have an understanding of tax-aware investing
principles and the ability to communicate effectively with other
membersofthequalifiedtriumvirate?
Questionsspecifictotax-awareanalysisandpositioninginclude:
❑ Whatisthetermofthetrust?
❑ Willincomebedistributedasordinaryincomeorqualifieddivi-
dends,betax-exempt,orbesubjecttotheAMT?
❑ Whatistheprojectcapitalgainsrealizationrate,andhowitismea-
sured for each fund/manager/partnership involved? What is the
anticipatedsplitbetweenshort-andlong-termcapitalgains?
❑ What fees need to be accounted for in the process, and to what
extentaretheydeductible?
❑ Whenassetsarecontributedtothetrust,aretheyeligibleforavalu-
ationdiscount?
Considering the tax characteristics of each entity in the overall mix
canaddmeaningfulvalueonanafter-taxbasis.Thespecificamountof
incrementalreturn,whencomparedwithnaiveassetlocationthatutilizes
thesamepercentageofeachassetclassacrosseachentity,dependsonthe
taxcharacteristicsoftheentitiesinvolved,thedollarscontributedtoeach
ofthem,theavailableuniverseoffunds/managers/partnershipseachentity
canfund,andthetaxprofileoftheinvestororclient.Whiletheexerciseto
achieveatax-awaresolutionmayatfirstappearcomplex,withexperience
PositioningAssetsbytheTaxCharacteristicsoftheEntity 269
itbedoneefficiently.Existingoptimizerscanbemodifiedtoachieveeffi-
cientportfoliosbasedonreasonableafter-taxinputassumptions.Usingan
iterativeprocesswillallowpositioningofinvestmentvehiclesthatarebest
suitedforthetaxcharacteristicsofeachentity.However,themostcom-
plexsituationswillrequiresophisticatedsoftwaresolutions.Thebottom
lineisthattax-awarepositioningbythetaxcharacteristicsofeachentity
involvedcanaddconsistent,positiveresultsandshouldnotbeoverlooked
bypractitionerswhentaxableaccountsandentitiesarepartoftheoverall
assetmix.
ChapterNotes
1. CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,2003),
28.
2. JamesM.PoterbaandAndrewA.Samwick,“TaxationandHouseholdPort-
folioComposition:USEvidenceFromthe1980sand1980s,”NBERWorking
Paper,1999.
3. Sid Mittra, Jeffrey J. Kirkman, and George H. Seifert, Practicing Financial
PlanningforProfessionals(RochesterHills,MI:RHPublishing,2002).
4. http://www.ntrs.com,accessedNovember27,2004.
5. StephenM.Horan,“AReexaminationofTax-DeductibleIRAs,RothIRAs,
and401(k)Investments,FinancialServicesReview,2001,87-100.
6. http://www.ntrs.com,accessedNovember27,2004.
7. StephenM.Horan,JeffreyH.Peterson,andRobertMcLeod,“AnAnalysisof
Nondeductible IRA Contributions and Roth IRA Conversion,” Financial Ser-
vicesReview(1997),243–256.
8. StephenM.Horan,“AReexaminationofTax-DeductibleIRAs,RothIRAs,
and401(k)Investments,”FinancialServicesReview(2001),87–100.
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CHAPTER19
TheRoleofSystemsSolutionsin
Tax-AwareInvesting
Systemsoftaxationneednotachievetheideal.Butthefactthat
theConstitutiondoesnotdemandpurereasonandissatisfiedby
practicalreasondoesnotjustifyunreason.
—FelixFrankfurter
G
radualimprovementinsystemstechnologyisallowingpractitio-
ners to gain the information required to make more informed
investeddecisionswhentaxesareafactor.Fifteenyearsago,the
generalconsensuswasthefirstaccountstohavethesophisticationtoad-
dresstherequirementsoftax-awareinvestingwouldbethelargestaccounts.
Thiswastrueforaboutadecade,butinthepastfiveyearsthemajority
of technology spending has shifted from serving the largest accounts on
a stand-alone basis to creating platforms to handle large numbers of ac-
counts.Thereasonforthisshifthastodowiththeeconomicsofsoftware
development.Itisfarmoreprofitableforasoftwarefirmtotakeonasingle
assignmentwithadeep-pocketedproviderthantoriskspendingthetime
andefforttomarkettolargetaxable-accountrelationshipsthataredifficult
toreach,wantacustomsolution,andinmostcasesareunwillingtopaya
reasonablepriceforthedeliverable.
There have been two noteworthy cases of attempts at platform de-
velopmentthathighlighttherisksandpotentialforsuccess.Thecaseof
myCFO is an example of “a bridge too far.”There was a noble vision
withsufficientfinancialbacking,butthedeliverablefellshortofexpecta-
tion.Ontheotherhand,Lockwoodwasabletosecuretheexpertiseand
experienceofindustryveteranJayN.WhippleIII,thefounderofSecurity
271
272 TheRoleofSystemsSolutionsinTax-AwareInvesting
APL,anddemonstratehowimprovementsinthefunctionalityoftheback
office could lead to a scalable solution. Lockwood was acquired by the
BankofNewYorkin2002,whichprovideditwithatechnology-driven
platformthatofferstax-awarestrategiesandafter-taxreporting.Thesuc-
cessachievedbyLockwoodsettherestoftheindustryinmotiontoachieve
equalorgreatersuccessorelserisklosingmarketshare.
TheauthorisextremelyappreciativeofJamesHollisofCutterAssociates
andMattSchottofTowerGroupforsharingtheirexperienceandexpertise
intheareaofsystemstechnology.HollisandhisassociatesatCutteruse
thephrase“portfoliomanufacturing”todescribetheapproachtoplatform
developmentthatwrapprovidersareembracing.Portfoliomanufacturing
isapplyingmethodsandprocedurestypicalofindustrialautomationtothe
portfoliomanagementprocesstoachievescaleandgreaterefficiencies.As
“just-in-time”inventorycontrolhashadaprofoundimpactontheauto-
motiveindustry,portfoliomanufacturingischangingthewaypractitioners
approachthemanagementofaccountswheretaxeshaveanimpact.The
useofportfolio-manufacturingsystemshasthreeimmediatebenefits.First,
ifproperlydesigned,portfolio-manufacturingsolutionshavethecapability
ofdeliveringauniformtax-awareapproachacrossthepractice.Second,it
allows for quality control and compliance checks throughout the entire
process.Third,acustomsolutionisnowpossibletoavoidpotentialcon-
cernsoverconflictswithRule3a4coveringunregisteredmutualfunds.If
wrapaccountprovidersadheretothisrule,theydonothaveregisterunder
theInvestmentCompanyActof1940.Thewrapindustryhasbeencriti-
cizedbecauseinmostinstancesitsmanneroftradingisnodifferentthan
a mutual fund’s, and clients do not have access to a solution that truly
satisfiestheirspecificneeds.AsHollisstates,“portfoliomanufacturingal-
lows for customization in an automated environment.”1This concept is
not a dream or vision. Portfolio-manufacturing solutions are being now
implementedthatwillhaveaprofoundimpactonhowthemembersofthe
qualifiedtriumvirateinteractwithclientsinthefuture.Unlikethetrend
insystemssolutionsfortheultra-high-net-worthmarketthatattemptto
overcomeaccountingchallengeswithpartnershipsanddirectinvestments,
the portfolio-manufacturing systems are providing tax-aware investment
strategyandafter-taxreporting.Itisimportanttodistinguishbetweenthe
twodeliverables.Taxsolutionsarefavoredbyaccounting-orientedCFOs
offamilyoffices,whereasportfoliomanufacturingoffersafarmorecom-
prehensive solution capable of delivering substantial investment benefits
aswell.Anindicationofthepotentialthatcanbeachievedwithportfolio-
manufacturingsolutionsisTowerGroup’sbeliefthatitisonlyamatterof
timebeforevendorswilloffersystemstoaccommodatepositioningofman-
agersbythetaxcharacteristicsofeachentity,asdiscussedinchapter18.
TheRoleofSystemsSolutionsinTax-AwareInvesting 273
TowerGroupestimatesthatwrapaccountswillgrowby18.5percent
ayearandtotalassetswillgrowfrom$458billionin2003to$1trillion
in2007.2Asaresult,itsanalysissuggestsspendingontax-awareoverlay
managementserviceswillgrowfrom$6.3milliontomorethan$230mil-
lionoverthesameperiod.3Themoneyisbeingspentbecausefirmsbelieve
itisabsolutelyessentialtohaveaviabletechnologyplatformtoremain
competitiveandmanagetheassetsofretiredbabyboomers.Onecommon
hurdlethatalmostallofthemajorwrapprovidershavehadtoovercome
isreplacingormodifyinglegacysystemsthatdonothaveatax-lotaccount-
ing capability. As in the case of after-tax reporting, not having tax-lot
accountinghindersthedevelopmentofportfoliomanufacturing.
Toachieveatax-awaresolution,manywrapprovidersareembracing
“overlaymanagement.”Noknowledgeableinvestorcangiveseriouscon-
sideration to traditional wrap platforms when their average fee is 1.75
percent.This is simply too high a hurdle. Once astute investors realize
whattheyaregettingforthecost,theywilllookelsewhereforamorecost-
efficientsolution.However,withoverlaymanagementthewrapplatform
offerstheinvestorsignificantimprovementinriskmanagementandthe
potentialtosaveperhapsasmuchas1percentannuallyintaxsavings.4
Theoverlaymanagementprocessisadministeredbyaqualifiedspecialist,
whooftenservesasbothanadviserandamanager.Theterm“specialist”is
usedherepurposely,soasnottoconfusethefunctionoftheoverlayman-
agementprocesswiththeroleofmoneymanagers.Theprocesscanbeac-
complishedbyallowingtheindividualmanagerstocontinuetotradetheir
portfoliosandretainresponsibilityfortheirspecifictaxlots,ortheycan
informtheoverlayspecialistofbuyandselldecisionsbasedonamodel
account.Itisthelatterformatthatisgainingacceptance,asitallowsfor
greaterflexibilityandeaseofmanagementbytheoverlayspecialist.Typi-
cally,thistypeofarrangementisdoneatareducedfee,becausetheoverlay
specialistassumesoperationalcontrolforactivityacrossallthemanagers
intheclient’smasteraccount.Thisprocessmayatfirstseemlikea“black-
box”solutiontotheinvestor,butitallowsforenhancedriskmanagement
andtaxoptimization.
Theoverlayspecialiststartstheprocessmuchasaninvestmentadviser
would—byassistingtheclientinestablishingastrategictargetallocation,
selecting managers, and incorporating appropriate constraints. These
dutiesoftheoverlayspecialistresembletheadviserfunction.Therespon-
sibilitiesoftheoverlayspecialistmaybedifferentfromfirmtofirm,but
theobjectiveissimilar.Theideabehindoverlaymanagementistoallow
traditionalmanagerstofocustheirattentiononselectingthebestsecuri-
tiespossibleandallowtheoverlayspecialisttoserveasthe“quarterback”
oftheoverallprocesstooptimizeoveralltaxefficiency.Itshouldbeno
274 TheRoleofSystemsSolutionsinTax-AwareInvesting
surprisethatsomeofthefirmsofferingquantitativetax-awareportfolios,
such as Parametric Portfolio Associates, also offer overlay management
services.Otherwell-knownoverlaymanagementprovidersareCiticorp
andPlacemark.Toassistthemintheircraft,thefirmsmentionedmay
employanoptimizerprovidedbyAxioma,Barra,ITG,orNorthfield.An
optimizerisemployedtomanagethedesiredtrackingerrorrelativetoa
benchmark,thewaytaxlossesareharvested,andthetradingcosts.The
optimizersareoftenmodifiedtoprovideadesiredcustomsolution.The
optimizationtechnologymustinterfacewiththeportfolioaccountingand
trade-ordermanagementsystems,whichallowsfortradesfromnumerous
accountstobebatchedandtransactedinacost-effectivemanner.
Theoverlayspecialistplaysacriticalroleintheallocationofassetsto
eachmanagersecurityoverlapanalysisacrossthemanagers,andtaxman-
agement. Challenges can arise with overlay management. For example,
onemanagermaybesellingasecurityataloss,whileanotheriscontem-
platingpurchasingit.Ifnotchecked,thistypeofactivityhasthepossibil-
ity of violating the thirty-day wash sale rule.Therefore, managers need
toreceiveinformationtoalertthemtopotentialwashsaleviolations.To
overcome these types of challenges, rules-based solutions are instituted.
Thesemayaddressissuessuchasindividualsecurityconstraints,changes
inthetargetallocation,contributionsandwithdrawalsfromtheaccount,
timingofpurchasesandsales,differenttaxrates,stateofresidence,andthe
alternativeminimumtax.Somemoneymanagersareunwillingtoaccept
lowerfeesandturntheirmodelportfoliosandtradingauthorityoverto
theoverlayspecialist,especiallyifthestrategyfocusesonless-liquid,thinly
tradedsmall-ormicro-capitalizationsecurities.Differentchallengesarise
withfixedincomesecurities,sincetheyaretradedinasecondarymarket
ratherthanonanexchangewithfullpricetransparency.
Whenyoucomparetheinvestmentmanagementindustrywithoth-
erfields,itisreallyinaprimitivetechnologicalstate.Therealbeautyof
portfoliomanufacturingliesinitspotentialtocompletelyintegrateand
streamlinethedevelopmentoftheinvestmentpolicystatement,assetal-
location, account-opening procedures, accounting, and performance-
reporting functions.This type of start-to-finish seamless solution is be-
ingaddressedinvariouswaysbyfirmssuchasADVISORport,Smartleaf,
SoftPak,Tamarac,Vestmark,andVistaAnalytics.Therearealsofirmsthat
specializeintradingandcompliancemodules,likeCharlesRiver,Latent
Zero,andLinedataLongView.Thesefirmsoffercompleteoutsourcingor
anàlacartesolution.Thecostsavingsfortheadviserandthesolutionof-
feredtheinvestorarefarsuperiortoanythingadviserscanpatchtogether
on their own. When manager recommendations and custom reporting
templatesareincluded,theadviserhasthepotentialtobrandtheoverall
TheRoleofSystemsSolutionsinTax-AwareInvesting 275
package.Gettingthejobdoneoftenrequireshiringconsultingfirmslike
Cutter Associates orTower Group just to gain an understanding of the
landscapeandwhoiscapableofsolvingaspecificneed.
Portfolio-manufacturingplatformsarenotwithoutrisk.Failuretose-
lecttherightprovidercanbeextremelycostlytocorrect,whichistrueof
anycustodialorreportingplatform.Whilethequalityandscopeofthese
supplierscontinuestoimprove,theprimaryriskstotheadviserandthe
investorarethefinancialhealthofthesupplierandthequalityoftheun-
derlyingmanagers.
Advisersneedtohaveahighdegreeofconfidencethesoftwareprovid-
erwillbeabletoevolveastheirbusinessmodelandtheindustrychange.
Interesting technology plays are emerging daily, but only a few will be
abletoachievethecriticalmassnecessarytoremainprofitable.Therefore,
itisimportanttoevaluatenotonlythequalityofthedeliverablebutthe
financialwherewithalofthecompanyaswell.
Portfoliomanufacturingoffersthepotentialtodeliveracost-effective
solution,buttheoverallperformanceofthemanagersintheprogramwill
havethemostimpactonclientretention.Outstandingperformancestill
hasawayofovercomingothershortfalls,butiftheoverallperformance
afterfeesandtaxesisnotonaparwithacombinationoflesscostlytax-
awaremutualandexchange-tradedfunds,theplatformswillprovetobe
nothingmorethancostlyentertainment.Therearefourmajorconcerns
withmanagerselectionandretentionthatwillinfluencetheultimatesuc-
cessofindividualwrapplatformsandthisnicheoftheassetmanagement
industryasawhole.
Efficienciesachievedbyportfoliomanufacturingaredrivenbyvolume.
Therefore,thegreatestinhibitortoachievingcompellinginvestmentre-
sultsisemployingmanagersinassetclasseswheretheabilitytogenerate
alpha diminishes quickly with an increase in assets under management.
Onceadvisersandconsultantsrecognizethis,theresultingflowoffunds
often drives performance more than picking the right securities does.
Quitesimply,ifasmall-capitalizationmanagertransactinginless-liquid
securities receives a higher proportion of funds than its respective asset
class,continualpurchasingofstocksinthemodelportfoliowillnaturally
leadtosuperiorperformance.Atsomepoint,managersreachalevelwhere
thetimerequiredtosellapositionbecomessogreattheonlywaytheycan
accomplishthetaskwithoutseverelyaffectingthepriceofthesecurityis
throughamergeroracquisitionbyanothercompany.Whenthispointis
reached,orthemanagerexperiencesanoutflowoffunds,theperformance
ofclientaccountsthatremaininvestedwiththefirmsufferaccordingly.
Toovercomethefirstchallengepertainingtoassetsundermanagement
requires that analysts be able to identify emerging managers with short
276 TheRoleofSystemsSolutionsinTax-AwareInvesting
trackrecords.Seasonedanalystswithextensiveindustryexperiencewho
canevaluatemanagersonprocessandotherintangiblesversusquantita-
tivemeasuresarenecessarytoaccomplishthistask.Unfortunately,most
firmsshortchangetheirresearchfunction,andyounginexperiencedana-
lystsbasetheirdecisionsprimarilyonquantitativescreensandmeasures.
Therefore,thesecondchallengeistoconstruct,orfortheinvestortoiden-
tify,aplatformthatbuildsarecommendedlistofmanagerswhofocuson
theprocessesthatwillleadtosuccessratherthansuperficialperformance.
Thethirdchallengepertainstofees.Oncemanagersarefound,they
needtobeconvincedthatbeingcaptivetoawrapplatformmakessense.A
manager’sreputationcanbedamagedthroughinvolvementinawrapplat-
form,asdiscriminatingbuyerssimplywillnotdealwithfirmsthatyield
to the asset-gatherer mentality. Moreover, other than diversifying across
distributionchannels,whyshouldsmall-capitalizationmanagersdiscount
theirfeewhentheyhavelimitedcapacity?Thefirmsthathaveanexclusive
offeringrealizetheydon’tneedtobendtofeediscountsandwon’t.There-
fore,itisdifficulttomaintainthequalityoftherecommendedmanagers
listunlessfavorabletermscanbeextendedtothemostattractivefirms.As
flowstomanagershaveslowedoverthepasttwoyears,investmentman-
agerswhohavenotreceivedmeaningfulflowsarenowlookingforways
togracefullyexitwrapandquasi-wrapseparateaccountplatforms.They
aresimplynotbeingpaidenoughtoovercometheintricaciesofperfor-
mance composites, higher-than-anticipated servicing requirements, and
demandsforfeeconcessionsandloweraccountminimums.Tosucceed,
theplatformprovidersneedtobewillingtooffermanagersreasonablefees
anddemonstratetheycanprovidemeaningfulflowsoffunds.Addition-
ally,theyneedtohavetheoperationalefficienciesnecessarytorespondto
managers’requestsforinformationinordertosatisfytheirfirm’sclaimof
compliancewithAIMRreportingstandards,ifdesired.Ifaninvestment
managerisgoingtohaveexposuretowrapaccounts,thenitisbestdone
withoneorafewcredibleproviderswherethemanagerwillhavegreater
control.Fortheplatformprovidertoofferarecommendedlistofmanagers
ofthemajorwrapmanagersjustincreasestheprobabilitytheinvestorwill
receivenomorethananexpensiveindexsolution.
Thelastandfourthchallengehastodowiththetransaction-oriented
mentalityofretailbrokeragethatcanspillovertowrapplatforms.While
technology may provide a viable solution, someone still needs to com-
municatewithandeducatetheclient.Unfortunately,thereisstillapor-
tionofthemarketthatapproacheswrapmanagerslikeindividualstocks
andterminatesthemfartoofrequently.Thecostofchangingmanagersis
highenoughinthetax-exemptarenabutisevenhigherwithtaxableac-
countsthatmissthebenefitofcompoundingreturnstax-free.Thisisone
TheRoleofSystemsSolutionsinTax-AwareInvesting 277
reasonwhythesophisticatedelementofthemarketavoidsrecommending
managerswhoparticipateinwrapassignments,astheydonotwanttheir
portfoliovaluesinfluencedbythewhimsofthewrapmarket.
Tovaryingdegrees,thefourchallengesnotedcanbeovercome.First,
theplatformneedstoadoptadefinedphilosophytodrivethedecision-
makingprocessinamannerconsistentwiththecultureoftheorganization.
Itshouldbenosurprisethatadoptingportfoliomanufacturingwillhavea
meaningfulimpactonthecultureofthefirm.Sinceitisprocess-oriented,
itwillnaturallydirectbehaviorinacompliance-orientedfashion.Forthe
benefitsoftax-awareinvestingtotakehold,theoverlayspecialisttakeson
theportfolio-constructionroletoachieveconsistency.Professionalsofthe
firmwhohavehadthefreedomtostructureclientportfoliosaccordingto
theirownpersonalbiaseswillfindtheseplatformstoberestrictive.Unless
theycanacceptthebenefitofthetax-awareapproachandrefocustheir
attentiontowardeducation,sales,andservicingactivity,theywillbeless
effective than individuals who are new to the environment and do not
carrythebaggageofthepastwiththem.Thisisthesameprocedurebanks
gothroughwhentheirinternalportfoliomanagersmustadjusttoopen
architecture platforms, as they soon discover clients place less value on
theirindividualsecurityselectionskillsthanontheoverallmanagement
oftheprocess.
Amajorplusofportfoliomanufacturingistheabilitytodeliveraqual-
ityperformancereport.Firmsarespendingmoreandmoreeffortonthe
performancereport,astheyrealizeitistheonecommunicationtoolthat
candistinguishthefirm.Todosomayrequireobtainingtheservicesof
other parties for pricing, security characteristics, benchmark and peer-
groupcomparisoninformation,etcetera.Withportfoliomanufacturing,
theseoutsidetoolscanbebroughtinasneeded,inacost-effectivemanner,
toenhancethecontentofthereport.Flashperformancereportscanalso
becreatedtoprovidemoretimelyinformation.Innovativesolutionsare
beingappliedtocompressthetimebetweentheendofthereportingperiod
andthedeliveryofthefinalreporttotheclient.Inparticular,consultants
areheldhostagetowaitingonpeer-groupinformationcompiledfromsep-
arateaccountmanagers.Toovercomethischallenge,mutualfundreturns
are being used to create custom composites, which are available within
severaldaysaftertheendofthereportingperiod.Inmanyplatforms,us-
ing separate account information makes little sense, because of account
minimums.Ifyourclientsareinvestinginequitymanagersthatwillaccept
minimumsof$500,000orless,whycomparethesemanagerswithapeer
group universe where 75 percent of the managers have higher account
minimums than the client is eligible for? Using mutual and exchange-
traded fund information is actually more relevant, because it represents
278 TheRoleofSystemsSolutionsinTax-AwareInvesting
theresultsofatrueinvestablealternativetotheseparateaccountmanagers
availableintheplatform.
Adoptingaportfolio-manufacturingapproachmakestheinvestorcli-
entmoredependentontheplatformprovider.Itisdifficulttoquantify
thisbenefitindollarsandcents,butitisimmensefromaclient-retention
standpoint.Portfoliomanufacturingfacilitatescreationofavarietyofre-
portingdeliverablesthatcanbeautomaticallysentbyregularorelectronic
mailthroughouttheannualandquarterlyreportingcycle.Forexample,
thesystemcouldcreateacustomreportinNovembertoaddressyear-end
taxissues.Duringthequarter,variousreportscanbesentatdesignated
intervalstokeepremindingthemofthebrand.Thiscapabilitycanserveto
educateclientsonadditionalproductofferingsthatcanrangefrominsur-
anceproductstocommoditiesandhedgefunds.Theseadditionalproduct
offerings can increase revenue and enhance the profitability of existing
investorrelationships.Atthesametime,gradualsystematicupwarden-
hancementoftheportfolio-manufacturingapproachmakestheinvestor
increasinglydependentontheprovider.Ifacompleteintegratedapproach
isachievedthroughportfoliomanufacturing,thelogisticsinvolvedsimply
becometooonerousfortheinvestortoevenconsidermovingtoanother
platform.
Therearestilldoubterswhodonotbelieveitispossibletoachievethe
idealinvestorexperiencethroughautomation.Attorneysespeciallyfindit
difficulttoacceptthattheircraftcanbecapturedthroughtechnology,as
theyseeestateplanningasanartformthatdoesnotlenditselftoasystems
softwaresolution.However,ifyouhavethenecessaryinputvariablesand
thehumanmindcansolveaproblem,asystemssolutionispossible.Back-
groundinformationcannowbeaggregatedandanalyzedinasystematic
fashion.Alongtheway,advisersassisttheinvestorbysittingside-by-side
toanalyzevariousoptions.Decisionscanbemadequicklyanddocuments
canbeprintedandsignedtosatisfycompliancerequirements.Moreover,
systemssolutionshavethebenefitofcreatingalternativesolutionswithout
personalbias.Thisallowssolutionstobeconsideredthatanattorneymay
possiblyoverlook.Softwaredevelopersthatcancapturetheknowledgeof
qualifiedaccountants,estateattorneys,andinvestmentprofessionalshave
thepotentialtocreatetax-awaresolutionsandpresentinformationthat
canbeeasilyunderstoodbyallpartiesinvolved.Thisenhancedcapability
willchangetherolesofthequalifiedtriumvirate,asitsmemberswillno
longer need to spend an inordinate amount of time analyzing existing
holdingsandpreparingalternativesolutions.Theseactivitieswillbedone
forthem.Intheportfolio-manufacturingenvironment,practitionerswill
beabletospendtheirprecioustimeonreviewingpotentialsolutionsto
achieveoptimalresults.
TheRoleofSystemsSolutionsinTax-AwareInvesting 279
Withthepropersecurity,thereisnothingstoppingtheadviserfrom
takingtheprocesstotheinvestor’shomeorofficethroughtheuseofa
portablecomputer.Thevirtual,Web-basedsolutionisalsoarealitythat
willsavetimeandallowfornearreal-timeaccess.Thistypeofaccesscan
unfortunatelybeadouble-edgedsword.Technologyisgreat,butdailyac-
cessoftenfacilitatestheday-tradingmentalitythatisdetrimentaltowealth
creation. Therefore, firms need to consider carefully how information
shouldberepresentedtoensureitisconsistentwithatax-awareapproach
toinvesting.
In the past, retail and ultra-high-net-worth platform providers have
haddifficultyestablishingcredibilitywiththeirclientinvestors,because
theapproachtoplanning,investment,after-taxreturnreporting,andtax
reportingneedsisinconsistentfortheassetsoftheirtypicalrelationship.
Inalmosteverycase,oneitemisgivenpriorityattheexpenseofothers,
dependingonthedistinctivecompetenceoftheplatformprovider.Mas-
tering portfolio manufacturing for the base-level investor client on the
platformestablishesasolidfoundationforfuturedevelopment.Thebasics
includeitemsliketax-lotaccountingandamortizationandaccretionfor
fixedincomesecurities.Oncetheplatformmastersthedeliverableforthe
simplestclientonitsplatformitcanbegintoallocatedevelopmentdollars
tosolvetheneedsofclientsofincreasingwealth.Gettingthisrightputs
theplatformproviderinanenviablepositionofbeingabletocaptureand
retainasignificantportionofthevastbaby-boomermarketthatisgradu-
allyrollingoveritsqualifiedemployerretirement-planassetstoIRAs.The
consequencesofmissingthismacroeconomictrendaresoseverethatfirms
feeltheymustcommitampleresourcestoprotectorenhancetheirexist-
ing market share.Therefore, the emphasis on portfolio manufacturing
will ensure that tax-aware investing and after-tax reporting receive the
prominencetheydeserve.
ChapterNotes
1. JamesHollis,indiscussionwiththeauthor,July19,2004.
2. MattSchott,“DiscretionaryOverlayManagement:TheRoutetoNotsoSepa-
ratelyManagedAccounts,”TowerGroupinternaldocument,2003,4.
3. MattSchott,“DevelopingScaleforManagedAccounts:AreOverlayProviders
SittingintheCatbirdSeat?”TowerGroupinternaldocument,2003,4.
4. RonPruitt,“AComprehensiveViewofAfter-TaxInvestingandTaxEfficiency,”
SeniorConsultantvol.6,no.5(May2003):1–6.
This page is intentionally blank.
SUMMARY
Theregoesanothertax-awareinvestorlaughingallthewaytothe
bank!
—DouglasS.Rogers
Tax-awareinvestmentmanagementreallyboilsdowntomasteringfour
simplesteps:
1 Utilizingafter-taxassumptionsintheassetallocationprocess
2 Allocatingassetclassesandmanagers/fundsaccordingthecharac-
teristicsofeachentity
3 Tax-awareequitymanagerpositioning
4 Identifyingtax-awaremanagers/funds
Atfirst,theymayseemcomplicated,butthrougheducationandex-
perienceanyopen-mindedadviserorinvestorwhodesirestocapturethe
opportunityforwealthcreationinherentintheprocesscanmasterthem.
While developments of the past decade have significantly enhanced
ourknowledgeoftax-awareinvestmentmanagement,therearestillareas
thatrequiresignificantresearch.Theseincludetopicssuchasdetermin-
ing the precise range for rebalancing target allocations, accounting for
unrealizedcapitalgainspositionsintheafter-taxreportingprocess,and
portfolioattributionthatincludestheimpactoftaxesonsecuritybuyand
sell decisions. Solving these challenges requires solutions that might be
asradicalastax-awareinvestmentmanagementwasonlyafewdecades
earlier.
Thepoliticalwindsarecertaintochangethetaxcodeinthefuture.
Whileratesmaychange,deductionsmaybeeliminated,andtruesim-
plificationmayevenbeadopted,theprinciplesoftax-awareinvestment
management will endure.The key for continued success of tax-aware
investment management lies in education and the basic profit motive
involvedintheprocess.Educationregardingtax-awareinvestmentman-
agementwillcontinuetogainmomentum,becauseyoungdegree-and
certification-seekingprofessionalswillsimplydemanditandseekuni-
281
282 Summary
versitiesandorganizationscapableofsatisfyingtheirthirstforknowledge.
Theprofitincentiveisalreadyinplaythroughportfoliomanufacturing,
andthespoilswillgotothosefirmscapableofdeliveringsystemstechnol-
ogythatwillprovideaclearcompetitiveadvantageinthefuture.There-
fore,theknowledgeandapplicationoftax-awareinvestmentmanagement
isnolongeraluxurybutanecessityforfuturesuccess.
APPENDIX
TopFederalIncomeTaxRatesonRegular
IncomeandCapitalGainsSince1916
T OPRATEAPPLIES
TOMARRIED
TOPRATEON TAXABLE TOPRATE
REGULAR INCOME ONCAPITAL NOTESON
YEAR INCOME OVER GAINS CAPITALGAINSTREATMENT
283
284 Appendix
TOPRATE
APPLIESTO
TOPRATEON MARRIED TOPRATE
REGULAR TAXABLE ONCAPITAL NOTESON
YEAR INCOME INCOMEOVER GAINS CAPITALGAINSTREATMENT
25%maximum
TOPRATE
APPLIESTO
TOPRATEON MARRIED TOPRATE
REGULAR TAXABLE ONCAPITAL NOTESON
YEAR INCOME INCOMEOVER GAINS CAPITALGAINSTREATMENT
TOPRATE
APPLIESTO
TOPRATEON MARRIED TOPRATE
REGULAR TAXABLE ONCAPITAL NOTESON
YEAR INCOME INCOMEOVER GAINS CAPITALGAINSTREATMENT
Notes: The definition of taxable income varied very substantially over the years.
Source:CitizensforTaxJustice,May2004
Taxableincomeismuchlessthanactualincome.Startingpointsforthetoprate(in-
dexed)areaverageswhenmultipleyearsareshownafter1987.Ratesfor1970–81
reflectalowertoponearnedincome(secondfigurelisted).
*1988–90 28.0% $31,050 28.0%
detail 33.0% $75,050 33.0%
28.0% $155,780 28.0%
**Ratesinparanthesesincludeanadditionaltaxonadjustedgrossincome(phasedout
startingin2006;repealedin2010).
ContinuingEducationExam
forCFPContinuingEducationCredit
andPACERecertificationCredit
EarnfivehoursofcredittowardyourCFPBoardcontinuing-education
requirementaswellasPACERecertificationcreditbypassingthefollowing
examonlineatwww.bloomberg.com/ceandenteringcode1576TAX8.
AllthematerialhasbeenpreviewedbytheCFPBoardofStandards.
Ifyouwishtofindoutifthisbookandexamcanbeusedtofulfillthe
CErequirementforadifferentorganization,pleasecontactitsgoverning
boarddirectly.
1. Fundsintaxableaccountsrepresentapproximatelywhatpercent-
ageoftheworld’sliquidfinancialassets?
A. 10percent
B. 25percent
C. 33percent
D. 50percent
2. Which industry niche had the greatest initial impact on the
evolutionofknowledgepertainingtotax-awareinvestmentmanage-
ment?
A. wealthyindividuals
B. propertyandcasualtyinsurancecompanies
C. nucleardecommissioningtrusts
B. medicalretirementtrusts
4. The“fatheroftax-awareinvestmentmanagement”isconsidered
bymanytobe:
A. CharlesEllis
B. PeterBernstein
C. Robert“Tad”Jeffrey
D. JohnBogle
5. Whichofthefollowingarticlespublishedin1993servedasthe
catalystfortax-awareinvestmentmanagement?
A.“OptimalStockTrading”byGeorgeM.Constantinides
B.“IsYourAlphaBigEnoughtoCoverItsTaxes?TheActiveManagement
Dichotomy”byRobertH.JeffreyandRobertD.Arnott
C.“DoAfter-TaxReturnsAffectMutualFundInflows?”byDanielBerg-
stresserandJamesPoterba
D.“RankingMutualFundsonanAfter-TaxBasis”byJoelM.Dickson
andJohnB.Shoven
6. Ayoungprofessionalaspiringtoobtainacomprehensiveeduca-
tionfocusedontax-awareinvestmentcanachievesuchbyfocusing
onthefollowingsource:
A. Oneofthemanyuniversitiesteachingfinancialplanning
B. AnMBAsecuritiesanalysisprogram
C. Aprofessionalcertificationprogram
D. Noneoftheabove
7. Ithasbeenshownthatsecuritiesareefficientlypricedwhentaxes
areconsidered.
A. True
B. False
8. Securitytrading,asmeasuredbytheportfolioturnoverrate,canbe
appliedtoachieveanaccuratemeasureofamanager’stax-efficiency.
A. True
B. False
9. Whichofthefollowingeventsledtothecreationofafter-taxreturns
formutualfunds?
A. Mutualfundsdistributingcapitalgainsof$238billionin1999and
$326billionin2000
B. TheMutualFundTaxAwarenessActof2000passingbyavoteof385
to2
C. TheSECissuingaproposalforpubliccommentinMarch2000
D. Alloftheabove
ContinuingEducationExam 289
10.Whataretheessentialfunctionsthatmustbeconsideredfortax-
ableaccountstomaximizeafter-taxresults?
A. Investmentfunctiononly
B. Investmentandtaxfunctions
C. Taxandregulatoryorestatefunctions
D. Investment,tax,andregulatoryorestatefunctions
11.Whenamutualfundreportsafter-taxperformance,theafter-tax
return will always be less than the before-tax return for the same
periodofmeasurement.
A. True
B. False
12.At what time is the tax impact accounted for when calculating
after-taxreturns?
A. Atthetimeofthetransactionordistribution
B. Attheendofthemonth
C. Attheendoftheyear
D. April15ofthefollowingyear
13.Tocalculateafter-taxreturns,aseparate-accountmanagermust
have access to a system or custodian that has a tax-lot accounting
capability.
A. True
B. False
14.After-taxreturnsaremandatoryforseparate-accountclientsfor
allfirmsclaimingcompliancewithAIMR/GIPSstandards.
A. True
B. False
15.Withtaxableaccounts,whatamanagerhasdoneinthepastcan
haveanimpactonfutureafter-taxperformance.
A. True
B. False
17.Thevalueofthecaptureratiocanbegreaterthan100percent.
A. True
B. False
18.TheMorningstartax-costratioformutualfundsisaderivation
oftheAIMRSubcommitteeforAfter-TaxReturnReporting’s“relative
wealthmeasure”forseparateaccounts.
A. True
B. False
19.Themutualfundwiththelongestperiodsinceinceptionofnot
distributingacapitalgainisthe:
A. VanguardIndex500mutualfund
B. StateStreetSPDRexchange-tradedfund
C. VanguardTax-ManagedGrowth&Incomemutualfund
D. Schwab1000Invmutualfund
20.“Tax-lossharvesting”isatradeconductedpurposelytoproduce
alossthatcanbeappliedtogainsintheexistingportfolioorother
portfolios,ordeferredinmostcasesforfutureapplication.
A. True
B. False
21.Sellingasecurityandinvestingtheproceedstemporarilyincash
(knownasa“nakedtrade”)makessensefrombothaninvestmentand
ataxperspective.
A. True
B. False
22.Fromatax-awareinvestmentmanagementperspective,whena
securityfallsinvalueitisbesttodoublethepositionandthensell
theoriginalpositionortaxlotwhenthesecurityreboundsinprice
(knownasthe“doubledown”trade).
A. True
B. False
23.Thepreferredmethodfortakingalossistosellthesecurityata
lossandtemporarilyreplaceitwithasimilarsecurityhavingslightly
differentcharacteristics(knownasa“pair-wise”transaction).
A. True
B. False
ContinuingEducationExam 291
24.A benefit of the accounting methodology for mutual funds, as
comparedwithseparateaccounts,isthatyoucannotdistributealoss
toshareholders.
A. True
B. False
25.Investors can rely on exchange-traded funds that focus on spe-
cificcountriestoobtainahighleveloftaxefficiency.
A. True
B. False
26.The tax-loss harvesting trade can add persistent tax alpha over
timeastheportfolioseasons.
A. True
B. False
28.Foraninvestortojustifyselectinganactivelymanaged,domestic
large-capitalizationportfoliostrategyoverafirmthatappliesaquan-
titative tax-aware methodology that emphasizes tax-loss harvesting
overthefirsttenyearsoftherelationship,theactivemanagerneeds
toproduceanalphaorreturnabovetheindexofatleastwhatper-
centagewhentheimpactoftaxesandfeesareaccountedfor?
A. 0.5percent
B. 1.0percent
C. 2.0percent
D. 3.0percent
29.When an individual investor is subject to the alternative mini-
mumtax,aladderofnon-private-activitymunicipalbondswillpro-
videanoptimalsolution.
A. True
B. False
292 ContinuingEducationExam
30.Whenreportingyieldstotaxableinvestors,thebestpracticeisto
“grossup”theyieldsfortax-exemptormunicipalbondssotheinvestor
cancomparetheresulttoyieldofasimilar-maturitytaxablebond.
A. True
B. False
31.What can an adviser or consultant do to enhance the tax effi-
ciencyofhedgefunds?
A. Lookforhedgefundswherethemanagerhassignificantownership
B. Ifpossible,locatethehedgefundinatax-exemptaccount
C. Identifyhedgefundderivatives
D. Alloftheabove
34. Theprimaryreasonwhydomesticlarge-capitalizationequityman-
agersdonotshowtheirclientsafter-taxreturnsisthattheirchanceof
outperformingtheS&P500onanafter-taxbasishasprovedovertime
tobelessthan15percentandtheywanttohidethisfromtheirclients.
A. True
B. False
35.Whenconductinganasset-allocationoptimizationexercisefora
high-net-worthfamily,itisbestto:
A. relyonbefore-taxreturnandstandarddeviationassumptions
B. conducttheoptimizationfortaxableandtax-exemptaccountssepa-
rately
C. place value-oriented managers with turnover rates of approximately
20percentintaxableaccounts
D. noneoftheabove
ContinuingEducationExam 293
37.ItmakessensetoconvertfromatraditionalIRAtoaRothIRA
when:
A. thereisashorttimehorizonbeforetheinvestorreachesage59½
B. theexpectedreturnislow
C. theindividualwillbeinalowertaxbracketatretirement
D. alloftheabove
38.Dependingonthecomplexityofthetaxableclientrelationship,
researchhasshownthatapplyingtax-awareinvestmentmanagement
principles is likely to add 0.5 to 2.5 percent per year in additional
performanceorsavings.
A. True
B. False
39.Which of the following isnot an element that can improve tax
efficiency?
A. utilizingafter-taxassumptionsintheassetallocationprocess
B. allocatingassetclassesandmanagers/fundsaccordingtothetaxchar-
acteristicsofeachentity
C. tax-awareequitymanagerpositioning
D. whentheassetsarelargeenough,alwaysusingseparateaccountman-
agersratherthanmutualorexchange-tradedfunds
40.Theareathatwillhavethegreatestbenefittobabyboomersfor
improvingthenetafter-taxreturnsoftheirretirementassetsis:
A. lowercommissionsbydiscountbrokers
B. agreaternumberofavailableexchangefunds
C. asignificantimprovementinthetechnologicalandreportingcapabili-
tiesofinvestmentplatforms
D. avastincreaseinthenumberofinvestmentpractitionersseekingpro-
fessionaldesignations
INDEX
accountant’sratio,95–96,136 educationplans,263–264
accountingconventions,roleof,68–71 individualretirementaccounts,
ADVISORport,274 262–263
AIMR.SeeAssociationforInvestment insuranceproducts,264–265
ManagementandResearch iterativeapproach,254–259
alternativeminimumtax(AMT),64–65, listingassetsaccordingtoentitytype,
160–164 249–252
AmericanAcademyofFinancialManage- retirementplans,tax-deferred,
ment,CharteredWealthManager 260–262
program,36–37 SocialSecuritybenefits,265–266
AmericanBankersAssociation(ABA),39 stepsfor,249
PrivateWealthManagementSchool, taxableassets,259–260
36 tax-costratio,relativewealthmeasures,
annuities,deferredvariable-rate,264–265 analysisof,253–254
AperioGroup,120 trusts,266–268
Arnott,RobertD.,6,22–23,26–27,30, AssociationforInvestmentManagement
210–211 andResearch(AIMR),7,8,39,57,
assetallocation 60,61,77–78,209
appreciationandincome,analysisof, AIMRPerformancePresentationStan-
213–216 dardsHandbook,77
assetclasses,identifying,212–213 averagecostaccounting,104
capitalgainsrealizationrate,217–218 AXAGroup,137–138
correlationcoefficients,220–222 Axioma,122,274
fees,estimating,218–219
historicalreturns,problemswith, BankofNewYork,272
209–211 BarclaysGlobalFundAdvisors,106,107,
income,estimatingtaximpact,218 156
revising,212 Barraindices,120,122,230,274
standarddeviation,before-tax, Beebower,GaryL.,210
219–220 BeecherInvestors,145
steps,211–212 benchmarks,79–80,120
taxprofile,calculatingclient’s, Bergstresser,Daniel,29
216–217 Berkin,AndrewL.,27
yield-to-maturityandinflation,analysis Bernstein,PeterL.,22,209
of,219–216 BernsteinTax-ManagedInternational
assets,categoriesof,243–244 Fund,113
assets,positioning Berra,Yogi,211
after-taxassumptions,useof,252–253 Beyer,CharlotteB.,7,36
294
Index 295
Boczar,Tom,167,173 139–140
Bodie,Zvi,34 clienttaxprofile,calculating,216–217,
Bogle,JohnC.,22,104,105 246–249
“BondManagementforTaxableInvestors” Clinton,Bill,57,58
(Davidson),149 collars,129–130
bonds.Seefixedincomefunds conferences,listof,39–40
Brilley,Michael,158 Constantinides,GeorgeM.,21,104
Brinson,GaryL.,210 corporatesinking-fundbonds,158–159
Brunel,JeanC.,42,237 correlationcoefficients,220–222
Brunel,JeanL.P.,6,42 Coverdellplans,263,264
BrunelAssociates,6 crossovertrade,158
Brusven,ArlandD.,4 CTCConsulting,5–6,118–119
custodians,121
capitalgains,after-taxreturnsand,14–16 CutterAssociates,272,275
capitalgainsdistributions,principlesfor
avoiding,103–104 Davidson,R.B.,III,149,150
capitalgainsrealizationrate(CGRR), “DeathtothePolicyPortfolio”(Jahnke),
217–218 209
CapitalTrustCo.,5 derivatives,172–173
captureratio,96 “DeterminantsofPortfolioPerformance”
CertifiedFinancialPlanner(CFP),35 (Brinson,Hood,andBeebower),
CertifiedFinancialPlannerBoardof 210
Standards,34 Dickson,JoelM.,6,25–26,30,103–105
CertifiedInvestmentManagementAnalyst Dietz,PeterO.,22
(CIMA),35 discretionaryarrangements,50
CertifiedPublicAccountant(CPA),35 diversificationissuestoconsider,130–131
CertifiedTrustandFinancialAdvisor “DoAfter-TaxReturnsAffectMutual
(CTFA),35 FundInflows?”(Bergstresserand
CFAInstitute,22,209 Poterba),29
CGMCapital,24–25 Dodge&CoxStockFund,15–16,98–99
charitableorganizations,payoutordistri- dollar-costaveragingprograms,68
butionpolicyfor,203–205 double-downtrade,137
CharlesRiver,274
CharteredFinancialAnalyst(CFA), EatonVance,129
34–35,40 EconomicGrowthandTaxReliefRec-
CharteredFinancialAnalystsInstitute,39 onciliationAct(2001),246,247,
CharteredLifeUnderwriter(CLU),35 259–260
Ciccotello,ConradS.,42 educationplans,funding,263–264
Citicorp,274 educationprograms/requirements,fortax-
Citigroupindices,197 awarepractitioners,34–37
clientassetinventory,193–194 EmployeeRetirementIncomeSecurityAct
clientcriteria,120 (ERISA)(1974),3
clientobjectives,servicing,145–146 England,Mark,118,119
client/providerrelationships,48,49–51, equityfunds,60,61
296 Index
break-evenanalysis,142–144 portfoliomanufacturing,276
elementsof,135 quantitativetax-aware,121–122
extendholdingperiodsandmonitor redemption,110
capitalgains,136 Fichtenbaum,Mark,173
focusontaxableaccounts,141–144 FidelityMagellanfund,24–25
HIFOaccounting,useof,138–139 FidelityValue,26
internationalaccounts,145 FinancialAnalystsJournal,22
maintainlowturnover,136 FinancialPlanning,40
performancestandardsandreporting, FinancialPlanningAssociation(FPA),
144–145 39,40
supportstaff,useofqualified,139–140 FinancialResearchAssociates(FRI),39
taxableincomelevels,adjusting,136 FinancialServicesReview,42
tax-lossharvesting,136–138,140–141 first,in,firstout(FIFO)accounting,68,
tax-lotaccounting,useof,138 69–70,71,104
washsalerule,140–141 FirstQuadrant,22,120,121,125,128
equityinternationalmanagers,questions MonteCarlosimulation,117–118
toask,186 529collegesavingsplans,263,264
equitymanagers fixedincomefunds,82
Seealsomanagers,styleof alternativeminimumtax,160–164
questionstoask,176–184 bondladders,problemswith,151–152
estateissues elementsof,150
exchange-tradedfundsversustax-man- insuranceindustry,159–160
agedfunds,109,110 maturitydates,159
quantitativetax-awarefundsversus municipalbonds,out-of-state,156
exchanged-tradedandtax-managed municipalbonds,upgradingof,
funds,126–129 158–159
exchangefunds,129 phantomincomeissues,155–156
exchange-tradedfunds(ETFs),80, premiumsanddiscounts,impactof,
105–107 154–155
comparedwithquantitativetax-aware returnsversusrisk,balancing,152–154
funds,125–131 taxablebonds,157–158
comparedwithtax-managedfunds, fixedincomemanagers
108–113 Seealsomanagers,styleof
Exchange-TradedFundsManual,The questionstoask,185–186
(Gastineau),108 401(k)plans,254–255,261–262
expenses,treatmentof,83 FranklinGrowth,26
FrankRussellCo.,22
FamilyOfficeExchange(FOX),7–8,39 Friedman,Gregory,6
FederalFarmCreditBank,157 full-liquidationmethod,85–86
FederalHomeLoanBank,158
fees GalaxyIISmallCompanyIndexFund,
assetallocationandestimating, 103
218–219 Gastineau,Gary,108
client/providerrelationshipsand, GeneralElectricCo.(GE),122,124
50–51,52–53 Gilmour,Paul,7
impactof,18–20 Giordani,Leslie,171
Index 297
Giordani,Schurig,Beckett&Tackett,171 income,estimatingtaximpact,218
GlobalInvestmentPerformanceStandards indexparticipationshares(IPS),105
(GIPS),85 individualretirementaccounts(IRAs),
Gordon,RobertN.,42,167 171,254–255,262–263
GovernmentNationalMortgageAssocia- inflation,assetallocationandanalysisof,
tion(GNMA)funds,155,157 219–216
Gratry&Associates,81 InformationManagementNetwork
Greycourt&Co.,6 (IMN),39
grossyieldbasis,154 INGGroep,137–138
InstituteforPrivateInvestors(IPI),7–8,
Hamilton,Sara,7 39
HedgeFundResearch,173 WhartonSchoolPrivateWealthMan-
hedgefunds agementProgram,36
derivatives,172–173 InstituteofCertifiedBankers(ICB),35,
examplesoffavorabletransactions,170 39
expenses,deductibilityof,168–169 InstitutionalInvestor,39
individualretirementaccounts,171 insuranceproducts,264–265
investingincompaniesthatown,172 IntegratedWealthManagement(Brunel),
managerownershipin,169 42
nondirectionalversusdirectional,170 internationalequities,47,145
offshore,168,171 internationalmanagers,questionstoask
partnershipaccounting,168 equity,186
privateplacementlifeinsurancepoli- InvestmentAdvisor,39
cies,171–172 InvestmentCompanyAct(1940),272
reasonsforinvestingin,167 InvestmentCompanyInstitute(ICI),26,
taxefficiency,169 57
Heebner,Ken,24 InvestmentCounselingforTaxableInves-
highin,firstout(HIFO)accounting,70, torsConference,8
104,138–139 InvestmentManagementConsultantsAs-
high-net-worthinvestors,cateringto,5–6 sociation(IMCA),WealthManage-
holdingperiods,14–16,136 mentCertificateProgram,36
Hollis,James,272 InvestmentPerformanceCouncil(IPC),
Holton,GlynA.,15 7,78
Hood,Randolph,210 investmentpolicydevelopment
Horan,Stephen,261,263 clientassetinventory,193–194
Horvitz,Jeffrey,203 profilemixreturnandriskinforma-
Howard,Joanne,142–143 tion,196–198
“HowWellHaveTaxableInvestorsBeen questionnaires,useof,198–199
Servedinthe1980’sand1990’s” riskprofile,195
(Arnott,Berkin,andYe),26–27 steps,192
HTMLformat,91 tax-lotaccounting,194–195
volatility,analysisof,195–196
IbbotsonAssociates,39 investmentpolicystatements
“ImplicationsofRebalancingtheInvest- charitableorganizations,payoutor
mentPortfoliofortheTaxable distributionpolicyfor,203–205
Investor,The”(Horvitz),203 elementsof,199–207
298 Index
optimizationtools,202 managementselection,portfoliomanufac-
rebalancing,impactof,202–203 turingand,275–277
useof,47–48 managers,styleof
Investments(Bodie,Kane,andMarcus), Seealsotax-awaremanagers;typeof
34 all-capitalization/style-specificmodel,
InvestorEducationCollaborative,36 232–233
IRS,Form1099-DIV,72–73 analysisof,236–240
iSharesindexmethodology,Morningstar, core-and-satelliteapproach,237–238
238–240 costsofrigid,227–231
iSharesMSCICanadaandSwedenETFs, modified,231–232
110 MorningstariSharesindexmethodol-
“IsYourAlphaBigEnoughtoCoverIts ogy,238–240
Taxes?”(JeffreyandArnott),6,22, optimaltax-awareequityallocation,
25 235–236
ITG,122,274 problemwithcategorizing,226
quantitativetax-awaremodelcombined
Jacob,NancyL.,5,6,118 withotherstyles,233–235
Jahnke,William,209–210 M&IBank,121
Jeffrey,RobertH.,6,22–23,30,104 ManGroup,172
Jennings,William,43 Marcus,AlanJ.,34
J.K.LasserProIntegratingInvestments marketcapitalization,225–226
andtheTaxCode(Reichenstein markettiming,137
andJennings),43 McLeod,Robert,263
JobsandGrowthTaxReliefReconciliation M.D.Sass,158
Act(2003),12 MetropolitanWest,164
JournalofPortfolioManagement,6,22 Minck,JeffreyL.,80
JournalofWealthManagement,42 Mittra,Sid,259
MorganStanleyCapitalInternational
Kane,Alex,34 (MSCI),120,197,230
Keoghplans,261 MorningstarInvestmentDetailReport,
Kirkman,Jeffrey,259 61–64,227
tax-costratio,63–64,97–100
Langstraat,Brian,118 MorningstariSharesindexmethodology,
LatentZero,274 238–240
LehmanBrothersAggregatebond,197 MotleyFool,58
LinedataLongView,274 Moulton,Marc,6
Lockwood,271–272 municipalbonds,64–65
LotsoffCapitalManagement,128 buyingbeforeupgraded,158–159
Lynch,Peter,24 buyingout-of-state,156
mutualfunds,reportingafter-tax,57–74
MainStayInstitutionalEAFEIndexFund, MutualFundTaxAwarenessAct(2000),7
103 myCFO,271–272
Maister,DavidH.,49
“MakingHedgeFundInvestingMore nakedtrade,136–137
Tax-Efficient”(BoczarandFichten- NationalAssociationofPersonalFinancial
baum),173 Advisors(NAPFA),39,40
Index 299
NewYorkSocietyofSecurityAnalysts managementselection,275–277
(NYSSA),40 outsourcing,274–275
NewYorkUniversity overlaymanagement,273–274
CertificateinWealthManagement,36 performancereporting,277–278
InstituteonFamilyWealthManage- risks,275
ment,40 wrapaccounts,272–273
NMSManagement,40 post-liquidationreturns,12–14,59–60,
nondiscretionaryarrangements,50–51 85
NorthernTrustGlobalInvestments,121 Poterba,James,29,80
Northfield,122,274 PracticingFinancialPlanningforProfession-
NuclearDecommissioningTrusts(NDT), als(Mittra,Kirkman,andSeifert),
4,40 259
nuclearpowerplants,decommissioning, pre-liquidationreturns,12–14,24,59
4–5 prepaidvariableforwards,130
Price,LeeN.,6–7,77,78,79,91
offshorehedgefunds,168,171 privateplacementlifeinsurance(PPLI)
operationalissues policies,171–172
exchange-tradedfundsversustax-man- Pruyne,RobertE.,7,77
agedfunds,109,110 PSNmanagerdatabase,146–148
quantitativetax-awarefundsversus publications,listofprofessional,42–43
exchanged-tradedandtax-managed
funds,125,126–127 quantitativetax-award(QTA)portfolio
organizations,professional,39–40 management
Osprey,91 benchmarkselection,120
overlaymanagement,273–274 clientcriteria,120
comparedwithtax-managedand
pair-wisetrade,137–138 exchange-tradedfunds,125–131
ParametricPortfolioAssociates,86–89, custodian,roleof,121
118–119,121,124,274 earlyexampleof,118–119
passiveforeigninvestmentcompanies(PF- elementsof,119
ICs),171 fees,121–122
performancereporting,277–278 portfolioconstruction,120–121
Peterson,Jeffrey,263 portfoliosoftware,122
phantomincomeissues,155–156 trackingerror,122–125
Phillips,Don,97,239 Quisenberry,Clifford,237
PIMCO,164
AllAssetFund,22 “RankingMutualFundsonanAfter-Tax
PEAValueAFund,98–99 Basis”(ShovenandDickson),6,
pipeanalogy,15–16 25–26
Placemark,274 realestateinvestmenttrusts(REITs),12,
PORTAX,6,248,258 136
portfoliomanagement.Seequantitative rebalancing,impactof,202–203
tax-awardportfoliomanagement Reichenstein,William,43
portfoliomanufacturing,272 reinvestmentofincome,12
benefitsof,278–279 relativewealthmeasure,96–97
fees,276 reporting,after-tax,144–145
300 Index
ResearchAffiliates,22 stand-alonesystems,89
retirementplans,tax-deferred,260–262 Standard&Poor’s
returns DepositoryReceipt(SPDR),105
componentsof,12 500stockindex,111–112,114,197,
pre-andpost-liquidation,12–14,24 225
riskprofile,195 standarddeviation,before-tax,219–220
Rittenour,RalphC.,Jr.,5,118 StandishMellon,152,156
Rogers,DouglasS.,7,91 StandishSmallCapitalizationTax-Man-
Rosen,JanM.,42 agedEquityFund,113–114
RosenbergCapitalManagement(RCM), StateStreetGlobalAdvisors,121
6,77,142 Stein,DavidM.,80,119,124,225
Russellbenchmarks,120 Stevens,Dale,210
RussellMidCap,226 stock,selling,130
Russell1000,226 “StockIndexMutualFundWithoutNet
Russell2000,197,226 CapitalGainsRealizations,A”
Russell3000,232 (DicksonandShoven),26,104
Ryan,Paul,68 Surz,RonL.,80,210
Ryzewic,SusanRemmer,36
Tamarac,274
SallieMae,158 Tavel,Bruce,172
Sauter,GeorgeU.,104 taxableassets,positioning,259–260
Saxton,Jim,67–68 taxalpha,81,104,117–118,133–134
Scholes,MyronS.,21 tax-awareinvestmentmanagement
Schott,Matt,272 elementsof,51–54
Schwab,Charles,25,26,30 evolutionof,3–8
Schwab1000IndexFund,25,26,104, tax-awaremanagers
105 Seealsomanagers,styleof
SecuritiesandExchangeCommission equityinternationalmanagers,ques-
(SEC),7,57–60,78 tionstoask,186
SecurityAPL,91,271–272 equitymanagers,questionstoask,
securitybreak-evenanalysis,142–144 176–184
Seifert,George,259 fixedincomemanagers,questionsto
separateaccounts,after-taxreporting, ask,185–186
77–92 inquisitivenessand,37–40
Sharpe,WilliamF.,197 knowledgeability/educationalrequire-
Sharperatio,197–198 mentsand,34–37
Shoven,JohnB.,6,25–26,30,103–105 passionand,41–43
Siegel,Jeremy,215 patienceand,40–41
Simpson,JohnD.,91 skillsneededby,45–54
SitInvestmentAssociates,158 traitsneededby,33
Smartleaf,274 tax-costratio,63–64,97–100
SocialSecuritybenefits,265–266 taxefficiency
SoftPak,274 exchange-tradedfundsversustax-man-
softwaresystems.Seeportfoliomanufac- agedfunds,108,109
turing hedgefundsand,169
StagecoachEquityFundIndex,61 quantitativetax-awarefundsversus
Index 301
exchanged-tradedandtax-managed UtilityPensionFundStudyGroup,4
funds,125,126
measuring,95–100 Vanguard,22,120
taxes 500IndexFund,6,23–29,30,104,
consequencesofsellingandbuying 110–112,227–231
securities,16–18 Mid-CapandSmall-Capindexfunds
federalincomeratesonregularincome 227–231
andcapitalgains,283–286 Tax-ManagedGrowthandIncome
impactoninvestments,11–20 Fund,58–59,61–64,105,
tax-lossharvesting,104,117–118 110–112
double-downtrade,137 TotalStockMarketIndexFund,
nakedtrade,136–137 228–229
pair-wisetrade,137–138 Vestmark,274
percentagebenefitfrom,80–81 VistaAnalytics,274
washsaleruleand,140–141 volatility,analysisof,195–196
tax-lotaccounting,138,194–195
tax-managedfunds WallStreetSecretsforTax-EfficientInvest-
comparedwith exchange-traded ing(GordonandRosen),42
funds, 108–113 washsalerule,140–141
comparedwithquantitativetax-aware Whipple,JayN.,III,91,271–272
funds,125–131 Wilshire5000stockindex,232
taxprofile,calculatingclient’s,216–217, Wimer,Mark,210
246–249 WindermereInvestmentAssociates,6
taxrates WindsorFund,22,104
calculatinganticipated,84 wrapaccounts,272–273
estateplanningissues,246
federalincomeratesonregularincome Ye,Jia,27
andcapitalgains,283–286 yield-to-maturityandinflation,analysisof,
marginalversusaverage,244–245 219–216
Todd,Christine,156
TowerGroup,272–273,275 zero-couponbonds,155–156
trackingerror,122–125
Treasuryinflation-protectionsecurities
(TIPS),156
trustedadviser,roleof,48–50
TrustedAdvisor,The(Maister),49
trusts,managing,205–207,266–268
turnoverrates,136
Twenty-FirstSecuritiesCorp.,128,167,
170,171
UniformPrincipalandIncomeAct
(UPIA),205
U.S.TrustCorporation,121,172
unrelatedbusinesstaxableincome(UBTI),
168
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ABOUTTHEAUTHOR
DouglasS.Rogers,CFA,hasbeeninthefinancialservicesindustryfor
nearly two decades and is a leading authority on tax-aware investment
management and after-tax reporting. He is a senior consultant and
managing director at CTC Consulting, founded in 1981, which serves
morethanonehundredhigh-net-worthretainerrelationshipsencompass-
ingmorethan$12billioninliquidfinancialassets.
Prior to joining CTC, Mr. Rogers served within the consulting in-
dustry as a chief investment officer and director of traditional manager
research,wherehehasimplementedtax-awarestrategyandcreatedopen-
architecturemanagerplatformstoservehigh-net-worthfamilies.Hehas
also worked with property and casualty insurance companies, nuclear
decommissioningtrusts,andmedicalretirementaccounts.
Mr. Rogers understands the taxable-account industry from multiple
perspectives,includinginvestmentpolicy,assetallocation,managersearch
activity, portfolio management, security analysis, and reporting. He is
the chairman of the AIMR Subcommittee for After-Tax Performance
Reporting,whichwasresponsibleforinteractingwiththeSecuritiesand
ExchangeCommissionontheafter-taxstandardsformutualfundsand
maderecommendationstorevisetheexistingseparateaccountstandards
totheircurrentform.
Mr.RogersisagraduateoftheUnitedStatesMilitaryAcademyand
holds an MBA from Southern Methodist University. A nationally rec-
ognizedspeakerandauthor,heisalsoaCharteredFinancialAnalyst.In
2001,hereceivedtheannualPeterDietzAwardforthemostsignificant
contributiontothebodyofknowledgeinperformancemeasurement,for
hisarticle“TheChallengesofAfter-TaxPerformanceReporting”inthe
spring2000issueoftheJournalofPerformanceMeasurement.
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