TAX-AWARE INVESTING IN THE EMERALD ALLOCATION STRATEGIES

We receive many questions from advisors about our approach to tax-management within our portfolio strategies.  In response, here is an overview.  Thanks for your interest, and let us know what other questions you have.
 
BACKGROUND AND OBJECTIVE: taxes are clearly a "cost" of investing for investors in taxable accounts and taxable investment vehicles.  Thus, active managers should attempt to strike a balance between keeping taxes low and pursuing competitive long-term pre-tax returns.  The better such a balance is achieved, the higher the after-tax returns (i.e. "what you keep") for the investor.

Since our strategies primarily use open-end mutual funds and Exchange-Traded Funds (ETFs), we need to understand the tax ramifications of those investment vehicles.  Also, since income is not a significant objective of our strategies, this discussion will focus on capital gains taxes, which are more relevant to our investment style and more pliable in the hands of the manager.

With mutual funds, an investor may be taxed two different but related ways.  They pay capital gains tax on any profits from sale versus purchase, and some funds pay "capital gain distributions" on net capital gains realized from security sales during the year (typically paid in the last two months of the calendar year).   
 
HOW TO "STRIKE THE BALANCE":
 
1.      Before a fund is purchased:  

• Review its "unrealized capital gain percentage," published by Morningstar.  This allows us to gauge the potential tax liability not yet incurred by the fund, which could be realized and distributed to shareholders in the future.
  
  
• Review the fund's trading turnover, published by Morningstar.  While this is considered by our industry to be a major determinant of a fund's tax-efficiency, we are not as focused on it.  Why?  Because we are not buying one fund, we are allocating across several, and that allows us to perform tax-related maneuvers within the larger portfolio to reduce overall tax cost to the client.  Thus, we are rarely deterred from buying a fund simply due to high historical trading turnover.  We look at turnover alongside performance.  If the fund manager has shown evidence that their very active style has produced return or risk-reduction benefits to shareholders over time, that is more important to us than one isolated statistic that we can overcome through our own allocation among various funds.

 
2.      After a fund purchase is made:

• We review each position's value versus cost each day as part of our daily portfolio review and assessment.  This allows us to identify potential areas of risk or opportunity from a tax standpoint. 
• We look for "tax swap" opportunities.  That is, if we have a fund with a loss versus purchase, and a similar security exists, we will at some point consider whether to sell the existing position and buy the other security as a "surrogate" holding.  After 30 calendar days have elapsed since this "swap" we can go back into the original position if we like.  If we go in prior to that time, the capital loss on the sale of that security will not be considered a capital loss.  This is known as a "wash sale" and the result is that we don't get to offset gains in the portfolio with that loss.
• Follow a sell-discipline.  Tax-efficiency is an attractive feature of our money management style for taxable investors.  However, we don't want to suffer such a large loss on a position that we will pat ourselves on the back for how much tax savings we generated by eventually taking a huge realized loss!  Any security that reaches a price at which we believe our thesis for buying it was wrong (and this differs for each holding) is reviewed by the investment committee.  Action may or not be taken but the loss condition is recognized and evaluated either way.

3.      During the fourth quarter of each year:  

• Track capital gains distribution potential for each mutual fund holding and act as needed.  Mutual funds are required to distribute their realized capital gains each year, and specify which are classified as short-term gains and which are long-term, as the two conditions are taxed differently to the investor.  When we reach the fourth quarter of the year, we have to be very aware of which funds could throw a large distribution at us.  We do not want to buy these funds until after they have paid out.  To help us make the best possible decisions and avoid being blindsided by the fund companies, each year we assign a staff person to call the companies that run each of the funds our clients own, as well as those we anticipate buying.  They make their first round of calls in late October and track the estimated payments and payment dates on a computerized grid we created years ago.  Because of the uncertainty caused by distribution season, as the last weeks of the year go by, our staff calls the mutual fund companies as often as needed to update estimate information and to confirm that distributions due to be paid have indeed been paid.  That frees us up to start using the funds again.  Also, if we have a fund that is about to pay a big distribution, and we were planning to sell it anyway, we may want to sell it before the distribution is paid. 
  
• Make adjustments prior to annual tax-transaction deadlines.  For separately managed accounts, the calculation of capital gains and losses is for activity during a particular calendar year, so we do what we can to prudently minimize tax costs for each year.  This involves reviewing accounts and investment models to estimate the tax liability, and capturing losses if it makes sense to do so (from both a tax and investment perspective). If we are managing the account through a "WRAP" program, such activity is done in response to a request from the financial advisor on the account.
   
  

The information provided herein is of general nature and is for informational purposes only. The information should not be considered as, or a substitute for, accounting, tax, financial, or legal advice. Although the material presented has been checked with resources believed to be reliable, some material may be affected by changes in law or in the interpretation of such laws. Further information on the firm and its advisory fees may be obtained from the firm's Form ADV Part II, which is available without charge upon request. Complete descriptions of all Emerald's products and benchmarks are available upon request.
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