Reduce Drag on Performance through Tax Managed Indexing

Tax changes in recent years have hit high-income earners, including investment income. These include an additional Medicare surtax, a new top rate for dividends and long-term capital gains, and the phase out of itemized deductions for affluent taxpayers. It’s increasingly important for advisors to help clients identify strategies to help them invest more tax efficiently.

Obviously, taxes can create a drag on wealth growth, but the amount may surprise you. Tax drag can reduce investment growth by 1%-3% annually. This is even higher than the amount many people pay in management fees. Given the current state of government debt and budget deficit, tax rates are not expected to be lowered any time soon. Advisers should assess their clients' exposure to the harsh tax rate environment and adjust accordingly. One powerful tool that advisers need to consider is tax-managed indexing.

Most advisers know about tax-efficient strategies such as the use of tax-deferred accounts, municipal bonds, year-end loss harvesting and low turnover indexing strategies. Indexing or passive index investing entails investing in a broadly diversified index like the S&P 500® or the Russell 3000®. One way to get exposure to these indexes is through an ETF or a mutual fund. Compared to active mutual funds, passive index mutual funds tend to be relatively tax efficient. This is because the indexes exhibit very low turnover and subsequently distribute few capital gains. ETFs, in general, tend to be a little more tax efficient than mutual funds because they are able to avoid some capital gain realization through in-kind redemptions, and because mutual funds are often forced to realize (and distribute) gains when investors redeem shares. Some mutual funds that are labeled tax advantaged strive to reduce capital gain distributions by realizing losses to offset any gains. While these approaches are tax efficient, by employing tax managed indexing in a separately managed account, one has the opportunity for additional tax efficient exposure.

As an alternative to ETFs and indexed mutual funds, separately managed accounts can offer flexibility that results in a hyper-tax-efficient index exposure. Unlike ETFs and index funds, a separately managed account can pass capital losses through to the individual investor. Realized capital losses are valuable because they can be used to offset capital gains, thereby reducing an investor's tax bill. A tax-managed separate account can be designed to seek index returns similar to those from an ETF or mutual fund, but with the added benefit of excess realized losses. Here's how it works.

Two goals of tax managed indexing are: (1) to track the selected index; and (2) to produce a tax benefit through excess realized losses. As an example, consider an S&P 500® benchmarked, tax-managed portfolio. Initially, the portfolio is invested in about 250 securities selected to track the index. The securities and weights are selected such that the portfolio very closely resembles the index in terms of sector and industry weights. Care is also taken to ensure that the portfolio lines up against the index in terms of risk factors like yield, beta, and market capitalization. After the initial portfolio is invested, it is continuously monitored for risk and tax-loss harvesting opportunities. With a portfolio of 250 securities, some equity prices will rise and some will fall. The names that go down present loss harvesting opportunities. When such opportunities occur, the portfolio is loss harvested. The tax lots exhibiting a loss are sold, and a replacement set of securities is bought. Care is taken not to violate wash sale rules. The intended result is a portfolio that closely tracks the index while also producing excess realized losses.

Excess losses realized by a tax-managed index portfolio can be used to offset gains that exist elsewhere in the investor's overall portfolio. Taxable gains may be generated from the investor's active manager investments, hedge fund investments, or sale of real estate or concentrated stock. In the end, the goal is for investors to pay fewer taxes, keep more of their money invested and reap the benefits of tax deferral.

With the recent increase in taxes, advisers need to consider tax-efficient strategies in order to help their clients retain more of what they earn. Tax-efficient solutions such as ETFs and mutual funds are a good start, but hyper-tax-efficient strategies like tax-managed indexing can be even better.

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