on Tax Management Best Practices
Techniques for Maximizing Portfolio Returns
Alain Cubeles and Christopher A. Fronk
- A fundamental principle of taxable portfolio management is that
portfolios and investor circumstances are unique and dynamic. Two
portfolios with identical holdings purchased five years apart are
significantly different because of the specific underlying tax lots
associated with the securities held in each portfolio. If a specific
security has had volatility over the five-year time horizon, then
one portfolio may own a security at a gain and another may own the
same security at a loss.
is important to understand tax lots and how they impact a portfolio.
A tax lot is created each time a security is purchased. For example,
if an investor purchased 200 shares of Pfizer, Inc., on February
15, 2007, for $36.14 per share, and 300 shares of Pfizer, Inc.,
on March 1, 2007, for $35.00 per share, then this investor has
two tax lots of Pfizer, Inc. The two lots represent the two different
purchases of Pfizer, Inc., on two different dates at two different
a portfolio effectively, a tax manager needs to know not only
what securities are held in the portfolio but also what the underlying
tax lots are for those securities. Continuing the example above,
a tax manager must not only know that the investor owns 500 shares
of Pfizer, but also that the investor purchased the shares on
two different dates for two different prices. Furthermore, there
could be two similar sets of portfolios and tax lots and yet the
optimal portfolio management solution may be different because
the investors’ tax circumstances and objectives differ.
For example, one investor may have a significant capital loss
carryforward and the other may have a net gain for the year. Therefore,
the application of a single “standard” strategy cannot
effectively meet all investors’ needs.
who want to successfully maximize investors’ wealth must
consider these kinds of issues. Investors can benefit from a better
understanding of what to expect from their tax manager.
Portfolio Management Approach
The foundation of a customized product structure is a flexible
portfolio management system that provides the portfolio manager
with analysis tools. The system must provide separate consideration
of short- and long-term gains and losses, and objective functions
designed to help an investor maximize losses and minimize gains
while monitoring active risk.
realized losses and minimizing realized gains are common objectives
for individuals with taxable investments because a net realized
loss can be used to offset some income (currently $3,000 for most
individuals), and minimizing realized gains reduces the investor’s
overall tax bill. Although this functionality may seem basic,
not all portfolio management tools can perform at this level of
customization. In such cases, the actual after-tax value may be
significantly reduced. For example, if the portfolio management
tool allows the tax manager only to generate a net loss, then
the tax manager may be generating unwanted gains. The parameter
of a net loss means that the system can generate both gains and
losses as long as the net loss equals the desired amount. In essence,
this reduces the manager’s after-tax returns by the amount
of gains generated due to the inadequate tool. After-tax returns
begin with the portfolio’s pretax return and then add in
or subtract out the impact of taxes on the portfolio. For example,
if a portfolio generates net realized gains, then the portfolio’s
after-tax return will be less than the pre-tax return because
the investor will have to pay taxes on the realized gains.
1 illustrates this point. In this example, both scenarios
generate a net loss of $100,000. Scenario 1 generates gross losses
of $200,000 and gross gains of $100,000 for a net loss of $100,000,
while Scenario 2 generates gross losses of $100,000. Understanding
how a net loss is achieved within an account is important because,
in this example, Scenario 2 will have lower turnover and lower
transaction costs. Furthermore, Scenario 2 retains $100,000 of
unrealized losses that can be realized eventually and used to
offset gains outside of this portfolio. This lack of functionality
often means that the system cannot differentiate between short-term
and long-term holding periods. This could mean that the tool is
generating a short-term gain and a long-term loss, which creates
a potential tax mismatch. Again, this lack of customization will
cost the tax manager from an after-tax performance standpoint.
the goal of a tax manager is to realize short-term and long-term
losses when they become available. At times a manager may need
to generate long-term gains, but at least the investor could expect
to benefit from lower capital gains rates (currently 35% for short-term
but 15% for long-term). One of the worst things a tax manager
can do for investors is to generate an unnecessary short-term
gain. A superior tax management tool better allows a tax manager
to minimize these inefficiencies.
and tax trade-off. Typically, choosing between an
active tax management strategy and one that aims to closely track
the benchmark returns involves a trade-off. This trade-off occurs
because in order to perfectly match a benchmark return, a portfolio
would need to perform exactly like the benchmark. To realize a
loss, the portfolio manager must sell one or several securities
that have declined in value. To avoid the IRS’s wash-sale
rule, these securities cannot be repurchased for at least 31 days.
During this time period, the portfolio manager uses optimization
techniques to mitigate the risk created by the underweight of
the securities sold relative to the benchmark. Put another way,
optimization techniques help the portfolio look similar to the
benchmark without exactly matching it. For example, if a Pfizer
tax lot is currently at a loss, then the optimization program
might recommend a sell of the Pfizer lot in order to realize a
loss. The optimization program then might recommend using the
cash from the sale of Pfizer stock to purchase additional shares
of Bristol-Myers Squibb, Johnson & Johnson, and Merck &
Co. to replace the Pfizer exposure.
2 shows another way to view this trade-off. At one extreme,
the manager will aggressively harvest losses and allow the portfolio
to drift away from its benchmark if necessary (upper-right). At
the other extreme (lower-left), loss-harvesting opportunities
may be forgone in order to minimize risk vis-à-vis the
benchmark. In many cases, however, the investor may want to strike
a balance in the middle, between directly tracking the index and
investor’s objectives are understood, a manager should use
the tax management system to help meet the tax objectives within
a predefined tracking error. Terms like “active risk,”
“estimated tracking error,” and “estimated deviation
from the benchmark” represent how closely a portfolio manager
believes the portfolio will perform on a pretax basis relative
to the underlying benchmark. An important aspect of this trade-off
is that a tax manager must allow an investor to dynamically change
preferences throughout the year. This is extremely important because
an investor’s tax situation may change due to gains realized
in other portfolios or gains realized in reducing a single stock
concentration. A flexible tax management system and tax manager
should be able to respond to an investor’s changing needs.
must also be able to analyze the impact of other strategies such
as charitable gifting, focusing on maximizing the amount of unrealized
gains removed from the portfolio while monitoring the resulting
effect on portfolio risk. In addition, basic analytical tools
used to describe a portfolio, such as tax-lot analysis and industry/sector
analysis, are necessary in order to understand the underlying
portfolio characteristics. The primary benefit of a flexible system
is that a tax manager can spend more time on analysis and developing
an investment strategy. The aggregation and sharing of this information
allows an investor, consultant, and tax advisor to make more-informed
decisions regarding the investor’s entire portfolio.
information. A tax manager must be able to provide
timely information on performance (pretax and after-tax) and the
portfolio’s tax situation (realized and unrealized gains
and losses). Information regarding performance is important because
it allows an investor to develop an understanding of the appropriate
level of tolerable tracking error. If the realized volatility
of returns is wider than the investor would like, then a portfolio
manager may reduce the active risk in the portfolio as directed.
Realized volatility of returns means how close an investor’s
portfolio return is relative to the underlying benchmark’s
return. The closer the two returns, the tighter the tracking error.
The after-tax return provides a gauge as to how well the portfolio
is performing given the investor’s specific circumstances.
For example, if an investor is looking to maximize loss realization,
does the after-tax return reflect that strategy given the specific
portfolio characteristics regarding available unrealized losses?
about the timing of gains and losses is critical for an investor’s
tax advisor. For example, if a mutual fund, which cannot distribute
capital losses, is going to make a gains distribution, then the
amount of gain generally is not known until it is made, typically
in November or December. This allows a tax advisor little or no
time to develop a strategy to offset these gains before year-end.
In contrast, a good tax manager not only provides an investor’s
tax advisor with updates throughout the year on expected gains
and losses, but also, because the portfolio is managed in a separate
account, typically can better control the realization of gains
late in the tax year.
Due to the
potential for turnover associated with tax-managed strategies,
a successful tax manager also must focus on minimizing transaction
costs. These include both explicit costs (e.g., commissions, custody
charges) that are directly visible to an investor and implicit
costs (e.g., bid/ask spread, market impact) that cannot easily
be seen. Portfolio turnover increases the transaction costs borne
by the investor, as shown in Exhibit
3. This illustrates the potential impact of commissions depending
on portfolio turnover and actual commission rate.
will increase as a consequence of two main factors: benchmark-generated
turnover (securities being added or deleted from the corresponding
index due to bankruptcy, mergers and acquisitions, and lack of
representation) and tax strategies (loss harvesting). A tax manager
must pay attention to the rebalancing rules and reconstitution
schedules dictated by the selected benchmark in order to ensure
proper tracking error. Index rebalancing and reconstitution occur
when the index provider (e.g., Standard & Poor’s, Russell)
changes the securities that make up the index.
a smaller company that grows in size may move from a small-company
index to a large-company index, which creates an index change.
The actual commission rates paid by a client should not be ignored.
For example, given a strategy with a 40% annual turnover rate,
the difference between executing trades at $0.01 per share versus
$0.05 per share would result in 10 basis points (bps) of difference
in return to the portfolio. This drag on performance can be substantial
(especially when compared to investment management fees), and
a conscientious manager will strive to obtain the best possible
commission rate. A manager who is part of a larger organization
typically can more easily leverage the overall relationship with
the broker community and obtain lower commission rates. (Incidentally,
some investment managers pay higher commission rates than others.
As a result, investors must consider both investment management
fees and commission costs when comparing two tax managers.)
a tax manager creates a list of securities to buy and sell, estimates
of both explicit and implicit costs must be incorporated into
the portfolio optimization process so that if all else is equal,
given a choice of two securities, the security with the lower
expected cost would be traded. Once this trade list is created,
the trading desk can use certain algorithms in an attempt to exploit
short-term trends in security price movements and find liquidity
across markets. For example, if a security is traded in multiple
locations and is offered at one cent lower in one location, then
the portfolio manager would want to purchase the security at the
lower price. While one cent may seem insignificant, Exhibit 3
shows that with 40% turnover this type of strategy would increase
the investor’s return by 2.5 bps.
in addition to recognizing that different types of trades require
different types of execution strategies, help a tax manager and
trader minimize transaction costs. Applied consistently over time,
the compounding effect of these strategies can significantly reduce
the total transaction costs in a portfolio, which directly increases
the investor’s after-tax return.
4 describes other special situations, such as cash flows and
transitions between portfolios, that may require additional communication.
During this communication, the portfolio manager would provide
the investor with scenarios or options that help an investor make
more informed decisions. For example, assume an investor wanted
to maximize losses realized in December. Also assume the investor’s
portfolio contained $1 million in unrealized losses and currently
had an estimated tracking level of 25 bps. A tax manager could
provide multiple scenarios detailing the amount of losses realized
and the resulting estimated tracking level. The scenarios might
look like this:
1: Realize $250,000 of losses; estimated tracking level rises
to 35 bps.
2: Realize $500,000 of losses; estimated tracking level rises
to 50 bps.
3: Realize $750,000 of losses; estimated tracking level rises
to 75 bps.
4: Realize $1 million of losses; estimated tracking level rises
to 175 bps.
that a higher estimated tracking level simply means that the portfolio’s
return may differ more from the underlying benchmark’s return.
Once the investor, the tax advisor, and the consultant have this
information, they can better understand what losses are available
and how they will impact the estimated tracking level in the portfolio.
Often this two-way flow of information can enhance the performance
of a strategy by allowing the investor to tailor the account to
his tax and investment needs. In addition, good investor–tax
manager communication provides a better opportunity for expectations
to be properly set and achieved.
Not Just About Returns
or consultant cannot expect to accurately measure a tax manager’s
effectiveness based solely on pretax or after-tax performance.
Doing so would ignore the extra value that a tax manager provides
for an investor: control and customization. Returns alone do not
capture the benefit of being able to gift low-cost basis securities
while understanding the impact to the portfolio’s characteristics;
nor do returns alone reveal the value of timely tax information
or a complementary tax strategy. How does one measure the value
of communication or a customized portfolio structure?
This is not
to suggest that one should completely ignore performance; it is
a key piece of information in judging a tax manager. It does suggest,
however, that the success of the strategy is not based solely
on pretax and after-tax performance. A successful tax manager
provides an investor with a more comprehensive array of benefits,
which should ultimately provide more efficiency for the investor’s
Cubeles is a senior vice president and senior investment
strategist in global quantitative management for Northern Trust
Christopher A. Fronk, CFA, CPA, is a senior vice
president and product strategist–tax advantaged equity in
global quantitative management for Northern Trust Global Investments.
A previous version of this article was published by Northern
in 2006. Used with permission.