Maintaining Your Portfolio’s Tax-Efficiency

By Nong Lin, Ph.D., CFA®, CTC Director of Quantitative Equity Research and Rakesh Uthamchand, CFA®, CTC Investment Analyst
February 1, 2022

While the consensus political view appears to be that the President’s comprehensive “Build Back Better” package is tabled in its current form, the potential for pieces of the plan to survive – especially pertaining to higher taxes on the wealthy – should not be dismissed altogether. 

Tax Efficiency
While major changes to the tax code may seem unlikely over the next year or two, even small “tweaks” can introduce challenges, so it’s important for investors to stay on top of events in Washington, D.C., and their own personal tax situation to keep from being caught off guard. Regardless of how the political winds blow, now is always a good time to assess your portfolio’s tax efficiency.

How does a portfolio get to be tax-efficient? There are a number of considerations and techniques, some of which are widely known to the general investing population. For example, a tax-efficient portfolio might be invested in municipal bonds rather than taxable bonds. Index exchange-traded funds (ETFs) can be more tax-efficient than mutual funds, as index ETFs generally distribute no or limited capital gains each year. 

In addition, strategies with high turnover (frequent trading, or portfolio “churn”) can produce short-term gains, as opposed to long-term gains that are taxed more favorably, not to mention higher transaction costs. To address this concern, portfolios can be invested in tax-aware or tax-managed equity strategies. Tax-aware strategies may be active strategies that constrain portfolio turnover in order to minimize short-term gains. A tax-managed strategy may be an index-like separately managed account strategy that actively pursues tax efficiency in order to lower an investor’s overall tax bill. Some basic principles of a tax-managed strategy might include the following:
● Avoidance of short-term gains
● Deferral of gains
● Active tax-loss harvesting

It’s easy to understand how the first two principles listed above might work. Short-term gains can be avoided by waiting to sell a stock until it is held in the portfolio for at least a year. Deferral of gains can be achieved through low turnover over time, especially if the turnover might produce gains.

The third principle, active tax-loss harvesting, can take considerably more skill but can provide a noticeable reward to the investor. The strategy may be structured to be index-like, with the goal of providing the same risk and return characteristics of an index, while owning considerably fewer stocks than the index at any given time. This allows the strategy to harvest losses while maintaining the risk/return profile of the index, ultimately producing a better after-tax return from the strategy than from the index. 

Here’s how it can work: Let’s say a strategy is benchmarked against the Russell 1000 Index, but the actual portfolio may only own half of the total large- and mid-capitalization stocks traded. The stocks held are selected so that the total portfolio looks like and provides returns similar to those of the larger universe of stocks. For example, the portfolio may intentionally own half the stocks in all industries. The other half are used as replacements when a stock is sold to harvest losses. If the portfolio owns, for instance, Coca-Cola and not PepsiCo, and the entire beverage industry drops on some bad news, the strategy may sell Coca-Cola at a loss and buy PepsiCo, still maintaining a risk/return profile in line with the index. When the beverage industry recovers, PepsiCo is likely to recover as well. The loss from Coca-Cola can be used to offset gains elsewhere in the client’s portfolio, perhaps in other asset classes. In the end, tax-managed strategies can achieve index-like returns and reduce near-term tax bills at the same time.

Tax-managed strategies aren’t for everyone. First of all, the portfolio must be large enough to hold a considerable number of stocks in order to maintain the profile of the index. Also, it’s best to fund the portfolio with cash, say, from a sale of a business, or with other stocks that have an unrealized loss or are stepped up in basis—you certainly wouldn’t want to be forced into selling stocks at a gain in order to fund a tax-managed portfolio. Also, an investor would want to be able to offset other gains in the investor’s total portfolio in order to realize the advantage of the harvested tax losses.

It’s important to note that many strategies advertised as “tax managed” may not have all the bells and whistles. Some may only limit turnover. On the flip side, a robust offering should be able to track individual tax lots so that there is more flexibility in taking losses. Also, it would be important to be able to avoid wash sales in connection with stocks in other parts of the investor’s portfolio.

Clearly, a tax-efficient portfolio can reap benefits for the investor. Gains that are offset or deferred over many years can allow greater compounding of the portfolio and increase an investor’s wealth.

Anyone interested in discussing how to employ more tax-efficient strategies on their investment portfolios is encouraged to contact a Commerce Trust Company wealth management advisor today.

Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of February 1, 2022.
This summary is intended to provide general information only, may be of value to the reader and audience, and any opinions expressed herein are subject to change.

This material is not a recommendation of any particular security or investment strategy, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.

Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation.

Commerce Trust Company is a division of Commerce Bank.
NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE  

 

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ABOUT THE AUTHOR

Nong Lin, Ph.D., CFA® Senior Vice President, Director of Quantitative Equity Research Commerce Trust Company
Nong is the director of quantitative equity research for Commerce Trust Company. His responsibilities include research and production of the proprietary quantitative equity selection models and optimal portfolio construction processes.

He serves as a co-manager for the Commerce value, growth, and mid-cap growth strategies. Prior to joining Commerce in 2001, Nong was the director of database marketing and modeling and a senior statistician.

He earned his Ph.D. degree in mathematics from Washington University in St. Louis in 1990. Nong holds the Chartered Financial Analyst® designation and is a member of both CFA Institute and CFA Society St. Louis. Since 2007, he has served in various positions for CFA Society St. Louis, such as: president, vice president of programming, board of director, and secretary. Nong enjoys running and hiking in his free time.

ABOUT THE AUTHOR

Rakesh Uthamchand, CFA® Assistant Vice President, Investment Analyst Commerce Trust Company 
Rakesh is an investment analyst for Commerce Trust Company. His primary responsibilities include research and quantitative analysis for selection of third-party managers offered in client portfolios, manager combinations, asset allocation studies, and institutional client studies.

Prior to joining Commerce in 2011, Rakesh was an investment analyst, where he was involved in manager research and analysis.

Rakesh has a Bachelor of Commerce degree from University of Madras in Chennai, India, and a Master of Business Administration degree from Missouri State University. Additionally, he holds the Chartered Financial Analyst® designation and is a member of both CFA Institute and CFA Society of St. Louis."