Tax aware investment management: The essential guide

Tax-Aware

InvestmentManagement

AlsoavailablefromBloombergPress

TheInvestmentThinkTank:

Theory,Strategy,andPracticeforAdvisers

editedbyHaroldEvenskyandDeenaB.Katz

RetirementIncomeRedesigned:

MasterPlansforDistribution

editedbyHaroldEvenskyandDeenaB.Katz

(AvailableApril2006)

FamilyWealth—KeepingItintheFamily:

HowFamilyMembersandTheirAdvisersPreserveHuman,

Intellectual,andFinancialAssetsforGenerations

byJamesE.HughesJr.

ManagingConcentratedStockWealth:

AnAdviser’sGuidetoBuildingCustomizedSolutions

byTimKochis

ThePPLISolution:DeliveringWealthAccumulation,

TaxEfficiency,andAssetProtectionThrough

Private-PlacementLifeInsurance

editedbyKirkLoury

WallStreetSecretsforTax-EfficientInvesting:

FromTaxPaintoInvestmentGain

byRobertN.GordonwithJanM.Rosen

Acompletelistofourtitlesisavailableat

www.bloomberg.com/books

ATTENTION CORPORATIONS

THIS BOOK IS AVAILABLE for bulk purchase at special discount. Special editions

or chapter reprints can also be customized to specifications. For information,

please e-mail Bloomberg Press, [email protected],Attention: Director of

Special Markets, or phone 212-617-7966.

Tax-Aware


THEESSENTIALGUIDE

DouglasS.Rogers

BLOOMBERGPRESS

n e w y o r k

© 2006 by Douglas S. Rogers. All rights reserved. Protected under the Berne Convention. Printed in the United States of America. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews. For infor-mation, please write: Permissions Department, Bloomberg Press, 731 Lexington Avenue, New York, NY 10022, U.S.A. or send an e-mail to [email protected].

BLOOMBERG, BLOOMBERG LEGAL, BLOOMBERG MARKETS, BLOOMBERG NEWS, BLOOMBERG PRESS, BLOOMBERG PROFESSIONAL, BLOOMBERG RADIO, BLOOM-BERG TELEVISION, BLOOMBERG TERMINAL, and BLOOMBERG TRADEBOOK are trademarks and service marks of Bloomberg L.P. All rights reserved.

Information provided by Morningstar® © 2006 Morningstar, Inc. All Rights Reserved. Such information contained herein (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

This publication contains the author’s opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the author, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader.

Firsteditionpublished200613579108642

LibraryofCongressCataloging-in-PublicationData

Rogers,DouglasS. Tax-awareinvestmentmanagement:theessentialguide/DouglasS.Rogers. p.cm. Summary:“Illustrateshowinvestmentstrategiesfortax-exemptaccountsdon’tworkforindividualssubjecttotaxes.Offerstechniquesforcomparingtax-efficiencyofmutualfunds,hedgefunds,andinvestmentmanagers,andpresentsmore-sophisticatedstrategiesforoffsettinggainsagainstlossesinwealthplanning,portfoliomanagement,andestateplanning.Includesresultsofhistoricalresearch,100tablesandcharts”--Providedbypublisher. Includesbibliographicalreferencesandindex. ISBN1-57660-180-3(alkpaper)1.Investments--Taxation--UnitedStates--Handbooks,manuals,etc.2.Portfoliomanagement--Handbooks,manuals,etc.I.Title.

HG4910.R6552006 332.6--dc222005030613

Acknowledgments................................................................ vii

Introduction.................................................. ...................... ix

PART ONE | EVOLUTIONOFKNOWLEDGEPERTAININGTOTAX-AWAREINVESTMENTMANAGEMENT 1

1 TheEvolutionofTax-AwareInvestmentManagement....... 3

2 TheSourcesandImpactofTaxeson

InvestmentReturns.................................................. ......... 11

3 SeminalResearch.................................................. ............ 21

4 TheTax-AwarePractitioner.............................................. 33

5 CreatingtheTriumvirateofQualified

Professionals.................................................. ................... 45

PART TWO | AFTER-TAXREPORTINGANDMEASURESOFTAXEFFICIENCY 55

6 MutualFundAfter-TaxReporting.................................... 57

7 SeparateAccountAfter-TaxReporting............................. 77

8 MeasuresofTaxEfficiency................................................ 95

PART THREE | TAX-AWAREPORTFOLIOMANAGEMENT 101

9 OutperformingtheIndexFund...................................... 103

10 QuantitativeTax-AwarePortfolioManagement

andConcentratedStock.................................................. 117

C O N T E N T S

11 PracticesofEliteTax-AwareEquityActiveManagers..... 133

12 PracticesofEliteTax-AwareFixedIncome

ActiveManagers.................................................. ............ 149

13 TheHedgeFundDilemma............................................. 167

14 AmendingtheSearchProcessforTax-Aware

ManagerSelection.................................................. ......... 175

PART FOUR | CHALLENGINGTRADITIONALASSETALLOCATIONMETHODS 189

15 ChallengesWithTraditionalInvestment

PolicyDevelopment.................................................. ...... 191

16 DevelopingAfter-TaxAssetClassAssumptions.............. 209

17 WhytheStyleBoxHurtsTaxableInvestors.................... 225

18 PositioningAssetsbytheTaxCharacteristics

oftheEntity.................................................. .................. 243

19 TheRoleofSystemsSolutionsin

Tax-AwareInvesting........................................................ 271

Summary.................................................. ............................. 281

Appendix.................................................. .............................. 283

ContinuingEducationExam............................................ 287

Index.................................................. ................................... 294

Tax-AwareInvestmentManagement:TheEssentialGuideembodiesthecol-lectivewisdomofmanypeoplewithwhomIhavebeenfortunateenoughtointeractduringmyinvestmentcareer.Iwanttoacknowledgethosewhohavesupportedmyeffortsandprovidedmemanyoftheinsightsneces-sarytocompletethiswork.IapologizetoanyoneImayhaveinadvertentlymissedinmyattempttogivecreditwhereitisdue.

IextendmygratitudetoRalphRittenourJr.,toJeffreyGrubb,andtomyotherassociatesatCTCConsultingfortheirbackingofthisproject.IamespeciallymindfulofthesupportofDonLindowandChrisArvaniwhorecognizedearlyoninmycareermydesiretotakeonnewandex-citingresearchpertainingto thenucleardecommissioningtrust (NDT)industry.MyparticipationatNDTconferencesandmyinteractionwithArlandBrusven,DavidKrause,JamesMeehan,JoanneHoward,MaryJoDempsey,ThomasTuschen,EricKnause,MaryMiller,andothersonlyheightenedmyenthusiasm.MichaelBrilleyandGeneSitencouragedmetosubmitmyfirstarticleforpublicationontax-awareinvestmentmanage-ment,whichsetthestageforotherprojectstofollow.SimilarappreciationisextendedtoLouiseWasso-JonikasandMichaelRadfordforencouragingmyinvolvementinCFAInstitute(formerlyAIMR)activitiesandpublicspeaking.

LeePricehasalwaysbeenarespectedmentor,andtoservewithhimonbothAIMRSubcommitteesonAfter-TaxReportinghasbeenanhonorandprivilege.IwillalwaysbeindebtedtothemembersoftheSubcommittee.TheirresponsetotheSECproposalforafter-taxreturnsonmutualfundsandrecommendedrevisionstotheexistingstandardswouldnothavebeenpossiblewithouttheassistanceofPaulinePilateandAleciaLicata.StanleyLeeandLizMilleroftheNewYorkSocietyofSecurityAnalystshavebeenconsistentsupportersofthistopicandrelatedissues.

IamtrulythankfulforthewillingnessofTadJeffrey,JamesGarland,RobertArnott,JoelDickson,JackBogle,PeterBernstein,MarcMoulton,Brian Langstraat, David Stein, and Bob Breshock to share their expe-riencesoncritical researchandproductdevelopment. JayWhippleIII,Ron Surz, James Hollis, and Matt Schott have played critical roles infurtheringmyunderstandingofsystemstechnology.RobertGordonand

A C K N O W L E D G M E N T S

vii

ThomasBoczarplayedasimilarrolewithtaxissuesastheyrelatetohedgefundinvesting.LeslieGiardaniandherresearchofferedvaluableinsightintothefuturedirectionoftheinsuranceindustry.TonyRochteandhisassociatesatBarclayssharedtheirknowledgeofexchange-tradedfunds,asdidGaryGastineau.WilliamReichenstein,WilliamJennings,andJamesPoterbawerethoughtfulenoughtointroducemetotheleadingcontribu-torsfromacademia.DonPhillipswasgraciousenoughtoallowtheuseofafter-taxreturndatafromMorningstarPrincipia.Whilestockpickersalwaysseemtotakecenterstageoverthosewhosespecialexpertiseisinfixedincome,ithasbeenajoytoshareideaswithpassionatebondportfo-liomanagerslikeGuyDavidson,ChristineTodd,andPaulJungquist.

HaroldEvenskywasinstrumentalinintroducingmetoJaredKieling,whohassupportedtheprojectwithsageeditorialadvice.JefferyYablonwaskindenoughtosharehisquotesfromTaxNotesthatappearasepi-graphs throughout the book.1 Encouragement from Nancy Jacob, JeanBrunel, andDaveSpaulding to continue topublishhasbeen adrivingforcethathasculminatedinthiseffort.

Thisbookcouldnothavecompletedwithoutthecontinuedencour-agementofclosefriendsandrelatives.Last,andmostimportant,Ithankmychildrenandmywife,SoonHee, fortheirunwaveringsupportandsacrificesmadeduringthemanyeveningsandweekendsthatwereneededtocompletethistext.

ChapterNotes

1. The tax-related quotations that open each part and chapter were compiledandarrangedbyJefferyL.Yablon,“AsCertainasDeath:QuotationsAboutTaxes(2004Edition),”TaxNotesvol.102,no.1(January5,2004):99-116.

viii Acknowledgments

TheImportanceofTax-AwareInvestmentManagement

Our Constitution is in actual operation; everything appears topromisethatitwilllast;butnothinginthisworldiscertainbutdeathandtaxes.

—BenjaminFranklinFoundingfather

Taxeshavebeenapermanentpartofthesocial-politicallandscapeintheUnited States since the Sixteenth Amendment to the Constitution wasratified in 1913. Soon thereafter, PresidentWoodrowWilson approvedtheformoffederalincometaxationthatweknowtoday.Initiallyaffect-ingonlythewealthy,itwasnotuntilafterWorldWarIIthatthefederalincometaxbegantohaveasignificantimpactontheeconomicwell-beingoftheaveragecitizen.1

Althoughnooneenjoyspayingthem,taxesserveanimportantpur-pose.Taxesarethesourceofrevenuethatenablesthegovernmenttobuildthe infrastructurenecessary tomaintainandenhanceourqualityof lifeandtoprovideforthecommondefense.Andlikethepricesofsecurities,taxeswillchange!Thepricesofsecuritiesfluctuatedailyasmarketpartici-pantsassesstheimportanceofthevariousforcesaffectingtheeconomy,whereastaxrateschangemoreslowly,reflectinggovernmentpoliciesandspending. Since the adoption of the federal income tax, tax policy hasbecomeanincreasinglyimportantstimulustoolwitheachsuccessivead-ministration.Therefore,majorchange inthetaxcode isexpectedtobethenormratherthantheexception.Forthisreason,tax-awareinvestmentpracticesareessentialtomaximizingwealth.

Tax-awareinvestmentmanagementreferstotheapplicationofsoundjudgmentthatresultsinoptimalresultsafteralltaxesandfeeshavebeenpaid.Itisnotaboutavoidingthepaymentoftaxesthroughquestionableaccountingorestateplanningorsimplyattemptingtopaynotax.Rather,

I N T R O D U C T I O N

ix

x Introduction

itisaboutmaximizingwhatisleftaftertaxeshavebeenpaid.Forexample,ifaninvestorhasthechoicebetweentwosecuritieswithsimilarfeatures,itisfoolishtoavoidpurchasingtheonethatwillrequireataxpaymentifitoffersasuperiornetoverallresult.Iftheinvestorreceivesahigherafter-taxreturn through effective tax-aware investment management, the moneymanagermakesareasonableprofit,thegovernmentcollects itsrevenue,andwehave achieved thebest of allworlds—everyone involved in theprocesshasgainedsomethingofvalue.

In themore thanninety years that the federal income taxhasbeenwithus,youwouldthinkthatacademicinstitutionsandprofessionalcer-tificationprogramswouldhavepaidsufficientattentiontotax-awarein-vestmentmanagementtotrainpeopleanddevelopproductstoservetheneedsofthetaxableinvestor.Unfortunately,thisisnotthecase.Ashort-ageofeducatorsandtrainedprofessionalsintax-awareinvestingpersistsbecauseofanearlier emphasison retirementplansandcharitableorga-nizations,whichare exempt from thepaymentof taxes.2All toooften,modernportfoliotheoryconceptsthathaveemergedfromthetax-exemptaccountarenaasgospelarenaivelyappliedtotaxableaccountsbywell-intentioned individuals, resulting in less-than-optimal, costly solutions.Thelackofattentiontotaxesintheinvestmentprocessissoseverethatmostprofessionals intheinvestmentmanagementindustryareunawarethat about half of the trillions of dollars of liquid assets in the UnitedStatesaresubjecttotaxation.

Fortunately, it is not all gloom and doom for individual taxpayers,trusts,andcorporationswithsignificanttaxableassets.Thereareseveralbrightspots.First,overthepastdecade,agroupofdedicatedpractitionershasemergedtomakesignificantcontributionstothebodyofknowledgeneededtoservetaxableaccounts.Second,uniformstandardsforreport-ingreturnsonanafter-taxbasisarenowinplaceformostmutualfunds,andagrowingnumberofseparateaccountmanagers3areadoptingthemfortheirclientsandforthepurposeofconstructingcompositeresultsformarketing purposes.Third, some managers are modifying buy-and-selldecisionstoincorporatetheimpactoftaxes,andinnovativetax-efficientproducts,suchasexchange-tradedfunds,arerapidlygainingrecognitionandacceptance.Fourth,traditionalmethodsarebeinganalyzedinordertobetterpositionassetsinbothtaxableandtax-exemptaccountsforultimatewealth creation. Furthermore, advancements in systems technology arecurrentlyimprovingthecapabilityandscaleoftheseprocesses.

Tax-awareinvestmentmanagementinvolvesfourcriticalelements:1 Utilizingafter-taxassumptionsintheassetallocationprocess2 Allocatingassetclassesandmanagers/fundsaccordingtothechar-

acteristicsofeachinvestmententity

Introduction xi

3 Tax-awareequitymanagerpositioning4 Identifyingtax-awaremanagers/funds

Implementing these steps has the potential to add from 0.5 to 2.5percentannuallytobottom-lineperformanceorwealthcreation.Theex-actamountofvalueaddedcanvarysignificantlybetweentaxableaccountrelationships for each element, ranging from 0 to 1.5 percent or moredepending on the complexity of the investment opportunity.The fourelements interact and complementone another.For example, youmayallocateatax-inefficientmanagertoatax-exemptaccountwherelackofattentiontotaxmanagementisnotanissueorreplacethemanagerwithanotherstrategythatmaycreatetaxbenefitsthatcanbeusedbeyondthereplacementmanager.Thisprocess lends itself tocreativityand innova-tive solutionsallwithina simpleunderstandingof the taxcode.A tax-aware solutionwill take into account the investment timehorizon, taxcharacteristicsof the investmententities involved (e.g.,personal taxableaccount assets, 401(k) retirement plans, and individual retirement ac-counts),theclient’staxprofile,projectedreturns,permissibleassetclasses,andstructure(e.g., fundsvs. separateaccountsvs. limitedpartnerships)of the investmentportfolios.Most important, it takes a knowledgeableand experienced professional to implement and orchestrate a tax-awareinvestmentmanagementprocess.Itisnotunrealisticforahigh-net-worthfamilytogainapproximately0.5percentfromusingafter-taxassumptionsforassetallocation,1.0percentfromlocatingmanagers/fundsaccordingtothecharacteristicsofeachinvestmententity,0.4percentfromoptimallycombiningequitymanagersinamannerquitedifferentthanthepension-consultingapproach,and0.6percentfromusingtax-awaremanagersforthetaxableaccounts.Allfouroftheelementsareimportantandignoringoneormoreleadstoalessthanoptimalsolution.

Tax-awareinvestingisequallyimportanttoinvestorsregardlessofthemagnitudeofwealth.Ifanultra-affluentfamilywith$100millioninliq-uidassetsdoesnottakeadvantageofthebenefitsoftax-awareinvesting,itisunlikelytochangetheirlifestyle.However,itwillcertainlyimpactthewealthoffuturegenerationsand,ifnotemployed,lessenthechancesofachieving andperpetuating a familydynasty.For a twenty-five-year-oldinvestor, a 1 percent advantage on a $10,000 portfolio will mean hav-inganadditional$4,889forretirementsomefouryears later.Witha2percentenhancementtheinitialinvestmentdoublesinslightlymorethanthirty-fiveyears,andtheindividualwillhave$12,080extraatretirement.Thus,fortheaverageinvestor,properlyemployingthecriticalelementsoftax-awareinvestingcanmeanthedifferencebetweenenjoyingretirementaccordingtoplanorperhapshavingtocontinuetoworkwellbeyondage

xii Introduction

sixty-five.Whetheryouareaninvestor,aportfoliomanager,orafinancialadviserfortaxableclients,employingtheelementsoftax-awareinvestmentmanagementwillallowyoutosignificantlyimprovenetafter-taxresultstothebenefitofwealthcreationandmaintenance.Thisisthedistinguishingvaluepropositionbetweenthemanagementoftraditionaltax-exemptac-countsandtheevolvingbodyofknowledgepertinenttoachievingoptimalresultswithtaxableaccounts.

Withinterestratesbottomingin2003,andtheFederalReservecon-tinuingtoincreasethefundsrate,thefixedincomemarketsareunlikelytoachievecompellingreturnsanytimesoon.Althoughtheequitymarketsex-periencedafavorablereboundin2003and2004,andcorporateearningsimprovedmeasurably, valuations are still athigh levelswhen comparedwithhistoricalnorms.Thus,theconsensusofstrategistsatthebeginningof2005isthatthemarketsareunlikelytodelivertheirpreviousaveragesof 11 percent for stocks and 6 percent for government bonds over thenexttenyears.Furthermore,nostrategistsarepredictingarepeatofthespectacularresultsachievedduringthe1980sand1990s.Inthistypeofmarketenvironment,theimpactoftaxesaccountsforagreaterpercentageofthetotalreturn.

Thetaxpayer in theUnitedStateshasexperiencedthreeyearsof fa-vorable tax legislation (from2001 through2003)and the secondBushadministrationhasalreadyexpressedthegoalofsimplifyingthetaxcode.Moreover,thepresidenthopestomakepermanentthetaxcodechangesimplementedduringhisfirsttermandpotentiallytoeliminatetheestatetaxaltogether.Theannualgovernmentbudgetdeficitisloomingat$400billion,however,andthefinancialsoundnessoftheSocialSecuritysystemremains a concern. For these reasons, many are questioning Congress’sabilitytomaintainthefavorablemaximumfederaltaxrateof15percentonqualifieddividendsandlong-termcapitalgains.Theseandothertaxis-sueswillbehotlydebatedintheyearsaheadbecausenooneseemssatisfiedwiththestatusquo.Forboththetaxableinvestorandtheadviserservingtaxableaccounts,personalbeliefs regardingthetaxcodearenot impor-tant.What does matter is how maximum value can be extracted fromtheavailableopportunities.This is especially true todaybecauseweareinalow-returnenvironment,andthegapbetweenapplyingatax-awaresolutionornotcanresultinanannualdifferenceof2percentormore.Aworkingknowledgeoftheevolutionofthetaxcodes,reportingstandards,portfolioconstruction,andallocationofassetsinatax-awaremannerisasvaluabletoday,ifnotmoreso,asitwaswhenthefederalincometaxwasestablished.

Introduction xiii

ChapterNotes

1. TouisAllenTalley, “CRSReport onHistory ofFederalTaxes,”CRSReportforCongress,January19,2001,1–8,http://www.taxhistory.org/thp/readings.nsf(accessedJuly7,2004).

2. UnderSection4940oftheInternalRevenueCode,charitableorganizationsmaybesubjecttoataxof2percentonnetinvestmentincome.

3. Throughoutthisbookthetermseparateaccountisusedinitstraditionalmean-ing, i.e., anestablishedaccountwithamoneymanager, rather than the retail-orientedwrap account industrywhere a bundle of investments and services isprovidedforasinglefee.

This page is intentionally blank.

EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement

P A R T O N E

1

Apersondoesn’tknowhowmuchhehastobethankfulforuntilhehastopaytaxesonit.

—AnnLanders(quotingananonymoussource)


3

Thecurrentbodyofknowledgepertainingtotax-awareinvestmentmanagement emerged in the early 1990s. With the passage oftheEmployeeRetirementIncomeSecurityActof1974(ERISA),

investmentfirmsandacademicinstitutionsallocatedtheirresourceswithaneyetowardissuesintheexpandingandhighlyprofitabletax-exemptaccountarea.1Asaresult,duringthe1970sand1980s,mostfirmsas-signedtheirbestandbrightestmanagerstomanageportfoliosandserveclientsforwhomtaxessimplywerenotafactor.

Whileplentyofassetswerebeingmanagedbythetrustdepartmentsofbanks,andbyaselectgroupofmanagersthatfocusedontheneedsofpropertyandcasualtyinsurancecompanies,verylittlewaspublishedonhowtomanageassetseffectivelywhentaxeswereafactor.Inaddition,themutual fundindustrywasgrowingrapidly,butmostfirmsviewedtheirmutualfundofferingsasanopportunitytoenhancerevenuebyreachinginvestorswhocouldnotqualifyfortheirseparateaccountminimums,uti-lizingthesameprocessfortheirtax-exemptaccounts.Thetaxableassetswerethere,buttheinvestmentmanagementindustryneededacatalyst.

OnlyGodknowswherewegotourtaxsystem.

—SamGibbonsMemberofCongress

C H A P T E R 1

TheEvolutionofTax-Aware


4 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement

DecommissioningNuclearPowerPlantsTheinitialcalltoactionfortheinvestmentmanagementindustrycame,oddlyenough,fromamarketnichethatmostpeopleareunawareof.In1984,Title26,Section468AoftheInternalRevenueCodewasamendedtoallowelectricutilitiestoclaimadeductionforcostsrelatedtodecom-missioning the nation’s 103 nuclear-powered generating plants.2 Withtheaverageestimatedcostofdecommissioningexceeding$200million,asmallgroupof investmentmanagerssawamajormarketopportunity.Theybegantoanalyzetheimpactoftaxesandtomodifytheirportfoliostrategies todistinguishthemselves fromthecompetition.Electricutili-tiesfirstturnedtotheirpensionmanagersforadvice,buttheyknewthatmorehadtobedone.TheUtilityPensionFundStudyGroup,foundedin1969,beganaseriesofannualconferencestodiscusstopicsrelatedtotheefficientmanagementofretirementassets.3

In1989,ArlandD.Brusven,treasurerofNorthernStatesPowerCom-pany,addedahalf-daytotheagendainordertoincludeissuespertainingtonucleardecommissioningtrusts.4Theresponsewasoverwhelming.Moreattendees sat through the sessionsonnucleardecommissioning than inthesessionsdevotedtopensionmanagement.5ThefirstNuclearDecom-missioningTrusts(NDT)FundStudyGroupConferencetoaddresstheinterestsofelectricutilitiesandmoneymanagerswasheldinWrightsvilleBeach,NorthCarolina,in1990.Inrecentyears,theeventhasattractedmorethan150attendees,andatleastthatmanyareexpectedin2006.

Thepresentationsbyinvestmentmanagersinitiallyanalyzedtheim-pactoftaxesontheNDTfundingprocessandmightbeconsideredprimi-tivebytoday’sstandards,buttheywereastepintherightdirection.Afteronlyafewyears,thelevelofsophisticationofthepresentationsimproveddramatically.Perhapsthemostimportantresultofthenucleardecommis-sioningexperienceisthattheinvestmentmanagementindustrycouldnolongeroperateinavacuumandcontinuetodisregardtheimpactoftaxesoninvestmentreturns.Furthermore,themanagerswhoachievedmean-ingfulmarket share in thisnichewere thosewho effectively communi-catedallrelevantfactorsthataffecttheday-to-dayportfolioconstructionandmanagementprocesstothepartiesinvolved.

For the NDT industry, the basic relevant factors include cost esti-mates;theestimatedremaininglifeofthereactor;anunderstandingoftheapplicablefederal,state,andlocaltaxcodes;allocationofassetsamongtrustssubjecttodifferenttaxrates;andtheevolutionofregulatorymat-ters.Unliketaxablecorporateassets,nuclearreactorshaveanestimatedlifeofapproximatelyfortyyears.Thefutureliabilityordecommissioningisfundedthroughtwotrusts.Theelectricutilitiesfirstfundeda“qualified

TheEvolutionofTax-AwareInvestmentManagement 5

trust”usinganannualamountagreeduponbyregulatorsthatcouldbedeductedfortaxpurposes.However,theamountpermittedtofundthequalifiedtrusttypicallyfellshortofthetotalestimatetocompletethede-commissioningofthereactor.Asaresult,theutilitieshavebeenallowedtofundtheshortfallina“nonqualifiedtrust.”Althoughnonqualifiedtrustsdonotreceivetheinitialfavorabletaxtreatmentofqualifiedtrusts,therehavebeenperiodswheretheyweregivengreatlatitudewithpermissibleassetclasses,andthetaxratesontaxableincomeandrealizedgainshavebeenadvantageous.Thetypesofassetclassesandthetaxprofilesofthetwodifferenttypesoftrustshavebeenquitedifferentandhaveevolvedovertheyears.Therefore,allinvolvedintheprocesshavebeenconfrontedwithanextremelycomplexformofasset/liabilitymanagement.Notonlyweremanagerschallengedtoprovidemoretax-efficientportfoliostrate-gies,butconsultantshadtoadjusttheirtax-exemptaccountprocedurestoincludetaxesinassetclassassumptionsandconducttheoverallopti-mizationonanafter-taxbasis.Additionally,theyhadtoaddresstheop-timalpositioningofassetclassesbetweenthequalifiedandnonqualifiedtrusts, taking into account various regulatory restrictions and evolvingtaxtreatment.Whiletheparametersofnucleardecommissioningtrustsdifferfromthoseofothertypesoftaxableaccounts,itbecameclearthatinvestmentprofessionalsneedtobecognizantofallrelevantfactorsinor-dertoachieveoptimumafter-taxreturns.Theimportanceoftheannualdecommissioningconferencescannotbeunderstated—thisforumprovedtobeandcontinuestobetheleadingthinktankfromwhichmanyofthetax-awareinvestingideasandconceptsevolvedthathavebecomesecondnatureintax-awareinvestingtoday.

High-Net-WorthInvestorsBanktrustdepartmentshadbeenservingtheneedsoftaxableinvestorsfor decades, but without a high level of sophistication. Recognizing amarketforconsultingservicestailoredtohigh-net-worthfamilies,RalphC.RittenourJr.foundedCapitalTrustCo.inPortland,Oregon,in1981,whicheventuallybecameCTCConsulting.NancyL.Jacob,theformerdeanoftheUniversityofWashingtonBusinessSchool,joinedRittenourlater.Whilethepartnershipwouldnotlast,andJacobwouldeventuallyestablishherownfirm,whatemergedduringtheirprofessionalrelation-shiphadaprofoundeffectontheindustry.

Foryears,investmentprofessionalsandconsultantsattemptedtoad-justreturnsofassetsfortheso-calledtaxhaircut,orimpactoninvestmentreturns,andtopositiontheminawaythatimprovedoroptimizedoverallresults.Forarelationshipwithonevehicleorentity, suchasapension


plan,401(k)plan,or trust,aspreadsheetsolutionwassatisfactory.Butwhenmultiplevehiclesorentitiesenteredthepicture,thesolutionwasoftenlessthandesirableinatleastoneaspect.WithfundingfromCTC,JacobteamedwithMarcMoultontodevelopthefirstcommerciallyavail-able software program that truly accounted for the impact of taxes—PORTAX.Otherconsultingfirms, investmentmanagementfirms, andbanksweredevelopingsimilarproductsforusewiththeirinternalclients,butnoneofthesecouldbepurchasedforindependentuse.

Although it is a complex tool to learn and master, the beauty ofPORTAXisthatitenablestheinvestortoincorporatetheimpactofthetaximplicationsofvariousentities,cashflows,andtimeintheoptimiza-tionprocess.Italsoallowstheusertoquantifytheimpactoftax-efficientassetlocation,atopicthatJacob,JeanL.P.BrunelofBrunelAssociates,andGregoryFriedmanofGreycourt&Co.had addressed inpreviouscollaborationsforarticlesandpublicpresentations.PORTAX,availablefromWindermereInvestmentAssociates,isstillconsideredtobethesys-temofchoicebymanagersworkingwithsophisticatedclientsandcom-plextaxablesituations.

PublicizingtheNeedThe adage about the squeakywheel getting the grease certainly appliestotheinvestmentcommunity’sreactiontothearticle“IsYourAlphaBigEnoughtoCoverItsTaxes?”byR.H.(“Tad”)JeffreyandRobertArnott,whichappeared intheJournalofPortfolioManagement inthespringof1993.6Thearticlehighlightshowlessthan20percentofthemutualfundstheauthorsanalyzedoutperformedtheVanguard500IndexFundonanafter-taxbasis.AtthesametimethatJeffreyandArnottwereworkingontheirarticle,StanfordprofessorJohnB.ShovenandgraduatestudentJoelM.Dicksoninitiatedaworkingpapertitled“RankingMutualFundsonanAfter-TaxBasis.”Althoughtherehadbeennocollaborationbetweenthetwoparties,bothstudiespointedtothefactthatmanagerswere ig-noringtheimpactoftaxes.Theresultsofthestudies,coveredingreaterdetailinchapter3,providedtheevidencethatwasneededtoshockfundmanagersintopayingattentiontotaxissues.Managerswereonnoticethattheirfailuretoaddresstaxesintheportfoliomanagementprocesswasap-parentandthattheinvestingpublicwouldbegintoholdthemtoahigherstandardofaccountability.

JeffreyandArnott,alongwithShovenandDickson,broughtthene-glectofmanagerstocenterstage,butastandardmethodofmeasuringresults on an after-tax basis was needed. In response to requests fromclients, Lee N. Price, of Rosenberg Capital Management, approached


theAssociationforInvestmentManagementandResearch(AIMR)withthe ideaofdevelopingstandards for reportingafter-taxreturns, similarto what was in place for before-tax returns.7 At the 1993 NDT FundConference,Price announcedhis vision and theAIMRSubcommitteeforAfter-TaxReportingwasformed.TheSubcommittee,co-chairedbyPriceandRobertE.Pruyne,consistedofworkingprofessionalswhohadextensiveexperiencewithtaxableaccounts.ThestandardswereadoptedbyAIMR in1994,butonly a fewfirms,primarily thosewithnucleardecommissioningaccounts,implementedthem.

SECIssuesaProposalThe importance of this initial work, spearheaded by Price, cannot beunderestimatedsinceitaddressedmanyofthekeyconceptsandlaidthefoundationforfutureinitiatives.Onceagain,however,amajorcatalystwas needed to achieve a lasting result, and that catalyst proved to bethe escalation of private wealth in the late 1990s. With the favorablereturnsoftheequitymarketsduringthisperiod,anincreasingnumberofinvestorswerebecomingconcerned,ifnotdownrightupset,aboutthecapitalgainsdistributions fromtheirmutual funds.TheSecuritiesandExchangeCommission(SEC)begantoresearchafter-taxreportingandissuedaproposalforpubliccommentinMarchof2000.TheU.S.HouseofRepresentativesunderscoredtheimportanceofthesubjectbypassingthe Mutual FundTax Awareness Act of 2000 in April, introduced byCongressmanPaulGilmourandadoptedbyavoteof385–2.8TheAIMRsubcommittee was reconstituted, with the author, Douglas S. Rogers,as chairman. A dozen uniquely qualified and dedicated Subcommitteemembersworkedselflesslyoverathree-yearperiodfirsttorespondtotheSEC’sinitiativeandlatertomakerecommendationstotheAIMRboardandtheInvestmentPerformanceCouncil(IPC).Mostmutualfundsarenowrequiredtoprovideafter-taxreturnsintheprospectus.Revisionstotheseparateaccountstandards for thosefirmswiththedesire toadoptthemwentintoeffectinJanuary2005.

ConferencestoShareInformationAnotherkeydevelopmentintheevolutionoftax-awareinvestmentman-agementhasbeenineducation,orthedisseminationofinformation.Ini-tiativesbytheFamilyOfficeExchange(FOX)andtheInstituteforPrivateInvestors (IPI), under founders SaraHamilton andCharlotteB.Beyer,respectively,addressed theneedsof the influentialbuyer in themarket-place—thehigh-net-worthfamily.BothFOXandIPImanagedtobring


together buyers and providers in a manner that facilitated an open ex-changeofinformation,forcingallpartiestoseekahigherlevelofknowl-edgeandsophistication.Theeffortreinforcedthelessonslearnedthroughthenucleardecommissioningexperience.Sincehigh-profilefamiliesandindividualinvestorsareeasiertoidentifywiththannuclearreactorsandhave influence with other buyers in the marketplace, these and similareducationeffortsbyotherorganizationsanduniversitiesarewhatfinallybroughthometotheprofessiontheimportanceoftax-awareinvesting.

Perhapsthemostimportantconferencesonthetopicoftax-awareinvestinghavebeenthoseheldbyAIMR.TheInvestmentCounselingforTaxableInvestorsConferenceheldinNovember1998wasthefirstoftheseannualeventsthatattractedspeakerswithexpertiseinvarioustaxable-account-relatedfields.9Thesemeetingscapturedanenormousamount of intellectual thought of the day, and the published AIMRConferenceProceedingscanbeorderedfromtheorganization.Forany-oneservinghigh-net-worthindividualsandfamilies,thesepublicationsareconsideredanessentialelementofthemanager’sprofessionallibrary.Althoughsomeofthearticlesfocusontheneedsoftheultra-affluent,the concepts presented can be applied to almost all taxable-accountopportunities.

BabyBoomersCauseaShiftWithmorethanfifteenyearsofprogressinthetheoreticalapproachtotax-awareinvestmentmanagement,andwithafter-taxreportingstandardsnowinplace,theemphasisisshiftingtowardimplementingstrategiesthroughscalablesoftwaresolutionsthattakeintoaccounttheuniquecharacteris-ticsofeachclientrelationship.Surprisingtomanyisthecurrentemphasisonallocatingresearch-and-developmentdollarstodevelopingsystemsforsmalleraccountsandtheretailsegmentoftheinvestmentbusiness.Thus,ratherthansoftwaredevelopmenttricklingdownfromthemoresophisti-catedportionofthemarket,itisnowbuildingmomentumfromdemandthatwascreatedfollowingtheSEC’smandatethatmutualfundsprovideafter-taxreturninformation.Manybelievethisisoccurringbecauseasthewealthofthebabyboomersincreases,theseinvestorsareshiftingtheiras-setsfrommutualfundstowrapaccounts.Theynaturallyaskthequestion,“Ifyourfirmcanprovideafter-taxreturnsonyourmutualfunds,whycan’tyoudoitherewhenthefeesarehigher?”Whichportionofthemarketgetstherefirstisreallynotimportant.Whatissignificantisthatthestateoftax-awareinvestmentmanagementhasneverbeenbetter:progressisbeingmadeandthefutureispromising.


ChapterNotes

1. U.S. Department of Labor, Employee Benefits Security Administration,http://www.dol.gov(accessedJuly27,2004).

2. Title 26 of the Internal Revenue Code, http://frwebgate.access.gpo.gov(accessedJuly27,2004).

3. UtilityPensionFundStudyGroup,http://www.upfsg.com,(accessedJuly27,2004).

4. NuclearDecommissioningTrustFundConference,http://www.ndtconference.com(accessedJuly27,2004).

5. ArlandBrusven,indiscussionwiththeauthor,July17,2004.

6. RobertH.JeffreyandRobertD.Arnott,“IsYourAlphaBigEnoughtoCoverItsTaxes?TheActiveManagementDichotomy,”JournalofPortfolioManagement(Spring1993):15–25.

7. TheAssociationforInvestmentManagementandResearchchangeditsnametotheCharteredFinancialAnalystsInstitute(CFAI)in2004.

8. SecuritiesandExchangeCommission,“SECRequiresDisclosureofMutualFundAfter-TaxReturns,”newsrelease,January22,2001.

9. Association for Investment Management and Research, AIMR ConferenceProceedings:InvestmentCounselingforPrivateClientsno.2(1999).


C H A P T E R 2

TheSourcesandImpactofTaxes

onInvestmentReturns

11

Anunderstandingofhowtaxesaffectinvestmentreturnsisessentialtoaportfoliomanager’sabilitytoaddvaluenetoffeesandtaxes.Whentheknowledgeiscombinedwithskill,managerscanevolve

from reacting to tax consequences to developing proactive procedurestobenefitfromthem.Theimpactoftaxesoninvestmentreturnscanbebrokendownintothefollowingareas:

❑ Componentsoftotalreturnandtheleveloftaxationimposedoneach

❑ Holdingperiodoftheinvestment❑ Taxconsequencesofsellingandbuyingsecurities❑ Fees

Usingthismodel,theindividualwhoisnewtotax-awareinvestmentmanagement should be able to determine, with the assistance of thetwomethodologiesmostcommonlyusedtomeasureafter-taxreturns,whichtypesofsecuritiesandinvestmentstylesarebestsuitedfortaxableaccounts.

Taxation,inreality,islife.Ifyouknowthepositionapersontakeson taxes, youcan tell theirwholephilosophy.The taxcode,onceyougettoknowit,embodiesalltheessenceoflife:greed,politics,power,goodness,charity.

—SheldonS.CohenFormerInternalRevenueServiceCommissioner


IncomeComponentofInvestmentReturnInvestment returns consist of three components: income, appreciation,andthereinvestmentofincome.Thethirdcomponent—reinvestmentofincome—isnotasignificantfactorforshortperiodsofanalysisbuthasameaningfulimpactforlongerperiods.Notallincomeistreatedequally.Forexample,theUnitedStatesandItalyaretheonlytwocountriesintheworld tooffer tax-exemptbonds.Tociteanotherexample,a significantprovisionoftheJobsandGrowthTaxReliefReconciliationActof2003istheloweringofthetaxrateon“qualified”dividendsfromtheordinaryincomeratetothemorefavorablerateforlong-termcapitalgains.Yetal-thoughmostdividendsqualifyforthelowerrate,taxedatamaximumrateof15percent,themajorityofincomedistributedfromrealestateinvest-menttrusts(REITs)doesnot.AsofDecember31,2004,commonstocksin the United States provided a dividend yield of 1.6 percent, whereasREITswereoffering a yieldof approximately4.6percent.Let’s assumeaninvestoranticipatesa10percenttotalreturnonstocksandREITsoverthenextyear,andthathecangointothemarketandpurchaseaunitofeach for$100. If the investordoesnothold theunits ina tax-deferredaccountandissubjecttothehighestfederaltaxrate,thenthecommonstockinvestmentwillgenerate$1.60individends,causingataxof$0.24($1.60 dividend taxed at 15 percent).The REIT investment, however,willgenerate$4.60innonqualifyingdividendstaxedatthemaximumrateonordinaryincome,resultinginataxof$1.61($4.60dividendtaxedat35percent).Severalsourcesreportthatupto25percentofREITsgeneratequalifieddividends,butthegeneralconsensusofportfoliomanagersserv-ingthisnichesuggeststhatqualifieddividendsfromREITsarequiterare.

Thekeycommontotheseexamplesisthatthenatureoftheincomematters. If youhave theopportunity,place investments that generate ahighleveloftaxableincome—intheprecedingexample,REITs—intax-deferredaccounts!

Pre-LiquidationandPost-LiquidationReturnPriorto2003,stockdividendsintheUnitedStatesweretaxedattheordi-naryincomerate.Thiscreatedadisparityinthepotentialafter-taxreturnsbetweentwostocksofferingsimilaroverallresultswhentherewasamean-ingfuldifferenceintheirdividendyields.Inthelasttwenty-fiveyearsorso,themaximumrateonordinaryincomehasfallenfrom50percentto35percent,andtherateonlong-termcapitalgainsfrom39.9percentto15percent.Inaddition,commonstockdividendyieldshavefallenfrom5percenttoapproximately1.6percent.Afewselectyearswereanalyzed

TheSourcesandImpactofTaxesonInvestmentReturns 13

tocreateprojectedafter-taxreturnsinFIGURE2.1usingabefore-taxtotalrateofreturnof10percentincommonstocksandapplyingtheaveragedividendyieldsofthetime.1

Inthecalculationsweassumea10percentannualrealizationofavail-ablecapitalgainsandshowreturnsoverone-yearandfive-yearperiodsforboth pre- and post-liquidation returns. Pre-liquidation returns assumethat only thedividendpayments and gains realized are taxed,whereaspost-liquidationreturnsincorporatethetaximpactofpre-liquidationre-turnsandalsotakeintoaccountthecompleteliquidationofalloutstand-ingcapitalgainsandlosses.Whileactualbefore-taxreturnsprovedtobequitedifferentfromtheassumed10percent,thisprocessenablesustoseehow theyieldcharacteristicsof themarket and the taxcodecreatedifferentcircumstancesforthetaxableinvestorattemptingtoformulatestrategy.Inthiscase,havingknowledgeofthepastmayprovebeneficialifhistoryrepeatsitselfandtaxratesbegintoriseduringthenextdecade.

Howwecalculateafter-taxreturnscaninfluenceourdecisions.There-fore,wedisclose after-tax returnsonbothapre- andpost-liquidationbasis.Fansofpre-liquidationreturnsbelievethesearemostappropriatewhen analyzing returns of individuals, since the tax code allows for astep-upinthecostbasisofsecuritiesatdeath.Supportersofthepost-liquidationmethodologypointtothefactthatmostportfoliosorsecuri-tiesareliquidatedorsoldmanytimesandthatyouneedtoemphasizethecostofmakingthesemovestogettheinvestor’sattention.Becausetherearevalidreasonsforboth,theywillbeshownwheneverpossiblethroughoutthetext.A10percentbefore-taxtotalreturn,10percentan-nualcapitalgainsgeneration,marketdividendyieldof1.6percent,and

Sourc

e:D

ougla

sS

.R

ogers

FIGURE2.1 ProjectedAfter-TaxReturnsona10PercentTotalReturninCommonStocks

AVERAGE TAX STOCK ON TAXON ONEYEAR FIVEYEARS

YEAR YIELD DIVIDENDS LTGAINS PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.

1978 5.0% 50.0% 39.0% 7.25% 5.00% 6.97% 5.50%

1994 3.0% 39.6% 28.0% 8.53% 6.04% 8.26% 6.81%

2000 1.2% 39.6% 20.0% 9.18% 6.04% 8.93% 7.46%

2005 1.6% 15.0% 15.0% 9.47% 6.82% 9.29% 8.17%


currentprovisionsofthetaxcodewereappliedtoachievetheafter-taxreturnsshowninFIGURE2.2.Whenthereisapositiveunrealizedcapitalgainsposition,pre-liquidationafter-taxreturnswillbegreaterthanthepost-liquidationafter-taxreturns.Asthefigureshows,thereisonepecu-liarityofpre-andpost-liquidationsreturns:oneserieshasthetendencytodecreaseovertimewhiletheotherincreases.

AsFigure2.2shows,pre-liquidationafter-taxreturnstendtohaveaslightdownwardtrend,whereaspost-liquidationreturnsincreaseandareappliedwheninvestmentmanagerswishtohighlightthebeautyofcom-poundingtax-freeoverextendedperiodsoftime.Thebuy-and-holdinves-tortakesfulladvantageofthisconcept,asheunderstandsthathisbesttaxbreakmaybenottosellandthusavoidrealizingcapitalgains.Thismakessenseaslongasthevalueofthesecurityisnotfallingandthegeneraltrendfortaxesisdecreasingorstable.

HoldingPeriodofanInvestmentIfwegobackjustafewyearstothetimewhendividendsweretaxedasordinaryincomeat39.6percentandlong-termcapitalgainsat20percent,wecananalyzehowtheleveloftaxableincomecanhaveasignificantim-pactonpotentialafter-taxreturns.

Therateoftaxationondividendsandshort-termcapitalgainsisthesame, sonaturallyallone-year returns, regardlessof thedividendyield,showareductionof3.96percent,inFIGURE2.3,fromthebefore-taxtotalrateofreturnof10percent.Notethemeaningfuldifferences,especially

FIGURE2.2 TrendsinPre-andPost-LiquidationAfter-TaxReturns

YEARS PRE-LIQUIDATION POST-LIQUIDATION

1 9.47% 6.82%

10 9.16% 8.44%

20 9.04% 8.63%

30 8.98% 8.70%

40 8.95% 8.74%

50 8.94% 8.77%

Sourc

e:D

ougla

sS

.R

ogers


ofthepre-liquidationafter-taxreturns,whencomparingtheresultsofthe1percentand5percentdividendyieldportfolios.Thegapnarrowswiththefive-yearpost-liquidationafter-taxreturnsofthe1percentand5per-centportfolios,butthedifferenceisstillsignificant.Higherportfolioyieldistypicallyassociatedwithvalue-orientedstockselection.2Althoughitisnotthepurposeofthistexttodebatewhethervalueoutperformsgrowthonapersistentbasis,allthingsbeingequal,lower-yieldingbuy-and-holdportfoliosofferthepotentialforhigherafter-taxreturnswhenthetaxondividendsisgreaterthanthetaxonlong-termcapitalgains.

Tradingactivitythatresultsintherealizationofpositivecapitalgainsiscostlytoafter-taxreturns.However,itmustbeunderstoodthatlowturn-overisnotnecessarilyaguaranteeofahighleveloftaxefficiencyandwhenrelied on can lead to erroneous conclusions.The Dodge & Cox StockFund is known to have an enviable record of long-term performance,typically ranking in the top10percentof all similarlymanaged funds.Althoughithasaportfolioturnoverratethataverages20percentorlessinmostyears,itstilllosesabout1.75percentannuallytothepaymentoftaxesfromdividendandcapitalgainsdistributions.3

PerhapsthebestwaytounderstandthedilemmafacedbythetaxableinvestorsintheDodge&CoxStockFundisthroughthe“pipeanalogy”developedbyGlynA.Holton.4Holtonlikensbuildinganunrealizedcapi-talgainspositiontowaterenteringapipe.Watercontinuestofillthepipeandeventuallywhatgoes inmustcomeouttheotherendastaxableorrealizedgains.Holtonequatesthelengthofthepipetotheleveloftrad-ingactivity.Thelengthorcapacityofthepipedictateshowmuchtimepassesbeforethepipeisfilled,theamountofwaterheld,andtheaverageamountoftimeittakesforwatertofillthepipe.Lowertradingactivity

Sourc

e:D

ougla

sS

.R

ogers

FIGURE2.3 ImpactofTaxableIncomeonAfter-TaxReturnsWhentheTaxonDividendsIsGreaterThantheLong-TermCapitalGainsRate

DIVIDEND ONEYEAR FIVEYEARSYIELD PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.

1% 9.25% 6.04% 9.00% 7.49%

3% 8.48% 6.04% 8.34% 7.16%

5% 7.82% 6.04% 7.68% 6.84%


isequivalenttoalongerpipe,whichneedsmoretimeandwatertofillit.TheDodge&CoxStockFundisaseasonedproductandthecapacityofits“pipe”hasgrownwithever-increasingassets.However,waterneedstofigurativelytricklefromitspipe,ortheturnovermustfallwellbelowthehistorical20percentlevel,ifthefundwantstolowerthetaxbite.Thisisbecauseittakesextremelylowlevelsofcapitalgainsrealizationtotrulybetax-efficient,asthepre-andpost-liquidationreturnsforthetwentyyearsshowninFIGURE2.4highlight.

Itmaybeunrealistictothinkthataproductcanbemanagedtogener-ate0percentcapitalgains,butitisbeingdone—andwithgreatsuccess,aswewillseeinlaterchapters.Forthisexercise,thecapitalgainsrealizationrate is thepercentageof capitalgains realizedwhencomparedwith theamountofappreciationduringthepastyear,plustheamountoftheprevi-ousunrealizedcapitalgainsoutstandingintheportfolioatthebeginningoftheperiod.

TaxConsequencesofSellingandBuyingSecurities

Acommonphrase—“thegood,thebad,andtheugly”—hasbeenusedtodescribetradingactivity.Discussingtheseinreverseorder,“ugly”tradingactivityleadstocapitalgainstaxedatthehighestleveloftaxation,whichiscurrently35percentforindividualswhensecuritiesareheldforaperiodofoneyearorless.TheonlyreasonFigure2.4doesnotshowa6.5percent

Sourc

e:D

ougla

sS

.R

ogers

FIGURE2.4 TheImpactofCapitalGainsRealizationonAfter-TaxReturns

ONEYEAR TWENTYYEARSRATE PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.

0% 6.82% 6.82% 9.76% 9.03%

5% 6.82% 6.82% 9.35% 8.81%

10% 6.82% 6.82% 9.04% 8.63%

25% 6.82% 6.82% 8.43% 8.21%

50% 6.82% 6.82% 7.80% 7.69%

100% 6.82% 6.82% 6.82% 6.82%


return in both the pre- and post-liquidation columns for the one-yeartime period is that qualified dividend income is currently taxed at themorefavorable long-termcapitalgainsrateof15percent.Thekeyhereisthatifyouholdthesecurityforonedaymorethanayear,youcansave20percentontherealizedportionofthecapitalgainposition!Ifyoutradeintheshortterm,andgenerategains,youhavetooutperformthetypicalmanagerthroughstockselectionby2.5percentayear—adauntingtaskinmoreefficientareasof themarket—just tokeepupwiththeaveragemanager,andthisdoesnottakeintoaccountthecostofcommissions,thebid/askspreadbetweensecurityprices,orsettlementcosts.

“Bad”tradingactivityresultsintherealizationofcapitalgainsthataresubjecttotherateoftaxonlong-termcapitalgains.Whilethisratehasbeenloweredfrom20percentto15percentbeginningin2003,itisstillcostlyandshouldstillbeavoided,ifpossible.Mostactivelymanagedstockportfoliosstillhavetheirfillof“bad”tradingactivity,asthevastmajorityofthemaremanagedbyindividualswhofail toaccountforthe impactof taxesprior to sellinga securitywithembeddedgainsandreinvestingthe proceeds in another security.This is evident in the average annualturnover rate forequitymutual funds,whichhas ranged froma lowof55percentin2003toahighof81percentin1987.5Themorefavorableratein2003ismostlikelyduetothegreaterflowstopassivefundsratherthantoachangeintradinghabitsofportfoliomanagers.AsthelastcolumnofFigure2.4shows,ittakeslevelsofcapitalgainsrealizationoflessthan5 percent annually to stay competitive on an after-tax basis.This maysounddifficult,butitispossibletorealizelowlevelsofcapitalgains,whichleadsustothefinaltypeoftradingactivity.

Itisnotasintotakegains.Theobjectivefortaxable-accountmanagersistoachievethehighestafter-taxreturnpossible,ratherthanpayingnotaxes.Therefore,ifaportfoliohasachievedasubstantialprofitinapartic-ularstock,andthereareclearsignsthatthefundamentalsofthecompanyaredeteriorating,sellthepositioninthemostefficientmannerpossible.Thisisnotthetimetobecomea“taxhero,”aswelearnedalltoowellwithtechnologyissuesafterthespringof2000.Takinggainswhentheoutlookisforrapidlyfallingpricesiscertainlygoodtradingactivity.Anothertypeof“good”tradingactivitythatmaybelessobviousinvolvesanalyzingthesale and purchase of two securities on an after-tax basis. If a purchasecandidateofferssuperiorreturnpotentialwhenthetaxpaymentonthatsecurityisincorporatedintheanalysis,thenthetrademakessense.

The best-known “good” turnover in tax-aware investment manage-ment circles is thepotential for realizing losseswhen they are availableintaxableaccountportfolios.Thiscanbeadifficultconceptforeventhemostseasonedinvestorstograsp.Itmayappearatfirstthatamanageris


purposelylosingmoneyfortheclient.Wedon’twanttogetcarriedawaylikeMichaelDouglas’scharacterinthemovieWallStreetwhosays“greedisgood,”butunlikeinthetax-exemptaccountarena,lossescanhavegen-uineeconomicvaluefortaxableaccountswhenproperlymanaged.Ifthereisanicefeaturewithinourtaxcode,itisthatlossescanbeusedtooffsetrealizedgains.Iftheycannotbeappliedinitially,theymaybe“saved”forthe future, and in some cases indefinitely.Youmay alsohear, “Tradingor turnover for taxable accounts is like cholesterol, in that our doctorsinformustherearebothgoodandbadformsofcholesterol.”Ifcholesterolisapermanentpartofourdailyexistence,thenwhynotfocusontakingadvantageofthegoodcholesterolandreducethenegativeimpactofthebadformofcholesterolasmuchaspossible?Thesamethoughtshouldbeappliedtotradingactivityandtherealizationofcapitalgains.Noportfoliomanagerwantstopurposelylosemoney,butthemarketdoesnotgoupeveryday.Sotakeadvantageofthenaturallyoccurringvolatilityofsecuritypricesand“harvest”losseswhenitmakeseconomicsensetodo.Besides,“tax-lossharvesting” reduces the costof theother two formsof “good”tradingactivitywhengainshavetoberealized.

We’veoftenheardthatthereisnosuchthingasafreelunch.Tax-lossharvestingmaynotbeafreelunch—therearetradingcostsassociatedwiththeprocess—butitmaybetheclosestthingtoafreelunchintheinvest-mentmanagement industry,andavoiding itmayultimately representamissedopportunitywithtrueeconomicvalue.Asmyfatheroncesaid,“Itmaynotbethebestthinggoing,butitsurebeatswhatisinsecondplace!”Inthepastdecade,greatstrideshavebeenmadeintheunderstandingandexecutionofthetax-lossharvestingtrade.Thereissimplynolongeravalidexcuseforthefailureofmanagersservingtaxableaccountstounderstandthestrengthsandweaknessesoftax-lossharvestingandtoknowwhenandhowitshouldbeapplied.

ImpactofFeesFeesarethelastfactorthataffectsafter-taxreturns.Becausefeestakeawayfromnetwealthcreation,tax-awareinvestorsconsiderfeesaformoftaxa-tion.Feescomeinmanyforms,allofwhichareworthyofscrutiny.Forthepurposeofthisdiscussion,however,wewillfocusonall-encompassingan-nualportfolioorfundmanagementfeesalongwithanysalesload.Study-ing the impactof feescanbeanextremelyworthwhileexercisebecausemanyfeesarenotreadilyapparenttotheinvestor.

Liketaxes,feesserveapurpose.Thereisnothingwrongwithcharg-ing a reasonable fee for a value-addedproductor service.Noone is intheinvestmentmanagementbusinesstoworkforfree.Thequestionthe


tax-awaremanagerorinvestormustaskiswhetherthefeesarereasonablefor the value that a particular product or service contributes to wealthcreation.Thesadfactisthatinmanycasestheanswerisno,andweoweittoourselvesandtoclientstodeterminewhatmakesthemosteconomicsense.Withtheaveragefeesforcommonstockmutualfundsat1.5per-centperyearandindexfundsatorbelow0.2percent,FIGURE2.5suggeststhatfeesareaformoftaxationandthattheyreallydomatter.

The first row of information in the figure suggests a 0 percent feescenario,andyoumightthinkthemanagerisworkingforfree.Thefactisthatlargeindexportfoliosoftenputtheirsecuritiesoutforlendingtobroker-dealers, which may generate sufficient revenue to create, in es-sence, close to a free or zero-cost proposition. Fees make it extremelydifficultfortheproduct-basedadviserdealingwithalimitednumberofofferingstocompeteinthetax-awarearenatoday.WhenyoulookatthelastrowinFigure2.5,itbecomesclearthatevenwithamildfront-endload,ittakesmanyyearsbeforethistypeofproductcancatchupwithitsno-loadcounterparts,unlessthefundisgeneratingextremelystrongpositiveresultsthroughsuperiorsecurityselectionthatislikelytogener-ateahighlevelofcapitalgains.Thisisespeciallytrueformilitaryperson-nel,whoareoftenapproachedbyadvisersextollingthemeritsofusingfront-end-loadedfundsanddollar-costaveragingintothemarketoveranextendedperiodof time.Theunderlying logicof these systematic sav-ingsplansissound,sinceoverseasdeploymentsmakeitparticularlychal-lengingformilitarypersonneltomanagetheirfinancialaffairs.However,whentheproductisnottax-efficient,themilitaryinvestorwithlimited

Sourc

e:D

ougla

sS

.R

ogers

FIGURE2.5 TheImpactofFeesonAfter-TaxReturns

FRONT FEE ONEYEAR TWENTYYEARSLOAD RATE PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.

None 0.0% 9.47% 6.82% 9.04% 8.63%

None 0.2% 9.26% 6.61% 8.82% 8.41%

None 0.5% 8.94% 6.30% 8.50% 8.09%

None 1.0% 8.42% 5.77% 7.97% 7.54%

None 1.5% 7.89% 5.25% 7.43% 7.00%

4.5% 1.0% 3.54% 1.01% 7.72% 7.30%


upsideearningspotentialcanfindhimself,tenorsoyearsdowntheroad,barelyabletoaffordtopaythetaxonthefund’scapitalgaindistributionwithoutliquidatingshares.Ifthemanagerhasthepotentialtoproducea superior return, he should be compensated with an appropriate fee.However,whentaxesareaccountedfor,itcomesasnosurprisethatmanymanagersarefallingshortofareasonableafter-taxreturnobjective.

Insummary,whentax-awarepractitionersorinvestorsarecognizantofthecausesandultimateimpactthattaxeshaveoninvestmentreturns,theycanbettermanagetheprocesstomaximizefutureresults.Thismeansidentifyingproductsthatareadvantageousfortaxableaccountswhilepo-sitioningothersintax-exemptaccountswheretheywillbeleastdetrimen-taltowealthcreation.Toassistintheprocess,managersshouldtakeintoaccountthefollowingprinciples:

❑ Whenthetaxrateishigherontaxableincomethanonlong-termcapitalgains,allelsebeingequal,lower-yieldingportfolioshaveanadvantage.

❑ Extendingtheholdingperiod,especiallybeyondoneyear,enhancesafter-taxreturns.

❑ Tradingactivitycansignificantlyinfluenceafter-taxreturns.❑ Ittakesextremelylowlevelsofcapitalgainsrealizationtobetax-

efficient.❑ Feesareaformoftaxation,andtheydomatter.

Withanunderstandingandanappreciationoftheseprinciples,youare in a position to fully comprehend how seminal research and theprocessesandproductsthatsubsequentlydevelopedhavebenefitedthetaxableinvestor.

ChapterNotes

1. Ibbotson2003Yearbook,Stocks,Bonds,BillsandInflation(Chicago:IbbotsonAssociates,2003).

2. DouglasS.Rogers,“After-TaxEquityReturnsforNon-QualifiedNuclearDe-commissioningTrusts,”FinancialAnalystsJournal(July-August1992):70–73.

3. MorningstarPrincipia(June30,2004).

4. GlynA.Holton,“TransientEffectsinTaxableEquityInvestment,”FinancialAnalystsJournal(May–June1994).

5. MutualFundFactBook2004(Washington,D.C.:InvestmentCompanyIn-stitute,2004),65.

C H A P T E R 3

SeminalResearch

21

Experienced advisers often wonder why it took until the 1990sbeforetax-awareinvestmentmanagementbegantogaintraction.Oneofthemanyreasonsforthiswasthelackofresearchavail-

abletotheinvestmentcommunityandinvestors.Toconductanytypeofanalysistakestwomainingredients:knowledgeableindividualstocon-ducttheexerciseandameanstomeasureresultsonthesubjecttheywishto investigate.The first research ingredient was present in academics,suchasGeorgeM.Constantinides,anotedprofessorattheUniversityofChicago,whowroteseveraloutstandingarticlesintheearly1980s.1Hisworkaddressesoptimal tradingofbothstocksandbonds,andhecoauthoredanarticlewithMyronS.Scholesonassetpricingthattakesintoaccounttheimpactofpersonaltaxes.Furthermore,areviewofhisreferencesquicklyrevealstherehadbeenagreatdealofworktakingtaxesinto account by noted individuals in the 1970s. However, the more-sophisticatedresearchofthetimeemphasizedhowtaxesinfluencedthepricingofsecurities,ratherthanwhetherornotanalystsandportfoliomanagerstookthemintoconsideration.Theotheressentialingredientishavingawaytomeasureresults.Unfortunately,westilldonothavedatabasesormethodstoaccuratelymeasureafter-taxresultsofseparateaccountmanagersinanymeaningfulway.Todothiswemuststillrely

Anditcametopassinthosedays,thattherewentoutadecreefromCaesarAugustusthatalltheworldshouldbetaxed.

—NewTestament


oninformationfrommutualfunds,whichishistoricallystillarelativelyyoungindustry.WhereasthefirstfundwaslaunchedinBostonin1924,the real structure and regulatory framework for the industry was notputintoplaceuntil1940,andthenumberoffundsdidnotsurpass500until1978.2

“IsYourAlphaBigEnoughtoCoverItsTaxes?”publishedintheJour-nalofPortfolioManagementinthespringof1993,wasthefirstarticletousemutualfundtax-relatedinformationtotrulycapturetheimpactoninvestmentreturns.3Thestorybehindthisarticleisworthsharing,asitoffersseveralvaluablelessons.4ThearticlewascoauthoredbyRobertD.ArnottandRobertH.Jeffrey.Atthetimethearticlewasprepared,Arnottwas thepresident ofFirstQuadrant, a firm recognized for quantitativeinvestingandinsightfulresearch.Mostrecently,hefoundedhisownfirm,Research Affiliates, and is the portfolio manager of the highly success-fulPIMCOAllAssetFund.Knownasaprolificauthorandcoauthorofnumerousarticlesonanarrayofinvestment-relatedsubjects,ArnottalsoservesaseditoroftheFinancialAnalystsJournal,theresearchjournaloftheCFAInstitute.Robert“Tad”Jeffreyisahands-onpractitionerandhaspublishedseveralnoteworthyarticles,aswell.

In1974,Jeffrey’sfamily’scompanysoldamanufacturingsubsidiaryforcash.Therefore,thefamilyhadtomakeamajoradjustmentfrommanag-ingoperatingcompaniestooverseeingataxableportfolio.Havingbeenahistorymajor,Jeffreyhadtolearnquickly.Itwasprobablyablessingindisguisethathedidnothaveaformalinvestmenteducation,ashisthink-ingwasnotinhibitedbytraditionalportfoliomanagementpractices.

Jeffrey made a very wise move by asking none other than Peter L.Bernsteintoassistasaconsultanttothecompany.BernsteinhadbeenateacheratWilliamsCollege.Shortlyafterhisdeparture,Jeffreyenrolledthereasastudent.Theymetlateranddevelopedawarmfriendshipovertheyears,andJeffreyaffectionatelyreferstoBernsteinashisprofessor.

BernsteinintroducedJeffreytosomeofthemostnotedpersonalitiesinacademia,investmentmanagement,andpensionconsulting.Throughoutthe1980sJeffreysentletterstotheseindividuals,suchasthelatePeterO.DietzofFrankRussellCo.,seekingmoreefficientwaystomanagetaxableassets.5Meanwhile, Jeffrey continued tohearoffirms that couldpossi-blyaddresshisspecialneedbutthattheyhadallthebusinesstheycouldhandle from themainstreamandwouldfind ituneconomical todiverttheirresources.JeffreyevensentJackBogleofVanguardalettersuggestinglaunchingaproduct similar to theWindsorFundthatwouldexplicitlytaketheimpactoftaxesintoconsideration,butVanguardwouldnotdi-rectlyaddresstheneeduntilsomenineyearslaterwhenitlaunchedthe“Tax-Managed”seriesoffundsin1994.6

SeminalResearch 23

LikeTadJeffrey,RobArnottwasconcernedabouttheimpactoftaxesonhisownportfolio.Knowingthatbothindividualshadapassionateinterestinthesubject,BernsteinintroducedthemafteroneofArnott’sarticlesontaxableaccountinvestinghadbeenrejectedbyFinancialAnalystsJournal.AsArnotttellsthestory,hehadwrittenaninternalpieceonhowtradingaffectsafter-taxresultsandshareditwithJeffrey.Afterreadingthearticle,Jeffreyremarked,“Thisisgreat,butweneedtoputsomethinginEnglishsotheaverageindividualcanunderstandit!”ToaddressJeffrey’sconcernaboutsimplicity,theydecidedonamorereal-worldversustheoreticalap-proach.Theycomparedtheafter-taxperformanceofallfundsclassifiedbyMorningstaras“growth”and“growthandincome”thathadatleast$100millioninassetsthroughouttheperiodof1982to1991.Obviously,thereissurvivorbiasinthestudy,asmanylesser-performingfundsthatcouldnotattractandmaintainthe$100millionthresholdwereeliminated.Ratherthanapplythemaximumfederaltaxratesforindividuals,theyapplieda35percentratesothattheresultswouldapplytothevarioustypesoftax-ableaccounts.Theresultsfromseventy-onefundsstudiedwerecomparedwiththeVanguard500IndexFund,andalsowithafictional“Closed-EndIndex500”asabetterbenchmark,sincemutualfundsaresubjecttotaximplications from shareholder redemption activity.The latter is a validcomparisonbecause,asJackBoglehasstated,closescrutinyonredemptionactivitydidnotbeginuntilsometimelater,andtheafter-taxresultsoftheVanguard500IndexFundwouldhavebeenhigherifcurrentcontrolshadbeeninplace.7FIGURE3.1givesthekeyresultsoftheirstudy.

FIGURE3.1 NumberofLargeActivelyManagedMutualFundsofSeventy-OneThatOutperformedtheRespectiveIndexFund(1982–1991)

“CLOSED-END VANGUARDTOTALRETURN INDEX500” 500INDEX

Pretax 15 15

AfterCapitalGainsTaxes 5 10

AfterCapitalGains

andDividendTaxes 6 9

AfterAllTaxes

IncludingDeferred 10 13

Sourc

e:R

obert

H.Je

ffre

yandR

obert

D.A

rnott

,“Is

YourA

lphaB

igE

nough

toC

ove

rIt

sTaxe

s?”J

ourn

alof

Port

folioM

anagem

ent

(Spri

ng1

99

3)


Readers,especially those in the investmentmanagementcommunity,wereshockedtodiscovernotthatonly21percent(15outof71)fundsbeattheVanguard500IndexFundonapretaxbasisbutthatonly13percent(9 out of 71) outperformed on an after-tax basis, once taxes on capitalgainsanddividenddistributionswereaccountedfor.Thismethodofcal-culationisnowknownasthe“pre-liquidationmethodology,”asthetaxontheunrealizedcapitalgainorlosspositionisnottakenintoaccount.Sincelarge-capitalizationstockindexfundshaveverylittleturnoverintheirhold-ings, capital gains distributions are primarily attributable to shareholderactivityormergersandacquisitionsthatareconsummatedasataxablecashtransactionratherthanasatax-freeexchangeofshares.Therefore,allelsebeingequal, index funds are likely tohavegreater embeddedunrealizedcapitalgainspositions thanactivelymanaged funds thatareconsistentlygeneratingcapitalgainsthroughthesaleandpurchaseofindividualsecu-rities.Evenwith themost conservativepost-liquidation calculationonly17percent(13out71)ofthefundsoutperformedtheVanguard500IndexFundonanafter-taxbasis.

Ofthethirteenmutual fundsthatoutperformedtheVanguard500IndexFundonanafter-taxbasis,onlytwodidsobyameaningfulmargin(seeFIGURE3.2).Thesewere theCGMCapital andFidelityMagellanfundsmanagedby legendarymanagersKenHeebnerandPeterLynch,respectively.The helm of Fidelity Magellan has changed hands severaltimessincePeterLynchmanagedthefund,butneitherfundhasrepeated

FIGURE3.2 Ten-YearPretaxandAfter-TaxGrowthofDollarsInvestedinVariousMutualFunds(1982–1991)

CGMCapital

Magellan

Closed-EndIndex500

Vanguard500Index

10

9

Dollars

8

7

6

5

4

3

2

1

Pretax

Aftercapitalgainstax

Aftercapitalgainsanddividendtax

Afterdefferredcapitalgainstax

Windsor

Figure3.2Rogers

Sourc

e:R

obert

H.Je

ffre

yandR

obert

D.A

rnott

,“Is

YourA

lphaB

igE

nough

toC

ove

rIt

sTaxe

s?”J

ourn

alof

Port

folioM

anagem

ent

(Spri

ng1

99

3)

SeminalResearch 25

overthepasttenyears,asFIGURE3.3shows.8Partofthetwofunds’in-ability to outperform an index fund canbe explainedby their growthstyleofinvestingbeingoutoffavorforthepastfiveyears.However,thepointofthisexampleistohighlighthowdifficultitistooutperformtheindexonafter-taxbasisoveralongperiodoftimeandthentorepeatthefeatinthefuture.

Evenaftermorethanadecade,“IsYourAlphaBigEnoughToCoverItsTaxes?”isstillconsideredtheseminalarticleintax-awareinvesting,asitclearlydemonstratedthedifficultyinattemptingtooutperformalow-fee,large-capitalization index fundonafter-taxbasiswhenrelyingon tradi-tionalportfoliomanagementpractices.The study alsohighlightedhowtaxconsequencesaremoreafactoroftheholdingperiodandtheirimpactdiminishesasturnoverincreases.Itsimpactontheindustryhasbeenpro-found,asitunderscoredtheamountofresearchthatneededtobedoneintotaxable-accountinvesting.

Over the years, financial services entrepreneur Charles Schwab de-veloped a supportive relationship with Stanford University. He fundedtheCharlesR.SchwabProfessorofEconomicsposition,whichwasfilledbyprofessor JohnB.Shoven.9After launching theSchwab1000 IndexFundwiththethoughtofofferingaproductwithafavorabletaxorienta-tion, Charles Schwab approached Shoven to conduct two studies.Thefirststudywastoillustratetheimpacttaxeshaveonmutualfundreturns.Schwabwashopingtheconclusionsofthestudywouldsupporthisvisionofaneedforatax-awarefund,andthemarketwouldthereforeembracehisfirm’snewproduct.

TosatisfySchwab’srequest,ShovenenlistedJoelM.Dickson,agrad-uatestudentwhohadaspecialinterestinmutualfunds,tocowritetheworkingpaper,titled“RankingMutualFundsonanAfter-TaxBasis.”10

FIGURE3.3 Ten-YearAfter-TaxPerformance(fortheTenYearsEnding12-31-2004)

RETURNAFTERTAXES RETURNAFTERTAXESMUTUALFUND ONDISTRIBUTION ONDISTRIBUTION&SALE

CGMCapitalDevelopment 8.60% 8.31%

FidelityMagellan 8.54% 8.11%

Vanguard500Index 11.32% 10.34%

Sourc

e:M

orn

ingst

ar

Pri

ncip

ia(

January

20

05

)


Theprojectkeptthecoauthorsbusy,astheysoonfoundoutthatthedatathey obtained from the Investment Company Institute (ICI) requiredalotofscrubbingbeforetheycoulddrawmeaningfulconclusionswithanydegreeofconfidence.Theyanalyzedreturnsgoingbackten,twenty,and thirty years andapplied tax rates applicable to low-,middle-, andhigh-tax-bracketfamilies.DicksonandShovennoticedtheVanguard500IndexFundimproved inrelativeperformance,movingfrom78.9onabefore-taxbasistothe85.0onafter-taxbasis.Theyalsocalculatedthatifthesmallamountofcapitalgainsdistributedhadbeenzero,thentheperformancewouldhaveendedupatthe91.8percentile.Theseresultswere consistentwithfindings ofArnott and Jeffrey and supported theconclusionthatmutualfundmanagerswerepayinglittleattentiontotheimpactoftaxes.

DicksonandShovenanalyzed147ofthelargestgrowthandgrowthandincomemutualfundsfrom1983to1992usingICIdata.Sincethefirstindexmutualfunddidnotcomeaboutuntil1976,theyfocusedtheirattentiononhowmanagerschangedinrelativerankingbetweenbefore-andafter-taxperformanceinrelationtotheirturnoverrates.Whentheylookedattheperformanceofindividualfunds,theyfoundsomeinterest-ing surprises.Asmightbe expected the fundwith the lowest turnover,Franklin Growth (only 3.2 percent annually), jumped 33.8 percentilesinranking,but the fundwiththehighest turnover,FidelityValue(296percent),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 notmakebroadsweepingstatementsaboutportfolioturnoverandtheimpactonafter-taxperformance.Atthetimetheyprobablydidnotenvisionhowsagethecomment“Wefeelthatmanagingafundsoastodeferallcapitalgains realizations is feasible”wouldprove tobe some tenyears later, astheSchwab1000 IndexFundhasnotmade a capital gaindistributionsinceitsinceptionin1991.Actually,thisstatementwasreallyapreludeofmorethingstocome,asCharlesSchwab’ssecondrequestwasforShoventoaddressmethodsthatcouldbeusedtooperateamutualfundwithoutgeneratingcapitalgains.Justayearafterpublishingthefirstpaper,theywouldcoauthor“AStockIndexMutualFundWithoutNetCapitalGainsRealizations.”11The importance of thisworkwill be covered in greaterdetail inchapter9,whichaddressesmethodsused tooutperformindexfundsonanafter-taxbasisindetail.

In 2000, Rob Arnott revisited the subject he had addressed sevenyearsearlierwiththefollow-uppaper“HowWellHaveTaxableInvestors

SeminalResearch 27

BeenServedinthe1980’sand1990’s?”12WithhisassociatesAndrewL.BerkinandJiaYe,hewentbacktotheoriginalstudyandcameupwithaninterestingobservationthat,uponfurtheranalysis,themagnitudeoftheaveragemarginofshortfallbythelargenumberoffundsunderper-formingwasmuchgreaterthantheaveragemarginofgainonthefundsthatoutperformedtheVanguard500IndexFundonanafter-taxbasis(seeFIGURE3.4).

Withthegrowthinthemutualfundindustrytherewerenowmanymorefundstoanalyze.Therefore,thelongertimehorizonandthegreaternumberofobservationscouldreinforcethevalidityoforpossiblyrefutetheirearlierfindings.Theystudiedthreetimehorizons:tenyears(1989–1998), fifteen years (1984–1988), and twenty years (1979–1988). De-pendingon theperiod and typeof calculationmethod,only4percentto16percentof themutual fundsconsistentlyhavingmore than$100millioninassetsoutperformedtheVanguard500IndexFundonafter-taxbasis.Therefore,thisstudyproducedresultssimilartothoseoftheoriginalstudyandvalidatedtheclaimsmadeyearsearlier.

Inthisstudy,thecoauthorsalsosubtractedthebefore-taxreturndif-ferentialfromtheafter-taxresultsbetweenthefundsandtheVanguard500IndexFundtoachievea“puretaxeffect.”Thereareseveralinterest-ingobservations(seeFIGURE3.5).First,sincetheVanguard500IndexFundhasoutperformedmostfundsonabefore-taxbasis,thedifferentialisnotasdramaticaspreviouslyshown.Second,thetotalcolumnisal-waysnegative,whichshowsthattheaveragefundpaysmoretaxesthantheindexfund.Lastly,notehowthepercentagesimproveineachcase

FIGURE3.4 MarginofGainandShortfallvs.VanguardIndex500

AVG.MARGIN AVG.MARGINTOTALRETURN WON OFGAIN LOST OFSHORTFALL

PretaxReturns 15 1.8% 56 –1.9%

AfterCapitalGains 5 1.0% 66 –3.5%

AfterCapitalGains

andDividendTaxes 6 0.9% 65 –3.1%

AfterAllTaxes

IncludingDeferred 10 1.1% 61 –2.4%

Sourc

e:

Robert

H.

Jeff

rey

andR

obert

D.

Arn

ott

,“Is

Your

Alp

haB

igE

nough

ToC

ove

rIt

sTaxe

s?T

heA

cti

veM

anagem

entD

ichoto

my,

”J

ourn

alofP

ort

folio

Managem

ent

(Spri

ng1

99

3):

15

–2

5


when you go from the row marked “After Capital Gains” to the rowmarked“AfterCapitalGainsandDividendTaxes.”Commonstockmu-tualfundscanapplytheincomefromdividendstooffsetfundexpenses,which lowers the taxburden to the shareholder. Since feesof activelymanagedfundsaremuchhigherthanthe20basispointsorlessfortheVanguard500IndexFundthistaxsavingismeaningful.

This also addressed the issue of survivor bias, which was not ad-dressedearlier.Asexpected,whenthisfactorwastakenintoaccounttheresults favored theVanguard500 IndexFundevenmore.Aswith theprevious study, informationprovidedbyMorningstarmade this studypossible.

FIGURE3.5 MutualFundPureTaxEffectvs.Vanguard500IndexFund

AHEADOFVANGUARD500INDEX BEHINDVANGUARD500INDEX

MARGINABOVE MARGINABOVE

NUMBEROFFUNDS VANGUARD500 NUMBEROFFUNDS VANGUARD500 TOTAL

10-YearResults(1989–1998)

AfterCapitalGainsTaxes 6 2% 0.21% 349 98% –1.68% –1.65%

AfterCapitalGains

andDividendTaxes 31 31% 0.39% 324 91% –1.27% –1.12%

AfterLiquidation 125 35% 0.50% 230 65% –0.47% –0.13%



AfterCapitalGains





AfterCapitalGains



SeminalResearch 29

After-taxinvestingisanobleobjective,butisthereevidencetosuggestthatinvestorshavetakennotice?Intheirpaper,“DoAfter-TaxReturnsAf-fectMutualFundInflows?”authorsDanielBergstresserandJamesPoterbaof theMITDepartmentofEconomicsofferedevidence to suggest thathightaxburdensareassociatedwithlowergrossinflows,andmutualfundsthatofferhigherafter-taxreturnsattractgreaterinflows.13Theystudiedalargesampleofequitymutualfundsfrom1993to1999.Itisencourag-ingthatBergstresserandPoterbadiscoveredthatinvestorstooknoticeablestepstoprotectthemselves,asitwasnotuntiltheendofthisperiodthatthefinancialpressbegantoaddressinameaningfulwaytheadversefinan-cialconsequencesfrompotentiallargecapitalgainsdistributions.

FIGURE3.5 MutualFundPureTaxEffectvs.Vanguard500IndexFund

AHEADOFVANGUARD500INDEX BEHINDVANGUARD500INDEX

MARGINABOVE MARGINABOVE

NUMBEROFFUNDS VANGUARD500 NUMBEROFFUNDS VANGUARD500 TOTAL



AfterCapitalGains





AfterCapitalGains





AfterCapitalGains



Sourc

e:

Robert

D

.A

rnott

,A

ndre

wL.

Berk

in,

andJi

aYe,

“H

ow

W

ellH

ave

Taxa

ble

In

vest

ors

B

eenS

erv

edin

th

e1

98

0’s

and1

99

0’s

?”

Journ

alof

Port

folioM

anagem

ent

vol.2

6,no.4

(S

um

mer

20

00

):8

4–9

4.


Reviewofthekeyarticlesontax-awareinvestinghighlightsfourimpor-tantfactors.First,changeinthefinancialmanagementindustryrequiresavision.BothTadJeffreyandCharlesSchwabaddressedanissuethatothersignored.Throughtwodecadesofpersistenceandinteractionwithcount-lessprofessionalsJeffreyshouldbedesignatedasthe“fatheroftax-awareinvesting,” anddue tohisfinancial supportCharles Schwabbeknownas “the godfather of tax-aware investing.”The second point is it oftentakesgiftedindividualstocommunicatethedreamsofothers.Therefore,weneedtobethankfulthatRobArnott,JohnShoven,andJoelDicksonrecognizedtheissueandwereabletocommunicatetheirconclusionsinamannerthatallowedpractitionersandinvestorstotakeaction.Third,thecontentofmaterialsavailabletotheinvestorwillcontinuetoimproveasneedsareaddressedbyserviceprovidersandregulators.Todemonstratehowtheindustryhasprogressed,refinementsintheMorningstarPrincipiadatabase now allow individual investors to conduct their own after-taxmutual fundanalysis—whichwould rival thepioneeringworkdonebyresearcherswithadvanceddegreesonlyadecadeago—onalmostanyas-setclassinamatterofminutes!Fourthandlastly,whilemoststockfundshaveunderperformedtheVanguard500IndexFundonanafter-taxbasis,it does not mean all funds should or will underperform in the future.Sincewenowunderstandwhat causes lackluster after-taxperformance,enlightenedpractitionersarenowofferingandcreatingdistinctiveservicesandproducts.However,compellingresultscannotbeachievedunlessin-vestorsortheirtrustedadvisersareabletoidentifythegrowingnumberofuniquelyqualifiedtax-awareprofessionalsinthemarketplacetoday.

ChapterNotes

1. George M. Constantinides and Myron S. Scholes, “Optimal Liquidation ofAssetsinthePresenceofPersonalTax,”JournalofFinancevol.35,no.2(1980):439–449;GeorgeM.Constantinides,“CapitalMarketEquilibriumWithPersonalTax,” Econometrica 51 (1983): 611–636; George M. Constantinides, “OptimalStockTrading With PersonalTaxes: Implications for Prices and the AbnormalJanuaryReturns,”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,“IsYourAlphaBigEnoughToCoverItsTaxes?TheActiveManagementDichotomy,”JournalofPortfolioManagement(Spring1993):15–25.

SeminalResearch 31

4. RobertD.Arnott,PeterL.Bernstein,JohnC.Bogle,andJamesP.GarlandandRobertH.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-TaxBasis,”NBERWorkingPaperno.4393,NationalBureauofEconomicResearch,July1993.

11. JoelM.DicksonandJohnB.Shoven,“AStockIndexMutualFundWithoutNetCapitalGainsRealizations,”NBERWorkingPaperno.4717,NationalBu-reauofEconomicResearch,April1994.

12. RobertD.Arnott,AndrewL.Berkin,andJiaYe,“HowWellHaveTaxableInvestorsBeenServedinthe1980’sand1990’s?”JournalofPortfolioManagementvol.26,no.4(Summer2000):84–94.

13. DanielBergstresserandJamesPoterba,“DoAfter-TaxReturnsAffectMutualFundInflows?”JournalofEconomicsvol.63,no.3(2002):381–414.


TheTax-AwarePractitioner

33

Whenindividualsheartheirfirstpresentationorreadtheirfirstarticleontax-aware investing, theyoftenask,“Howdoyouidentifyorbecomeatax-awarepractitioner?”Thisisanexcel-

lentquestion,sincethereisnodirectrouteavailabletoacquirethebodyofknowledgerequiredtoeffectively serve taxableaccounts.Although itisdifficulttopinpointaspecificqualificationasthetelltalesignofexcel-lence,therearefourtraitssharedbyallelitetax-awarepractitioners:

❑ Knowledgeability❑ Inquisitiveness❑ Patience❑ Passion

Thischapterisdevotedtoindividualswhoappreciatethevalueoftax-aware investmentmanagementanddesiretosharpentheirskills forthebenefitoftheirclients.Thesetraitsandtheirdevelopmentareespeciallyimportant,notonlyforpeoplejustenteringtheindustrybutalsoforin-vestorswhoareevaluatingtheirproviders’potentialtoservethemproperlyinthefuture.

Whatisonereallytryingtodointheinvestmentworld?Notpaytheleasttaxes,althoughthatmaybeafactortobeconsideredinachievingtheend.Meansandendshouldnotbeconfused,how-ever,andtheendis tocomeawaywith the largestafter-taxrateofcompound.

—WarrenBuffett

C H A P T E R 4


Knowledgeability

Theprocess of acquiring knowledgebeginswith education.Many aca-demicinstitutionsofferoutstandingprogramsthatbuildabaseofknowl-edgeinfinance,accounting,andpersonalfinancialorestateplanning.Theareathattodayisperhapsmostalignedwithincorporatingtaxesinmakinginvestmentdecisionsispersonalfinancialplanning.Toscreenforapoten-tialfit,thecollege-boundstudentshouldstartwithoneofthedozenorsocollegeguidesavailableinbookstoresorontheInternet.AnotherexcellentsourceistheCertifiedFinancialPlannerBoardofStandardswebsite(www.cfp.net),whichlistsmorethaneightyschoolsthatofferundergraduateandgraduateprograms.

Most practitioners begin their careers by first obtaining degrees inaccounting, finance, or law. Although these academic majors considertaxesinoneformoranother,noneofthemadequatelyaddresstheim-pactoftaxesonsecuritybuyandselldecisions,portfolioconstruction,policydevelopment, or asset allocation and location.To illustratehowlittle information is available to students: the leading college textbookInvestments,FifthEdition,byBodie,Kane,andMarcus,isapproximatelyathousandpages,anddevotesonlythreepagestotheimpacttaxeshaveon investment considerations and asset allocation.1 The author couldmentioninstanceswherenotedtitlesactuallymisstatetheimpactoftaxesoninvestmentreturns,buttheobjectiveofthistextistoenlightenreadersaboutthebenefitsoftax-awareinvestingratherthantocriticizethesinsandneglectofthepast.

Toaddcompellingvaluewith taxable accounts,practitionersneed tohaveatleastabasicworkingknowledgeofthetaxestheirclientsaresub-jectto.Itisunrealistictoexpectoneindividualtoknoweverythingthereisaboutinvesting,thetaxcode,orestateplanning,butwhenindoubt,tax-awarepractitionersneedtoknowwheretolocate—orwhomtocontacttoobtain—accurateinformation.Additionally,theymustbeawareofhowthepaymentoftaxesaffectsthereturnsofpermissiblesecuritiesidentifiedbytheclient.Moreover,theymustbeabletoseethebenefitoftheoptimalalloca-tionofvariouscategoriesofassetsandinvestmentstylesbetweentaxableandtax-deferredaccountstoachievethehighestafter-taxreturnspossible.Lastly,theymustunderstandhow tomeasure success and realize that tax-awareinvestingandreportingareevolvingartforms,asopposedtosciences.

Uponentering theprivate sector, sincerepractitionerswill generallyobtainoneofthefollowingprofessionaldesignations,dependingontheiremploymentspecialty:

❑ CharteredFinancialAnalyst (CFA), a globally recognized stan-dardformeasuringthecompetencyandintegrityofanalysts—TheCFAprogram’sself-studycurriculumallowseventhebusiestinvest-

TheTax-AwarePractitioner 35

mentprofessionaltoparticipate.Thecurriculumdevelopsandrein-forcesafundamentalknowledgeofinvestmentprinciples.Thethreelevelsofexaminationverifyacandidate’sabilitytoapplytheseprin-ciplesacrossallareasoftheinvestmentdecision-makingprocess.Andtheprogram’sprofessional-conductrequirementsdemandthatbothCFAcandidatesandcharterholdersadheretothehigheststandardsofethicalresponsibility.2

❑ CertifiedFinancialPlanner(CFP),acertificationthatconsumersrecognize,respectanddemand—BeforeapplyingfortheCFPcertifica-tionexamination,candidatesneedtocompletetheeducationrequire-mentssetbytheCFPBoard.Therearemorethan285academicpro-gramsatcollegesanduniversitiesfromwhichtochoose,pluscertaindegreesandprofessionalcredentialsfulfilltheeducationrequirement.Aten-hourexamteststhecandidates’abilitytoapplytheirfinancialplanningknowledgetoclientsituations.3

❑ CertifiedInvestmentManagementAnalyst(CIMA)—TheCIMAoffersanintenseeducationalfocusonassetallocation,managersearchandselection,investmentpolicy,andperformancemeasurement.Theprogrambeginswithaself-studyLevel1programandexam.TheLevel2materialsandexamcanbecompletedeitherbyattendingaone-weekclassheldataleadingbusinessschooloronline.4❑ CharteredLifeUnderwriter(CLU)—TheCLUisconferredonlyuponsuccessfulcompletionofaten-partcoursethatcoversfundamen-talsof economics,finance, taxation, investments, andother areasofriskmanagementastheyapplytolifeinsurance.Thecourseofstudycanbe completed throughhome studyorbyattendingcourses at abranchoftheAmericanSocietyofCharteredLifeUnderwritersoratanaffiliatedcollegeoruniversity.5

❑ CertifiedPublicAccountant (CPA)—Oneof theworld’s leadinglicensing exams, the CPA examination serves to protect the publicinterestbyhelping toensure thatonlyqualified individualsbecomelicensedascertifiedpublicaccountants.CPAexaminationsareofferedthroughouttheyear,andrequirementsvarybystate.6❑ CertifiedTrustandFinancialAdvisor(CTFA)—ToearntheCTFAcredential,candidatesmustmeettheexperience,education,ethics,andexaminationrequirementsdeterminedtobecompetencymeasuresforpersonaltrustprofessionals.ApplicantsmusttakeapersonaltrainingprogramapprovedbytheInstituteofCertifiedBankers(ICB)forpre-certification.7

Inadditiontopassingoneormoreexams,theremayberequirementssuch as signing an ethics statement, demonstrating particular types of


experience, and providing professional references. Some of the profes-sional-designationcertificationprogramsalsohaveacontinuing-educationrequirement.Unfortunately,noneofthemadequatelytrainthebeginningprofessionalintheareaoftax-awareofinvesting,butweaknessesincurricu-lumarebeingaddressed.Severalsupplementaleducationinitiativesareun-derwaytoimprovethecurriculumandtestingtoenhancethecapabilitiesofthetaxable-accountpractitioner.Oneinitiative—theMay2004launchingoftheInvestorEducationCollaborativebyCharlotteB.BeyerandSusanRemmerRyzewic—isextremelypromising,astheprincipalsinvolvedhaveextensivehands-onexperienceineducationfortheultra-affluent.8Inthemeantime,thesefiveprogramsservetheneedsofpractitionerswhofocusonthehigh-net-worthfamilyorindividualmarket:

❑ AmericanBankersAssociation(ABA)PrivateWealthManagementSchool—The school introduces seasoned relationship managers touniqueconsultativesalesapproachesfordeliveringfinancialservicestowealthyclients.Duringasix-dayresidentsession,studentsreceivein-termediate-levelinstructiononbuildingtheskillsnecessarytobecomeamorecompetentandproactiveadviser.Recognizedpractitionersandindustry experts assemble at the Duke University Fuqua School ofBusinesstoserveasfacultyandcounseltostudents.Twomodulesareofferedoverconsecutiveyears.9❑ InstituteforPrivateInvestors(IPI)/WhartonSchoolPrivateWealthManagementProgram—Throughclass lectures and interactive case-work,participantscanincreasetheirdepthofknowledgeinkeyareasofwealthmanagement.Aspartofthecorecurriculum,theprogramplacesparticipantswithinafictitiousfamilywithworldwidebusinessesand investments.Duringa six-day resident session, theymakedeci-sionsthatwillaffectthefamily’swealthforfuturegenerations.10

❑ InvestmentManagementConsultantsAssociation(IMCA)WealthManagement Certificate Program—This program teaches the toolsand techniques for creatingand implementing strategic solutions tothecomplexchallengesassociatedwithwealthyclients.Thecurriculumisdividedintothreephasesreflectingthenaturallifecycleofwealth.Studentsstudyassignedmaterials,completeonlinequizzes,andthenattendafulldayseminar.Itculminateswithatwo-daysymposium.11

❑ New York University Certificate in Wealth Management—Thiscourse isdesigned toenhance the relationshipbetweenadvisers andhigh-net-worth clients to achieve desired goals.The curriculum in-cludescorecoursespluselectivesthataddressinvestmentmanagement,alternativeinvestments,andwealthtransitionandtransfer.12❑ AmericanAcademyofFinancialManagementCharteredWealthManager—The five-day program offers a core group of courses


focusedonskillsforhigh-net-worthconsulting.Prerequisitesincludearecognizeddegree,aprofessionalcertification,andfiveyearsofre-latedindustryexperience.13

Schooling, certification, and supplemental education provide thefoundationofknowledge,buttax-awareinvestingasanartformisstillrelativelynew.Moreover,aswillbecomeobviousinthefollowingchap-ters,thecurriculumoftheprogramsnotedaboveusuallydonotcovertheapplicationoftax-awareprinciplestosecurityselection,portfolioman-agement,assetallocation,andlocation,astheysimplylackfacultywhoarequalifiedtoteachit.Additionally,onemustbecarefulaboutusingtheterms “wealth management” and “high-net-worth client.”These termswere previously reserved for clients with liquid financial assets above$100million.Withthe“retailization”oftheinvestmentmanagementin-dustry,thesetermsareoftenusedbyoverzealousmarketersandfinancialplannersthatreflectanyopportunitywherethereareinvestableassets,nomatterwhatthemagnitude.Therefore,thetax-awarepractitionershouldseekeveryopportunity for self-improvement throughavenues thatwillallowforcontinualimprovementofthepractitioner’sskill.

Inquisitiveness

Thetax-awarepractitionerknowsthatmanymarketsandindividualsecuri-tiesareinefficientlypricedwhentaxesareconsidered.Agreatdealoftrulyoutstandingworkhasbeendoneinthemoderneraofinvestingtodevelopwell-known theories, suchas the efficientmarkethypothesis andcapitalassetpricingequation,butinmostcasestheimpactoftaxeswasnotpartoftheprocess.Therefore,arbitrageopportunitiesareoftenavailableforthetax-awarepractitionerwho iswilling toquestion the traditionalwisdomthatwasdevelopedfortax-exemptaccounts.Moreover,manyofthesecon-ceptsaresimpleandrequirenomorethana“backoftheenvelope”expla-nation.Forexample,before2003,thetaxrateondividendsintheUnitedStateswasalmosttwicetherateforsecuritiessoldwithgainsheldtwelvemonthsormore.Let’screateascenariooftwocommonstocksthathavethelong-termpotentialtoproduceatotalrateofreturn,dividendsplusappre-ciation,of10percentperyear.AsFIGURE4.1shows,theresultsaresimilarforthestocksofthetwocompanies(AandB),withtheexceptionofhowmuchoftheirearningstheypaytoshareholdersindividends.

Investorswhoareconsideringthetwosecuritiesforatax-exemptac-countshouldbeindifferenttowhethertoholdstockAorB,astheyendupwiththesameamountofdollarsattheendofeachyear.However,let’sseewhathappensifwestartwitha$100purchaseofbothstocksandsellthemafterone-,five-,andten-yearperiodswithdividendssubjecttoatax


of39.6percentandlong-termcapitalstaxedat20percent,whichwasthecasenottoomanyyearsago(seeFIGURE4.2).

Again, we started with $100 invested in each stock. Dividends aretaxedeachyearat39.6percentandthedollaramountofthe“taxhaircut”isdeducted.Fortheone-yearscenario,weassumetheholdingperiodisjustlessthantheamountoftimerequiredtoqualifyforthemorefavorabletaxrateonlong-termcapitalgains.Therefore,bothdividendsandappre-ciationfortheone-yearscenarioaresubjecttoataxrateof39.6percent.Inthiscase,regardlessofwhetherinvestorsholdstockAorstockBinatax-ableaccount,theyendupwith$106.04afterpayingfederaltaxes.Astimeincreases,weuncoverthepotentialofanarbitrageopportunitycreatedbyjusthavingarudimentaryunderstandingofthetaxcodeforindividuals.StockAhas3percent(4percentdividendyieldofstockAversus1percent

FIGURE4.2 TerminalDollarValueofTwoStocksWithDifferentDividendYields

(39.6%TaxonOrdinaryIncomeand20.0%TaxonLong-TermCapitalGains)

YEARS STOCKA STOCKB

1 $106.04 $106.04

5 $142.69 $147.27

10 $206.62 $222.04

FIGURE4.1 StocksofSimilarCompaniesWithDifferentDividendYields

Figure4.1Rogers

Appreciation6%

Appreciation9%

StockA StockB

Income4%

Income1%

Sourc

e:D

ougla

sS

.R

ogers

Sourc

e:

Dougla

sS

.R

ogers


dividendyieldof stockB)moreof the total returnattributable todivi-dends,whicharesubjecttothehighertaxrateof39.6percent.Plus,thetaxondividendsispaidannually,whereasthetaxoncapitalgainsatthelowerrateisnotpaiduntilthesaleattheendofholdingperiod.Inthisex-ample,anindividualinvestorsubjecttothehighestfederaltaxrateswouldbebetteroffholdingstockBinsteadofthehigh-dividend-payingstockAby$4.58and$15.42overthefive-andten-yearperiods,respectively.Onemaycounterthatthisarbitrageopportunityforlongerperiodsnolongerexistssincethefederaltaxratesondividendsandlong-termsgainsarenowequal.Thatistrue,buttheopportunityexistedforyearsandnotenoughinvestorsunderstooditspotentialor,moreimportant,tookadvantageofit.Additionally,thisexamplehighlightsthevalueofbeingfamiliarwiththehistoryofthetaxratesandrecentlegislation,asthetaxondividendswillreturntoregulartaxratesonordinaryincome,currently35percent,in2009unlessthereisadditionallegislation.Soiftheopportunityisnotavailabletoday,weneedtobeawareofhowwemightbeabletotakead-vantageofaparticulartax-drivenscenariointhefuture.

Arethereopportunitiesfortax-advantagedalternativestoday?Yes,forexample,listedoptionsaresubjecttoa60/40blendofthelong-termcapi-talgainandordinaryincometaxrateseveniftheyareheldlessthanayear.Iftheholdingperiodisshortandthemarketislikelytorally,consideraqualifiedoptionorfuturecontract,insteadofholdingamutualfund,andpocketthesubstantialtaxsavings.Thepointhereisthattax-awareprac-titioners lookfortheseopportunitiesandtakeadvantageofthemwhentheymakesense.

Toobtainanunderstandingofconceptslikethoseshowninthetwoexamples above, the tax-aware practitioner will benefit from attendingconferencesandkeepingabreastofthelatestdevelopmentsintheindus-try.This can be done by attending one or several national conferencessponsoredbythefollowingorganizations:

❑ AmericanBankersAssociation❑ CharteredFinancialAnalystsInstitute(formerlyAIMR)❑ FamilyOfficeExchange(FOX)❑ FinancialPlanningAssociation(FPA)❑ FinancialResearchAssociates(FRI)❑ IbbotsonAssociates❑ InformationManagementNetwork(IMN)❑ InstituteofCertifiedBankers(ICB)❑ InstituteforPrivateInvestors❑ InstitutionalInvestor❑ InvestmentAdvisor❑ NationalAssociationofPersonalFinancialAdvisors(NAPFA)


❑ NewYorkUniversityInstituteonFamilyWealthManagement❑ NMSManagement❑ NuclearDecommissioningTrust(NDT)

RegionalandlocalprogramsarealsoarealsoofferedbytheCFA,FPA,andNAPFAorganizationsandtheirlocalchapters.TheNewYorkSocietyofSecurityAnalysts(NYSSA),a localchapteroftheCFAInstitute,hasaccesstosomuchtalentitconsistentlyproduceshigh-caliberprogramsonaparwiththefinestnationalorganizations.Additionally,FinancialPlan-ningpublishesannuallyanextensive listofbroker-dealerprograms thatmaybeofinterest.Thekeyhereistobuildanassociationwithorganiza-tionsandindividualsthatbestsuittheneedsoftheclientsyouserveandtostayintunewithinnovativedevelopments.

Patience

Toaccomplishsuperiorresultswithtaxableaccountstakestimeandpatience!Someonewhohasadaytrader’smentalityandwantstobeasuccessfultax-awarepractitionerwillhavetoattaintheself-disciplinenecessary.Therearenoshortcutshere,andthatiswhyitissodifficulttoeducateindividualsonthebenefitsoftax-awareinvestmentmanagementwhenforyearstheymayhavebeensubjecttoatransaction-orientedarrangement.A1to2percentenhancementinperformanceisnotoutofthequestionwhenapplyingtax-awareprinciplesandconcepts.14Thisincrementmayinitiallyseeminsignifi-canttosomeindividuals,butthelong-termbenefitoftax-awareinvestmentmanagementismeaningful,ashighlightedinFIGURE4.3.

Wewillstartwithaportfolioof$10,000.Obviously,mostclienttax-ableportfoliosaremuch larger,but thisamount isused for the sakeofsimplicity. For an initial $10,000 investment, the benefit of tax-awaremanagementinthefirstyearis$100to$200andmayatfirstappeartobehardlyworththeeffort.However,astheinvestmenthorizonincreasesandthebenefitcompounds,thetotaldollarbenefitbecomesmoremeaningful.Notethatwitha2percentannualbenefit,assetsdoubleinvalueinslightlymorethanthirty-fiveyears.Thatmayseemlikealongtime,butitiscer-tainlynotanunreasonableoneforyoungprofessionalsjustoutofcollegeentering theworkforcewhoare establishing a savingsplanor for long-termtrusts.Moreover,thisisnotjustanexerciseforthewealthy.Failingtoachieveoptimalresultsmostlikelywillnotdisruptthelifestyleofwealthypeople,butitcouldmeanthedifferencebetweenenjoyingretirementandhavingtoworkforafewadditionalyearsforaverageindividualinvestors.Toanalyzeaspecificsituation,simplydividethesizeoftheclientportfolioby$10,000andmultiplytheresultbythelevelofbenefitfromthetable.Forexample,ifyouhavea$1millionportfolio,andthelevelofbenefit


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-freeloanfromthegovernment!

Passion

Tax-aware practitioners are passionate about their craft. This passionbuildsover time,because they realize theyare“doing the right thing.”Manywilltakethetimetosharetheirwisdomandknowledgetofurtherthebodyofknowledge.Ariskinherentwithwritinganytextrelatingtotaxesisthataftersomeonehaslaboredforhourstocompleteit,amajorchangeinthetaxcodecanrenderitobsolete.Therefore,itisimportanttoidentifysourcesofinformationthatexplainconceptsandmethodsinad-ditiontothosethatsuggestaparticularstrategythatmaycomeaboutorchangewiththedynamicsofthetaxcode.Anotherchallengeforresearchontax-awareinvestingisthatinformationonpretaxreturnsforsecuritiesandassetclassesisfarmorereadilyavailablethaninformationonafter-taxreturns.Perhapsthegreatestchallengeforeducationrelatingtotaxableaccountsingeneralistryingtoobtainfunding,becausethegroupthatbenefits the most from the process is typically wealthy individuals. Asonewell-knownpractitionerintheindustryputit,“Ifyouaskawealthy

FIGURE4.3 DollarBenefitofTax-AwareInvestmentManagement(BeginningWith$10,000)

LEVELOFBENEFITYEARS 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

50 $6,446 $16,916

Note: At 2% growth, the principal amount doubles in slightly more than 35

years.

Sourc

e:D

ougla

sS

.R

ogers


individualorcharitableorganization to fundacharitablecause for theless-privileged inadistant landtheycanrelate to theneed,butaskingthemtofundanefforttoteachthosewhoarealreadyconsideredtobeprivilegedsimplydoesnotresonatewiththem.”Thepointhere isthatthoseofusintheindustryandourclientsarealreadydoingwell,solim-itedresources shouldbe sharedwith those thathave thegreatestneed.Many journals are supported by the certification programs mentionedearlier.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,hasbeenabletoattractnoteworthysubmissionsfrommanyofthewell-knownpractitio-nersyouwilllikelyencounteratnationalandregionalconferences.

Thefollowingthreebooksshouldbeinthelibraryofanyoneattempt-ingtounderstandtaxable-accountinvestingandarerecommendedfortheprofessionalabilityoftheirauthors.

❑ IntegratedWealthManagement,byJeanL.P.Brunel(InstitutionalInvestorBooks)—Presentsthenewparadigmofwealthmanagementforultra-affluentclients.❑ WallStreetSecretsforTax-EfficientInvesting,byRobertN.GordonwithJanM.Rosen(BloombergPress)—Offersaworkingknowledgeoflittle-knownacceptedmethodstoefficientlyconducttaxabletrans-actions.


❑ J.K.LasserProIntegratingInvestmentsandtheTaxCode,byWil-liamReichensteinandWilliamJennings(JohnWiley)—Explainsthemodelingofasavingvehicle’staxstructureanddiscussesrelatedinvest-mentimplications.

Eachofthebooksservesadistinctpurposeorparticularlevelofwealth,asnotedabove.Tax-AwareInvestmentManagement:TheEssentialGuideisintendedtocomplementthemandroundoutthebodyofknowledgeespeciallysothoseinvolvedintheday-to-daymanagementoftaxableac-countscanmakebetter-informedinvestmentdecisions.

Thetax-awarepractitionermustrealizethatnoteveryoneagreeswiththisconcept,assomeputthemotiveforprofitbeforetheclient.Thereisstillalotoftimeandeffortinvestedinthe“sinsofthepast,”andmanyclientswillbe reluctant tochangeuntil theyaremadeawareofamorecompellingstrategyorproduct.Passioncausespersistence,andalthoughtheprocessmaybe longandgradual, the conceptsof tax-aware invest-mentmanagement aregainingground, andenhancements inproducts,methods,andtechnologyarefollowingatarapidpace.Thefunofbeingatax-awarepractitioner is in implementingastrategythatworkstotheadvantageofallconcernedand,duringorattheendoftheprocess,seeingsolidevidencethatyouhaveaddedvaluewellinexcessofthefeethatischarged.

Thebodyofknowledgepertainingtotax-awareinvestmentmanage-mentcontinuestoexpand,buttorealizethefullpotentialoftheprocessweneedtocodifysoundmethodsandprinciples.Additionally,wemustconvinceothersthatpeopleenteringtheindustryneedaccesstoeducationtoovercomethe steepand long learningcurve typicallyassociatedwithtaxableaccounts.Futuretax-awarepractitionersalsoneedtobeempow-eredwithsoftwaresolutionsthatareonlynowbeginningtoaddresstheneedfortailoredsolutionsacrossmultipleaccounts.Fortunately,fortax-ableinvestorsorclients,thefuturefortax-awareinvestmentmanagementispromisingandislimitedonlybytheimaginationandthewillingnesstodevotesufficientresourcestoachievedesiredsolutions.

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(accessedJuly27,2004).


4. InvestmentManagementConsultantsAssociation,“CertifyYourProfession-alism,”http://imca.org(accessedJuly27,2004).

5. CaliforniaStateUniversity,Northridge,“AGuidetoProfessionalCertificationPrograms,”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 ManagementCertificateProgram,”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:CanItAdd250BasisPointstoYourReturns?” Journal of InvestmentConsultingvol. 6,no.1 (Summer2003):82–89.

CreatingtheTriumvirateof

QualifiedProfessionals

45

Toachieveoptimal results in investmentmanagementwhen taxescomeintoplayrequiresthreedistinctskillsets.Thisapplieswheth-eryouareofferingadvicetoanindividualinvestor,high-net-worth

family,propertyandcasualtyinsurancecompany,nucleardecommission-ingtrust,voluntaryemployeebeneficiaryassociation,oranyothertypeoftaxableaccount.Thethreeskillsetsare:investmentmanagement,tax,andregulatoryorestatematters(seeFIGURE5.1).Alltaxableaccountsrequiretheinvestmentmanagementandtaxskillsets.Thefactorthatisdifferentfortaxableaccountsiswhetherregulatoryorestatemattersinfluencedeci-sions.Individualsandhigh-net-worthfamiliesneedtoaccountfortheim-pactofestatetaxes,whereastaxablecorporateentitiesmustaddressongoingregulatorymatters.

Eachoftheskillsetsandelementsisimportantseparately,butifoneormoreiseliminatedorovershadowed,theclientwillreceivealessthanoptimalsolution.Thedifferentrequisiteskillsshouldcomplementonean-otherandworkinunison.Everyattemptshouldbemadetoavoidconflictoroperatingasseparateunits.

The complexity of the assignment will dictate the level of skill orqualification necessary to achieve a satisfactory outcome. For example,a financialplannerwith an accounting and legalbackgroundoperating

All the Congress, all the accountants and tax lawyers, all thejudges,andaconventionofwizardsallcannottellforsurewhattheincometaxlawsays.

—WalterB.Wriston

C H A P T E R 5


separatelymaybeabletoprovideoutstandingserviceandadvicetoanin-dividualinvestorifthefirmisabletopreparethenecessarydocumentsforwills,etcetera.However,theprocessforpropertyandcasualtyinsurancecompanies typically incorporates sophisticated asset/liability modeling,custom portfolios, extensive involvement with the firm’s financial staff,and coordination with highly specialized lawyers and accountants whoassistinguidingthefirmthroughthemazeoffederalandstateregulatoryrequirements.Theone aspect that permeates throughout the “qualifiedtriumvirate”ofskillsistheimpactoftaxes.Thisfeatureaddsanotherlayerofcomplexitytothetraditionaltax-exemptaccountandmakestax-awareinvestmentmanagementchallenging.Itisalsowhyqualifiedpractitionerswhoarerecognizedfortheirexpertiseinthisarenacandemandapremiumfortheirservices.

Toavoidcostlyerrors,itisbesttobringtheseskillsetstogetherandestablish aplanbefore funding takesplace.High-net-worth individualsoftenacquiresubstantialliquidfinancialassetsthroughthesaleofaprivatecompany.Inthesecases,itiscriticalthatthefamilyestablishthequalifiedtriumviratebeforediscussingthesaleoftheassetwithinvestmentbank-ers.Thereisonedistinctionbetweenthevalue-addedpropositionofthetaxandestateelementsandthatoftheinvestmentmanagementprocess.The savingsorvalue added from the tax andestate elements canoftenbeaccomplishedinashortperiodoftimeandinvolvesubstantialsums,

FIGURE5.1 TheTriumvirateofQualifiedProfessionals

Regulatory

orEstate

Investment

Management

Tax

Figure5.1(Triumvirate)Rogers

Sourc

e:D

ougla

sS

.R

ogers

CreatingtheTriumvirateofQualifiedProfessionals 47

whereastheinvestmentprocesstypicallytakesanextendedperiodoftimetoproducegradual,meaningful results. In thecaseofahigh-net-worthfamily,havingtheproperestatestructureinplacebeforethesaleofabusi-nessmaysavemillionsofdollars.Whiletheestateattorneyandaccountantmayleadthediscussionduringthisphaseoftheengagement,thefinancialadviserneedstobepresentandpreparedtoofferaprofessionalopiniononwhetherthereturnassumptionsarereasonableandwhethertheevolu-tionoftheestateplanorultimatestructurewillleadtoaviablelong-termportfoliomix.

Verysimply,actionsoughtnotbetakenfortaxsavingsalone,astheymayresultinasituationthatwillforceacostlysolutioninthefuturethatfaroutweighstheinitialbenefits.Anexampleisusingtaxablebondsinatrust,inlieuoftax-exemptormunicipalbonds,asawealthtransferstrat-egy,becausetheparentspaythetaxbill.Atfirstthismayseemlikeasoundidea,becausethetaxadviserandestateattorneyrecommendtransferringasmuchwealthaspossibleoutoftheparents’estatesothatatdeaththedollaramountoftheestatetaxwillbeminimalorsubjecttolessthanthemaximumtaxrate.First,tax-exemptbondstypicallydonottradeatadis-countequaltothemaximumfederaltaxrate,sotheclientendsuppayingunnecessarytaxesonaportionofthereturn.Moreimportant,thisapproachdoesnottakeintoaccountalternativeoptionsthatcanbeachievedusinghigher-yieldingequityportfolios,purposelytaking long-termgains,andraisingthecostbasisof theequityportfolio,whichwill likelyprove farmorebeneficialovertimeespeciallyafterthedeathoftheparents.Withoutbringingintax-awareinvestmentstrategyanalysisintheplanningprocess,thewealthtransferstrategymayactuallybenefitthegovernmentfarmorethanthetax-payingclient.Anotherexampleisplacinganinternationaleq-uitymanagerinataxableinvestmententityversusatax-exemptonesolelytorecapturethedividendwithholdingtax.Therecapturemaybeabenefit,butitistypicallyaminoroneintheoverallschemeofmanagerlocation.Thistaxnuanceofinternationalequitiesisworthconsidering,buttherateatwhichcapitalgainsarerealizedisgenerallyamoresignificantfactorinthedecisiontoplacethemanagerinataxableortax-exemptinvestmententity. Equally important, the financial adviser should not try to forcea premature asset allocation plan or the funding of managers. Patiencebythefinancialadviserduringtheinitialplanningstagesiscritical.Eventhoughyieldsmaybepaltryduringthistime,itisprudenttomaintainaliquidpostureuntilallpartiesinvolvedagreeoncriticalelementsoftheplan.Thiswillavoidpotentiallycostlyandembarrassingsituationslater.

Clientsoftenunderestimate the importanceofandtimerequiredtodevelop a comprehensive plan or investment policy statement. Duringthiscriticaldevelopmentperiod, the financialadviserneedstokeepthe


clientfocusedandengagedintheprocess.Everyattemptshouldbemadetoaddressandeliminatedistractions,especiallywhentheclientgetsofftrackandbeginsdiscussingthevariousattributesofspecificmanagersandfunds.Having the clientwork closelywith thequalified triumvirate tofinalizetheplaniscritical,asthetax-awarepositioningofassetclassescanaddasmuchormorevaluethantheidentificationoftherightmanagersorfunds.Ifpreparedproperly,thefinaldocumentwillserveasablueprintor business plan. Many professionals open their meetings by reviewingthisdocument,asitreinforcescorevaluesanddirectsbehaviortoachievecommongoalsandobjectives.

Membersofthequalifiedtriumvirateofferprofessionaladvicetheybe-lievewillofferthegreatestvalue.Indoingso,theywillgraduallypositionthemselvesinrelativeimportanceintheeyesoftheclient.Thisinteractionultimatelyleadstooneprofessionalachievingtheloftypositionof“trustedadviser.”Thisisperhapsthemostoverusedterminthefinancialservicesindustrytoday,yetitsimportancecannotbedenied.Becomingthetrustedadviserprovidestwodistinctadvantagesoverotheradvisersintheprocess.First,thetrustedadviseristheonethattheclientwillusuallygotofirstwhenheorshehasaquestion,aproblemtobesolved,orevenapersonalissuetovet.Second,throughthisadvantageouspositioning,thetrustedadviserhassignificantinfluenceovertheflowofadditionalservicesandproducts.Thereisnooneruleastowhichoftheprofessionalsinvolvedshouldserveasthetrustedadviser.Itsimplydependsonthefinancialsitu-

FIGURE5.2 HierarchyofClient/ProviderRelationships

October15,2004:CommencecalculationofthreedifferentindicesfortheS&P500:•S&P500CLASSIC•S&P500HALFFLOAT•S&P500FULLFLOAT

Phase2:OfficialS&P500movestoafull-floatadjustedcalculation

Phase1:OfficialS&P500movestofreefloatadjustedcalculationbasedon50%oftheintendedfloatfactorforeachconstituent

DepthofPersonalRelationship

Bre

adth

of

Busi

ness

Iss

ues

Trust-Based

Relationship-Based

Needs-Based

Service

Offering-Based

Figure5.2Rogers

Sourc

e:D

avi

dH

.M

ais

ter,

TheT

rust

edA

dvi

sor

(New

York

:Touchst

one,2

00

1),

9–1

0


ation andpersonal chemistry between the client and eachprofessional.Whileallpartiesmaynaivelybelievetheyserveasthetrustedadviser,thetruedesignationisultimatelyawardedtotheprofessionalthatearnstheclient’strustwiththemostsensitivematters.

Unfortunately,theterm“trustedadviser”maybeusedasamarketinggimmickwithoutunderstandingthetruemeaningandsignificanceofthedesignation.DavidH.Maisteroutlinesinhisbook,TheTrustedAdvisor,thehierarchyofclient/providerrelationships,showninFIGURE5.2.1Hethenliststhevariouscharacteristicsoftherelationshiplevelsinatable(seeFIGURE5.3).

AsFigure5.2suggests,establishingtruststandsatthepinnacle,aboveprovidingeducation,solvingproblems,andgeneratingideas.Trustisnotsomething that is immediately achieved; it grows over time. Moreover,it cannot be achieved solely within the physical confines of the serviceorganization,asinteractionwiththeclientismandatory.Itmayalsocrossthe fine line from developing a professional relationship to a long-last-ingfriendship.Fromanethicalstandpoint,developingtrustcanbestbeachievedby“doingwhatisrightfortheclient,”whichmayinvolveoffer-ingsolutionsthatforgoimmediateprofitsinordertodevelopamutuallyrewarding,long-termrelationship.

Whyistheconceptofthetrustedadvisersoimportanttotax-awareinvestmentmanagement?For the simple reason that if theadviserdoes

FIGURE5.3 CharacteristicsofRelationshipLevels

ENERGY CLIENT INDICATIONS FOCUSON SPENTON RECEIVES OFSUCCESS

Service- Answer, Explaining Information Timely,

Based expertise, high-quality

input responses

Needs-Based Business Problem Solutions Problems

problem solving resolved

Relationship- Client Providing Ideas Repeat

Based organization insights business

Trust-Based Client Understanding Safehaven Varied—

individual theclient forhard e.g.,creative

issues pricing

Sourc

e:

Davi

dH

.M

ais

ter,

TheT

rust

edA

dvi

sor

(New

York

:Touchst

one,

20

01

),9

–1

0


notbelieve inthephilosophyor isnotalignedwithprovidersandplat-formsthatembracetax-awareinvestment,thenitwillbeastruggleatbesttoachieveafavorablesolution.Eveniftheinvestmentadviserisnotthe“trustedadviser,”optimalresultscanstillbeaccomplished,buttheothermembersofthequalifiedtriumviratehavetobelieveinthetax-awareprac-titioner’sapproachandbewillingtosupportitwhenquestionedbythecli-ent.Thisiswhyitissoimportanttodeveloprelationshipswithpreferredprovidersandtakethetimetosharethebenefitsofthetax-awareprocess.

Theabilitytoachieveatax-awaresolutionisinfluencednotonlybytheexpertiseoftheprofessionalsofthequalifiedtriumviratebutalsobythecharacteristicsofthefinancialservicesplatform.Therearetwoprimarytypesofplatformsorservicearrangements:discretionaryandnondiscre-tionary.Underadiscretionaryarrangementthefinancialadvisercanmakedecisionson the client’s behalf,whereas in anondiscretionaryplatformtheultimatedecisionrestswiththeclient.Discretionaryplatformsusu-allyworkbestwith clientswhoaremigrating froma retailbroker, andwheretheskillsetofthequalifiedtriumvirateisusuallycontainedwithinthe same organization. Discretionary platforms lend themselves bettertostandardizationandtheabilitytoofferproprietary,internalproducts.Thefirmsthatservethisnichemayoffercommingledproductsthatserveparticularclientriskprofiles.Itisalsoeasiertoshowprospectspotentialresults,astheoutcomesaremoreuniform.

Moreknowledgeableandhands-ontypeclientstypicallyprefernondis-cretionaryplatforms,givingthemaccessto“bestofbreed”serviceprovid-ers.Eachsolutionofanondiscretionaryplatformisultimatelyapprovedordrivenbytheclient.Theclientisofferedseveralmanagerorfundop-tionswithineachassetclassandchoosesacustomsolution.Asaresult,thereturnsofindividualclientsmayvarywidely.Itisalsomoredifficultforprospectstograsptheprovider’sabilitytoaddvalue,sincetheultimatemixofassetsandmanagers/fundswasdecidedbyeachclient.

Perhapstheeasiestfeaturetounderstandaboutthenondiscretionaryplatformisfees,whichtypicallyconsistofcustodian,manager,andadviserfees.Adviserfeestypicallyincludereportingservices.Additionally,adviserstypicallynegotiatewithoutsidemanagersonbehalfofalltheirclientsenmassetoobtainamorefavorablearrangementthanifclientsapproachedthemanagersontheirown.Theabilitytoaccomplishthisdifferswiththeassetclassandwitheachmanagerontheadviser’srecommendedlist,butthesavingsmaybesufficientwheretheadviserultimatelybecomesaprofitcenter,ratherthanacostofdoingbusiness.Ontheotherhand,thepric-ingofnondiscretionaryplatformscanbeconfusing,asfeesaretypicallybundledtogether,anditisoftendifficulttodeterminethecostofanyoneserviceorproduct.Thisisespeciallytruewhendiscountsareofferedfor


usinginternalproducts,suchastradingthroughthefirm’sbroker-dealer,whichmaycreatepotentiallayersofhiddencosts.

Likemarriages, relationships between clients and their providers donot always last until death. When clients have security positions withsubstantialunrealizedgains, thedecisiontoendtherelationshipcanbecostly.Therefore,itisimportantfortheinvestorseekingtaxable-accountservicestoconsidernotonlytheinconveniencebutespeciallythefinan-cial consequences if itbecomesnecessary for any reason to terminate arelationship.With a nondiscretionary platform, the advisory, custodial,andmanager/fundservicesareusuallymodularandcanbereplacedsepa-rately.Replacingaparticularelementmayrequiretimetoselectanotherproviderandattention todetail to transfer the responsibility,but if thetransition is conducted with new providers that appreciate and under-standtax-awareinvestmentmanagement,thetimeanddisruptioncanbeminimal.Atransferof“assetsinkind”ofexistingsecuritypositionstonewmanagerswithoutsellingwillallowthenewteamtodowhatisbestfortheclient.Ifdoneproperly,itmaytaketax-awareportfoliomanagersayearormoretomakethetransitiontotheirmodelportfolio.However,withthediscretionaryplatform,especiallywhenproprietyproductsare involved,clientswillbeforcedtoliquidatealltheholdingsandbeginanewifthere-lationshipisterminated.Nondiscretionaryplatformscanbeagoodfitforcertainclientprofiles.However,investorsthatchoosethemneedtohaveamuchhigherdegreeofconfidenceinthesoundnessoftheirdecisionmak-ingthaninvestorsselectingdiscretionaryplatforms.

With the proliferation of high-net-worth individuals, as a result ofwealthcreatedduringthelatterhalfofthe1990s,thenumberoffirmsem-ployingnondiscretionaryserviceplatformsalsoproliferated.Theprimaryreasonisthatittakesanextremelyexperiencedinvestmentprofessionaltocarrythesophisticatedrelationshiprequiredforadiscretionaryplatform,andthesupplyislimited.Thissituationgetsevenmorechallengingwhenthe client desires exposure to alternative investments.Therefore, manyfirmshavenochoiceinwhatplatformtheyoffer.Asaresult,individualsseeking an independentdiscretionaryplatformwill likelydiscover theirnicheisservedbyonlyasmallnumberoffirms.

Thepotentialofaparticularplatformtoachieveatax-awaresolutiondependson the ability to satisfy the four critical elements of tax-awareinvesting:

1 Utilizingafter-taxassumptionsintheassetallocationprocess2 Allocatingassetclassesandmanagers/fundsaccordingtothechar-

acteristicsofeachinvestmententity3 Positioningtax-awareequitymanagers4 Identifyingtax-awaremanagers/funds


Thefirstthreeelementspertaintoprocessandthefourthtoproduct.Having all four elements inplace is optimal, butnot all platforms canachievethis.Accomplishingthefirstthreerequireseducatingthefinancialservicesproviders,whichmanyplatformshavenotyetembraced,butthissituationisgraduallyimproving.Ifthelimitationsofaplatformaresuchthatitcannotdelivertax-awaremanagersandfunds,thencaveatemptor,orbuyerbeware.Thekeyfortheinvestoristoevaluatethefouressentialele-mentstodetermineifthefinancialservicesprovideriscapableofsatisfyingorexceedinghisorherexpectation.

Thereisasayinginthefinancialplanningcommunitythat“individu-alsarewillingtopayfortheirhealth,butnotfortheirwealth.”Thereisalotoftruthtothisstatement,assomeindividualsjustcannotgetoverthefact thatapersonoffering themfinancialadviceneeds tobefinanciallyrewardedforthatservice.Therewillalwaysbesomeindividualswho,forwhatever reason, will not pay for advice, so the only way they can beservediswhenfeesareembeddedintheportfoliostrategiesrecommended.This aspect segments the financial planning community into fee-basedversusproduct-basedproviders.Itisextremelydifficulttocreateoptimaltax-awaresolutions in theproduct-basedsegment.Unfortunately,manyof thedesirableproductsavailable in themarketplace todayare low-feeinnatureanddonotofferawayforproduct-basedproviderstobecom-pensated.Itisasadfactthattheinvestorseekingtheproduct-basedroutemayunfortunatelyenduppayinganopportunitycostthatfarexceedsthecostofafee-basedplannerwhooffersatax-awaremenuofmanagersandmutualfunds.

Feearrangementshaveanimpactontheabilityofserviceproviderstoaligntheirinterestswiththeclient.Thefollowingdiscussionwillal-lowinvestorstogainabasicunderstandingofthepositiveelementsandconcernsofthemostcommonfeearrangements.First,thereisthehourlycharge,whichiscommonwithaccountantsandestateattorneys.Hourlyfeesareeasyformanyclientstoaccept,becauseyouareonlychargedforservicesutilized.Hourlyfeesaretypicallyhigherduringtheinceptionoftherelationship,asthereismoreworknecessarytodevelopaneffectivefinancial plan. Second, there are clients who prefer retainer fees overhourly fees. They believe this arrangement to be superior, since thechargeisbasedonaddressingtheneedsoftherelationship.Clientswhoprefertheretainerfeestructurefeelitfacilitatescommunication,sincethey do not feel compelled to limit the interaction to avoid excessivecharges.Additionally,theyfeelthereisnoneedfortheproviderstoin-undatethemwithadditional ideas,asmightaretailbroker.Thethirdtypeof fee arrangement is to charge apercentageof theoverall assetsundermanagementorsupervision.Thisisthemostcommonapproach


byfinancialservicesproviders,whichmayofferaslidingscaletoachieveavolumediscount.Advocatesofthisapproachbelievethattheserviceprovidersare rewardedas theclient’swealth increases.Skepticsof thisarrangementbelieve it causes theproviders tooffermorehigh-return,high-riskoptions.Forexample,theportfoliomixcouldbemoreheav-ilyorientedtowardequitiesthannecessary,sincehistoricallytheyhaveprovidedhigher returns thanfixed income securities.The fourth typeof fee arrangement is one based on performance.The manager mustachieveareturnaboveadesignatedhurdleratebeforetheincentiveorperformancefeekicksin.Plus,theremaybeahigh-watermarktomakesurethemanagerisonlypaidtheperformancefeeswhenpreviousshareorunitvaluesareexceeded.Itisencouragingthattherearenowmanag-erswillingtoacceptassignmentswheretheperformancefeeisbasedonexceedingahurdleratecalculatedaftertaxes.Thefifthandlastareaishiddenfees.Theseillustratewhyitsoimportantforprospectstoasktherightquestionstogainanunderstandingofallfeesinvolved.Thisgrayareamayincludeitemssuchasmarketingfees,softdollarcommissions,ortradingthroughthefirm’sbroker-dealer.Theimportanceofthislastarea cannot be underestimated, because costs—like taxes—influencethenetresult.Nofeearrangementisperfectforallsituations,andthelow-costsolutionmaynotbetheonethatcandeliveroptimalafter-taxresults.Theinvestorverysimplyneedstodetermineifthefeearrange-mentofferedwillmotivatetheproviderstoachieveanoptimaltax-awaresolution.

Investorsorprospectswhoareseekingfinancialserviceprovidersandwishtodevelopaqualifiedtriumvirateofprofessionals,shouldconsiderthesequestions:

❑ Cantheskillsrequiredofthequalifiedtriumviratebesatisfiedbyone 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 todeliveratax-awareapproach?


Tax-awareinvestmentmanagementrequireslong-lastingrelationshipstoachieve favorableresults.Therefore,providers thatoffer thequalifiedtriumvirateofnecessary skillswith servicingplatformsand fee arrange-mentsandcanultimatelyobtaintheclient’strustwillbetheonesmostlikelytosucceed.

ChapterNotes

1. DavidH.Maister,TheTrustedAdvisor(NewYork:Touchstone,2001),9–10.

P A R T T W O

55

All taxes are a drag on economic growth. It’s only a question ofdegree.

—AlanGreenspan

After-TaxReportingandMeasuresofTaxEfficiency


1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

C H A P T E R 6

MutualFundAfter-Tax

Reporting

57

The after-tax reporting standards proposed by the Securities andExchangeCommission(SEC)weresignedintolawasthelastof-ficialactoftheClintonadministration.Sinceearly2001,after-tax

returnshavebeenrequiredintherisk/returnsummaryoftheprospectus,withtheexceptionofmoneymarketfundsandthosemarketedsolelytotax-exemptaccounts.1Thislegislationhashadaprofoundimpactontax-aware investmentmanagementbyensuring that the impactof taxesoninvestmentreturnswouldreachthemillionsofindividualinvestorswhoholdmutualfunds.

Thepaintaxablemutualfundshareholdersexperiencedduringthelat-terhalfofthe1990screatedthedemandforafter-taxreporting,asFIGURE

6.1fromtheInvestmentCompanyInstitute(ICI)highlights.2Figure6.1Asmentionedinchapter1,Congressaddressedtheconcernoffund

shareholdersinMarchof2000.Concurrently,theSECissuedaproposalforpubliccomment.Itreceivedinputfromprofessionalorganizationssuchas the Association for Investment Management and Research (AIMR),whichadoptedafter-taxreportingstandardsforseparateaccountsin1994,alongwithseveralhundredresponsesfromindividualmutualfundinves-tors.Asexpected,AIMRandmutual fund shareholderswereextremelysupportiveoftheSECinitiative.Interestinglyenough,thegreatestnum-

It’snotwhatyoumake,it’swhatyoukeep.

—Anonymous

58 After-TaxReportingandMeasuresofTaxEfficiency

berofcommentscamefromvisitorstotheMotleyFoolwebsite.Theweb-site’seducationinitiativewascertainlynotfoolishwithregardtotax-awareinvestmentmanagement,andvisitorswereencouragedtorespondtotheSECinsupportoftheproposal.However,severalprofessionalorganiza-tionslobbiedtooverturnthestandardsevenaftertheyweresignedintolawbyPresidentClinton.Inspiteofthesechallenges,U.S.SecuritiesandExchangeCommission,FinalRule:DisclosureofMutualFundAfter-TaxReturns,SectionII.D,cameaboutonApril16,2001.Readerscanobtainacopyofthemutualfundafter-taxstandardsbyvisitingtheSEC’swebsite(www.sec.gov). This document should certainly be part of the libraryofanyprofessionalwhointeractswithtaxable investorsholdingmutualfunds.

Aperformancedisplay fromanactual fundreport for theVanguardTax-Managed Growth and Income Fund for periods ending June 30,2004,willhighlight severalkeypointsabout the standards (seeFIGURE

6.2).Ithasanenviablerecordofnothavingmadeanycapitalgainsdistri-butionssinceitsinceptionin1994.3Thisfundwasselectedforillustrativepurposes,notasanendorsementoftheproduct.

Sourc

e:In

vest

ment

Com

pany

Inst

itute

,2

00

4M

utu

alFundF

act

Book(

ww

w.ici.org

).R

epri

nte

dw

ithp

erm

issi

on.

FIGURE6.1 CapitalGainDistributionsPaidbyMutualFunds,1996–2003(billionsofdollars)

*Householdsaredefinedtoexcludemutualfundassetsattributedtobusinesscorporations,financialinstitutions,nonprofitorganizations,fiduciaries,andotherinstitutionalinvestors.

Note:Componentsmanynotaddtothetotalbecauseofrounding.

100

1996

53

30

17

183

1997

97

60

26

238

1999

143

68

27

326

2000

194

95

37

165

1998

97

49

18

Tax-DeferredHouseholdAccounts*

TaxableHouseholdAccounts*

Non-HouseholdAccounts

16

2002

952

69

2001

49

14 6

14

2003

753

Figure6.1Rogers

*Householdsaredefinedtoexcludemutual fundassetsattributedtobusinesscorporations, financial

institutions,nonprofitorganizations,fiduciaries,andotherinstitutionalinvestors.

Note:

Componentsmaynotaddtothetotalbecauseofrounding.

MutualFundAfter-TaxReporting 59

ThefigureshowsthetwodifferentmethodsrequiredbytheSECforpresentingafter-taxreturnsinalogicalprogressionthatbuildsonthebe-fore-taxreturns.Thefirstrow,“ReturnBeforeTaxes,”isthesameinfor-mationrequiredfordisplayingpretaxreturnsandincludestheimpactoffees.Thesecondrow,“ReturnAfterTaxesonDistributions,”takes intoaccountonlythetaxesonincomeandcapitalgainsdistributions.Asmen-tioned in chapter 3, this is known as the pre-liquidation methodologyfor calculating after-tax returns.The third row, “ReturnAfterTaxesonDistributionsandSalesofFundShares,”isknownasthepost-liquidationcalculationmethodology.

Bothcalculationmethodologiesprovideusefulinformation.Togethertheyallowthetaxablemutualfundinvestortomakebetter-informedin-vestmentdecisions.There are caseswhereonecalculationmethodologyor type of after-tax return is more appropriate than the other. For ex-ample,thepre-liquidationafter-taxreturninformationisappropriateforindividualswhowilltakeadvantageofthestep-upinbasisatdeath.Forsomeonewhoisrebalancingaclient’sassetallocation,thepost-liquidationmethodologyismoreappropriate,becauseittakesintoaccounttheimpact

FIGURE6.2 SampleDisplayofMutualFundAfter-TaxReturnReporting

VanguardTax-ManagedGrowthandIncomeFund

AverageAnnualTotalReturns*

PERIODSENDEDJUNE30,2004

SINCE

ONEYEAR FIVEYEARS INCEPTION**

ReturnBeforeTaxes 17.86% –2.16% 11.06%

ReturnAfterTaxeson

Distributions 17.58 –2.56 10.76

ReturnAfterTaxeson

DistributionsandSalesof

FundShares 11.95 –2.04 9.77

*Allfundreturnsareadjustedtoreflectfees.EachoftheVanguardTax-ManagedFundsassessesa2

percentfeeonredemptionofsharesheldinthefundforlessthanoneyearanda1percentfeeonre-

demptionsofsharesheldinthefundforatleastoneyearbutlessthanfiveyears.

**InceptiondateisSeptember6,1994.

Sourc

e:Vanguard

Gro

up,

Vanguard

Tax-

ManagedF

unds

Sem

iannualR

eport

,Ju

ne3

0,

20

04

,1

9.


oftheclient’sunrealizedcapitalgainorlosspositionontheafter-taxreturnwhenfundsharesaresold.

TheSECrequiresthehighestfederaltaxratestobeappliedwhencal-culatingafter-taxreturns.Althoughthismaynotrepresentthetaxprofileoftheaverageinvestor,itdoesprovidethemostconservativescenario.Ifyourowntaxsituationorthatofyourclientsisdifferent,checkthewebsiteofyourmutualfundprovider,assomefirmshavecreatedonlinecalcula-torsthatallowinvestorstoapplytheirpersonaltaxprofiletoanalyzehis-toricalafter-taxresults.

Inthe“OneYear”column,thehighestfederaltaxrateisappliedeventhoughthefundwouldqualifyforthemorefavorablelong-termcapitalgainsrateifheldforonemoreday.Thiswasoneofthemorecontrover-sialelementsof theafter-taxproposal,asmanyprofessionalswithinthefundindustrythoughtitwasunrealistic.However,theSECfeltstronglythiswasnecessary,sincetheaverageholdingperiodformutualfundshadfallensignificantlyduringthe1990s.Thisrequirementhighlightsthecon-ceptthatifyoudon’tholdafundformorethanayearitisimpossibletotakeadvantageofthebenefitofthelowerrateforlong-termcapitalgains,currently15percent.

Anotherkeypointisthatafter-taxreturnscanbegreaterthanpretaxreturns for information shown in the row“ReturnAfterTaxesonDis-tributions andSales ofFundShares” calculatedby thepost-liquidationmethodology.Ifthefundissoldwhenthemarketvalueisbelowcost,acreditisgiventotheafter-taxreturn,becauseliketheAIMRstandardsforseparateaccounts,theSECstandardformutualfundsassumesthelosscanbeusedtooffsetagaininanotherfundorportfolioorbeappliedinthefuture.Forexample,ifafundisheldlessthanayear,the35percentfed-eraltaxrateapplies.Therefore,ifthebefore-taxreturnis–10percentwithnodividenddistributions,the“ReturnAfterTaxesonDistributionsandSalesofFundShares”wouldbeonly–6.5percent(10%×[1–35%]).Anexampleofthissituationisinthecolumnmarked“FiveYears”inFIGURE

6.2.Allthereturnsarenegative,butthe“ReturnAfterTaxesonDistribu-tionsandSalesofFundShares”(–2.04percent)isgreaterthanthe“ReturnAfterTaxesonDistributions”(–2.56percent)and“ReturnBeforeTaxes”(–2.16percent).Althoughthedifferencesinthisexamplearequitesmall,theywouldbemuchlargerifthedisplayhadbeentakenfromthespringof2003,whenlarge-capitalizationstocksonaveragehadbeensubjecttothreeyearsofnegativereturns.

While the SEC after-tax standards provide mutual fund investorswithmeaningfulinformation,twoadditionalitemsshouldbeconsideredtomaketrulyinformedinvestmentdecisions.Thefirstpertainsprimarilytoequityfunds,whereasthesecondappliestobondfunds.Eventhough


itwasanAIMRSubcommitteerecommendation,theSECultimatelyde-cidednot to require thepercentageofunrealizedgainsor losses in theperformance display.4 With taxable accounts—in contrast to the tax-exemptaccountarena—whatthefundhasdoneinthepastinfactcananddoeshaveasignificantimpactonfutureafter-taxreturns.Tohigh-lightthispoint,recallthatinvestorsinthelatter1990swereconcernedabouthowtoavoidequityfundswithsubstantialunrealizedcapitalgainspositions, which reached 50 percent of total assets or more for large-capitalization,growth-orientedstylefunds.Forexample,theStagecoachEquityFundIndex–AFundhadanunrealizedgainpositionof70per-cent!5Somepractitionerseventhoughtfundswithlargeunrealizedcapi-talgainspositionsshouldhaveincludedawarninglabel,similartotheoneonapackofcigarettes,statingthatinvestinginthemcouldresultindetrimental taxconsequences.The situationbecamesuchaconcern in1999 that some fundgroupscontemplatedopeningvintageyear indexfunds for their taxable investors.By the springof2003 thependulumhadswungtotheoppositedirection,andafterthreeyearsoflossestherewasanopportunitytopurchasefundswithsubstantialembeddedunreal-izedlosses.Whilethepercentageofunrealizedcapitalgainsembeddedinafundislimitedto100percentofassets,thepercentageoflossescanbegreaterthan100percent.Thisoccurswhenfundmanagerssellsharesandlossescannotbepassedthroughtoshareholders,becauseoftheaccount-ingconventionthatfundsmustapply.Iftheredemptionsaresignificantand the manager must sell shares below cost, the amount of losses indollarscanexceedtheremainingassetsinthefund.AsofJune30,2004,therewereapproximately5,900mutualfundsonMorningstarPrincipiathatshowedanegativepercentageofunrealizedcapitalgainswithafewcloseto–1,000percent!6Adviserscanaddmeaningfulvaluefortheircli-entsbyconsideringthepercentageofunrealizedcapitalgainsofpossiblefundalternativeswhentheymakepurchaserecommendationsforthetax-ableportionofassets.Giventwofundsthatareequalineverydimensionexcept theunrealizedcapitalgainsposition, the tax-aware investorwillalwayschoosetheonewiththeleastamountofunrealizedgainsorgreat-estamountofunrealizedlosses.Aswewillseelaterinthischapter,theaccounting convention lends itself to arbitrage opportunities, or whatsomemayconsidera“freelunch.”

Fortunately for the taxable investor, information pertaining to thepercentageofunrealizedcapitalgainsor lossescanbeobtained fromaMorningstar InvestmentDetailReport (againusing theVanguardTax-Managed Growth and Income Fund as an example).7 As FIGURE 6.3shows,thisparticularfundhadaninternal+6percentunrealizedcapitalgainsposition.Thispercentagechangeswiththemarketvalueofsecuri-


FIGURE6.3 ExampleofMorningstarPrincipiaDisplay

MutualFundAfter-TaxReturnInformation

TAXANALYSIS TAX-ADJRTN% %RANKCAT TAX-COSTRATIO %RANKCAT

3Yr(estimated) 2.78 35 0.46 36

5Yr(estimated) –2.72 43 0.44 23

10Yr(estimated) 11.50 7 0.53 8

PotentialCapitalGainExposure:6%ofassets

*Allfundreturnsareadjustedtoreflectfees.EachoftheVanguardTax-ManagedFundsassessesa2

percentfeeonredemptionofsharesheldinthefundforlessthanoneyearanda1percentfeeonre-

demptionsofsharesheldinthefundforatleastoneyearbutlessthanfiveyears.

**InceptiondateisSeptember6,1994.


1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 12-04 HISTORY

9.77 13.16 15.89 20.88 26.55 31.81 28.66 24.93 19.15 24.23 26.36 NAV

–1.70* 37.53 23.03 33.31 28.67 21.12 –9.03 –11.93 –21.95 28.53 10.83 TotalReturn%

0.00 0.09 –0.04 0.10 0.08 0.07 –0.05 0.14 –0.14 –0.04 +/–S&P500

–0.24 0.58 0.46 1.65 0.21 –1.24 0.52 –0.30 –1.36 –0.57 +/–Russ1000

0.00 2.58 2.14 1.77 1.40 1.19 0.94 1.05 1.31 1.79 1.95 IncomeReturn%

34.95 20.89 31.54 27.27 19.93 –9.97 –12.98 –23.26 26.74 8.88 CapitalReturn%

12 28 13 15 37 63 44 42 29 35 TotalRtn%RankCat

0.09 0.25 0.28 0.28 0.29 0.31 0.30 0.30 0.33 0.34 0.47 Income$

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 CapitalGains$

0.20 0.20 0.20 0.17 0.19 0.19 0.19 0.17 0.17 0.17 ExpenseRatio%

2.82 2.37 2.04 1.62 1.32 1.11 0.96 1.44 1.44 1.63 IncomeRatio%

6 7 2 4 4 5 5 9 5 TurnoverRate%

31 98 235 579 1,352 2,240 2,427 1,606 1,077 1,321 1,395 NetAssets$mil

*InceptiondateisSeptember6,1994.

Sourc

e:M

orn

ingst

ar


tiesheldintheportfolioandshareholderpurchaseandredemptionactiv-ity.Figure6.3alsoshowstheafter-taxreturns,tax-costratios,andrelativerankinginformationMorningstarprovidesitssubscribersforthree-,five-andten-yearperiods.Anexplanationoftheinformationprovidedinthefourcolumnsfollows:

1 Tax-AdjustedReturnPercentage—ThisisMorningstar’scalcula-tionthatfollowstheSECguidanceforreturnaftertaxesondistribu-tions,orpre-liquidationafter-taxreturns.Itshouldbenotedthatafter-taxreturnsalsoincludetheimpactofloads,whenappropriate.2 PercentileRankCategory—Morningstargivesthefund’srelativepercentile rankingwithin its peer group.Figure6.3 shows that forthepasttenyears,theVanguardTax-ManagedGrowthandIncomeFundwasrankedat7,whichmeanssixoutof100fundshadsuperiorresults.3 Tax-CostRatio—In this column,Morningstar employs apro-prietarymeasuretocalculatetheamountofreturnthatwouldhavebeenlosteachyeartopaymentoftaxes.Forthepasttenyearsthis


1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 12-04 HISTORY

9.77 13.16 15.89 20.88 26.55 31.81 28.66 24.93 19.15 24.23 26.36 NAV

–1.70* 37.53 23.03 33.31 28.67 21.12 –9.03 –11.93 –21.95 28.53 10.83 TotalReturn%

0.00 0.09 –0.04 0.10 0.08 0.07 –0.05 0.14 –0.14 –0.04 +/–S&P500

–0.24 0.58 0.46 1.65 0.21 –1.24 0.52 –0.30 –1.36 –0.57 +/–Russ1000

0.00 2.58 2.14 1.77 1.40 1.19 0.94 1.05 1.31 1.79 1.95 IncomeReturn%

34.95 20.89 31.54 27.27 19.93 –9.97 –12.98 –23.26 26.74 8.88 CapitalReturn%

12 28 13 15 37 63 44 42 29 35 TotalRtn%RankCat

0.09 0.25 0.28 0.28 0.29 0.31 0.30 0.30 0.33 0.34 0.47 Income$

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 CapitalGains$

0.20 0.20 0.20 0.17 0.19 0.19 0.19 0.17 0.17 0.17 ExpenseRatio%

2.82 2.37 2.04 1.62 1.32 1.11 0.96 1.44 1.44 1.63 IncomeRatio%

6 7 2 4 4 5 5 9 5 TurnoverRate%

31 98 235 579 1,352 2,240 2,427 1,606 1,077 1,321 1,395 NetAssets$mil

*InceptiondateisSeptember6,1994.

Sourc

e:

Morn

ingst

ar


fundwouldhavelost0.53percentonaverageeachyeartothepay-mentoftaxes.4 PercentileRankCategory—Morningstaralsogivesarelativeper-centilerankingonthetax-costratio.Inthisexample,thefundhasarankingof8basedonthetax-costratiooverthepastten-yearperiodofanalysis.

Abitofexperienceandseveralpiecesofinformationarerequiredtomakesagedecisionswhenrecommendingmutualfundsfortaxableinves-torsorforpersonalinvestment.Inadditiontoreturn-relatedinformation,itisalsohelpfultoreviewthehistoryofincomeandcapitalgainsdistribu-tionsplusexpenses.

Fortunately,theMorningstarInvestmentDetailReportprovidesthisinformation,aswell(seeFIGURE6.4).8Reviewingthecalculation-onlyin-formation,oneimmediatelywonders,whyisn’tthetax-costratiorelativepercentile ranking for theVanguardTax-ManagedGrowth and IncomeFundhigherthan23forthefive-yearperiodofanalysis?The23percen-tilerankingisgood,butonemightexpectthemeasuretobehigher,es-pecially sinceonly a smallpercentageof stock funds truly focuson taxmanagement.The tax-cost ratio isdrivenby three factors: capital gainsdistributions fromtradingactivity, theamountof incomeordividends,andtheexpenseratio.Asmentionedearlier,theMorningstarreportshowsthis fundhasnevermadeacapitalgainsdistribution,asevidentby therowmarked“CapitalGains$,”sothisisnotacontributingfactor.There-fore,theamountoftaxesmustbearesultoftheamountofnettaxabledividendsgeneratedby theportfolio.Fromthefigure, youcanalso seethefund’s“IncomeRatio%”for2003was+1.63percent.Additionally,thefundhashadalow“ExpenseRatio%”ofonly0.17percentforthepastthreeyears.Therefore,in2003itwouldhavehadagrossincomeordividendyieldbeforefeesof+1.80percent(1.63percent+0.17percent).Inthiscase, theportfolioreplicates thecompositionof theStandard&Poor’s500stockindex.Tolowerthetax-costratioandimprovetherelativeranking,Vanguardcouldremovethe1percentredemptionfee,manageaportfoliothatpaysdividendsequaltoorlessthanitsfeesof+0.17percent,orincreasethemanagementfee.Totakeanyofthesemeasureswouldnotmakesense.Sotherelativerankingof23percentforthefive-yearperiodisaboutashighascoreasVanguardislikelytoachieve.Thissimpleex-ample demonstrates that it often takes several pieces of information tomakesound,tax-awareinvestmentdecisions.

Theotherfactorpertainstotax-exemptormunicipalbonds.Unlessthereisachangeinthetaxcodeforindividuals,moreandmoreinvestorswillbesubjecttothealternativeminimumtax(AMT)(seeFIGURE6.5).9


Mostinvestorsdonotrealizethatfundsholdinglessthan20percentofprivateactivitybondsissuedafter1986subjecttotheAMTarepermittedtocallthemselvestax-exemptbondfunds,whereasfundsholdinggreaterthan20percentofAMTissuesareclassifiedasmunicipalbondfunds.ForindividualssubjecttotheAMT,privateactivitybondsaretaxedatarateof26percentor28percent,dependingontheamountofalternativemini-mumtaxable income(AMTI).10Tax-awareadvisersestablishprocedurestoavoidplacingclientssubjecttotheAMTinmunicipalortax-exemptbondfundswithAMTexposure.Todealwiththischallenge,itisessentialtoperiodicallycallfundcomplexestoobtaintheirexposuretoprivateac-tivitybondssubjecttotheAMT.

Althoughthe titleof thischapteremphasizesafter-taxreporting,wecannotsimply ignorethe impacttheaccountingconventionformutualfund investinghason theactual after-tax results investorsmayachieve,which canbenefit certain taxable shareholders anddisadvantageothers.Unlikeseparateaccounts,mutualfundscannotpasslossesthroughtoin-vestors.Furthermore,theycanonlytakeadvantageofalossbyusingittooffsetarealizedgainforaperioduptoeightyears,whereaswithaseparateaccountanindividualcanusethemindefinitely.

Wheninvestorspurchasesharesinamutualfund,theyestablishtheircostbasis.Thefollowingexampleillustrateshowthetimingofapurchasecanresultinquitedifferenttaxconsequenceswhenadistributionofcapi-talgainsismade.Let’sassumeamutualfundiscreatedonJanuary1witha$10,000purchaseofsharesbyourfirstinvestor,andineachofthenext

FIGURE6.5 IndividualAMTReturnsandTaxesCollected

Rogers/TaxAwareFig.6.5

18

16

14

12

10

8

6

4

2

–

50

45

40

35

30

25

20

15

10

5

–1990 1995 2000 2005 2010

AM

Tr

etu

rns

($m

illions)

AM

Tr

eve

nue(

$b

illions)

AMTreturns

AMTrevenue

Sourc

e:C

ongre

ssm

anJ

imS

axt

on,C

hair

man,Jo

int

Econom

icC

om

mit

tee,

The

Alt

ern

ati

veM

inim

um

Tax

for

Indiv

iduals

:A

Gro

win

gB

urd

en,

Congre

ssio

nal

Budget

Off

ice2

00

1,

U.S

.C

ongre

ss,M

ay

20

01

.


ninemonthsanewinvestorpurchases$10,000ofshares.Additionally,thefundappreciates1percenteachmonth(seeFIGURE6.6).

Attheendoftenmonths,thefundhasteninvestorswhohavecon-tributedatotalof$100,000.Thenetassetvalueofthefundis$11.05.After tenmonthsof consistent appreciation, the fundhas a total value$105,704.52(9,566.02shares×$11.05).Thefundhasincreasedinvaluebeyond the contributions of shareholders by $5,704.52 ($105,704.52–$100,000).OnNovember1,thedirectorsofthefundannouncethatallshareholdersofrecordonthatdaywillreceiveacapitalgainsdistributionof$5,704.52,or100percentoftheprofitearnedsinceJanuary1.Sincetherearenow9,556.02sharesoutstanding,acapitalgainsdistributionof$0.59($5,704.52/9,556.02shares)willbemadetoeachshare.

ThelastcolumninFIGURE6.7showsthedollaramountofthecapitalgainsdistributionmadetoeachofthetenshareholders.Notethediffer-encebetweenthecolumnsmarked“Profit”and“CapitalGainsDistribu-tion”forinvestors1and10.Shareholder1hasmadeaprofitof$1,050,takingintoaccountthecurrentclosingpriceofthefund,butonlyhastopaytaxeson$590incapitalgains,whereasshareholder10hasaprofitof

FIGURE6.6 MutualFundShareholderAccountingExample

MONTHLY ENDINGMONTH INVESTOR INVESTMENT VALUE SHARES VALUE

January 1 $10,000.00 $10.00 1,000.00 $10.10

February 2 $10,000.00 $10.10 990.10 $10.20

March 3 $10,000.00 $10.20 980.30 $10.30

April 4 $10,000.00 $10.30 970.59 $10.41

May 5 $10,000.00 $10.41 960.98 $10.51

June 6 $10,000.00 $10.51 951.47 $10.62

July 7 $10,000.00 $10.62 942.05 $10.72

August 8 $10,000.00 $10.72 932.72 $10.83

September 9 $10,000.00 $10.83 923.48 $10.94

October 10 $10,000.00 $10.94 914.34 $11.05

Total 10 $100,000.00 9,566.02

Sourc

e:D

ougla

sS

.R

ogers


only$103.46andhastopaytaxeson$539.46incapitalgains.Whenyoucompare the twocolumns,no investorhasaprofitexactlyequal to thecapitalgainsdistribution.Thisexampleisfairlystraightforward,butinves-torstypicallymakeinvestmentsovermanyyearsandmostfundshavebothincomeandcapitalgainsdistributions.

Howdramaticcanthisinjusticebetweenshareholdersbe?Toanswerthisquestionweneedtolookbackto1987.Duringthe“correctionof1987,” stocks rose significantly during the summer and early fall, butthentheyhemorrhagedinthethirdweekofOctober.ManymutualfundshaveOctober31astheirfiscalyear-end.Therefore,therewerecaseswhereindividualinvestorspurchasedsharesinequitymutualfunds,sawtheirinvestmentdrop20percentorsoinvalue,andthengothitwithasizablecapitalgainsdistribution.Fortunately,themarketgraduallyrebounded,butmanyofthoseinvestorswereforcedtosellsharesatunfavorablepric-estocovertheirtaxbillthefollowingyear.

Congress has attempted to rectify this situation, but though well-intentioned,thesolutionoftendisregardsthebasicfailureofmanagerstotaketaxesintoaccountwhenmanagingtheirfunds.Forexample,Con-gressmanJimSaxtonhasproposedlegislation(H.R.168)thatwouldallow

Sourc

e:D

ougla

sS

.R

ogers

FIGURE6.7 MutualFundExample:Profitvs.CapitalGainsDistributions

DOLLAR MARKET CAPITALGAINS INVESTOR INVESTMENT SHARES VALUE PROFIT DISTRIBUTION

1 $10,000.00 1000.00 $11,050.00 $1,050.00 $590.00

2 $10,000.00 990.10 $10,940.61 $940.61 $584.16

3 $10,000.00 980.30 $10,832.32 $832.32 $578.38

4 $10,000.00 970.59 $10,725.02 $725.02 $572.65

5 $10,000.00 960.98 $10,618.83 $618.83 $566.98

6 $10,000.00 951.47 $10,513.74 $513.74 $561.37

7 $10,000.00 942.05 $10,409.65 $409.65 $555.81

8 $10,000.00 932.72 $10,306.56 $306.56 $550.30

9 $10,000.00 923.48 $10,204.45 $204.45 $544.85

10 $10,000.00 914.34 $10,103.46 $103.46 $539.46


each individualanannualdeduction fromcapitalgainsdistributions.11Also, Congressman Paul Ryan has introduced legislation (H.R. 1989)thatwouldrequire individuals topay taxesoncapitalgainsonlywhentheysellfundshares.12Bothproposalsareintendedtomakethingseasierformutualfundinvestors.However,whatisoftenignoredisthatthesebillswouldonlyexacerbatetheproblemofportfoliomanagersignoringtheimpactoftaxes.Moreover,aswewilldiscoverinchapter9,therearealreadyfreemarketsolutionsthathavesolvedthisissue.Unfortunately,tax-awaresolutionsdonotvoteandtheshareholderswhousethemstillrepresentasmallportionofthemarket.IfCongressreallywantstopro-videinvestorswithameaningfulchange,itshouldchangetheaccountingconventionformutualfundstoallowlossestoflowthroughtoinvestors.Itmaytakeseveralyears, ifever,forafundmanagertotakeadvantageof the lossposition,whereas individual investorsmaybeable toapplythemimmediatelysincetheytypicallyholdmultiplefundsandportfolioswheregainscanbetaken.

Theactualafter-taxreturns for individualswhoinvest indollar-costaveragingprogramsorreinvestfunddistributionscanbequitedifferent,dependingonwhataccountingconventiontheypersonallyapply.Therearethreeprimaryaccountingconventionsthatinvestorsandtheiradvisersshouldbeconcernedwith:

❑ Firstin,firstout❑ Specificlotidentification❑ Averagecost

TheIRSallowsinvestorslatitudeinchoosingtheirpreferredmethod.Theaveragecostmethodistypicallythedefaultmethodusedbycustodi-ans.Therefore,ifyoudesiretoapplyoneofthefirsttwoconventions,youneedtomakeanelectionbeforetransactionsareaccountedforbytheaver-agecostmethod.Theparticularaccountingconventionappliedcanhaveasignificantimpactontheamountoftaxesthatwillbepaidinanyyear.Itwillnotchangethedollaramountofcapitalgains,butitcanchangeorshiftthetaxliabilityconsiderably.Thiscanbeseeninthefollowingexam-ple,usingmonthlypricesfromtheVanguard500IndexFundin2003.13TheinvestorstartswithaninitialpurchaseinJanuaryof$3,000tosatisfytheaccountminimumandmakesadditionalpurchasesineachofthenextsevenmonthsforatotalinvestmentof$10,000(seeFIGURE6.8).

Duringthistimeframe,themarketbottomedinthespringandralliedstronglyfortheremainderoftheyear.Eventhoughtheinvestorintendedtohavealong-terminvestmenthorizon,inDecemberheranintoasitua-tionthatforcedhimtosellthirtysharesatthepriceof$102.67.Hewillbe


requiredtopaytaxesonthetransactionatthefederalshort-termcapitalgainsrateof35percent.AsFIGURE6.9shows,thethreedifferentaccountingconventionsresultintaxobligationsrangingfrom$326.93to$709.85.

Firstin,firstout(FIFO)accountingismechanicalinnatureandprob-ablysatisfactoryforfixedincomefundswhereappreciationisusuallynota significantpartof the total return.AsFigure6.9 shows, thirty shareswereusedtoestablishthecostbasisfromthefirstpurchase.Ifmorethan37.97shares—thenumberofsharesacquired inthe initialpurchase,ortax lot—were sold, itwouldbenecessary to examine the second-oldestpurchaseandcontinuetheprocessuntilsharesequalingtheamountofthesaletransactionwereaccountedfor.

Specificlotidentificationrequiresabitofextrawork,butthebenefitcanbewellworththeeffort.AsFigure6.9shows, thefirst lotchosenwas the one with the highest cost basis, followed by the lot with thenext-highestcostbasis,andsoonuntilatotalof30sharesisreached.Therefore, only 8.37 of the total 11.11 shares in tax lot 6 are used.Theremaining2.74shareswillbeaccountedforduringafuturesaleofshares.Thismethodrequiresaccurateaccountingrecords.Theexampleaboveisquitesimpleanddidnotincludeanyreinvestmentofdistribu-tions.Toensurethattheyarekeepingadequaterecordsandadheringtoproperprocedures,taxableinvestorsandtheiradvisersshouldadoptthe

Sourc

e:D

ougla

sS

.R

ogers

FIGURE6.8 MutualFundAccountingConventionExample

DOLLAR PURCHASE ENDING PROFIT/MONTH PURCHASE INVESTMENT PRICE SHARES VALUE LOSS

January 1 $3,000.00 $79.02 37.97 $3,897.87 $897.87

February 2 $1,000.00 $77.82 12.85 $1,319.33 $319.33

March 3 $1,000.00 $78.27 12.78 $1,311.74 $311.74

April 4 $1,000.00 $84.73 11.80 $1,211.73 $211.73

May 5 $1,000.00 $89.19 11.21 $1,151.14 $151.14

June 6 $1,000.00 $90.02 11.11 $1,140.52 $140.52

July 7 $1,000.00 $91.59 10.92 $1,120.97 $120.97

August 8 $1,000.00 $93.36 10.71 $1,099.72 $99.72

December 10 $10,000.00 102.67 119.34 $12,253.03$2,253.03

formatshowninIRSPublication564,MutualFundDistributions (seeFIGURE6.10).14

Highin,firstout(HIFO)isanotheraccountingconventionthatmayencounteredwithseparateaccountmanagement,withslightlylessoner-ousrequirementsthanspecificlotidentification.FIFOoftenyieldsaresultequalorsimilartospecificlotidentification,butthelatterstrategyoffersmorefreedomofchoice.

Averagecostissimplycalculatedbytakingthetotalamountoffundsusedtopurchasesharesanddividingbythetotalnumberofshares.Again,thisisthedefaultmethodusedbymostcustodians.Inthisexample,thetaxobligationusingaveragecostfellbetweenthoseusingtheFIFOandspe-cificlotidentificationconventions,butthismaynotalwaysbethecase.

Ourexamplefocusesonlyon2003.However,thefutureisimportantaswell:inthiscase,thenextsalewillmostlikelycausesomeorallortheremainingpurchasesortaxlotstoqualifyforthemorefavorablerateon

FIGURE6.9 MutualFundAccountingConventionExample

PURCHASE FIRSTIN SPECIFICLOT AVERAGE LOT SHARES PRICE FIRSTOUT IDENTIFICATION BASIS

SharesSold 30.00 30.00 30.00

Price $102.67 $102.67 $102.67

TotalValue $3,080.10 $3,080.10 $3,080.10

Cost 1 30.00 $79.02 $2,370.60

8 10.71 $93.36 $1,000.00

7 10.92 $91.59 $1,000.00

6 8.37 $90.02 $753.52

All 30.00 $83.79 $2,513.70

TotalCost $2,370.60 $2,753.52$2,513.70 Gain/Loss $709.50 $326.58 $566.40 TaxRate 35.0% 35.0% 35.0% TaxDue $709.85 $326.93 $566.75


Sourc

e:D

ougla

sS

.R

ogers


long-termcapital gains.TheFIFOmethodwillmost likelyprove evenmorecostly, as itwouldhaveexpendedmostof theoldest lotwith thegreatestamountofappreciationpersharetobetaxedat35percentandasmalleramountofcapitalgainsnowremainsintheportfolio.Thisex-ampledemonstratesthatitmaybeworththeadditionaltimeandexpensetouseanaccountingconventionotherthanaveragecostfortheparticulartypeoffundandthesizeoftheinvestment.

The tax actof2003maygodown inhistory as “the taxbreak theaverageindividualneverreceived!”15Mutualfundscansaveshareholderstaxesbyapplyingtheincometheyreceivefromdividendstooffsetfundexpenses. Prior to 2003, this worked to the advantage of the averageshareholder,asitdoesn’tmakesensetodistributeadividendandpaya38.6percent(themaximumfederalrateatthetime)taxonitwhenitcanbeavoided.However,whenthetaxonqualifieddividendswasreducedto15percent,manyholdersof activelymanaged equitymutual fundsreceivedalmostnoneofthetaxbreak.Forexample,thefeeontheaverageactivelymanageddomesticstockiscurrently1.5percentandtheaveragedividendyieldisonly1.6percent.Sinceonly0.1percentoftaxabledivi-

FIGURE6.10 SampleMutualFundAccountingFormat

ACQUIRED1

SOLDOR REDEEMED

NUMBER COST ADJUSTMENTTO ADJUSTED2 NUMBER

MUTUAL DATE OF PER BASISPER BASISPER OF

FUND SHARES SHARE SHARE SHARE DATE SHARES

1Includesharereceivedfromreinvestmentofdistributions.

2Costplusorminusadjustments

Sourc

e:In

tern

alR

eve

nueS

erv

iceP

ublicati

on5

64


dendsaredistributed,thereisverylittleincomeleft,ifany,afterthefundusesittooffsetexpenses.Thegroupsofshareholdersreceivingalmostallofthebenefitofthefavorabletaxlegislationarethoseinvestedinlow-feeindex-oriented mutual or exchange-traded funds. For a shareholder inafundwithafeeof0.2percent,thelowertaxondividendsresultedinan enhancement in after-tax returnof0.33percent ([1.6%–0.2%]×[38.5%–15.0%])annuallyversus0.02percent([1.6%–1.5%]×[38.5%–15.0%]), or almostnothing for the average activelymanaged equityfund.Onceagain, this example showshow important fees andabasicunderstandingofthetaxcodecanbe.Whenthislegislationcameabout,theauthorwas interviewedbyamajorfinancial servicesmagazineandmadethishisnumberonepoint.Doyouthinkitwasincludedwhenthestorywenttopress?Ofcoursenot,becauselow-feefundsdon’tsupportadvertisingbudgets!Thisoccurrencesupportsthepremisethattax-awareproductsareboughtbyinformedinvestorsandnotsoldthroughexpen-sivemarketingandadvertisingefforts.Onceagain,educationprovestobeparamountintax-awareinvesting.

MutualfundtaxinformationisreportedtotheshareholderonForm1099DIV,whichisshowninFIGURE6.11for2003.AswithallIRSforms,theformatofForm1099-DIVmaychangefromyeartoyear,dependingonchangesinthetaxcode.

Themostcritical information thatan investorwill encounter is ad-dressedinthefollowingsectionsoftheform:

1a Total ordinary dividends—includes ordinary income and short-termcapitalgains.

1b Qualifieddividends—dividendsthatqualifyforthemorefavorablerateonlong-termcapitalgains.

2a Totalcapitalgainsdistributions—long-termcapitalgains.2d UnrecapturedSection1250gains—attributabletodepreciablereal

estateinvestments.3 Nontaxabledistributions—distributions thatarenot taxable,but

thecostbasismustbereducedbythisamount.6 Foreigntaxespaid—aninvestormaybeabletotakeadeductionfor

thisamount.

Sections1through2aapplytomostfunds,whereassections2dand3applytorealestateinvestmenttrustsandsection6appliestointerna-tional stock funds.Oneof theproblemswithmutual fund tax report-ingisthatshort-termcapitalgainsarelumpedinwithtaxableincome.Therefore,ifaninvestorhasshort-termlossesthatcouldbeusedtooffsettheshort-termgainsfromthefundholding,thereisnowaytoobtaintheinformation.16


Alltoooften,theinvestorpaystaxesonthedistributionwhenreportedonForm1099-DIVandthenagainwhensharesaresold.Thus,thein-vestormayinadvertentlypaytaxesonthesameamountofcapitalgainstwice!This happens more frequently than most people realize, becausemanyfundshareholdersdonotunderstandtheaccountinginvolvedandfailtokeepgoodrecords.Thisbringsustothefollowingrulesofthumbformutualfundinvestors:

❑ Besuretocheckwhenthefund’sfiscalyearendsandtheamountof incomeandcapital gainsdistributions anticipatedbeforemakingan investment, soyouwillnotenduppaying taxesona significantamountofcapitalgainsyoudidnotearn.❑ Keepinmindthatwhennewinvestorsmakecontributionstoafundinarisingmarket,taxablegainsarelikelytobedistributedtoagreaternumberofshareholders,whichcanenhanceafter-taxreturns.Ontheotherhand,wheninvestorssellsharesinadecliningmarket,theportfoliomanagermaybeforcedtotakegains,tothedetrimentofthedwindlingnumberofremainingshareholders.❑ ConsiderwhetherspecificlotidentificationorFIFOisworththetimeandefforttoachieveapotentiallymoredesirableresultthantheaveragecostconventionofaccountingforgainsandlosses.❑ Keepgoodrecordsofmutualfundpurchases,reinvestmentofdis-

Sourc

e:In

tern

alR

eve

nueS

erv

ice

FIGURE6.11 SampleIRSForm1099-DIV


tributions,andsalesoffundsharestoavoidinadvertentlypayingtaxestwice.

TheSEC’srequirementthatmutualfundsprovideafter-taxreturnshasbeenfarmorevaluablethaninvestorsrealize.Thedisplayformatisrelativelysimple andprovidesuseful information thatnotonly allows investors tomakemoreinformeddecisionsbutalsoservesasawaytoeducatethemonthebenefitoflongerholdingperiods.WiththeSEC’safter-taxstandards,thereisnowafoundationofinformationtobuildon.Overtime,modifica-tionscanbemadetoaddressissuessuchasthosetheauthorhasnotedtoimproveonwhatisalreadyextremelyvaluableinformation.SincemoreandmoreinvestorsarebecomingcomfortablewiththeSEC’safter-taxstandards,theyarebeginningtoaskprovidersinothernichesofthetaxablemarket-place,“Ifmymutualfundcanprovideafter-taxreturns,whycan’tIreceivetheminthisplatform?”Providersthatarerespondingtothiscallarealreadybeginningtodistinguishthemselves.Asaresult,theyareattractingthemorediscriminatingandknowledgeabletax-awareinvestors.

ChapterNotes

1. SecuritiesandExchangeCommission,“FinalRule:DisclosureofMutualFundAfter-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:ProposedRuleforDisclosureofMutualFundAfter-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-nativeMinimumTax for Individuals:AGrowingBurden,CongressionalBudgetOffice2001,U.S.Congress,May2001.


10. CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,2003),¶1401,p.449.

11. ChairmanJimSaxton,TheTaxationofMutualFundInvestors:Performance,SavingandInvestment,JointEconomicCommittee,U.S.Congress,April2001.

12. InvestmentCompanyInstitute,“BilltoHelpMutualFundInvestorsEarnsStrongICIEndorsement,”May7,2003,http://www.ici.org (accessedOctober18,2004).

13. Vanguard500IndexFund,http://finance.yahoo.com(accessedOctober17,2004).

14. IRSPublication564,MutualFundDistributions,http://www.irs.gov/publications/p564/ar02.html(accessedOctober17,2004).

15. JackC.Bogleindiscussionwiththeauthor,September2,2004.

16. Gary I. Gastineau,The Exchange-Traded Funds Manual (NewYork: JohnWiley,2002),99–100.


SeparateAccountAfter-Tax

Reporting

77

Thefirstformalattempttocreateuniformstandardsforafter-taxreportingwas initiatedbyLeeN.Price.His firm,RosenbergCapitalManagement(RCM),wasservingnucleardecommis-

sioning trust (NDT) clients and they requested after-tax returns formanagercomparisonpurposesandtosatisfyregulatoryrequirements.PriceapproachedtheAssociationforInvestmentManagementandRe-search, which formed aTaxable Portfolios Subcommittee chaired byPrice andRobertE.Pruyne.1Thesubcommitteeconsistedofworkingprofessionalshavingextensiveexperiencewithtaxableaccounts.2Itsrec-ommendationswereadoptedandcanbefoundintheAIMRPerformancePresentationStandardsHandbook.3Onlyaboutahalfdozenfirmsthatwereservingmore-demandingNDTclientsadoptedthestandards.Vendorsofportfolioaccountingsoftwarewereslowtorespond,astheywereunwillingto commit the resourcesnecessary tomodify their tax-exempt-account-oriented portfolio accounting systems until there was a catalyst to doso.ThecatalystprovedtobetheSecuritiesandExchangeCommission’safter-taxstandards,astheretailportionofthemarketnowhadbetterin-formationthanthemoresophisticatedanddemanding,separateaccountsegmentofthemarket.

The AIMR Subcommittee for After-Tax Return Reporting was re-

Theincidenceoftaxationdependsuponthesubstanceofatrans-action.

—HugoL.Black

C H A P T E R 7


constituted inthespringof2000,first torespondtotheSECproposalandthentoreviewtheexistingafter-taxstandardsforseparateaccounts.Ablue-ribbonpanelofexpertsinvariousrelatedfieldsvolunteeredcon-siderabletimeandeffort torecommendrevisionstotheexistingAIMRafter-taxstandards.4LeePricewasagainasignificantcontributortothisprocessandasaresultshouldbeforeverknownasthe“fatherofafter-taxreporting.”TheAIMRboardadoptedthemodificationstotheafter-taxstandardsonFebruary8,2003.Followingthisaction,theInvestmentPer-formanceCouncil (IPC) then endorsed themodificationsonMarch6,2003.WhileeffortsbytheSEC(inregardtomutualfunds)andAIMR(inregardtoseparateaccounts)havepavedthewayforafter-taxstandardsintheUnitedStates,itishopedthattheIPCwillsoonrespondwithaglobalinitiativesothatothercountriescanadoptappropriateafter-taxstandardswithrelativeeasebasedontheirrespectivetaxcodes.Thusfar,AustraliaandCanadahaveshowninterest.

After-tax standards for separate account reporting composites areoptional,asnotallfirmsmanagetaxableaccounts.TherevisionstotheexistingAIMRafter-taxstandardstookeffectJanuary1,2005.Firmsfo-cusedonservingtheneedsoftaxableinvestorshavetakenactionandhavealignedthemselveswithserviceproviderstoallowthemtoprovideafter-taxreturnsforindividualaccountsaswellasforcompositeconstructionforuseinmarketingpresentations.FIGURE7.1isfromtheafter-taxprovi-sionsoftheAIMRPerformancePresentationStandards.5

TobeincompliancewiththeAIMRstandardsforafter-taxreporting,fiverowsofinformationbeyondwhatisrequiredforbefore-taxreportingmustbeprovided.Theserowsareshadedinthe“required”sectionofthetemplate.

Therearealsothreeadditionalrowsof“recommended”informationthatmaybeprovidedifafirmbelievesitcanaddvaluebeyondtheman-datory elements.The first item, adjusting for nondiscretionary capitalgains,isintendednottopenalizethemanagerforarequesteddistribu-tionfromanaccountthatisbeyondthemanager’scontrol.Thistypeofrequest frequentlyhappenswithhigh-net-worth family accountswhenthere is aneed topay taxesor fund amajorpurchase, such asbuyinga secondhome.When theportfoliomanager responds to a request toliquidatefundsofthisnature,despiteattemptstominimizetheimpactof taxes, inevitably somegainswillbe realized.Since thismeasure canonlyworktotheadvantageofthefirm,itispossibleforthemanagerto“game”thesituationbyclassifyingcertaingainsasnondiscretionarythatperhapsarenot.Inallinstances,theportfoliomanagershouldworktothebenefitoftheclientandincludeonlythosegainsthataretheresultofspecificrequests.Foradetaileddiscussiononthistopic,see“Calcula-

SeparateAccountAfter-TaxReporting 79

tionandReportingofAfter-TaxPerformance”byLeeN.Price6andthe“InterpretativeGuidance”sectionoftheAIMRStandards.7

Thenextrecommendeditemofinformationistheafter-taxbenchmarkreturn.Currently,thereisnocentraldepositoryforafter-taxreturnsonthe

FIGURE7.1 SampleAIMR-PPSCompliantPresentationforanAfter-TaxComposite

XYZU.S.EquitiesAfter-TaxComposite

2004 2005 2006 2007 2008

REQUIRED(IFCOMPLIANTWITHAIMR-PPSSTANDARDSANDSHOWINGAFTER-TAXPERFORMANCE)

After-TaxTotalReturn(%) 21.99 31.03 25.02 22.02 –6.17

After-TaxCompositeDispersion(%) 3.1 5.1 3.7 3.2 2.4

Before-TaxTotalReturn(%) 24.31 34.02 27.33 24.03 –8.44

Before-TaxBenchmarkTotalReturn(%) 22.95 33.35 28.58 21.04 –9.01

Before-TaxCompositeDispersion(%) 2.9 3.3 2.6 1.8 1.5

%ofUnrealizedCapitalGains

toCompositeAssets 9 25 37 43 19

%ofTaxablePortfoliosIncludedin

BoththeU.S.EquitiesAfter-Tax&

Before-TaxComposites 75 78 81 79 82

Dollar-WeightedAnticipatedTaxRate 44.2 44.3 44.5 44.1 43.9

NumberofPortfolios 26 32 38 45 48

TotalAssetsatEndofPeriod(U.S.$millions) 165 235 344 445 420

PercentageofFirmAssets 33 36 39 43 37

TotalFirmAssets(U.S.$millions) 500 653 882 1,035 1,135

RECOMMENDED

After-TaxReturnAdjustedfor

Non-DiscretionaryCapitalGains(%) 21.99 31.07 25.25 24.12 –5.99

After-TaxBenchmarkReturn(%) 21.78 32.05 27.78 20.21 –9.37

PercentageBenefitfromTaxLoss

Harvesting 0.00 0.00 0.00 0.00 3.51

Sourc

e:

AIM

R/C

FA

Inst

itute


mostcommonphysicalbenchmarksorindiceswherethetaxramificationson individual security positions are taken into account. Unfortunately,standardpracticesdonotexistforconstructingbenchmarks,andsomeofthemethodsusedbyprovidersmakethecalculationofafter-taxreturnsadaunting,ifnotimpossible,task.Justafewoftheitemsofconcernareavailabilityofdata,reconstitutionofthe indices,andtreatmentofdivi-dends.Forfixedincomebenchmarks,pricingissues,thelargenumberofsecurities,andamortizationandaccretionoffixedincomesecuritiesmakecalculatingafter-taxreturnsamostchallengingtask.

Practitioners need to be careful with the use of after-tax benchmarkinformation.Forexample,theyshouldnotlinkinformationwhenafter-taxreturnsarecalculatedaccordingtothepost-liquidationmethodology,astheinceptiondateoftheportfolioandbenchmarkwilllikelyhaveasignificantimpactonthegainsandlossesthatwillultimatelyberealized.Fortunately,after-taxreturnscalculatedbythepre-liquidationmethodologyarenotaf-fectedbythelevelofthemarketsattheinceptiondateofmeasurement.Until a database for thephysical benchmarks canbe created andmain-tained,mostpractitionersareusingafter-taxreturnsfrompassiveportfoliosofindexandexchange-tradedfunds(ETFs)forcomparativepurposes.AbenefitofusingmutualfundsandETFsisthatthefrequencyofdistribu-tionsisusuallynogreaterthanmonthly,sofarlesseffortisneededtocollecttheinformationnecessarytocalculatetheafter-taxreturn.Theinformationcanbeextractedstraightfromthefund’sprospectus,butthesourceofin-formationshouldbeproperlyfootnoted.Perhapsthemostcompellingrea-sontouseafter-taxreturnsfromfundsforcomparisonisthatmutualfundsandETFsareinfactinvestablealternativesforinvestors.Asaresult,thismethodisgaininginpopularitywithtax-awaremanagers.However,whenmanagerswhodonotconsidertaxesinthesecurityselectionprocesscom-pare their resultswithan indexmutual fund, theyquicklydiscoverhowdifficultitistooutperformthisproxyonanafter-taxbasis,asthearticlesbyArnottandJeffreyandbyDicksonandShovenconcludedadecadeago.Sincemanymanagersareevenlesscompetitiveonarelativebasisthanwithbefore-taxresults,mostfirmscontinuetoavoiddevelopingaprocesstoof-ferafter-taxreturnstoprospectsandclients.Thosereaderswishinggreaterdetailwithregardtoafter-taxbenchmarksshouldseekarticlesbyJeffreyL.Minck(1998),DavidM.Stein(1999),andJamesM.Poterba(1999).8Oneissuethatrequiresspecialtreatmentissignificantcashflows.Innova-tivesolutionshavebeensuggested,like“shadowportfolios”byRonL.Surz,wherethebenchmarkexperiencesflowssimilartotheclientportfolio’s.9

Thelastitemofrecommendedinformationisthepercentagebenefitfromtax-lossharvesting.Itshouldbenotedthattax-lossharvestingistypi-callymostprolificandvaluableindecliningmarketsandattheinception


ofalong-termrelationship.Therefore,thebenefitdisplayedmayvarysig-nificantlyamongclientportfolioswithdifferent inceptiondates,sothisinformation shouldbeusedonly as a guide.Thedegreeof the tax-lossharvestingbenefitmaynotbereplicableforfutureinvestors,asthedirec-tionofthemarketmaynotcreateasimilaropportunisticenvironment.Firmswith strategies that relyheavily on tax-lossharvesting should ac-companythisrowofinformationwithafootnoteexplainingtheconcept,asthiscanbeamajorsourceoftaxalphafortax-awaremanagers.Alphaistheincrementalreturnforagivenlevelofrisktakenbythemanager.Ifhetakesthesamelevelofmarketrisk(beta)astheStandard&Poor’s500stock indexandoutperforms itby2percent, then this isconsidered tobehisalpha.Bygeneratinglossesthatcanbeusedtooffsetgainsinotherportfolios,themanagergenerateswhatisreferredtoastaxalpha.Atthesametime,amanagercouldhaveabefore-taxalphalessthan,equalto,orgreaterthen0percentthatcomesfromsuchtraditionalsourcesofin-crementalvalueassectorallocationandsecurityselection.Obviously,theidealisforamanagertohaveapositivealphabothbeforeandaftertaxes.Thisistheultimategoal,andmoreseparateaccountmanagersarejoiningaselectgroupofelitepractitionersthatareaccomplishingboth,aswillbediscussedinchapter12.

Oneoftheconcernsoftheinvestmentmanagementindustrywasthepossibilitythattheadditionalcostofcalculatingafter-taxreturnsforclientreportingandmarketingcouldonlybeabsorbedbylarger,moreprofit-ablefirms.Interestinglyenough,oneofthefirstfirms,ifnotthefirst,toconquer the task of preparing composite information according to theAIMRafter-taxstandardswasGratry&Associates,a smallboutique inCleveland,Ohio,specializingininternationalAmericandepositaryreceipt(ADR)portfolios.BymonitoringtheactivityoftheAIMRSubcommitteeandworkingcloselywiththeirproviders,GratrywasabletoachievethisaccomplishmentalmostimmediatelyfollowingtheannouncementoftheproposedrevisionsandmorethanayearandahalfbeforetheJanuary1,2005,implementationdate.ToGratry,havingthecapabilitytoshareitsafter-taxperformanceresultswasextremelyimportant,asthefirmhasahistoryof adding incremental value for its clients through tax-losshar-vesting,inadditiontowhatisachievedfromcountrypositioning,sectorallocation,andsecurityselection.

With the enhancement in trade management systems over the pastdecade,firmsmanaging tax-exempt accountshavebeen able to achieveextremely lowvariabilityordispersionof individual account returns. Ifthefirmisconsideringtheimpactoftaxesduringthebuy-and-selldeci-sionprocess,dispersionwithtaxableaccountreturnsshouldnaturallybegreater.Significantlyhigherdispersionmayinfactreinforcethatthefirm


is adhering to a philosophy of managing each taxable account accord-ingtoitsownuniqueobjective.Thefirmshouldevaluatethekeyfactorsitbelievesdifferentiatesitstaxableaccountsresultsanddevelopafter-taxreturncompositesthatreflectthemajordifferences.Therefore,afirmmayhave multiple taxable-account composites for a given portfolio strategybutonlyonecomposite for tax-exemptaccounts. If sufficient timeandeffort isput intodeveloping the composites,dispersionof the after-taxreturnswillmostlikelybecomelessofaconcern.Thefollowingisalistoffactorsafirmmightconsiderwhenconstructingcompositeswhenreport-ingafter-taxreturns:

❑ Thetypeoftaxableaccount—forexample,individualorhigh-net-worth family, nuclear decommissioning trust, voluntary employeebeneficiaryassociation,orpropertyandcasualtyinsurancecompany

❑ Theclients’anticipatedormaximumfederaltaxrate❑ Theclients’stateofresidencefortaxpurposesandtherespective

taxrate❑ Vintageyearoryearoftheinceptionoftherelationship❑ Accountsstartingwithacashportfolioversusexistingholdingsor

aconcentratedposition❑ Accountsthattreatexpensesdifferently,suchasmutualfundsand

trustsversustaxableseparateaccounts

Thetypeoftaxableaccountcanhaveasignificantimpactonportfo-liomanagementdecisions.For example, themethodology employed toeffectively manage property and casualty insurance company portfoliosperiodicallyemphasizesrealizingcapitalgainsforannualfinancialreport-ingpurposes.

The federal tax rate towhich individual investorsare subject tohasagreaterinfluenceonsecurityselectionforfixedincomeaccountsintheUnitedStates,becausewehaveboth taxable and tax-exemptbonds.Atlow-enoughfederaltaxrates,clientsmaybebetteroffholdingaportionor theentireportfolio intaxablebonds,as theirafter-taxyieldsmaybegreater than what is offered from similar effective maturity tax-exemptbonds.Fixedincomeportfoliosthattakeintoaccounttheclient’staxpro-fileandadjusttheallocationtotaxableandtax-exemptbondsdependingontheirafter-taxreturnpotentialarereferredtoas“crossover”portfolios.Additionally, thepercentageof tax-exemptbondsheld fromtheclient’sstateofresidencefortaxpurposesintheportfoliomightbequitedifferentforaclientinahigh-taxstatelikeNewYork,comparedwithTexaswheretheresidentsarenotsubjecttoastateincometax.

Thevintageyearisespeciallyimportantforequityportfoliostrategiesthatemphasizetax-lossharvesting.Obviously,forthefirstthreeyearsof


therelationship,theopportunitiestoaddvaluefromthisprocesswouldhavebeenfargreaterforaccountsbeginningin2000,ascomparedwiththoseinitiatedin1996.

Somefirmshavemadethedecisiontoincludeonlyaccountsthatstartwith100percentcashintheircomposites,astheybelievethisisthewaytoensuretheaccountsrepresenttheirdiscretionarymanagementprocess.Thefirmislikelytoinheritportfolioswithsubstantialunrealizedcapitalgains,whichare likelytoproduceafter-taxresults inconsistentwiththediscretionarycomposite.Itmaytakemonthsoryearsbeforesomeoftheseportfoliosmirrorthediscretionaryportfolio.Theyshouldbemonitoredandmovedtothediscretionarywhentheyachieveasatisfactorylevelofconsistency.

Thelastelementpertainingtocreatingcompositesishowexpensesaretreated.Unlikemutualfunds,asdiscussedinchapter6,moststand-aloneseparateaccountscannotoffsetincomewithexpenses.Therefore,theywillhavelowerafter-taxreturnswhencomparedwithmutualfundandtrustportfolios,whereincomemaybeoffsetwithexpenses.Toaccommodatethesedifferences,itisrecommendedthattheafter-taxreturnsbeadjustedfor thetaxbenefitof theoffset.Forexample, ifamutual fund isbeingplaced inacompositeofequity-strategyseparateaccounts for individu-alinvestorsanditchargestheindustryaverage1.5percentfee,itwouldbepropertoincreasetheannualafter-taxreturnsofthemutualfundbyapproximately by 0.23 percent (1.5% fee × 15% tax rate applicable toqualifieddividends),orthefirmmightdecidetomaintaintheaccountsasseparatecomposites.Insuchcases,adisclosureshouldbemadestatingwhytheafter-taxreturnwouldbedifferentifthestrategywereheldinastand-aloneseparateaccountarrangement.

The list of items to consider certainlyneednotbe limited to thoselistedhere and inotherAIMRdocuments.Thekey isnot to limit thecompositestosomepreconceivednumberbutrathertocomeupwiththenumberofcompositesnecessarytoallowpractitionerstoeffectivelycom-municatetheresultsoftheirtaxableaccountsaccordingtotheiruniquecircumstanceswithclients,prospects,andinterestedthirdparties.

Therearethreemainpointsthatshouldbeunderstoodwiththerevi-sionstotheAIMRafter-taxreportingstandards.Previously,applicationoftheclients’maximumfederaltaxonordinaryincome,currently35per-cent,wasmandatorywhencalculatingafter-taxreturns.Therevisedafter-tax standards favor theapplicationof theclients’ “anticipated” tax rate.Thiswasdoneforseveralreasons.First,formoststrategiesitissimplypartofaprofessional’sdutytoascertainfromtheclientwhattypesandleveloftaxationneedtobeconsideredinordertomakesoundinvestmentdeci-sions.Second,asmentionedearlier,afixedincomemanagermayelectto


purchaseataxablebondiftheinitialafter-taxyieldtomaturityisgreaterthanthereturnfromatax-exemptbondofsimilareffectivematurity.Intheseinstances,applyingthemaximumfederaltaxratefortheclienttypewouldresultinafter-taxreturnsthatwouldnotreflectthemanager’sabilitytoaddvalue.Third,firmsthatwerecalculatingafter-taxreturnsdiscoveredthat their performance measurement professionals were actually calcu-lating and maintaining two separate after-tax returns for each account,andtheamountofworkrequiredtodothiswassimplyoverwhelming.After-taxreturnsusingthemaximumfederaltaxratewerebeingusedforcompositepurposes,yetclientswereprovidedinformationusingthepre-ferred“anticipated”taxrates,whichweremore in linewiththeiractualexperience.Sincethereisadeductionatthefederallevelforthepaymentofstateandlocaltaxes,theanticipatedtaxrateislessthanorequaltothesumwhenmorethanonerateisconsidered.Theformulatocalculatetheanticipatedtaxrateis:

TRanticipated=TRfederal+(TRstate×[1–TRfederal]) +(TRlocal×[1–TRfederal]),

whereTRstandsfortaxrate.Iftheclientissubjecttoa35percentfed-eraltaxrate,10percentstatetaxrate,anda2percentlocaltaxrate,thentheanticipatedtaxrateisequalto42.8percentasshownbelow:

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’sactualtaxratewillbeacombinationoftheanticipatedtaxratesforordinaryincome,short-termcapitalgains,quali-fieddividends,andlong-termcapitalgains.Tocomeupwiththismorepreciseweighted ratewouldbe extremely time-consuming.Besides, thetaxinformationforseparateaccountsislot-specific.Therefore,useoftheanticipatedtaxratebasedontherateofordinaryincomeatleastgivesthereviewerofthecompositeinformationaframeworkastohowinvestmentdecisionsmayhavebeenaffectedbytheleveloftaxation.Therearelegiti-matecases,likewraprelationships,wheretheclientdoesnothaveaccesstothisinformation.Intheseinstances,usingthemaximumfederaltaxisacceptableandshouldbeencouraged.

Advocatesofusing themaximumfederal ratesclaimthatuseof theanticipatedtaxdoesnotfacilitatecomparingafter-taxresultsofmultiplemanagers.Thisimpliesalevelofaccuracythatissimplynotobtainableor


reasonable,asadditionalinformationisrequiredtomakesounddecisions.Evenbefore-taxreportingisanestimateofperformance,butthecaseisfarmoresowithafter-taxresults.

Thesecondkeyfeatureoftherevisedafter-taxstandardsisthatAIMRinstitutedaspecificmethodforthetreatmentoftaxes.Thislendsitselftoaformofbranding,andundertheGlobalInvestmentPerformanceStan-dards(GIPS)afirmcanputonaclient’squarterlyperformancereportthat“the after-tax returnshavebeen calculated in amanner consistentwiththeAIMRafter-taxreportingstandards,”orwordstothiseffect.Thisisnotablebecausemanyfirmsviewthequarterlyperformancereportastheirmostimportantcommunicationtool.Whilefirmsmayonlyusethepre-liquidationafter-taxreturnsforcompositeconstruction,thefirm’sclientsarelikelytoaskforboth.Therefore,firmsshouldlookforthiscapabilitywhenselectingsoftwarevendors.

The thirdkeyelementof theAIMRafter-tax reporting standards isthattheSubcommitteewascarefultoensuretheywereconsistentwiththeSECstandardsformutualfunds,exceptwheremodificationwaswarrant-ed.TheonemajordifferenceisthattheSECstandardsrequirereportingof returns after taxes on distributions and sale of fund shares—knownas the post-liquidation calculation methodology—whereas the AIMRstandarddoesnot.Thepost-liquidationmethodologydoes in factpro-vide extremelymeaningful information for a single separate accountorindividualmutual fund.UnliketheSEC’safter-taxstandards,whichal-low individual investors to make better-informed investment decisionsonspecificfunds,theAIMRstandardswereoriginallydevelopedwithanemphasis presenting results froma composite of accountsmanaged ac-cording to adistinct style, such asdomestic large-capitalizationgrowthequityportfolios.Withperformancecomposites,accountsarecontinuallybeingaddedordropped.Unfortunately,theflowofaccountinformationincompositesdistortspost-liquidationafter-taxreturnstothepointtheycannotbereliedontoproviderelevantinformation.Ifthecompositele-gitimatelyconsistsofonlyoneaccount,afirmcouldcertainlyprovidethisadditionalinformationifitmightbehelpfultoprospects.Thisdoesnotmeanothermethodsofcalculatingafter-taxreturnsshouldbeignored,butifsupplementalinformationisprovideditshouldbemarkedassuchandthepre-liquidationreturnsmustbeshownprominently.Onesuchcaseisafixedincomepractitionerthatappliesthe“full-liquidation”method,inwhichthecompletetaximpactiscalculatedfortheunitofmeasurement,currently monthly. This method is more appropriate for fixed incomeportfolios and usually results in the most conservative after-tax return.Sincepropertyandcasualtyinsurancecompaniestypicallyhaveamajorityoftheirassetsallocatedtofixedincome,theiradviserswilloftensupport


use of the full-liquidation methodology. However, this fails to accountforthebenefitofcompoundingtax-freebyextendingtheholdingperiod,whichisextremelyimportantwithequityportfolios.Readersdesiringtoreadmoreaboutvariousafter-taxcalculationmethodologiesshouldrefertoLeeN.Price(1995).10

InboththeSECandAIMRafter-taxreportingstandards,thetaxim-pact isaccountedforwhenthetaxableeventtakesplace,ratherthanatthe endof a period.A system that utilizes the client’s data fromForm1040andend-of-yearcustodialrecordsmayinfactprovideextremelyac-curateafter-taxreturninformation,butitisinconsistentwiththeAIMRstandard.TherationalebehindtheAIMRafter-taxstandardsistocapturetheportfoliomanagerorfirm’sdecisiontotaketheclient’staxprofileintoaccountat the timeof the transaction,versus establishinganextremelyaccurateaccountingreport.Ifthelatterwastheobjective,thenahigh-net-worthindividualaccountthathasataxableeventinJanuarywouldnot,inmanycases,seeanafter-taxreturnuntilperhapstwenty-oneormoremonthslater,asmanyfamiliesdonotfinalizetheirtaxesuntilthefollow-ingfall.Applicationofthisrationalealsomakesitmucheasierforthefirmwhenaretroactivetaxbilloccurs,whichhappenedin2003.Eventhoughthebillwaspassednearmidyear,thelowertaxrateonqualifieddividendsof15percentwasretroactivetothebeginningoftheyear.Applyingthisapproachagainensuredthattheafter-taxreturnscapturedhowportfoliomanagerswereaccountingfortaxes,asuntilthebillwaspassedtheyhadtooperateundertheassumptionthattheexistinghigherrateonordinaryincomewouldapply.Moreover,performance-measurementprofessionalswerenotburdenedwiththetaskofrecalculatingsixmonthsofpreviousreturnsforaccountssubjecttothechangeinthetaxcode.

Significant cash flows require attention with tax-exempt accounts,but even more so with taxable accounts. Constructing composites thattakeintoaccountthevariousfactorsnotedabovewillgiveprospectsmoremeaningful information,butequally important,portfoliomanagerscanapplytheinformationmoreeffectivelyintheday-to-daymanagementoftheirtaxableaccountsintheirquesttoproducesuperiorresults.

Thekeytoafter-taxperformanceisthatitisanartform,ratherthanascience.Itissimplyfoolishtothinkyoucancompareonereturnagainstanotherandcometoavalidconclusionwithoutanalyzingadditionalin-formationaffectingday-to-daytaxmanagement.Thetax-awarepractitio-nerneedstobecognizantofthemarketenvironmentinwhichtheportfo-liomanagerwasoperatingtounderstandhowtaxconsequenceshavebeenmanagedandtodrawmeaningfulconclusions.

FIGURES7.2,7.3,and7.4,courtesyofParametricPortfolioAssociates,showhowafirmcandistinguishitselfthroughafter-taxreporting.These


exhibitsarepartofthequarterlycommuniquéthatParametricsendseachof itsseparateaccountclients.ThePortfolioPerformancesectionofthecommuniquéstartswithpretaxandafter-taxcomparativeresultsagainstanappropriatebenchmarkforthecurrentquarter,year-to-date,andsinceinceptionoftheaccount(Figure7.2).Thiscanbeviewedastheincomestatementofthereport.Inthecolumnlabeled“yeartodate,”youcanseethattheportfoliolaggedtheperformanceoftheS&P500by0.5percentbeforetaxes,butitoutperformedonanafter-taxbasisby1.0percent.Thishighlights the potential of a tax-loss harvesting strategy, which is para-mounttothesuccessofParametricandotherfirmsfocusedonthisnicheof the market. Note that the “since inception” annualized value-addedfrom theprocess is +2.5percent (4.1percent after-tax return forPara-metricascomparedto1.6percentfortheS&P500).ThisexampleisforperiodsendingDecember31,2003.ItshouldbenotedthatParametricisoneofthefewfirmsthatattemptstocalculatetheactualafter-taxreturnforacomparativebenchmarkportfolioofsecurities.Todothisproperlyrequires runningbenchmarkportfolios for thedifferent inceptiondatesforallaccountsundermanagement.

ThePortfolioValuesectionhighlightsthebalancesheetoftheaccountfromataxaccountingperspective(Figure7.3onthefollowingpage).Asshown,theportfoliohas lessthan0.2percent inunrealized losses.Thistellstheclienttwothings.First,Parametrichasbeendiligentintax-lossharvesting.Second,unlesssomeoftheholdingsfallsignificantlyinprice

FIGURE7.2 PortfolioPerformance—IncomeStatement

ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport

FOURTH YEARSINCEINCEPTION(10/23/1998) QUARTER TODATE CUMULATIVE ANNUALIZED

PretaxPerformance

Portfolio 11.7% 28.2% 13.3% 2.4%

Benchmark 12.2% 28.7% 11.9% 2.2%

After-TaxPerformance

Portfolio 11.6% 29.4% 23.4% 4.1%

Benchmark 12.1% 28.4% 8.5% 1.6%

Sourc

e:P

ara

metr

icP

ort

folioA

ssocia

tes


during the months ahead there will be less opportunity to add valuethroughtax-lossharvestinginsubsequentperiods.

TheIncomeandRealizedGainssectionofthecommuniquéservesasthecashflowstatementofthereport(Figure7.4).TheParametricformataddressesthethreekeyareasessentialtotaxplanningforacommonstockportfolio:dividendincomeandnetrealizedshort-andlong-termcapitalgains.Bytrackingthe“yeartodate”column,membersofthequalifiedtriumvirateservingtheclientareabletomakebetter-informeddecisionsastohowthenetlossescanbemosteffectivelyutilized.Additionalinfor-mationcanbeprovidedtohighlightthecriticalportfoliocharacteristicsthatreflecttheparticulartypeofstrategy.ForafirmlikeParametricthat

FIGURE7.4 IncomeandRealizedGains—CashFlowStatement


INVESTMENTFLOWS FOURTHQUARTER YEARTODATE CUMULATIONS

DividendIncome $13,751 $49,402 $196,860

NetRealizedGains

ShortTerm 0 –$73,784 –$555,053

LongTerm 0 –$26,458 –$287,224

FIGURE7.3 PortfolioValue—BalanceSheet


AT12/21/03

MarketValue $3,366,382

CostBasis $2,283,892

UnrealizedGains

ShortTerm $152,440

LongTerm $934,995

UnrealizedLosses

ShortTerm $660

LongTerm $4,286

Sourc

e:P

ara

metr

icP

ort

folioA

ssocia

tes

Sourc

e:

Para

metr

icP

ort

folioA

ssocia

tes


hopestoreducetrackingerrortoadefinedbenchmark,itemssuchasthenumberofsecuritiesintheportfolioandsectorweightingsareimportant.Otherfirmsmaywishtofocusoncharacteristicssuchasdividendyieldandvaluationmetricstoemphasizeaparticularstyleororientation.Todevelopaclientperformancereportofthisqualityrequiresasignificantcommitmentofresourcesonthepartofthefirm,but likeGratrywithitsafter-taxcompositeinformation,Parametricthoughtitwasworththeeffort tohighlight thevalueof itsprocess anddemonstrate itsdistinc-tive competencewith the onedocument that ismost important to itsclients.

After-tax returns should be a source of pride for a firm.Therefore,firmsthatunderstandthevalue-addedpropositionfromtax-awareinvest-mentmanagementaretheonesmost likelytoprovideafter-taxreturns.Serviceprovidersrespondingtotheneedsoffirmscanbesegmentedintothefollowingcategories:

❑ Portfolioaccountingstand-alonesystems —IDS —Osprey —Shaw —Sungard❑ Separateaccountsupplementalsystems —iKindi —Meradia —PricePerformanceSystems❑ Systemsdevelopmentandsupport —AccountingfirmswithAIMRauditingpractices —CutterAssociates —Meradia —Osprey —TowerGroup

Theseareproviderstheauthorisawareofasofthesummerof2005.Thelistdoesnotrepresentanendorsementofanyfirm.Theremaycer-tainlybeotherwell-qualifiedprovidersavailable,andadditionalfirmsarelikelytooffersimilarservicesinthefuture.

Stand-alonesystemsarethecalculationandreportingenginefortheassetmanagementfirm.Supplementalsystemsworkinconjunctionwithinformationprovided from the stand-alone systemor custodial reports.Price Performance Systems offers an equity-oriented product, whereasiKindihasundertakenthechallengingtaskofprovidingtheabilitytocal-culateafter-taxreturnsforfixedincome,takingintoaccountamortizationandaccretionofpremiumsanddiscounts.


Therearevariousprovidersofsystemssupport.Thekeytoestablishinganafter-taxreportingcapabilityistoensureallkeydecisionmakersarein-cludedintheprocess.Iftheplanningisdonewithcare,thefirmwillmostlikelyavoidcostlymistakesandsolutionsthatdonotsatisfytheneedsofclients and investmentprofessionals.Anyfirmconsidering entering therealmoftaxableaccountinvestingtodaywouldbefoolishtoentertainaproposalfromasoftwarevendorthatdoesnotalreadyofferanafter-taxreportingcapability consistentwith theAIMRprovisions. It isdifficultenoughtobecomeAIMRcompliantwithbefore-taxreturnsandhavingtorecalculatehistoricalreturnsorreconstructcomposites,buttodosoforafter-taxreturnsmaybealmostan insurmountable task,especiallywithfixedincomeaccounts.

Asmentionedinchapter6,firmsdesiringtoincludeafter-taxbench-marksreturnsintheircompositedisplaysareencouragedtoutilizeafter-taxreturnsfromanappropriateindex-orientedmutualorexchange-tradedfund.Meaningfulofferingsarenowavailablefortraditionalassetclasses—with the exceptionofmunicipalbonds, forwhicha competingmutualfundproductofsimilardurationandqualityshouldbesufficient.Anotheralterativeistouseataxablebondmutualfundandjustapplytheaveragehistoricalspreadbetweenitandamunicipalbondbenchmark.Dependingon theaveragehistorical term(cashequivalents, short, intermediate,orlong)thespreadtobeappliedmayrangefrom70percentforshorter-termbenchmarksto85percentforlonger-termbenchmarks.Forexample,let’ssayyourmunicipalbondproductisintermediatetermandafteranalyzingthespreadbetweenappropriateLehmanbondindicesyoudecidetomul-tiplyreturnsoftheBarclaysGovernment/CreditETFby0.80.Althoughitwillnottrackthemunicipalbondmarketperfectly,clientswillappreciatethatyouareattemptingtomeasureandcommunicatetheimportanceoftaxesoninvestmentreturns!

Thechallengesofcreatinganafter-taxreportingcapabilityaremagni-fiedforconsultingfirms,especiallythosewithhigh-net-worthclients.Un-fortunately,thisnichehasbeenservedbyproviderswithpension-consult-ingsoftwarethatdoesnotconsidertaxes.Ifthesystemcalculatesreturnsbysecuritypositionversustransactioninformationitneedstobereplacedbyonethatcanprovideanafter-taxreportingcapabilityconsistentwiththeAIMRmethodology.Tax-lotaccountingandtransaction-basedinfor-mationare simplyamust, and thereareno shortcutsor alternatives tothem.Thetypicalsourceofinformationisthecustodialstatement.Thepropertyandcasualtyinsuranceconsultingindustryisabletoobtainthesameinformationfromasmallnumberofprovidersofstatutoryinforma-tion.11Thismakestheprocessmuchmoreefficient.Therefore,consultingfirmsingeneralcanbenefitiftheylimittheirclientstoaselectfewsources


of account information.Efficientdata feeds are critical so that the rec-onciliationprocessfocusesonexceptionsratherthaneverypieceofdata.Also,havingalltheinformationinonedatabaselendsitselftotheuseofthird-partyproviderstoachieveconsistentpricing,portfoliocharacteris-tics,etcetera.Oncethecalculationsaremade,acustomreportwritercancreateaproducttorespondtovariousclientneeds.Onewaytosimplifytheentireprocess istoestablishanindustryHTMLformatforsecuritytransactioninformation,anideathatwasproposedtotheauthorbyJayWhippleIII,thefounderofSecurityAPLandOsprey,well-knownpro-vidersofportfolioaccountingsoftwareandsolutions.Thiswouldalleviatethechallengesofapplyingvariousaccountingconventionsandmatchingsaleswithspecifictaxlots.

Atthisjuncture,firmsarestillspendinginordinateamountsoftimeand effort choosing aportfolio accounting system to calculate after-taxreturns.FirmsembarkingonthisdecisionshouldreadarticlespreparedbyDouglasS.RogersandLeeN.Price(2002),JohnD.Simpson(2003),andDouglasS.Rogers(2000,2003).12IfthefirmdesiresanAIMR-compliantsolution,thesystemmustincludethesecriticalelements:

❑ TheabilitytoincorporatetheimpactoftaxesasoutlinedbyAIMRforthemodifiedDietz,dailyvaluation,ormodifiedBAImethods

❑ Tax-lot accounting that captures the amount and date of everytransaction

❑ Theimpactofeachandeverytransaction❑ Maintenanceoftheinformation,includingsuchitemsastheamor-

tizationandaccretionoffixedincomesecuritiespurchasedatalevelotherthanpar

❑ Informationthatcapturesthetaxparametersofthetypesoftaxableclientsthatwillbeenteredintothesystem

❑ Abilitytodistinguishbetweenvarioustypesofsecurities,suchastaxablebondsversustax-exemptbondsorgovernmentbondsex-emptfromstatetaxesversusothers

❑ Theabilityofthesoftwareprovidertokeepupwithchangesinthetaxcodefortheclienttypeyouareservicing

Thereisone“lastfrontier”intheareaofafter-taxanalysisandreport-ingthathasyettobesolved:after-taxperformanceattribution.Utilizingcurrent attribution softwareon taxable accounts is almost auseless, andinsomecasesadetrimental,exercise,becausenoneoftheexistingsystemstakeintoaccountthecapitalgain/losspositionofasecurity.Forexample,aparticularsecuritythataportfolioownedmayhavelaggedtheperformanceofitspeersinthesameindustry,andtheindustryinturnmayhavealsolagged theoverallperformanceof thebenchmark.Therefore,onemight


havenaivelyconcludedthatthemanager’ssecurityselectionandsectoral-locationwasnegativefortheperiod.However,thesecuritymayhavehadasubstantialshort-termunrealizedcapitalgainposition,andsellingtheposi-tionwouldhavebeendetrimentaltotheclient.Resolvingthisquandarycan potentially integrate attribution with the portfolio decision-makingprocess.Bydoingthisproperly,theperformancemeasurementprofessionalwouldbecomepartofa forward-lookingvalue-addedpropositionratherthanjustprovidingbackward-lookinginformationtoexplainpasteventsandactivity.13

SinceLeePricefirstrespondedtoclients’requestsintheearly1990s,substantialprogresshasbeenmadetomastertheartofafter-taxreport-ing.Wenowhaveacceptedafter-taxreportingcalculationmethodologiesandstandardsthatenablebothtaxablemutualfundinvestorsandseparateaccount investors tomakebetter-informed investmentdecisions.Fortu-nately,thereareaselectgroupofsoftwareprovidersthatprovedthatthestandardscanbesuccessfullyimplemented,giventhedesireandresources.It takes a meaningful commitment of resources to achieve an after-taxreportingcapability,butevensmallboutiquefirmshaveaccomplishedit.Therefore,thereisnolongeravalidexcuseforinvestmentmanagersnottoofferthiscapability.Firmsthatembraceafter-taxreportinginitiallywillmostlikelybethosethatwillbenefitbycommunicatingtheirresultsac-cordingtoanacceptedformat,allowingothers toevaluateandconfirmtheirvalue-addedpropositioninwaysneverbeforepossible.

ChapterNotes

1. Muchofthediscussiononseparateaccountafter-taxreportinghasbeentakendirectlyorsummarizedfromtheauthor’sarticlewithSeanW.Egan,“EvaluatingandClassifyingTaxableAccountManagers,”JournalofWealthManagement(Fall2004):49–62.

2. ThefirstAIMRSubcommitteeforAfter-TaxReportingconsistedofco-chairsLeeN.PriceandRobertE.PruyneandScottR.Abernethy,MichaelS.Caccesse,RobertH. Jeffrey,CatherineM.O’Connor, JohnR.O’Toole, andDouglasS.Rogers.

3. Association for Investment Management and Research, AIMR PerformancePresentationStandardsHandbook,2ded.(Charlottesville,Va.:AIMR,1997).

4. TheAIMRSubcommitteeforAfter-TaxReportingreconstitutedin2000waschairedbyDouglasS.Rogers.MembersincludedJenniferP.Cahill,ThomasF.Drumm,PaulJ.Jungquist,SeanS.Keogh,DanielW.Koors,DavidA.Krause,JamesPoterba,NeilE.Riddles,DavidM.Stein,RonaldJ.Surz,andCeciliaS.Wong.LeeN.Priceservedasanobserver.


5. AIMR Performance Presentation Standards (AIMR-PPS)—Amended andRestatedastheAIMR-PPSStandards,theU.S.andCanadianversionofGIPSandInterpretiveGuidanceontheAIMR-PPSAfter-TaxProvisionsContainedinSection9,February8,2003,23.

6. LeeN.Price,“CalculationandReportingofAfter-TaxPerformance,”JournalofPortfolioManagement(Winter1996):6–13.

7. AIMR Performance Presentation Standards (AIMR-PPS)—Amended andRestatedastheAIMR-PPSStandards,theU.S.andCanadianversionofGIPSandInterpretiveGuidanceontheAIMR-PPSAfter-TaxProvisionsContainedinSection9.G.,February8,2003,25–26.

8. JeffreyL.Minck,“Tax-AdjustedEquityBenchmarks,”JournalofPrivatePort-folio Management (Summer 1998): 41–50; James M. Poterba, “After-Tax Per-formance Evaluation,” AIMR Conference Proceedings: Investment Counseling forPrivateClients(Charlottesville,Va.:AIMR,1999),92-105;DavidM.Stein,BrianLangstraat,andPremkumarNarasimhan,“ReportingAfter-TaxReturns:APrag-maticApproach,”JournalofPrivatePortfolioManagement(Spring1999),10–21.

9. RonL.Surz,indiscussionswiththeauthorduringspeakingengagementsandtheAIMRSubcommitteeforAfter-TaxReportingwherethesubjectofshadowportfolioshasbeenraised.

10. Lee N. Price, presentation on after-tax return calculation methodologies,1995.

11. Peter N. Gunder, director–insurance consulting, for Cardinal InvestmentAdvisors,indiscussionwiththeauthor,August3,2004.

12. DouglasS.RogersandLeeN.Price,“ChallengesWithDevelopingPortfo-lioAccountingSoftwareforAfter-TaxReporting,”JournalofPerformanceMea-surement(Supplement2002):12–18;JohnD.Simpson,“SearchingforaSystemtoMeetYourAfter-TaxPerformanceReportingNeeds,”JournalofPerformanceMeasurement(Supplement2003):22–28;DouglasS.Rogers,“TheChallengesofAfter-TaxPerformanceReporting,”JournalofPerformanceMeasurement(Spring2000):10–15;DouglasS.Rogers,“TheStateofAfter-TaxReporting.”Monitor(November/December2003):26–27.

13. Douglas S. Rogers, “A Call to Arms!The Next Frontier forTaxable Ac-counts—After-Tax Return Performance Attribution, Journal of PerformanceMeasurementvol.9,no.3(Spring2005):43–46.


MeasuresofTaxEfficiency

95

Therearefourkeycalculationsthatpractitionersmayencounterfor measuring the tax efficiency of the portfolio managementprocess:

❑ Accountant’sratio=$amountoflong-termcapitalgainsrealized/$amountoftotalcapitalgainsrealized

❑ Captureratio=Rat/Rbt,whereRequalsthereturnafter-taxandRbtequalsthereturnbefore-tax

❑ Relativewealthmeasure1=([Rat–Rbt]/[1+Rbt])×1,000❑ Morningstartax-costratio2=(1–[(1+Rat)/(1+Rbt)])×100

Thischapterexaminesthecharacteristicsofeachandhowtheycanbeappliedtoallowinvestorsandadviserstomakebettertax-awaredecisions.3

Accountant’sratio:Thisratioisappliedtoseeiftheportfolioman-ager is taking advantage of the lower tax on long- versus short-termcapitalgains.Thedifferencebetweenthe twotax rates iscurrently20percent.Obviously,thehigherthepercentageoftheaccountant’sratiothebetter,withtheidealbeing100percent.Theratioisbestusedfordiscussionswithinthefirm,as ithasseveralweaknesses.First, there isnodirectlinkagebetweenthismeasureandtheactualafter-taxreturns.Second,itdoesnottakeintoaccounttheoffsettingofrealizedgainsand

Acitizencanhardlydistinguishbetweenataxandafine,exceptthatthefineisgenerallymuchlighter.

—G.K.Chesterton

C H A P T E R 8


losses.Third,itcan’tdifferentiatebetween“good”and“bad”turnover,aswediscussedinchapter3.However,evenwithitsweaknesses,somefirmshave found ituseful to communicate to their clients a commit-menttotax-awareprinciples.

Captureratio:Thismeasureiscertainlytheeasiesttounderstandandwaswidelyacceptedbytheconsultingcommunityalmostwithoutques-tionuntil2000.Whenthebefore-taxreturnis10percentandtheafter-taxreturnis8percent,themanagerhas“captured”80percentofthebefore-taxreturn.Itssimplicityiswhatmakesthecaptureratiosoattractivewhencommunicatingtaxefficiency.Unfortunately,theusefulnessofthecaptureratiodiminisheswhen returns areother than the idealupward-sloping,smoothshape—orwhatiscalledthe“hockeystickmarket”—andwhenthemagnitudeofreturnsdeviatessignificantlyfromaverageannualhis-toricalreturns.

ThefirsttworowsinFIGURE8.1makesense,buttheresultsinthelastthreerowsaredifficulttoexplaintoclientsandhavelittleornorelevance.

Relativewealthmeasure:TherelativewealthmeasurewasdevelopedbymembersoftheAIMRSubcommitteeforAfter-TaxReporting.Theireffortwasindirectresponsetothefrustrationwiththeweaknessofthecapture ratio. An equation was proposed and simplified to the currentform.Ratherthancallingitaratio,theSubcommitteedecidedtolabelitmoreappropriatelyasameasure.Therelativewealthmeasureisarangebound by a rough estimate of the maximum tax rate applicable to theclient portfolio. For example, if the client is subject to the 35 percentfederalmaximumtaxrateonordinaryincomeandtheportfoliorealizedamaximumamountofshort-termcapitalgains,therelativewealthmeasureisroughly–35,butmorepreciselyitis–31.8.Ontheotherhand,ifthe

FIGURE8.1 ChallengeswiththeCaptureRatio

RETURNBEFORE-TAX AFTER-TAX CAPTURERATIO

10.0% 9.0% 90.0%

10.0% 11.0% 110.0%

2.0% 1.0% 50.0%

–1.0% 1.0% –100.0%

–8.0% –6.0% 75.0%

Sourc

e:D

ougla

sS

.R

ogers

MeasuresofTaxEfficiency 97

portfolioharvestedthemaximumamountoflosses,themeasurewouldbe+35,or+31.8tobeexact.Ifthereisnonettaxliabilityorcredit,thenthemeasureis0.

Thebeautyoftherelativewealthmeasureisthatitdeliversreasonableresultsregardlessofthedirectionormagnitudeofthemarket.Therefore,itovercomesthemajorshortcomingofthecaptureratioandhasservedtoadvancetheunderstandingoftaxefficiency.However,itisabitchalleng-ingtoexplaintoclientswhentheyencounteritforthefirsttime.

Morningstartax-costratio:Thisratiowascreatedaftertherelativewealthmeasureandprovidesameaningfulimprovementoverotherratiosandmeasures.AsshowninthefourexamplesinFIGURE8.2,theMorn-ingstartax-costratioisaderivationoftheAIMRsubcommittee’srelativewealthmeasure.

Theseriesofnumbersisthesameineachcalculation.Thedifferencesaretheplacementofthedecimalpointandwhethertheresultispositiveor negative. As you can see, the relative wealth measure has a negativesignwhentheresultisdetrimentaltothetaxpayer,whereasthetax-costratio is positive.Morningstar intended the ratio to be a “percentage ofan investor’s assets thatare lost to taxes,”or thedifferencebetween thebefore-taxandafter-taxreturn.4Thus,thepositivesignoftheoutputoftheequationmakessense.Thismethodologyiseasiertoexplaintoclientsand,therefore,wellsuitedtomoreretail-orientedmutualfundinvestors.DonPhillipssharedastoryaboutreceivingacallfromadisgruntledinves-torwhenMorningstarlaunchedthetax-costratio.Theinvestor’sconcernwasthatourcountrywasinapension-fundingcrisisandfuturemarketreturnswouldmostlikelybelowerthaninthelate1990s.Nowthatthe

FIGURE8.2 ComparisonofRelativeWealthMeasureandTax-CostRatio

AIMRSUBCOMMITTEE MORNINGSTAR RETURN RELATIVEWEALTH TAX-COST

BEFORE-TAX AFTER-TAX MEASURE RATIO

0.100 0.090 –9.091 0.9091

–0.100 –0.110 –11.111 1.1111

0.080 0.100 18.519 –1.8519

–0.100 –0.080 22.222 –2.2222

Sourc

e:D

ougla

sS

.R

ogers


mutualfundinvestorshavethisinformation,theconcernedindividualfeltitwouldonlyheightentheawarenessofthemagnitudeoftheproblem.5Fortunately, for the rest of investors who do wish to be informed, theeducationalvalueofthetax-costratiohasbeenextremelypowerful,andmutualfundinvestorsnowhaveareliablewayofanalyzingtheimpactoftaxesonbefore-taxreturns.

The problem with all the ratios and measures adopted thus far isthatnone of themhave been able tofind away to account fairly fortheimpactoftheinternalunrealizedcapitalgainsposition.Therefore,toanalyzemanagersproperly, it isessentialto incorporatebefore-andafter-taxreturns,ameasureoftaxefficiency,andthepercentageofun-realizedcapitalgains.

Thetwo large-capvalue funds inFIGURE8.3havesimilaroutstand-ingbefore-taxperformanceforthefiveyearsendingJune30,2004.6TheDodge & Cox Stock Fund has been the more tax-efficient of the twofunds,asevidentbythelowertax-costratio.Therefore,youwouldexpecttheafter-taxperformanceoftheDodge&CoxStockFundtobesuperiorto thePIMCOPEAValueAFund. In this case, thedifference is 0.84percentannuallywhenonlytaxesondistributionsareaccountedfor.SincePIMCOPEAValueAhas6percent less capital gainsoutstanding, thedifferenceinafter-taxperformancenarrowsto0.80percentusingthesale-of-fund-sharesmethodology.

Anotherpieceofinformationthatcanbevaluablewhentryingtoan-ticipate futuretaxefficiency is thetrend inthe fund’snetpurchaseandredemptionactivity,asshowninFIGURE8.4fortheDodge&CoxStockFundandPIMCOPEAValueAFund.Thisiscalculatedbymultiplyingthebeginningyear-endassetvalue(row2)bythefund’stotalrateofre-turn(row3)plus1fortheyear(row4).Thensubtractthisresult(row5)fromthecurrentend-of-yearassets(row1)tofindthenetpurchaseandredemptionactivity(row6).

FIGURE8.3 InformationRequiredtoAnalyzeAfter-TaxCapability

R E T U R N S UNREALIZED BEFORE-TAX AFTER-TAX TAX-COST CAPITAL

MUTUALFUND DISTRIBUTIONS DIST&SALE RATIO GAINS

PIMCOPEAValueA 8.26% 6.77% 6.42% 2.67 14%

Dodge&CoxStock 8.23% 7.61% 7.22% 1.73 20%

Sourc

e:M

orn

ingst

ar,

Dougla

sS

.R

ogers

MeasuresofTaxEfficiency 99

ThisquickcalculationshouldhaveraisedaflagfortheDodge&CoxFund. Upon further investigation you would have discovered that thisfundisclosedtonewinvestors.Asdiscussedinchapter6,themostad-vantageouspositionforashareholdertobeinisthatofanearlyinvestorinafundthatiscontinuinggrow,asthecapitalgainsaredistributedtoagreaternumberofinvestors.Sincethereisnocashflowfromnewinves-tors,existingtaxableshareholdersshouldanticipateexperiencingahigher-than-normalperiodofgainsrealizationuntilthefundreopens.Thiscaseiscertainlynotofthemagnitudeachievedduringthespringof2000,whengrowthfundshad50percentunrealizedcapitalgainspositionsandsalesandnetredemptionactivityresultedincapitalgainsdistributionsequaling15to20percentoffundassets.

Thequestiontax-awarepractitionersshouldaskis:Whatarereasonablemeasuresoftaxefficiencyfortax-awareproductsorportfolios?FIGURE8.5providesreasonablemeasuresoftaxefficiencyforbothseparateaccountandmutualfundproducts.Theratiosandmeasurescanchangesignificantly,dependingonthemarketenvironment.Theinformationprovidediswhatshouldbeexpectedwithaveragehistoricalreturnsoveraten-yearperiod.Aswewillseeinchapter9,year-to-yeartaxefficiencycanswingdramatically.What is important is thatthepractitionerbefamiliarwiththestrengthsandweaknessesofeachtax-efficiencymeasureandknowwhenandhowtoapplythem.Therelativewealthmeasure,eventhoughabitcomplex,isbestsuitedforseparateaccounts,whereasthetax-costratioworksquitewellwhenreturnsafterdistributionsarereportedformutualfunds.Withthesemeasuresandtechniques,investorsandinvestmentprofessionalscananalyzeafter-taxresultsmoreeffectivelythaneverbefore.

FIGURE8.4 EstimatingPurchaseandRedemptionActivity

DODGE&COXSTOCK PIMCOPEAVALUEA

1. Assetsend2003(millions) $34,156 $484

2. Assetbeginning2003(millions) $29,437 $237

3. 2003Return 32.34% 43.99%

4. 1+2003Return 1.3234 1.4399

5. Return-basedassets $38,957 $341

6 Netpurchase(+)/redemption(–)activity –$4,801 $143

Sourc

e:M

orn

ingst

ar,

Dougla

sS

.R

ogers


ChapterNotes

1. AIMR Performance Presentation Standards (AIMR-PPS)—Amended andRestatedastheAIMR-PPSStandards,theU.S.andCanadianversionofGIPSandInterpretiveGuidanceontheAIMR-PPSAfter-TaxProvisionscontainedinSection9.G.,February8,2003,32–33.

2. “Morningstar’sTaxCostRatioTool,”Morningstar.com,http://news.morningstar.com/doc/article/0,1,833313,00.html(accessedOctober23,2004),1–4.

3. Much of the discussion on measures of after-tax reporting has been takendirectlyorsummarizedfromtheauthor’sarticlewithSeanW.Egan,“EvaluatingandClassifyingTaxableAccountManagers,”JournalofWealthManagement(Fall2004):49–62.

4. “Morningstar’sTaxCostRatioTool,”Morningstar.com,http://news.morningstar.com/doc/article/0,1,833313,00.html(accessedOctober23,2004),1.

5. DonPhillips,indiscussionwiththeauthor,October14,2001.


FIGURE8.5 EfficiencyRatiosandMeasuresforTax-AwareProducts

SEPARATEACCOUNT MUTUALFUND CAPTURE RELATIVEWEALTH CAPTURE TAX-COSTASSETCLASS RATIO MEASURE RATIO RATIO

Tax-AwareCoreEquity 113% 10.2 98% 0.18

Large-CapIndex 96% –3.6 96% 0.36

ActiveLarge-CapGrowth 94% –5.5 92% 0.55

ActiveLarge-CapValue 90% –9.1 88% 1.09

ActiveSmall-CapGrowth 88% –10.9 86% 1.27

ActiveSmall-CapValue 86% –12.7 84% 1.45

ActiveInternational 92% –5.5 90% 0.91

ActiveInternationalwith 85% –13.6 83% 1.55

CurrencyOverlay

Tax-AwareMunicipalBond 105% 4.5 99% 0.09

Sourc

e:M

orn

ingst

ar

Tax-AwarePortfolioManagement

P A R T T H R E E

101

Incaseyoudidn’tknow,ethanolismadebymixingcornwithyourtaxdollars.

—PaulA.Gigot


OutperformingtheIndexFund

103

Thus far,wehavedemonstrated throughvarious studies and ex-amplesthatitisdifficulttooutperformanindexfundonanafter-taxbasis.Weshouldnote,however,thatnotallindexfundsare

createdequal,norhavetheyallbeentax-efficientwithlowfees.Forex-ample,in1997theGalaxyIISmallCompanyIndexFundandMainStayInstitutionalEAFEIndexFundhadcapitalgainsdistributionsequalto34.4percentand25.4percentoftheirassets,respectively,andsomeindexfundschargefeesclosetothoseofactivelymanagedproducts.1Chapter3describedhowCharles Schwab funded twoworkingpapers by JohnShovenandJoelDicksonofStanfordUniversitytosupporttheSchwab1000IndexFund,whichsinceitsinceptionhasnevermadeacapitalgainsdistribution.Thepurposeofthefirstworkingpaperwastodemonstratethecomparativevalueofatax-awareproduct,whereasthepurposeofthesecondwastoexplaintechniquesthatcouldbeemployedtoachievetheloftygoalofmanagingafundwithoutcapitalgainsdistributions.Shovenand Dickson identified the following principles as critical to avoidingcapitalgainsdistributions:

1 When you have to take gains, sell the highest-cost-basis sharesfirst.

2 Realizecapitallossestooffsetfuturecapitalgainliabilities.

I’m putting all my money in taxes—it’s the only sure thing togoup.

—Anonymous

C H A P T E R 9

104 Tax-AwarePortfolioManagement

3 Establish rules to overcome limitations created by the wash salerule.

Thefirst elementwas enhanced through theapplicationofhigh in,firstout(HIFO)accounting,versusfirst in,firstout(FIFO)oraveragecostaccounting.DicksonandShovenrecognizedthatabuy-and-holdap-proach to portfolio management would not be sufficient to obtain thedesiredgoal.Therefore, theydetermined itwasnecessary to take losseswhen they were available and noted that as early as 1983, George M.ConstantinidesoftheUniversityofChicagodemonstratedthatsecuritieswithgreaterpricevolatilityoffermorepotentialforthe“tax-lossharvest-ing”trade.2Lastly,thewashsalerulecreatedachallenge,becausetogetcreditforalossyouhadtoensureyoudidnotpurchasethesamesecurityagainwithinthirtydays.Ifflowscomeintothefundandcertainsecuritiescannotbepurchased,thenthecharacteristicsoftheportfoliomightdeviatefromtheactualindex.Therefore,ruleshadtobeestablishedforwhenasecurityshouldbesold,howmuchofthepositiontosell,andwhattheminimumindexweighttoholdis.Bymodelingthisprocess,theydiscov-eredtheycouldpotentiallyaddanother0.85to0.95percentinincremen-talreturn,ortaxalpha,beyondthebefore-taxreturnsoftheindex.3

Launchedin1991,theSchwab1000IndexFundwasalreadybuildinganenviablerecordofachievementwhenDicksonandShovenbegantheirresearch.Atthebeginningoftheirsecondworkingpaper,theyacknowl-edgedthecontributionofGeorgeU.“Gus”Sauter,chiefinvestmentofficeratVanguardInvestmentsfor“providinguswithkeydataandinsightintothemanagementofVanguard’s500IndexFund.”SoitisnocoincidencethatVanguardfounderJackBogletooknoteoftheirconclusions.ForatleasteightyearspriortothattimeBoglehadbeenencouragedonmorethanoneoccasionbyTadJeffreytorunatax-awarefundsimilartotheWindsorIIFund,buthe justcouldn’tbeconvinced itcouldbedonesuccessfullyoveralongperiodoftimewithanactiveapproach.4SinceBoglehadhisheartandsoultiedtopassiveinvesting,thiswascertainlynosurprise.ItwastheworkofDicksonandShovenin1993thatfinallyconvincedhimthathispositiononapplyinganindex-basedportfoliowastheproperapproachandthattheprocesscouldbedonewithoutharmingVanguard’sreputa-tion.Shortlythereafter,inSeptemberof1994,Vanguardlaunchedaseriesoftax-managedfunds.WiththesuccessofGoogle,onehastowonderiftheStanfordteamofDicksonandShovennowlookbackandwishtheyhadpersonallycashedinonthepracticalvalueof“AStockIndexMutualFundWithoutNetCapitalGainsRealization”ratherthansharingtheirfindingswiththepublic.InDickson’scase,hewouldsoonputhisknowledgetouse:aftercompletinghisdoctorate,hespentashortstintattheFederalReserve

OutperformingtheIndexFund 105

analyzingthemutualfundindustry,andthenBoglemadeoneofhismanyastutebusinessdecisionsbyhiringhimtoassistGusSauterwithoperationofVanguard’sindexandtax-managedfunds.5

By adhering to and building on the three principles outlined byDickson and Shoven, the Schwab 1000 Index Fund andVanguardTax-Managed Funds collectively boast well over a half century of operatingwithoutdistributingcapitalgains.AsBoglehassaid,“theyhavebeenout-standingfortheirshareholders,butamarketingdisappointment.”6Thesearecertainly theproducts that shouldhavevirtuallyeliminatedhigh-costvariable-annuityproducts.TheSchwabandVanguardtax-managedprod-uctsofferatax-deferralmechanismsimilartoavariableannuitybutwithsignificantlylesscostanddailyliquidity.Moreimportant,ifheldmorethanayear,theappreciatedamountofthetax-managedproductsaretaxedatthefederalrateforlong-termcapitalgainsratherthanthemuchhigherordinaryincometaxrateforvariableannuities.Sowhy,insomeyears,aremorethan$50billionofvariableannuitiesissued?Forthesimplereasonthatannuitiesare“sold”toinvestorswhodonotrealizethereisavastlysuperioralterna-tive,whereastax-managedproductsare“bought”mostlybyself-educatedtax-awareinvestors.Onceagain,thekeyiseducation,becauseifinvestorsunderstood the tax ramifications of various investment alternatives, theywouldlikelymakequitedifferentpurchasedecisions.

Tax-managedmutualfundsmayhaveredemptionfeesthatarewaivedafteradesignatedperiod.Thisfeatureisintendedtoattractonlythosein-vestorswithlongtimehorizonsortodeterotherswhofrequentlyredeemshares.TheVanguardtax-managedseriesemploysa2percentredemptionthefirstyearand1percentforthenextfouryears.Boglebelievesthatal-thoughthefeaturewasneededandperhapsaheadofitstime,ithasbeendetrimentaltothegrowthoftheproducts,asheknowstherearesizableamountsoftaxableassetsintheirS&P500IndexFundeventhoughtheTax-ManagedGrowth&IncomeFundhasmorepotentialtoachievesu-periorafter-taxreturns.

AtthetimeDicksonandShovenwereworkingontheirpapersthereemergedanothertax-efficientproduct:theexchange-tradedfund(ETF).ThelargestandmostrecognizableETFistheStandard&Poor’sDeposi-tory Receipt (SPDR), which appeared in January 1993. However, theideaoftradingaportfolioasasharebeganwithindexparticipationshares(IPS),whichbegantradingontheAmericanandPhiladelphiastockex-changesin1989.Theseproductswereoriginallydesignedforinstitutionsthatsoughtavehiclewithintradayliquiditytoincreaseordecreasesignifi-cantmarketexposure inacost-effectivemanner.Likesomanyitemsintax-awareinvesting,theinnovationrequiredacatalysttoattractsufficientattention.Thismarketwasprettymuchdormantuntilinvestorsembraced


the“QQQ”thatreplicatesthetechnology-ladenNasdaq-100Indexinthespringof2000.AsFIGURE9.1shows,theworldwidemarketforETFshasgrownsteadilyfromlessthan$1billionin1993tomorethan$200billiontodaywithapproximately300differentofferings.7

Alongtheway,investmentprofessionalsbegantorecognizeauniquefeatureofETFsthatwasn’tbeingtouted.Throughanin-kindtransferofshares,whichwasoriginallydonetoallocateexpenses,ETFscanachievealeveloftaxefficiencythatrivalsthetax-managedfunds.

TherearetwotypesofmarketsforETFs:aprimarymarketof“autho-rizedparticipants”andasecondarymarketof individual investors.ETFsarecreatedwhenanauthorizedparticipantsendsinabasketofsecuritiestofunda“creationunit.”Acreationunitisusuallyablockof50,000shares.Unlike mutual funds, there is no exchange of cash with the authorizedparticipant,justanexchangeofsecuritiesforsharesintheETF.Whenhewants to redeemhis shares, the authorizedparticipantwill exchangehisETFsharesforsecurities.Thisisknownasthein-kindtransfer.Whenasmallerinvestorwishestobuyshares,hedoessothroughabrokerbypur-chasingthemthroughanexchange.Inthiscase,hepayscashforthesharesandreceivescashwhenhesells.However,histransactiondoesnothaveataximpactontheunderlyingsecurities.Thisprocessisillustratedinasche-maticprovidedbyBarclaysGlobalFundAdvisors(seeFIGURE9.2).

Thisprocessisquitedifferentfrombuyingandsellingsharesofatradi-tionalopen-endmutualfund,inwhichcasetheportfoliomanagerofthe

FIGURE9.1 WorldwideETFGrowthA

ssets

in U

SD

Millions

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Mar.’04

$811 $1,122 $2,302 $5,258 $8,234 $17,596 $39,605 $74,337 $104,800 $141,621 $212,016 $229,308 3 3 4 21 21 31 33 92 202 280 282 32

0

50,000

100,000

150,000

100

150

200

250

300

50

10

200,000

$250,000

Num

ber

of

ETFs

Assets in USD Millions

Number of ETFs

Figure 9.1 Rogers

Sourc

e:M

org

anS

tanle

yR

ese

arc

ha

ndB

loom

berg


fundbuysandsellssecuritiestosatisfydailynetpurchaseandredemptionactivity(seeFIGURE9.3).Ifthesecurityissoldata levelotherthanthecurrentcostorbookvalue,thenataxableeventoccurs.Therefore,froma tax standpoint, theopen-endmutual fund isvery susceptible todailyshareholderpurchaseandredemptionactivity.

Whenanauthorizedparticipantredeemsshares,itdoesnotcauseatax-ableeventforotherETFshareholders,becausethereissimplyanexchangeofsecuritiesfortheETFshares.Afterward,theauthorizedparticipantcandowhateverhedesireswiththebasketofsecurities,butagainithasnotaximpactontheETF.Betteryet,whenacreationunitisredeemed,themanageroftheETFdoesnothavetogivebacktheoriginalshares.Since

FIGURE9.2 CreationofaniShare

iSharesCreationUnitsBasketofSecurities

iSharesFund(Trademarkof

BarclaysGlobalFundAdvisors)

CapitalMarkets

Investor(buyer)

Bro

kera

geA

ccou

nt

Exch

ange iShares

MarketMakers

Cash

iShares

Cash

Securities

AlthoughiSharesmaybeboughtandsoldontheexchangethroughanybrokerageaccount,iSharesarenotindividuallyredeemablefromtheFund.InvestorsmayacquireiShares,andtenderiSharesforredemption,throughtheFundinCreationUnitaggregationsonly.

Figure9.2Rogers

FIGURE9.3 TraditionalMutualFundProcess

CapitalMarkets

Investor(buyer)

Cus

tom

erS

ervi

ce

Fund

Cash

SharesofFund

Cash

Securities

Figure9.3Rogers

Sourc

e:

Barc

lays

Glo

balIn

vest

ors

Sourc

e:B

arc

lays

Glo

balIn

vest

ors


hecanchoosewhichsharestodistributethroughtheapplicationofspe-cificlotidentificationaccounting,hewillmostlikelydistributetheshareswith the lowestcostbasis.Thiscauses theaveragecostof the securitiescomprising theportfolioof theETF to trendupwardover time. Ines-sence,thein-kindtransferisasubstituteforthetax-lossharvestingtrade,thatis,theETFmanagerlowerstheamountofembeddedcapitalgainsinthefundthroughthein-kindtransfer,whereasthemutualfundmanagertakeslosseswhenavailabletooffsetgains.

Likeindexfunds,ETFshaveverylowexpenseratios.Unlessthebuyerisanauthorizedparticipant,ETFsarepurchased inthesecondarymar-ketthroughabroker,whoreceivesacommission.SinceETFsaretradedintraday,theunderlyingsecuritiesneedtobesomewhatliquid.Althoughtherearemore than100ETFsavailable to investorsandnewETFsarebeing launched almostweekly, the structure isnot suitable for all assetclasses.Unfortunately,asaresultofchallengeswithliquidityandpricing,noneoftheprovidershavebeenwillingtoundertakeamunicipalbondETF,eventhoughthereistremendousdemandforsuchaproduct.

SomeadvisersarefansofETFs,whileothersprefertax-managedopen-endmutual funds.Unfortunately,neitherETFsnortax-managedfundsaretherightchoiceorperfectsolutionforallsituations.Therefore,tax-awareadvisersneedtobeawareofthetaxconsequencesofeachsothattheycanoffertheirclientssageadvice.

FIGURE9.4buildsonaschematicutilizedbyGaryGastineauinTheExchange-TradedFundsManualtocompareatypicalmutualfund,ETF,andaholder,whichisaportfolioofstocks.8Theevaluationsystemofthefigureisthesame,butitislimitedtoacomparisonofatax-managedandexchange-traded funds.The fields have been expanded and subdividedintothreemajorareas:taxefficiency,operational,andestate.

Taxefficiency:Bothtax-managedmutualfundsandETFsbenefitthetaxableinvestorbytakingadvantageofspecific-lot-identificationaccount-ingandoffsettingfundexpenseswithtaxableincome.Thekeydifferenceinhowtax-managedmutualfundsandETFsattempttoachievetaxef-ficiency is their reliance on the internal tax-loss harvesting trade versusthe in-kind transfer.Both typesof fundscan selldepreciated securities,harvesttheloss,andapplyitagainstgainsinthefuture.However,ETFstypicallyachievebettertaxefficiencyfromexchanginglow-cost-basisforhigh-cost-basisshares.PerhapsthegreatestadvantageETFshaveovertax-managedfundsishowthein-kindtransfercanhandleitemslikeindexre-constitution,deferralofshort-termgains,andstocksacquiredinmergers.Withtheseadvantages,ETFsofferamoretax-efficientsolutionfortaxableinvestorswhowanttoobtainexposuretosmall-andmiddle-capitalizationdomesticequities.


FIGURE9.4 ComparingTax-ManagedandExchange-TradedFunds

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

Step-UpofBasisatDeath + +

+ Best

0 OK

– Worst

Sourc

e:

Gary

Gast

ineau,

Dougla

sS

.R

ogers


Operational:TheETFcanbeboughtandsoldintraday,butunlessinvestorsareauthorizedparticipantscreatingandredeemingETFshares,theymustpay abroker’s commissionon the transactions.The investormaypayaslightpremiumforthisadditionalliquidityintermsofabid/askspread,but thesedifferencesaresmallwithhigh-volumeproducts.Mu-tualfundshareholdersbenefitwhentheyinvestearlyinafundandfuturecapitalgainsaredistributedacrossagreaternumberofinvestors.However,ETFinvestorsbenefitwithredemptionswhenthemanagerexchangesoutoflow-costbasisshares.Bothtax-managedfundsandETFsofferinvestorsreasonableorlowfees,withsomeETFschargingfeeslessthan0.10per-centannually.ETFstypicallydonothaveredemptionfees.Redemptionfeescanbebothapositiveandnegativefortheinvestorinatax-managedfund.Thenegativesideisinvestorsmayhavetopaythemiftheyredeemtheir shares earlier thananticipated.However, redemption fees assist indrivingawayhotmoneythatleadstocapitalgainsgeneration.Also,theredemptionfeesareleftinthefund,whichcanboostfundperformance.ETFsarenotimmunetocapitalgainsdistributions.Therearetimeswhenthey simplyhave to sell a security and cannot avoid taking a gain.Forexample,country-specificfundsmaynotbeabletoavoidacapitalgainsdistributionifacertainholdingexceedsthelimitsetbyvariousregulatorydiversificationrulesandhastobesold.Perhapsthebest-knownexamplesaretheiSharesMSCICanadaandSwedenETFs,whicheachhaddistri-butionsofmorethan18percentofassetsin2000.9IntheCanadaETF,Nortelbecamemorethan25percentofthecapitalizationoftheportfolio.AsNortelcontinuedtoincreaseinsizerelativetootherstocksintheCan-adaportfolio,themanagerwasforcedtosell.Fortunately,thissituationisprimarily limited to thecountry-specific funds,but ithighlights thatadvisersneedtobeinformedofhowgainscanbegeneratedwithETFssotheycanavoidpotentiallyembarrassingsituationswiththeirclients.

Estate: Tax-managed funds and ETFs are pretty much equal whenitcomestocharitablegivingandtakingadvantageofthestep-upincostbasisatdeath.

The information in Figure 9.4 enables advisers to check a client’spersonalsituationofbeforerecommendingatax-managedorexchange-tradedfund.Unlesstheyaredealingwiththesamesizeandtypeofclientwithidenticalcircumstances,oneproductmaybemoresuitableinsomeinstancesthantheother.Additionally,managersoftheseproductsareal-wayslookingforwaystorefinetheirprocessesandenhanceperformance.Therefore, it is recommendedadvisersmaintain a similar checklist thatincorporatesthemostrecentdevelopments.

FIGURE9.5 showstenyearsofbefore-andafter-taxperformancefortheVanguardTax-ManagedGrowthandIncomeFund,ETFSPDR,and


Vanguard500IndexFund.Thesethreefundswerechosenforthiscom-parisonexercisebecausetheyallusetheS&P500stockindextoconstructtheunderlyingportfolioofstocks.

From this limited amount of information come three conclusions.First, it is readilyapparent that thedifferences inperformancebetweenthe three funds are extremely small. Second, each of the funds has anextraordinarilyhighleveloftaxefficiency,astheMorningstarten-yeartax-costratiosrangefromonly0.52to0.63.Therefore,allofthemanagersofthefundshavedoneanoutstandingjobofexecutingtheirstrategyinatax-awaremanner.

Overextendedperiodsoftime,therearetwokeyfactorsthatdictatewhetherthemutualfundorETFformatisbetterformanagingtheunreal-izedgainposition.Manageableredemptionactivitybenefitstheremain-ing shareholders of the exchange-traded fund, whereas reasonable pricevolatilityof individualsecuritiesbenefits thetax-managedmutual fund.Extremesineithercasemayresultinacascadeofredemptionactivitythatcould force the saleordistributionof shares,withameaningfulcapitalgaindistributiontofollow.

Theresultsshownthusfarareallnetoffees,whichiscustomarywithmutual and exchange-traded funds. Now let’s examine the results on agrossoffeebasistotheactualreturnoftheS&P500(seeFIGURE9.6).

Notethatallthreefundshaveachievedgrossbefore-taxreturnsclosetotheS&P500stockindex.Twoofthefundshaveactuallyexceededtheresultsofthebenchmarkbyasmallmargin.Manypractitionerscallfundsandaccountsofthisnature“passive”investmentsorportfolios.Therefore,thethirdandperhapstheprimaryteachingpointofthisexerciseisthattax-aware investing is anythingbutpassive! In fact, theremaybemore

FIGURE9.5 Before-andAfter-TaxReturnsofSimilarTax-ManagedandExchange-TradedFunds(Forthe10-YearPeriodEndingDecember31,2004)

AFTER-TAXEXCHANGE-TRADED DISTRIBUTIONS&ORMUTUALFUND BEFORE-TAX DISTRIBUTIONS SALEOFSHARES

VanguardTax-ManagedG&I 12.09% 11.51% 10.48%

SPDRTrustSeries1 11.88% 11.23% 10.21%

Vanguard500Index 12.00% 11.32% 10.34%

Sourc

e:M

orn

ingst

ar

Pri

ncip

ia,Ja

nuary

20

05


tradingactivityintheseportfoliosthaninthetypical“actively”managedfund.Thedifferencehereisthatitisinformedtradingactivitythatworkstothebenefitofthetaxableinvestor.

Thereareanumberoftechniquesthatarevaluableinmanagingindex-basedportfolios.Theseinclude:

❑ Cost-efficienttradingthatincludeselectroniccrossingnetworks❑ Purchasingderivativeswhentheyareinitiallycheaperthantheun-

derlyingstocks❑ Pledgingsecuritiesoftheportfolioforsecuritylending❑ Purchasingstocksbeforetheyareaddedtotheindex❑ Takingadvantageofanimbalanceinaparticularsecurity

Anything themanager cando that leads to superior resultswithouttakingonundueriskshouldbeencouraged.

ThelastpointisthatETFshavelaggedtheperformanceoftheirmu-tualfundtax-managedpeerswithsimilarportfoliosbyaveryslightmarginbeforetaxbuthavedonequitewellaftertax.Oneofthereasonsfortheminordifferentialinbefore-taxreturnsoftheSPDRTrustSeries1isthatithasnotbeenallowedtoreinvestthedividendsitreceivesfromitsport-folioholdings:thecashmustbeheldinamoneymarketfund.Addition-ally,sharescannotbeputoutforsecuritieslending.EarlyETFs,liketheSPDR,wereregisteredasunittrusts,whereasnewerETFsareregisteredasopen-endmutualfundsanddonotfacethisdisadvantage.Thisweak-nessisknownandhasbeensharedwiththeSEC.Inthemeantime,somebrokerage houses have established cost-effective dividend reinvestmentplanstominimizethis impact.10Hopefully,apositiveresolutiontothis

FIGURE9.6 Before-andAfter-TaxReturnsofSimilarTax-ManagedandExchange-TradedFunds(Forthe10-YearPeriodEndingDecember31,2004)

EXCHANGE-TRADED GROSSORMUTUALFUND BEFORE-TAX STATEDFEE BEFORE-TAX

VanguardTax-ManagedG&I 12.09% 0.17% 12.26%

SPDRTrustSeries1 11.88% 0.12% 12.00%

Vanguard500Index 12.00% 0.18% 12.18%

Benchmark:S&P500StockIndex 12.07%

Sourc

e:M

orn

ingst

ar

Pri

ncip

ia,Ja

nuary

20

05


challengewillbeprovidedsoon.Anotherfeaturethatmayhavebenefitedtax-managedfundsduringthisperiodistheredemptionfee.Whilemostinvestorsintax-managedproductsplantostaywithafundforfiveyearsormore,unforeseenpersonaleventscanoccurthatforcethemtosellshares.Also,redemptionactivityintheVanguardTax-ManagedFundsincreasedduring thebearmarketof2000 to2001,but itwas still farbelow theindustry average. Investors that redeemed shares during their first yearwouldhave received98percentof theirnet asset value, and those thatwereintheone-to-five-yearrangereceived99percent.Thedollarsofthe1to2percentredemptionfeesremainedwiththefundandhadasmallbutfavorableimpactonperformance.

Dotheresultsof these three fundsmeantax-aware investors shouldnotownETFs?Absolutelynot:ETFsareaninnovativesolutionthattax-awareinvestorscanaddtotheirarsenalofweapons,andtherearemanycaseswheretheyinfactoffertheoptimaltax-efficientsolution.Moreover,ithasonlybeensinceabout2000thatthemanagersofETFshavecometofullyrecognizehowimportantthetaxadvantageofthein-kindtransferistotheirtaxableinvestors.Nowinvestorsandadvisersneedtodeterminewhenitisbesttoapplythem.BarclayshasbeenextremelyproactiveinthemarketbyofferinginvestmentseminarsthatemphasizegeneraleducationonETFsratherthanemphasizinghowtheirproductsmaybesuperiortothecompetition.Asaresult,moreadvisersarebeginningtounderstandthetaxbenefitsofETFsandapplyingthemininnovativeways.Mostim-portant,onceinvestorsbecomecomfortableusingtax-efficientproductsandseethefavorableresultwhentheirtaxesaredue,theyarereluctanttoreverttousinglesstax-efficientmutualfundsandseparateaccountprod-uctsandmanagers.

Mutualfundsthatincludetermssuchas“tax-managed,”“tax-aware,”or“tax-efficient”intheirtitlesarerequiredtoincludeafter-taxreturnsintheiradvertisingmaterials,whereasitisoptionalforothers.11However,thisdoesnotguaranteeaninvestorwillreceiveatax-efficientoutcome.Therearetwonoteworthyhistoricalexamplesofshareholderswho,unfortunately,didnotreceive tax-efficientoutcomes.12Thefirstexample involves theBernsteinTax-ManagedInternationalFund.Thisinitiallysuccessfulfundattractedameaningfulamountofassetsanddevelopedasubstantialunrealizedcapitalgainsposition.Thenthepricesforinternationalstocksbegantofall,andalongwiththisdevelopmentcameshareholderredemptions.Althoughthemanagerattemptedtominimizethecapitalgainsdistributions,therewasonlysuchmuchhecoulddo.Eventuallyhewasforcedtosellshareswithembeddedgains.Thisexamplehighlightshowshareholderactivitybeyondthe control of the manager can influence the after-tax returns of share-holderswhoremaininthefund.TheotherinstanceistheStandishSmall


CapitalizationTax-ManagedEquityFund.Inthiscase,theteammanagingthe fund sold largepositions in technology andbiotechnology shares inthespringof2000,andsoonthereafterdepartedforanotheremployer.13Standish’scompliancepersonnelwerenaturallyconcernedthattherewouldbesignificantredemptionsasaresultofthedepartureandthatnotdistrib-utingthecapitalgainswouldbeunfairtoshareholdersthatremainedinthefund.Theydecidedtoannounceacapitalgaindistributionratherthantowaitandseeiftherestofthefiscalyearwouldofferthepotentialtosellsomesharesatlossestoreducethemagnitudeofthedistribution.Withthemarketdeclinein2000,thedistributioncametomorethan19percentofthefund’sassetvalueatyear-end.14Thesetwoexampleshavebeenprettymuchforgottenbyinvestors,butatthetimetheydrewalotofnegativeattentiontotheemergingnicheoftax-awaremutualfunds.Theseexamplesarementionedasillustrationsofthepotentialchallengesindeliveringonatax-awaregoal,despitewhataparticularfundtitlemayimply.

Itwillbeinterestingtomonitorhowindex,tax-managed,andexchange-traded funds will manage the reconstruction of the S&P 500, MidCap400,SmallCap600,andREITCompositeindicesforfullfloatadjustment.Previously,Standard&Poor’sderivedthepercentagefortheallocationbytakingintoaccountthetotalsharesoutstandingversustheavailablefloatinthemarketplace.Thesepercentagescandiffersignificantlyifacontrol-lingfamilyoracompany’streasuryfunctionisholdingasignificantstake.Therefore,theamountofsharesofaparticularcompanyavailabletoinves-torsasmeasuredbytheoutstandingfloatcanbequitedifferentthanwhatwaspreviouslyportrayedby index funds.Standard&Poor’s announcedthemethodologyandanalysisof the adjustment forfloatonSeptember28,2004,thusgivingmarketparticipantsknowledgeofwhatwilleventu-allytakeplaceandwhen.TheS&Pplanisfortheindicestobehalffloat-adjustedonMarch18,2005.Theexamplegivenintheannouncementis:“acompanywithan80%floatfactorwillbeadjustedtoa90%factor—halfwayfrom100%to80%.”OnSeptember16,2005,allS&Pindicesaretobefullyfloat-adjusted.15Forsomestocks,theshiftwillbedramatic,suchasWal-MartStores,whichadjustedtoahalf-floatfactorof0.80onMarch18, 2005, and was scheduled to adjust to a full float factor of 0.60 onSeptember16,2005(seeFIGURE9.7).16

Thisprocedurewillresultinareductionintheoutstandingfloatofap-proximately20percentofthestocksintheS&P500.Toavoidgeneratingsubstantialcapitalgainsfromthisexerciseisgoingtotakecarefulplanningandcoordinationonthepartofthefundmanagers.

Managers of exchange-traded and tax-managed funds realize todaymorethaneverhowimportantmaintainingtheirreputationsandrecordsfor tax efficiency are to future success. Evolving risk-management tools


allowmanagerstostress-testportfoliostodeterminethepotentialforgainsinadversemarkets.Asaresult,managersarebetterpreparedforchallengingsituationsthaneverbefore.Althoughitwouldbefoolishtosayinvestorsseekinga tax-efficient fundsolutionwillnotencounteranother instanceofasizablecapitalgainsdistribution,theexperiencesofthepastandthegrowingbodyofknowledgepertainingtotax-awareinvestingshouldresultinattractivefundproductsthathaveahighprobabilityofoutperformingtheunderlyingindexofsecuritiesonanafter-taxbasis.

ChapterNotes

1. AaronLucchetti,“IndexFundsAren’tAlwaysTaxEfficient,”WallStreetJournal,July28,2000.

2. GeorgeM.Constantinides,“CapitalMarketEquilibriumWithPersonalTax,”Econometrica51,611–636.

3. JoelM.DicksonandJohnB.Shoven,“AStockIndexMutualFundWithoutNetCapitalGainsRealizations,”NBERWorkingPaperNo.4717,April1994,1–26.

4. RobertH.JeffreytoJohnC.Bogle,May29,1985,andJuly6,1990.

5. JoelDickson,indiscussionwithauthor,September21,2004.

6. JackBogle,indiscussionwithauthor,September2,2004.

FIGURE9.7 Standard&Poor’sFreeFloatSchedule

Oct.15,2004 Mar.18,2005 Sept.16,2005

S&P500Classic

S&P500Classic

S&P500HalfFloat

S&P500FullFloat

October15,2004:CommencecalculationofthreedifferentindicesfortheS&P500:•S&P500CLASSIC•S&P500HALFFLOAT•S&P500FULLFLOAT

Phase2:OfficialS&P500movestoafull-freefloat-adjustedcalculation

Phase1:OfficialS&P500movestofreefloat-adjustedcalculationbasedon50%oftheintendedfloatfactorforeachconstituent

Theabovetimelineappliestothefollowingindicesandtheirrelatedsub-indices:S&P500,S&PMidCap400,S&PSmallCap600,S&PComposite1500,S&P100,andS&PGlobal1200

S&P500CLASSIC

S&P500HALFFLOAT

S&P500FULLFLOAT

Figure9.7RogersSourc

e:S

tandard

&P

oor’

s


7. “MeetingInvestmentChallengesWithETFs,”ForbesSpecialAdvertisingSec-tion,http://www.federalreserve.gov/releases(accessedOctober30,2004).

8. Gary L. Gastineau, The Exchange-Traded Funds Manual (New York: JohnWiley&Sons,2002).

9. Dawn Smith, “An Education in ETFs,” http://www.smartmoney.com (ac-cessedOctober30,2004).

10. KarenDamato,“For IndexFunds, theDevil Is in theDetail,”WallStreetJournal,September7,2004.

11. Securities and Exchange Commission, “Final Rule: Disclosure of MutualFundAfter-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,August12,2004.

117

Inthischapter,weintroducetheconceptofthequantitativetax-aware(QTA)portfoliostrategyandcompareitwithothermethodsofdi-versifyingaconcentratedstockposition.TheQTAinvestmentstrat-

egyissimilartowhatatax-managedmutualfundmanagermayemploywithtax-lossharvesting.Unlikelossesrealizedinmutualfunds,lossesinseparateaccountscanbeusedtooffsetaclient’sgainsinotherportfoliosandarenotsubjecttotheeight-yearcarryforwardlimitationthatappliestomutualfundlosses.Therefore,thisstrategyisideallysuitedforcom-biningwithtax-inefficient,high-alpha-generatingstrategiesorforuseasa tax-efficientmechanismto transitionconcentrated stockpositions todiversifiedportfolios.Asaresult,tax-inefficientactivemanagementstrat-egies shouldbereviewed inconjunctionwithotherconcentrated-stockdiversificationstrategiessuchasexchangefunds,collars,andprepaidvari-ableforwards.

FIGURE10.1illustratestheimpactoftax-lossharvestingovertimewitha portfolio funded all in cash. It shows a First Quadrant Monte Carlosimulation of 500 observations, taking into account an average annualyieldof1.44percentandtotalreturnof7.92percentwith15percentan-nualstockvolatilityanda35percentmarginaltaxrate.Individualstockvolatilitywas31percent.Obviously,theresultsmaychangewithdifferent

Taxissuesarefun.Gettingtolovethemmaytakeabitofeffort,butthesameistrueforBeethoven’sstringofquartets,andthinkofhowmuchpleasuretheygiveifonedoesmaketheeffort.

—PeterL.Faber

C H A P T E R 1 0

QuantitativeTax-Aware

PortfolioManagementand

ConcentratedStock


assumptions,buttheparametersappliedhereareverytypicalofwhatonewouldapplytoday.

Thekeypoint is the tax alpha is far greater at the inceptionof therelationship thanwhen theportfoliobecomes seasoned.However, evenaftertwenty-fiveyears,therearestillopportunitiesforlossesthatproduceataxalphaofabout0.5percentayear.1Unfortunately,therewillalwaysbesurpriseslikeEnronandMCI,butatleasttax-lossharvestingextractseconomicvalue fromdeterioratingsituations.Atcurrent levelsof taxes,theestimatedaverageannualalphaforthefirsttenyearsisapproximately1.3percent,whereasithadbeenabout1.5percentbeforethelong-termcapitalgainstaxwasreducedfrom20percentto15percentandtaxonqualifieddividendsfrom38.6percentto15percent.

Separateaccountportfoliosthatemphasizetax-lossharvestinghavebeenaroundforonlyaboutadozenyears.In1992,ParametricPortfolioAssoci-atesreceivedacallfromCTCConsultinginPortland,Oregon.CTChadalargefamilyclientintheNorthwestforaboutadecade,andbothCTCandtheclienthadbecomedisgruntledwiththelackofattentiontheirac-tiveequitymanagerswerepayingtotheimpactoftaxes.Parametricwasinthecustomindexbusiness,butuntilthistimeithadnottakenonataxableaccount.The inquiry caught the attention of the firm’s chief investmentofficer,MarkEngland,andheassignedportfoliomanagerBrianLangstraattoassisthimwiththisspecialproject.TheylistenedcarefullytocommentsfromtheclientandCTCconsultantsRalphRittenourandNancyJacob.

Parametric first ran the strategies with a typical before-tax approachaccordingtovalueorgrowthmandatesbycapitalization.Thetaxableturn-

FIGURE10.1 PortfolioValueAlphas


8%

9%

10%

7%

6%

5%

4%

3%

2%

1%

0%

Months

0 50 100 150 200 250 300 350

Alp

ha

75thPercentile

Median

25thPercentile

Sourc

e:

Robert

D.

Arn

ott

,A

ndre

wL

.B

erk

in,

andJ

iaY

e,

“Loss

Harv

est

ing:

What’

sIt

Wort

ht

ot

heT

axa

ble

Inve

stor?

”Jo

urn

al

of

Wealt

hM

anagem

ent

(Spri

ng2

00

1):

10

–1

8.

QuantitativeTax-AwarePortfolioManagementandConcentratedStock 119

overinlarge-capitalizationstockindiceswasrunninglessthan5percentayearandwasattributedprimarilytomergersandacquisitionsthatwereconsummated by a cash transaction rather than an exchange of shares.Therefore,theindexapproachbyitselfwasavastimprovementovertheclient’spreviousmanagers’ taxefficiency,or lack thereof.Parametricwasbeginningtoanalyzehowitcouldaddvaluebyapplyingotherthantradi-tionalapproacheswhenthearticlesbyJeffreyandArnottandDicksonandShoven in1993caught itsattentionand,more important, thatofotherCTCclients.In1995,Parametricbeganmakingtax-lossharvestingtrades,andoneclientsoonturnedintothree.MarkEnglandretired,andthingsreallypickedupwhenParametrichiredDavidSteinas chief investmentofficerin1996.Parametricsoonfoundthatitsearlyleadinthisnewnichewouldhave anoverwhelming impact on the future of its business.Lessthanfiveyearslater,itfoundthatdemandforitsapproachwouldnecessi-tatethatitabandonthelow-margin,tax-exempt,indexingcommoditytypeofbusinessforretirementplans,foundations,andendowmentsandfocusitsattentiononthehighlycustomizedtaxableaccountbusiness,whereitsuniqueapproachofferedclientsatruevalued-addedproposition.

Parametricwastheearlyleaderinwhatsomerefertoaspassiveinvest-ing,butismoreappropriatelydesignatedasquantitativetax-awareinvest-ing(QTA).Thepassivenomenclatureofthisnichecomesfromtheearlyportfolioshavingbeenmanagedaccordingtothetraditionalformofindexinvesting.Obviously,advocatesoftheefficientmarkethypothesisbelievethisisreasonenoughtoemployapassiveratherthananactiveapproachtoinvesting.However,shortlyafterhissuccessfularticlewithTadJeffreywaspublished,RobArnottbroughtFirstQuadrantintothedebate.His-torically,FirstQuadranthadmanagedportfoliosusingsophisticatedmath-ematicalmodeling—knownas thequantitative,or“quant,”approach toinvesting—initsefforttoprovideclientswithabefore-taxalpha,whichithassuccessfullydoneovertime.Therefore,theindustrysoonhadofferingsthatprovidednotonlyatax-advantagedapproachbutalsotheoptiontocloselytrackadesignatedindexortopotentiallyachieveincrementalreturnonabefore-taxbasis,aswell.Moreover,asmentionedinchapter9abouttax-managedandexchange-tradedfunds,theportfoliomanagementtech-niquesandtradingofthesestrategiesisanythingbutpassive.

SohowdoQTAstrategieswork?Thefollowingisalistofkeyelementsthattheadviserandtheclientshouldunderstand:

❑ Benchmarkselection❑ Clientcriteria❑ Custodian❑ Fees❑ Trackingerror


Benchmarkselection:ThefirststepintheQTAprocessistoselecttheappropriateequitybenchmark.Today,almostanyequitybenchmarkintheworldcanbefollowed,aslongasthemanagercanreceivetheunderlyingpercentageallocationstoeachsecurity.Forlarge-capitalizationcoretypeindices, theprocess ispretty straightforward.Whenattempting tohaveaportfoliomanagedforaparticularstyle,itisimportanttounderstandhowtheindexproviderconstructsitsstylebenchmarks.Forexample,theRussell style benchmarks have a 30 percent overlap, whereas the Barraindiceshavenone.ThemanagerwilllikelysteeryoutowardtheRussellin-dices,sincetheyprovideagreaternumberofsecuritiestoworkwith.TheMorganStanleyCapitalInternational(MSCI)indices,nowemployedbyVanguard,utilize“bufferzones”forchangesincapitalizationassignment.Forexample,ifthereare500stocksintheindexanda100stockbufferapplies,thestockwouldhavetodropbelow600beforeitistakenoutoftheindex,orastockwouldhavetoreach400beforeitisincluded.Thisfeatureisdesirableforsomeoneinterestedinasmall-ormid-capportfolio,asittonesdowntheamountofreconstitutionthatgeneratesgains.Asageneralrule,QTAportfoliosaretypicallymoreadvantageouswithvalue-styleandlarge-capportfolios.Growthindexportfoliosarenaturallymoretax-efficient,astopperformersstayintheindex.Astockisremovedfromthegrowthindexbecauseitsrelativevaluationhasfallen.Therefore,theamountofappreciationmaybeinsignificant,oritmayeventransitionataloss.Ontheotherhand,whenastockshiftsfromthevalueindextothegrowthindex,itcanonlydosobyasignificantimprovementinrelativevaluation,whichislikelytoresultinsubstantialgainsrealization.

Clientcriteria:Therearecriticalclientfactorsthatthemanagerneedsto know before he can attempt to provide an optimal solution. Obvi-ously,thetaxprofileoftheclientortaxableentityisessential.Informingthemanagerofthemagnitudeandtimingofanticipatedcashflowsandwithdrawalswillallowhimtobettergaugetheleveloftaxefficiency.Themanagermaysuggesttheflowsbereceivedjustpriortoanticipatedrecon-stitutiondates, as thatwill givehimgreaterflexibility in shifting fundstowardincreasingsectorandindustryallocations.Iftheportfolioperiodi-callyreceivesacontributionofcash,thenahigherleveloftaxefficiencycanbeperpetuatedthanshowninFigure10.1.Also,ifdividendsaretobereinvested,thatallowsforabitmoreflexibilityinrebalancingtheportfo-lio.Thesizeoftheportfoliodictateswhetherodd(lessthan100shares)orround(100-shareincrements)arepurchased.SincetheQTAmanagertypicallybatchestrades,oddlottransactionsarenotaproblem.

Portfolioconstruction:Todaythereareaboutahalf-dozensignificantplayers inthis space.Theyare listedhere inalphabeticalorder toavoidtheappearanceofapersonalpreference:AperioGroup,FirstQuadrant,


M&IBank,NorthernTrustGlobalInvestments,ParametricPortfolioAs-sociates,StateStreetGlobalAdvisors,andU.S.TrustCorporation.Thesefirmsallhaveexcellentwaysofservingthetaxableinvestorandattempttodifferentiatethemselvesbytheirslightlydifferentapproaches,thecli-ents they serve, and their product design. For example, Parametric hasanoutstandingreportingcapabilityandservesanarrayofvariousclienttypes,NorthernTrusttypicallyholdsagreaternumberofsecuritiesintheportfolio toemphasize reduction in trackingerror,FirstQuadrantaimstoachieveabefore-taxalpha,M&IBankisknownforahigher-yieldingproduct,andU.S.TrustCorporationfocusesmoreoncustomsolutionsinconjunctionwithothersecuritiesandderivatives.Plus,someofthefirmsaresubadviserstomutualfundsandvariousmanagerplatforms.

Twosituationsthatinvestorsoftenfailtotakeintoaccountarethatthemanagerdoesnotalwaystakealosswhenitmayappearobviousfromtheaccountstatementtodosoandthatthemanagermayactuallytakesomegains.Bothoftheseactionsaretakentoreducethereturnorperformancetrackingerroroftheaccount.Investorsshouldavoidattemptingtoover-ridethemanager’smethodologybydirectinglossesifpossible.Thosewhointend todo thismaybebetter offworkingwith a broker rather thanwith one of the managers mentioned above, who employ sophisticatedapproaches.

Custodian:Forthesestrategiestobeeffective,thecustodianplaysamajorrole.Iftheaccountsizeissmall($3millionorless),theclientwishestoreplicatetheS&P500with250holdings,andtradingturnoveraverages15to35percentayear,thentherearegoingtobenumerousindividualtransactions.Thecostoftheaveragecommissionandsettlementchargesdictateshowfarthesecurityhastofallinpricebeforeitiseconomicaltoconductthetrade.Somecustodiansaremorecost-effectivewithQTAac-counts.Therefore,aclientmayfind iteconomicallybeneficial tohousethequantitativetax-awareportfoliowithonecustodianorplatformandtheremainderofassetswithanother.Intheinstanceswherethismayoc-cur,theclientshouldseekreferencesfromtheQTAmanagerofthosewhohaveestablishedasimilararrangement.

Fees:OneoftheadvantagesofQTAportfoliostrategiesisfeesaretypi-callyhalfthoseofactivemanagers,dependingonthesizeoftheaccount,butdon’texpectthemtobesimilarlow-feeindexedportfolios.Again,thesearereallyactiveratherthanpassivestrategies.Itisimportantthattheadviserunderstandcompletelynotonlythemanagementfeebutalsothecustodial,commission,andsettlementfeesandcharges.Youmayencounterasitua-tionwheretheentirefeeisbundled.SinceM&IBank,NorthernTrust,StateStreet, andU.S.TrustCorporationhavewell-knowncustodialplatforms,theycanoftenbeverycompetitiveintheirpricing,butthisnicheshould


notbelookedatasacommoditybusiness,asthereturnsnetoffeesandtaxescanbemeaningfullydifferent.

Trackingerror:Trackingerroristhedifferencebetweenthereturnsofaportfolioanditsbenchmarkindex.Itismeasuredbythestandarddeviationofthedifferenceinreturnsbetweentheclientportfolioandthebenchmark.ThereareseveralfactorsthatcancontributetotrackingerrorfortheQTAportfolio.First,themanagermustdeterminetheoptimalnumberofstockstoholdintheportfolio.Forexample,aQTAportfoliothatisintendedtomirrortheS&P500willtypicallyholdone-halfoftheunderlyingsecuritiesoftheindex.Determiningthenumberofsecuritiesisanartratherthanamatteroffollowingascientificrule.Sincethesuccessofthestrategyistax-driventhroughtheapplicationoftax-lossharvesting,portfoliomanagersmustensurethethirty-daywashsaleruleisnotviolated.Therefore,theymustmakesuretherearesecuritiessimilarinnatureorsubstitutecandi-datesthatarenotownedandavailableforpurchase.Thetrickformanag-ers is toensurethesecuritiestheyselect for investmentwillsatisfactorilyrepresenteachofthesectors,industries,andotherportfoliocharacteristicstheydeemimportant.FIGURE10.2isanexampleofthecharacteristicsthatParametricincludesinitsquarterlyreporttofacilitateahealthydialoguewitheachclient.

Modelingoranalyzingtheportfolioisusuallydonethroughasophis-ticated risk-management software solution provided by Axioma, Barra,ITG,orNorthfield.Todistinguishthemselvesinthemarketplace,QTAfirmswillcustomizethesolutionasaresultoftheirinternalresearchorwork in consultation with other knowledgeable individuals. They arealsointerestedinminimizingthedifferences inmodernportfoliostatis-tics,suchasbeta(amountofmarketrisktheportfolioissubjectto)andR-squared(amountofreturnthatcanbeexplainedbythebenchmark),betweentheclient’scustomportfolioandthedesignatedbenchmark.Thefirmsmayapplyvariousruleswhenconstructingaportfolio.Forexample,theymayavoidsecuritieswithinsufficienttradingvolume,astheymakeitdifficultifnotimpossibletoexecutetax-lossharvesting.Whenrulesofthisnatureareestablished,theymayonlyinfluenceasmallamountoftheoverallcapitalizationoftheindex,buttheycanhaveasignificantimpactonperformance.Forexample,manyoftheseless-liquidsecuritiespricedunder$5asharehadstellarperformancesduring2003,butiftheywerenotheldbythemanager,thebefore-taxreturnoftheportfoliocouldhavefallenshortofthebenchmarkby1percentormore.

Themanagerhas tobeextremelycareful toavoidexcessive trackingerrorwithtax-lossharvesting.Thiscanhappenwhenasecurityissoldforalossanditbehavesquitedifferentlyinpricethanthesubstitutesecurity.This is especially so with the top holdings in the benchmark. General


FIGURE10.2 PortfolioCharacteristicsandFiveLargestHoldings


PORTFOLIO BENCHMARK

NumberofHoldings 301 500

Beta 1.0 1.0

DividendYield 1.60 1.62

WeightedAvg.Cap.(inmillions) $88,266 $90,008

ECONOMICSECTORWEIGHTS(%) PORTFOLIO BENCHMARK

BusinessEquip.&Serv. 3.3 3.2

CapitalGoods 2.3 2.6

ConsumerDurables 1.2 1.2

ConsumerNondurables 8.2 8.5

ConsumerServices 4.4 4.9

Energy 5.4 5.8

FinancialServices 20.3 20.2

HealthCare 13.1 13.2

Multi-industry 4.6 4.1

RawMaterials 2.1 2.4

Retail 7.8 7.0

Shelter 1.6 1.3

Technology 17.6 17.8

Transportation 1.6 1.6

Utilities 6.4 6.3

POSITIONWEIGHTS(%) PORTFOLIO BENCHMARK

GeneralElectricCo. 3.1 3.0

ExxonMobilCorp. 2.7 2.6

McrosoftCorp. 2.6 2.9

PfizerInc. 2.5 2.6

CiticorpInc. 2.5 2.4

Sourc

e:

Para

metr

icP

ort

folioA

ssocia

tes


ElectricCo.(GE)waslistedintheParametricreportasthelargesthold-ingintheportfolio.Thefive-yearhistoricalpricechartforGEwaspulledfrom theBloombergProfessionalService to showhow this canhappen(seeFIGURE10.3).Let’senvisionaQTAportfolioisbegunafterGEsharessplitinthemiddleof2000.Laterthatyear,thepriceofthesecuritybegantofall,andsometimein2001itwouldhavebecomeacandidatefortax-lossharvesting.ButnotethatfourdifferenttimesbetweenMarch2001andJanuary2003whenthestockdroppeditquicklyreboundedinprice.IftheentireholdingofGEwassoldduringthesetimesandthereplace-ment lagged the upward price movement, the portfolio tracking errorwouldhavebeensignificant.Toprotectagainstthistypeofadverseaction,the portfolio manager typically only sells a portion of a large holding.Therefore,thedifferencesovertimearelikelytoaveragethemselvesout,andnoonetransactionshouldprovetobedetrimental.Thiscouldbetrueespeciallyifanentireholdingwassoldforalossandthenthecompanywasacquiredthroughamergerandthetake-outpricewassubstantiallyhigher.AsDavidSteinofParametricsays,“Youcangiveamanasword,butthatdoesn’tmakehimaswordsman.”Furthermore,ifheisn’ttrainedintheuseofthesword,hemayendupcuttinghisownthroat.

Toavoidexcessive trackingerror, theportfoliomanagerperiodicallyrunsanoptimizationinaworkstation-typeenvironment.Theleveloftax-lossharvestingisoftendictatedbytheamountofprojectedtrackingerrorthemanagerpredeterminesasaninputvariable.Theoutputwillsuggestwhichstocksandhowmuchofeachtosell.Itwillalsosuggestreplace-mentorpurchasecandidatesandtheappropriatenumberofshares.Then

FIGURE10.3 GeneralElectricStockPrice

▲

Split

Sourc

e:B

loom

berg


theportfoliomanagerreviewseachsuggestiontodetermineafinaltraderecommendation.Hemayvoidaparticulartradeandreruntheoptimiza-tionifheisaware,forexample,thataparticularstockmaybesubjecttoacorporateaction.Again,thesimulationwillprovidehimwithaprojectedtrackingerror,andwhenheissatisfiedthetradeswillbeconsummated.Sincetheinceptiondateinfluencestheinitialcostbasis,itisconceivablethatafirmcouldhavenotwoportfolioswiththesameholdingseveniftheyaremanagedtotrackthesamebenchmark.

ForQTAfirmswitha largenumberofaccounts,ordersarebatchedbeforeapredesignatedcutofftime.Variousformsoftradingareemployedtoachieve“bestexecution”onbehalfoftheirclients.Thismayinvolvein-teractionwithnumerousbroker-dealersandtheuseofelectroniccrossingnetworks.SinceQTAstrategiesare technology-driven, theirfirmsnatu-rallyembracethelatestsolutionstoenhancetradingsystems.Asaresult,thecostoftradingisonlypenniesashareonaverage.

With theexceptionofFirstQuadrant,whichattempts toachieveabefore-taxreturngreaterthanthebenchmark,positivetrackingerror—orareturnhigherthanthebenchmark—isasignthemanagerhasaweak-ness in its risk-controlmanagement system,and in the future it couldjustas likelyexperiencenegative trackingerror.The importanceof thebefore-taxtrackingerrorof theaccountcannotbeunderstated, for thesimple reasonthat if themanagercannotdeliver thebefore-taxreturn,then you may actually better off with a tax-managed mutual fund orexchange-tradedfund.

In a similar fashion towhatwedid in chapter 9,wenow comparethecharacteristicsofaQTAseparateaccountportfoliotoatax-managedmutualfundandETF(seeFIGURE10.4).TheminimumaccountsizeforQTAstrategiesreplicatingtheS&P500typicallybeginsat$500,000.

Taxefficiency:ThemajoradvantageoftheQTAstrategyistheabil-itytopassthroughlosses.Additionally,individualinvestorscanusethelossesindefinitely.Inmostcases,specificlotidentificationandhighin,firstoutaccountingareavailable,but thereare still custodians thatdonotofferthisvalue-addedfeature.Inamutualfund,theshort-termgainsarelumpedtogetherwithordinaryincome.Thisshouldnotbeanissuewithseparateaccountreporting,sinceonlyiftheclientandhisadvisermakeaspecialrequestshouldtheQTAmanagergeneratenetshort-termcapitalgains.

Operational:WheretheQTAstrategystandsoutinthisareaisthattheholdingsarenotsubject toregulatorydiversificationrules. If sode-sired,theclientcanobtainatrulycustomizedportfolio,whichisgaininginpopularitywithindividualslookingforsociallyresponsibleinvestmentrestrictions.


Estate: With QTA portfolios, individual securities can be selectedfromtheportfolioforgifting.Whenarequestofthisnatureismade,themanagerwilltypicallyrecommendthemosthighlyappreciatedsecurities,whichwillallowhimtoreducepotentialtrackingerror.

TheonlymajorconcernindividualshavewithQTAportfoliosissomepeoplefeelthatafterfifteenortwentyyears,theportfoliosmaynotnec-essarilyresemblethetruenatureofthe indexandperiodicallyadjustingthemmaybecostlyfromagains-realizationperspective.Thishasnotbeenamajor issue thus far,butQTAstrategieshaveyet to reach their tenthanniversary.OneoftheinterestingtwistsontheQTAconceptisrevers-

FIGURE10.4 ComparingTax-ManagedFunds,Exchange-TradedFunds,andQuantitativeTax-AwareSeparateAccountStrategies

TAX- EXCHANGE- QTASEPARATE MANAGED TRADED ACCOUNT

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


ingthetax-lossharvestingenginewhenyouhaveaclientinapersistentnetoperatinglossposition.Inthissituation,youcanconsistentlyharvestgains!Thebeautyof thisexercise is thatyoudon’thavetoworryaboutthe wash sale rule, and you are constantly raising the cost basis of theportfolio.

QTAstrategiesarenowenteringanothereraofsophistication.Sincetheinvestingpublichasbecomecomfortablewiththem,opportunitiestoexpandtheirusefulnessarebeingexploredinextremelyinnovativeways.One rapidly growing use is the “overlay” application that is becomingmoreprevalentwithwrapproviders,whichwillbecoveredingreaterde-

FIGURE10.4 ComparingTax-ManagedFunds,Exchange-TradedFunds,andQuantitativeTax-AwareSeparateAccountStrategies

TAX- EXCHANGE- QTASEPARATE MANAGED TRADED ACCOUNT

ShareholderWithdrawals – + O

DiversificationRules – – +

AbilitytoManageaCustomPortfolio – – +

Estate

GiftAppreciatedSharestoCharity O O +

Step-UpofBasisatDeath + + +

ManagementValueAdded

ElectronicCrossingNetworks + +/+ +

PurchasingDerivatives + +/N/A +/–

OvernightLending O + –

PurchasingStocksPriortoBeingAdded

totheIndex + + +

ImbalanceinaParticularSecurity + + +

CostofPurchasingandSellingSecurities – + –

AdjustPortfolioforChangeinLifeStyle – – +

+ Best

0 OK

– Worst

Sourc

e:

Gary

Gast

ineau,D

ougla

sS

.R

ogers


tailinchapter19.Sincetaxratesarehistoricallylow,firmsareconduct-ingresearchonwhetheritmakessensetosellsecuritiesthathaveprofitstoreplenishtheportfolio.Perhapsthemostinterestingmethodincludescombiningtax-lossharvestingwithleverage,whichhasbeendonebyLot-soffCapitalManagement.Todo this successfully requires sophisticatedriskmodelingandclosecoordinationwithaprimebrokertohandletheborrowingoffundsproperly.

Sincetheirinception,QTAstrategieshavebeeneffectivelyemployedtoreduceconcentratedstockpositions.Ideally, theclientshouldhaveasignificantamountofcash,equalingonetotwotimesthesizeoftheinitialQTAportfolio.Theprocess is quite simple.AQTAportfolio is setupandthenperiodically,usuallymonthly,theprofessionalcoordinatingtheeffortdeterminesthedollaramountoflossesthatcanbetakenandsellsacorrespondingofamountoftheconcentratedstockposition.Again,theobjective is tooffsetgainswith losses, taking thevariousprovisions forshort- and long-termgains and losses into account.When the stockoftheconcentratedpositionissoldatagain,thecashfromthesettlementofthetransactionistransferredtotheQTAportfolio.Thisrefreshesthecostbasisoftheportfolio,enhancingtheopportunitytoharvestlossesinfutureperiods.Theprocesscontinuesuntilsufficientlosseshavebeentakentoeliminatetheconcentratedstockposition.

FirstQuadrantandLotsoff,inconjunctionwithTwenty-FirstSecurities,have conducted creativederivationsof this strategy.One suchderivationinvolvesamarket-neutralstrategywhilealsoborrowingandtakinglossesontheshortposition.Themanagersmayalsobetryingtoachieveapositiveal-phaforboththelongandshortportionsoftheportfolio.Since,onaverage,themarketsappreciateby5percentormoreannually,thereisgreaterop-portunityforlosses.Ofcourse,thenetbenefitoftheshortpositionisinflu-encedbythecostofborrowing.Amarket-neutralstrategyobviouslymakesriskmanagementoftheportfoliofarmorecomplicated.Totakethesimplestcasepossible,considerthatwithalong-onlyS&P500portfolio,youwouldholdapproximately250securitiesandusetheremainderasareservefortax-lossharvesting.Whentheportfolioisbothlongandshort,youneedtohaveapproximately125securitieslongandanother125short,with250securi-tiesagainservingasthetax-lossharvestingreserve.Thisprocesscanexpeditetransitioningaconcentratedpositionusingalong-onlyQTAstrategy,whichtakesapproximatelysevenyears,toaleveragedlongandshortQTAstrategy,whichtakestwoyearsorless.Obviously,thisprocessisfarmorecomplicatedthanthelong-onlyQTAstrategy,butifitisdonecorrectlytherewardsareobvious.

QTA strategies areoften comparedwithotherdiversification strate-gies.Abriefdiscussionofeachalternativefollows,alongwithappropriate


questionstoassistadvisersorownersofconcentratedpositionsindeter-miningwhichstrategyisbestsuitedfortheirspecificsituation.

Exchangefunds:Anexchangefundisapartnershipinwhichthepart-nerseachcontributehighlyappreciatedstockinordertoachievediversi-ficationanddeferthetaxliability.EatonVanceoffereditsfirstexchangefundin1961and,asofthespringof2004,hasapproximately$16billionassetsinthisniche.2Otherprovidersincludetheinvestmentbanks,sincetheyoftentakecompaniespublicandtheirclientsare seekingawaytodiversifytheirconcentratedstockriskwithoutpayingcapitalgainstaxes.The investor retains his cost basis in the exchange fund shares, so thisshouldbeconsideredataxdeferralratherthanataxminimizationoption.Toqualifyforatax-freeexchange,theinvestor’sstockmustremaininthefund for at least sevenyears.For the fund to satisfy regulatory require-ments, at least 20 percent of assets must be maintained in “qualifyingassets,”whicharetypicallyrealestateinvestments.Theinvestormayholdshares longerthansevenyears,andsomefundshavealmostaperpetualinclination.Aninvestorwhoredeemssharesmaybegivenaselectgrouporbasketofstocksoraproratadistributionofsharesheldbythefund.Theportfolioconstructionprocessmayexcludecertain typesof stocks,dependingon themanager’s acceptance criteria.Therefore, the investormayhavetocheckwithseveralproviderstodetermineiftheywillaccepttheconcentratedholding.Aswithallportfolios,thereisinvestmentriskanda componentof activemanagement.Therefore, the exchange fundmayachieveareturndifferentfromthemostcommonstockbenchmarks.InthecaseofEatonVance,itmanagesitsexchangefundsinconjunctionwithitsTax-ManagedGrowthFund,whichhasahistoryofneverhavingdistributedanycapitalgains.3Investorsandtheiradvisersneedtounder-standthevariousprovisionsofthefundtheyareconsidering,astheremaybeearly-withdrawalpenaltiesoradversetaxconsequencesiftheseven-yearholdingperiodcannotbesatisfied.Feesonexchangefundstypicallyrunabout1percentor slightly less annually.The exchange fundmayofferestateplanadvantages.Iftheinvestmentintheexchangefundisintendedtobe a gift, it is likely ameaningful discount to the face value for taxpurposescanbeachieved.Fromtimetotime,exchangefundshavecomeunder the scrutinyof legislators and regulators.Most recently, it is theSECtryingtodetermineifcorporateinsiderswereusingthemtoreducetheirexposurewithoutsendingasignaltoinvestors.4

Collars:Therearemanywaysofconstructingcollarswithderivatives,butthemostcommonisthecashlesscollar.Bysellingcallsandpurchas-ingputoptions,theinvestorcanbracketboththeupsideanddownsideoffuturereturns.Inthiscase,theproceedsfromthecallareusedtooffsetthecostoftheput.Thetradeisdoneinconjunctionwiththestock.Settle-

mentcanbedoneeitherbyphysicallydeliveringstockorincash.Physicalsettlementrequiresactuallysellingthe investor’sstockposition,whereaswithcashsettlementcashisdeliveredandtheinvestorretainscontrolofthestock.Whether thestockclosesabovethestrikepriceof thecallorbelow the strike of the put will dictate whether stock or cash must bedelivered.Ifthestockclosesbetweenthetwostrikepricesandtheoptionsexpireworthless,theinvestorcanagainreviewhisvariousalternatives.

Prepaidvariableforwards:Thisstrategyisbestsuitedforaninves-torthatplaceshighpriorityonprotectingagainstadropinthepriceofthe concentrated stock and has a need for immediate liquidity. In thisstrategy,aninvestorsellsavariableamountofhisconcentratedstockatafuturedateforcash.Theinvestorreceivesapredeterminedamountofcashforthefuturesale.Theactualamountofsharestheinvestorwillhavetodeliverinthefutureisdeterminedbyanagreed-uponformulathatadjustsforthechangeinthepriceofthestock.Thisallowstheinvestortoreceivea known range of outcomes with some potential for appreciation.TheproceedsfromtheprepaidvariableforwardcanalsobeplacedinaQTAportfoliotoreducethetaximpact.

Saleofthestock:Oneshouldnotignoretheoptionofsimplysellingthestock.Withthelong-termcapitalgainstaxatitslowestlevelduringthepost–WorldWarIIeraandlargegovernmentdeficitslooming,manyinvestorsbelieveitisonlyamatteroftimebeforetherateisincreasedforwealthyindividuals.Therefore,simplysellingthepositionandpayinga15percenttaxhaircutisaviableoptiontoconsider.

Factorsthatinvestorsshouldconsiderwhenselectingadiversificationstrategyinclude:

1 Does the strategy have the potential to save tax dollars, or is itpurelyadeferralmechanism?

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?



12Iftheinvestorisanemployee,officer,ordirectorofapubliccorpo-ration,shoulda10b5-1planbeconsidered?

13Havethe strategiesbeinganalyzedbeenchallengedbyregulatorsinthepast,andisthislikelytohappeninthefuture?Ifso,whatisthedownsidewithanadverseruling,andistheinvestorwillingtoendurepotentialadverseconsequences?

14Howattractiveisthestrategywhentakingintoaccounttheageoftheclientandthestep-upinbasisatdeath?

In less thantenyears,QTAstrategieshaveestablishedthemselvesasacompellingalternative to less-tax-efficient traditionallymanagedstockportfolios.Additionally,theirapplicationtoconcentratedstockpositionsnowprovidesamethodtoachievediversificationandpayminimalcapitalgainstaxratherthanjustdeferringit.ThenextgenerationofQTAstrate-gies will certainly continue to enhance risk control through the use ofderivatives.However,thegreatestadvancementinperformancewillcomefrom incorporating short sales and leverage in themix,whichare skillsmore closely alignedwithhedge fundpractitioners.Will the asset classmanagers andbanks thathave thus fardominated theQTAmethodol-ogylandscapefulfillthisneed,orwillanewsetofprovidersemergewhoaremorewillingtotakeahigherlevelofriskanddemandapremiumfortheirservices?Regardlessofwhowillsatisfythisdemand,QTAmanagerswillbecomeapermanentpartofthetaxable-accountsolution,barringachangeinthetaxcodethatwouldeliminatethebenefitsoftax-losshar-vesting.

ChapterNotes

1. RobertD.Arnott,AndrewL.Berkin,andJiaYe,“LossHarvesting:What’sItWorthtotheTaxableInvestor?” JournalofWealthManagement(Spring2001):10–18.

2. EatonVanceinternalmarketingpresentation,August2004.


4. RandallSmith,“SECLooksatHowInsidersUseExchangeFunds,”WallStreetJournal,September7,2004.


PracticesofEliteTax-Aware

EquityActiveManagers

133

That statementbyChrisDavishasmore truth thanmost inves-torswould like to admit.There are timeswhen thebest thingthe investorcando tomaximizeafter-tax returns is simplynot

to sellpositionswith substantialunrealizedcapitalgains.FIGURE11.1,byParametricPortfolioAssociates,highlightsthefutureperformancethemanagerorinvestormustachievetobreakevenandovercometheem-beddedcapitalgainhurdle.1

The table shows theadditional return themanagermustachieve,de-pendingonthepercentageofcostrelativetothemarketvalueofthesecuritythatwillbesoldandoverwhattimeperiodinyears.Thisadditionalreturniswhatallmanagersstriveforandisknownastheiralpha.Forexample,ifamanagerplanstosellasecuritywherethecostbasisis50percentofthemarketvalue,itwouldrequireapretaxalpha,oradditionalannualreturn,of3.5percentforthreeyearsjusttocoverpayingthetaxesonthesaletobreakeven.Thistablewaspreparedbeforethetaxonlong-termcapitalgainswasloweredfrom20percentto15percent,butthemessageisclear.Managingportfolioswithoutconsideringgainsrealizationmakesitextremelydifficultforlow-alpha-generatingstrategiestobecompetitiveonanafter-taxbasis.Unfortunately,therearefewactivemanagerswhoincorporatethistypeofanalysiswitheachbuyandselldecisionfortheirtaxableinvestors.

Myfatherhasagreatexpression:‘Thecapital-gainstaxhascreatedmoremillionairesthananyothergovernmentpolicy.’Thecapital-gains tax tends to make investors hold longer. That is almostalwaystherightdecision.

—ChrisDavis

C H A P T E R 1 1


Activeportfoliomanagementcanoutperformpassiveinvestingonanafter-taxbasis,butitisanextremelylow-probabilitybetwhenrelyingontraditionalmethods.At this juncture,nontraditionalmethodsare thosethatincorporatetheimpactoftaxesintheportfolioconstructionprocessandtradingpracticesthatarenotpartofthetax-exemptaccountindustry.Thehopeis thatthesetax-awaremethodswillbecometraditionalprac-tices in the years to come,but they are currently onlybeing employedastutelybyapproximately2percentofpractitionersin2005.Itisabeliefoftheauthorthatmanagerswhoemploythesetax-awaremethodshaveagreaterthan50percentchanceofoutperformingpassivemanagementonanafter-taxbasis,whichishigherthanthesuccessrateofmostmanagersbeforetax.Thisisbecausetax-awaremethodshaveamuchhigherprob-abilityofcreatingalphathanthetraditionalmethodsofsectorallocationandsecurityselection.

Impressiveafter-taxreturnsthatarebothlong-termandconsistentdonothappenbychance.Tax-awareinvestmentmanagementistrulyanartformthatthusfarhasonlybeenmasteredbyasmallnicheofelitetax-awarepractitioners.2Theyarethemostproactivetowardestablishingandenhancing their taxmanagementcapabilitiesand theonesmost seriousaboutmaximizingtheirafter-taxreturns.Theyallocatesignificantresourc-es toward creating,monitoring, andmaintaining their tax-managementprocess,whichshowstheircommitmentandwillingnesstobesuccessfulin this area.To facilitate an understanding of what it takes to becomeanelitemanager,wewillexamineaprogressivelistofelements.Thetenelements may change with revisions to the tax code—for example, the

FIGURE11.1 TaxAlphaRequired(PerYearforHoldingTimetoJustifyaSaleatGivenCostBasis)

COSTBASIS COSTBASIS 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

1Yr 24.4 21.5 18.6 15.9 13.3 10.9 8.5 6.2 4.1 2.0 0.0

2Yrs 11.6 10.2 8.9 7.7 6.5 5.3 4.2 3.1 2.0 1.0 0.0

3Yrs 7.6 6.7 5.9 5.1 4.3 3.5 2.8 2.0 1.3 0.7 0.0

4Yrs 5.7 5.0 4.4 3.8 3.2 2.6 2.1 1.5 1.0 0.5 0.0

5Yrs 4.5 4.0 3.5 3.0 2.5 2.1 1.6 1.2 0.8 0.4 0.0

PracticesofEliteTax-AwareEquityActiveManagers 135

amountoftaxableincomeinanequityportfolioisnotasimportantnowasitwasbefore2003.

ElementsoftheHierarchyofTax-AwareInvesting

(EquityPortfolioManagement)

1 Maintaininglowturnover2 Extendingtheholdingperiodbeyondayearandmonitoringthe

levelofshort-versuslong-termcapitalgains3 Adjustingtheleveloftaxableincome,whenappropriate4 Tax-lossharvestingasanend-of-yeardrill5 Incorporatingtax-lotaccountingindecisionmaking6 Applying specific lot identification or high in, first out (HIFO)

versusaveragecostorfirstin,firstout(FIFO)accounting7 Havingqualifiedprofessionalsservetaxableaccounts8 Tax-loss harvesting opportunistically throughout the year, with

knowledgeofthewashsalerule9 Havinganalystsandportfoliomanagerswhofocusonlyontaxableac-

countsandincorporatetaximplicationsineachbuyandselldecision10Beingcommittedtoafter-taxperformancestandardsandreporting

The truly elite practitioners have mastered all ten elements shownabove.Thefollowingdiscussionhighlightstheimportanceofeach.

FIGURE11.1 TaxAlphaRequired(PerYearforHoldingTimetoJustifyaSaleatGivenCostBasis)

COSTBASIS COSTBASIS 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

1Yr 24.4 21.5 18.6 15.9 13.3 10.9 8.5 6.2 4.1 2.0 0.0

2Yrs 11.6 10.2 8.9 7.7 6.5 5.3 4.2 3.1 2.0 1.0 0.0

3Yrs 7.6 6.7 5.9 5.1 4.3 3.5 2.8 2.0 1.3 0.7 0.0

4Yrs 5.7 5.0 4.4 3.8 3.2 2.6 2.1 1.5 1.0 0.5 0.0

5Yrs 4.5 4.0 3.5 3.0 2.5 2.1 1.6 1.2 0.8 0.4 0.0

Sourc

e:P

ara

metr

icP

ort

folioA

ssocia

tes


1Maintaininglowturnover:Thisisthefirststeporelement.Lowturnoverisnice,butinmostcasesisnothingmorethanwhatcomesoutofthebasicsecurityselectionprocess.Alltoooften,ithasnothingtodowithattemptingtoenhancetheafter-taxreturnsoftheportfoliostrategy.Moreover,lowturnoverbyitselfdoesnotleadtoacceptablelevelsoftaxefficiencyunlessitiskeptbelow5percentannually.Manyvaluemanag-erswill state their strategy is tax-efficientbecausetheyhaveturnoverof20percentayearorless.However,asnotedinpreviouschapters,thisoftenresultsintax-costratioswellabove1.5percentannually.

2Extendingtheholdingperiodbeyondayearandmonitoringthelevelofshort-versuslong-termcapitalgains:Thiselementisveryba-sic,butithasameaningfulimpactonafter-taxperformance.Ifamanagercandelaysellingasecurityforseveraldaysorevenamonthsothatitben-efitsfromthelowertaxrateonlong-termcapitalgains,thedelayshouldbeencouraged.Thistypeofactivitycanbemonitoredinternallybyuseoftheaccountant’s ratio, asdiscussed inchapter8.Humanexperience shouldbebrought intoplay,because if theprice is likelytofallmorethantheamountofthetaxbenefit,thesecurityshouldbesold.Itisimportanttoremembertheprocessshouldbeorientedtomaximizingafter-taxreturnsratherthanminimizingthepaymentoftaxdollars.

3Adjustingtheleveloftaxableincome,whenappropriate:Withthechangeinthetaxcodein2003,thisfeatureisnolongerasimportantasitwaspreviously,buttherearestillsomesituationswhereitapplies.More-over,thelowerrateonqualifieddividendsisscheduledtobephasedoutin2009unlessadditionaltaxlegislationisenacted.Equityportfoliomanagersneedtobecarefulwhentheypurchasesharesofrealestateinvestmenttrusts(REITs)andforeignsecurities,whichmaynotproducequalifieddividends.SinceREITspayamuchhigherlevelofincomethanmostothersectorsofthemarket,taxable-accountmanagersshouldincorporatethisdifferentialintheirdecision-makingprocess.Oneprovisionofthetaxactof2003thatmustrememberedisthatsharesmustheldsixtydaysoutofthe121-dayperiodthatbegansixtydaysbeforetheex-dividenddatefordividendstoqualifyforthepreferentialtaxtreatment.

4Tax-lossharvestingasanend-of-yeardrill:Therearethreecom-mon ways to execute tax-loss harvesting trades. If conducted properly,thesetradescanaddtremendousvalue.However,asexplainedbelow,twoofthethreemethodsmayyieldlessthandesirableresults.

a. Thefirstmethodiswhatisreferredtoasthe“naked”trade.Inthiscase,themanagersellsthesecurityorfundandthengoestocashforat least thirtydaystoavoidviolatingthewashsalerule.Typically the same security or fund is repurchased at that time.Thisleavestheinvestorunexposedtothedesiredsecurity,sector,


orassetclass,thustheterm“naked.”Thisprocedureistantamounttomarkettimingandshouldbeavoidedwheneverpossible.Don’tbesurprisedifyouencounterasituationwheretheclientdirectsthistypeofactivityandtheassetmanagementfirmrespondswithaformbythecomplianceofficerthattheclienthastosign,relievingthefirmofanyresponsibilityforthetradebeforeanylossescanbetaken.Additionally,onceittakesthelosses,itwillattempttoleavetheproceeds in cash.This is a telltale sign thefirm is incapableofadequatelyservingtaxableaccounts,contrarytotheirclaimsinmarketingpresentationsandthelike.

b. The secondmethod is known as the “double-down” trade, aphrasefromthegameofblackjack.Amanageremploysthistacticwhena securitydrops inpricebyameaningfulamountandthemanagerstillbelievesinthefundamentalmeritsofthesecurity.Asinblackjack,toexecutethistrade,amanagerdoublesthepositionsizebypurchasing an amountof shares equal to thosepresentlyowned.Themanagerdoesthisbecauseheexpectsthesecuritytoreboundinpricesothattheoriginalpurchasepricecanbereachedorexceeded.Oncethisoccurs,theoriginaltaxlotissoldtoavoidpayingtaxes.Thisstrategyrepresentsmoreofavaluepropositionthanatax-managementtechnique.Itlacksatax-managementpro-spectivebecauseevenifsuccessful,ataxlossisnevertaken—itonlydelaysataxpayment.Moreover,whentheremainingtaxlotissold,themanagerincursagreatertaxliabilityfortheclient,asthepo-sitioncarries amuch lowercostbasis than theoriginalposition.Althoughthisstrategycanbeaneffectivetradingstrategy,itservesmore to increase individual position risk and falls into a “valuetrap”andonlyincreasestheclient’staxliability.Thisisafavoritetoolofvalue-orientedmanagersandisasigntheyhavenotgivenserious consideration to tax efficiency.Like thenaked trade, thedouble-downtradeistobeavoided.

c. Thepreferredmethodforexecutingatax-lossharvestingtradeincorporatesa“pair-wise” transactionbysellingonesecurityandpurchasinganotherthatissomewhatsimilarorcorrelated.Correla-tionismeasuredinmanydifferentways,includingbutnotlimitedtobuyinga security in the same sectoror industry,witha simi-larbeta,orinfluencedbysimilareconomicfactors.AnexampleofsuchatradewouldbeaninternationalmanagersellingINGGroep,N.V.,theworld’slargestinsurer,foralossandtemporarilyreplac-ingitwithAXAGroup,theworld’ssecondlargestinsurer.Theideaisthatamanagerisabletorealizealossfortaxpurposeswithoutlosing(inthisexample)theglobalinsuranceexposure.Ofcourse,


nootherinsurancecompanystockwillbeaperfectmatch,soin-dividualcompanyriskwillneverbeentirelyeliminated.TherewillalwaysbetheopportunitycostifINGappreciatesonfirm-specificnews thatwouldnotnecessarily affectAXA.This trade ismuchstrongerthanthetwomentionedpreviously,asitallowstheman-agertorecognizetherealizedloss,maintaintheportfolio’sexposureandriskprofile,andreturntotheoriginalsecurityafterthirtydays.Thismethodoftax-lossharvestingcanleadtosignificanttaxalphawithnewaccountsfundedwithcash,especiallythoseinafallingmarketenvironment.Managersopposedtopair-wisetradingmaygrousethat theycannotfindsuitablereplacementsecurities.Theevolutionofexchange-tradedfundsformajormarkets,countries,andsectorsinvalidatesthisargument.Forexample,expandingonthepreviousexamplewithING,themanagerhasseveralotherop-tions available through ETFs. Instead of using AXA, which themanager might not like for a particular reason, he could use aNetherlands index fund,MSCIEurope,Australasia, and theFarEast(EAFE)fund,oraglobalfinancial-sectorETF,dependingonwhatmarketexposuresofINGheistryingtoreplicate.Someman-agerswillevenuseopen-endmutualfundsoroptionsorfuturestoharvestthetaxloss,astheyunderstandthisisoneareawheretheycanaddtremendousvaluetowardafter-taxperformance.

Thetax-lossharvestingtradeisparamounttotax-awareinvesting.Ifequitymanagersignorethisbasicexercise,theyshouldnotbeconsideredforhire,unlesstheycanconsistentlydeliveranalphaofatleast3percentayearonabefore-taxbasis.

5Incorporating tax-lot accounting in decision making: Surpris-ingly, in2005youwillfindsomemanagersandcustodiansthatdonothave thiscapability.Tax-lotaccounting is theessentialelement thaten-ablesmanagerstomaketradingdecisionsbasedonthecostbasisortaxlotsofindividualsecurityholdings.Wheneveramanagerbuysasecurity,thepriceofthatsecurityisrecordedintotheportfolioaccountingsystem.Ifamanagerbuysthesamesecurityinseveraldifferentlotsovertime,thesystemwillbeabletorecordthepurchasepriceanddateofeachtransac-tion.Thebenefitcomesatthetimeofsale,whenthemanagercanusethetax-lotaccountingsystemtoidentifythemostadvantageoustaxlotorlotstosellsoastominimizerealizedgainswhenconductingapartialsaleoftheoverallposition.

6ApplyingspecificlotidentificationorHIFOversusaveragecostorFIFOaccounting:AsDicksonandShovenadvancedasearlyas1994,theaccountingconventionemployedhasameaningfulinfluenceonafter-


taxresults.Thisfeatureisoperationalinnature.Whenitispresent,thiselementisaclearsignatax-awareculturepermeatesthroughoutthefirm.

7Havingqualifiedprofessionalsservetaxableaccounts:Thedeg-radationoftheaccount-servicingfunctionisoneofthekeyreasonswhytax-aware investing is having difficulty gaining ground. Unfortunately,with the asset management industry changing from a boutique cultureto an asset-gathering one, highly qualified servicing positions necessaryto maintain a tax-aware relationship have been eliminated in droves.Many relationshipshavebeen terminated,because theeconomicsofanassetgathereraredifferentthanthoseofaboutiquefirm.Boutiquefirmstypicallystartwithafewentrepreneurs.Afterasuccessfulstarttheypayofftheir initialdebtandachieveacomfortableexistence.Theygrowbyproviding a distinctive service. However, there comes a time when thefoundersofthefirmwouldliketocashinontheirsuccessandtypicallyselltoanassetgatherer,whichpaysapremiumforthehighlyprofitableoperation.Unfortunately,onlythroughrapidgrowthandcostcuttingwilltheacquisitionbesuccessful,asitnowhasatremendousdebtloadoranextremelyhighgoalforreturnoncapital.Sofollowingthetransaction,theservicepositions areoften eliminatedor turned into salesormarketingjobs.Nowindividualsarecompensatedbygatheringassetsratherthanbysatisfyingtheneedsoftherelationship.Additionally,oftenapersonfromatax-exemptaccountbackgroundisassignedtherelationship.Asaresult,it is only amatterof timebefore the taxable client looks elsewhere forservice.

Thelackofservicingisalsoamajorconcerninopen-architecturesys-tems,whichinsomeinstancesarenothingmorethanglorifiedwrapsitua-tions.Whiletheyprovideaccesstoanaccountstrategyatareasonablefee,theydonotguaranteeameaningfulrelationshipbyaqualifiedservicingprofessional.All toooften, theopen-architecture system is a crutch forminimallyqualifiedsalesandservicingprofessionalswhoareonlycapableofpresentingprospectsandclientswithsuperficialperformancerecords.Openarchitecture,oraccesstomultiplefirms,isavalue-addedproposi-tionwhen the servicing function can take theunique circumstances oftheclientandallocateassetstomanagersinatax-awaremanner,whichiscoveredindetailinotherchapters.

Tax-awareinvestingisaboutprocessfirstandlong-termrelationshipsservicedbyknowledgeableindividuals,butaccomplishingthisrequiresed-ucatedandexperiencedprofessionals.Youknowyouhaveawinnerwhenyouhearafirmperiodicallypullsinall itsservicingprofessionalsforaninternalconferenceatleastannuallytohearaboutthelatestintax,estate,orregulatoryissues.Fortunately,therearestillfirms,bothlargeandsmall,thatarecommittedtoprovidingtheirclientswiththistypeofvalue-added


expertise.Thekeypointhereisthatfirmsmayhaveexcellenttax-awareproducts,buttheyhavelessvalueunlessqualifiedindividualscaninteractwiththetaxableclients.

8Tax-lossharvestingopportunisticallythroughouttheyear,withknowledgeofthewashsalerule:Atthislevelintheprogressionoftax-aware elements, we are getting to the point where active managementcanofferatruevalue-addedpropositionaboveandbeyondwhatcanbeachieved throughpassive investing.This canbe statedbecausedoing itrequiresadherencetoallthepreviouselements.Continuoustax-losshar-vestingrequiresameaningfulcommitmentbythefirmintermsofsystemstechnologyandtrading.Codingofaccountsforvariousfeaturesallowsthistobedoneinvolume.However,itrequiresclosecoordinationbetweentheinvestment,servicing,operational,andperhapseventhecompliancefunc-tionsofthefirm.

Thesemanagersneedtohavesystemsinplacetomonitorwashsalesrulestoensuretheydonotrepurchaseasecuritywithinthirtydaysafterthesale.IRSPublication550states:“Youcannotdeductlosseswhenyousellortradestockofsecuritiesatalossandwithin30daysbeforethesaleyou:

—Buysubstantiallyidenticalstockorsecurities. —Acquiresubstantiallyidenticalstockorsecuritiesinafullytax-

abletrade,or —Acquireacontractoroptiontobuysubstantiallyidenticalstock

orsecurities.”3

Thequestionmosttaxableinvestorshaveis,Whatconstitutesasub-stantiallyidenticalsecurity?Unfortunately,theInternalRevenueServicehasnotprovidedaprecisedefinitionoftheterm.4Thetax-exemptfixedincomecommunitywasoneoffirstnichestoapplythistrade,andhereishowtheyapproachit.Wewilldemonstrateaswapthatwouldbecon-sideredanacceptabletradewithintheindustry,usingfictitiousmunicipalbonds.Atthebeginningof1994,theportfolioholdsaNewYorkSewermunicipalbondwitha6.0percentcoupondueMay15,2014.Thebondwaspurchasedatpar.Asyoumayrecall,therewasageneralincreaseinthelevelofinterestratesacrosstheyieldcurveofapproximately2percentin1994.Sincethebondhasadurationofapproximately10years,itfallsinpriceby20percent.Youdecidetosellthesecuritytoharvestthelossandwishtopurchaseanotherbondwithoutcausingamajordisruptiontothecharacteristicsoftheportfolio.YounoticeanIllinoisGeneralObligationmunicipal bond available for purchase with a 5.0 percent coupon dueSeptember15,2013.Inthisexample,thereareseveralitemsthatshowthebondsarenotidentical:differentissuer,sectorortypeofcredit,coupon,andmaturity.Thebondsmayhavesimilarbutnotidenticalexpectedprice


movementtochangesininterestrates,soyoudecidetomoveforwardwiththetrade.Aswediscoveredoverthepastfiveyears,therewillalwaysbeafewindividualswhowillpushtheenvelopeonaccountingissues—eventhewashsalerule.Forexample,theywillownamutualfundthatreplicatestheS&P500stockindex,sellitataloss,andpurchaseanETFthatholdstheexactsamestocksaccordingtothesameallocationscheme.Whilethetwovehiclesmayhavesomewhatdifferent liquiditycharacteristics, theyhaveanR-squared(percentageofreturnexplainedbyanotherbenchmarkorsecurity)ofalmostexactly1,or100percent.Inthiscase,youshouldnotbesurprisedifsomeoneeventuallyquestionsthetrade.Tobeonsafegroundwhenconductingatax-lossharvestingtrade,youshouldanalyzeifthereisameaningfulamountofcapitalatriskwhenyoucomparethepastreturnpatternsofthesaleandpurchasecandidates.Ifso,thenyouareprobablysafe.Thethreeconsequencesofawashsaleare:

—Youarenotallowedtoclaimthelossonyoursale. —Your disallowed loss is added to the basis of the replacement

stock. —Your holding period for the replacement stock includes the

holdingperiodofthestockyousold.

Managerswholooktoharvesttradesonlyattheendoftheyearareseverelylimitingthenumberofavailabletax-lossharvestingopportunitiestheycanexploit.Forinstance,ifaninvestmentmanagerconductsalltax-lossharvestingtradesattheendofyear,hemayhavemissedopportunitiesinthebeginningof theyear,as in2003whenthemarketdroppedandthenrebounded.Wheninterviewingfirms,itisparamounttounderstandhowoftentheyreviewaccountsfortax-lossharvesting.Ifitisonlydonequarterlyorso,theywillbeunabletoextractthetruenaturallyoccurringadditionalvaluecreatedbymarketvolatility.

Notallaccountsneedorcantakeadvantageoftax-lossharvesting.Forexample,youmayhaveclientswhoareinanetoperatinglosspositionandthereforehavetheluxuryofneedingtoharvestgains.Insuchcases,thetax-lossharvestingenginecanbereversed,andyoudon’thavetoworryaboutthewashsalerule.Betteryet,whentheclientgetsoutofthenetop-eratinglossposture,hisportfoliowillhaveacostbasiscloseorequaltothemarketvalueoftheportfolioandhecaneasilystarttakinglosses.Thisisjustanotherexampleofhowknowledgeoftax-awareinvesting—orinthiscase,“tax-gainharvesting”andthewashsalerule—canbenefittheclient.

9Havinganalystsandportfoliomanagerswhofocusonlyontax-ableaccountsandincorporatetaximplicationsineachbuyandselldecision:Wearenowgettingtothepinnacleoftax-awareinvestingforequitymanagers.Thesemanagersandtheirfirmsunderstandthattaxable-


accountinvestingshouldserveasadistinctseparatebusinessunitandtheytreatitassuch.Theygotheextradistancetomodeltheimpactofeverypotentialsaleintheirinvestmentdecisions.Incertainsituations,theim-pactofsellingsecuritieswithlargeunrealizedgainscanbesignificant.AsFigure11.1shows,itmighttakeseveralyearsormoreforthenewsecurity(thepurchasecandidate)torecapturethecostsofpayingthecapitalgainstax.Thesemanagersaddressthisissuebyusingoptimizersandperformingbreak-evenanalysis todetermine the tax impactof everypotential sale.Usingassumptionsthatareoftencustomizedtothespecificsofeachtax-able client’sportfolio, themanager considers all tax implicationsbeforemakingasale.Whattheprocessentailsis:

—Calculatingthedollaramountofthecapitalgainthatislikelytoberealized.

—Determininghowmuchof thepriceper shareof the securityconsidered for purchase must be adjusted upward for the taximpactofthepotentialsale.

—Recalculatingtheprojectedreturnofthesecuritybeingconsid-eredforpurchasewiththeupward-adjustedprice.

—Iftheprojectedreturnofthesecuritybeingconsideredforpur-chasedoesnotclearlyexceedtheprojectedreturnofthesecurityheld,calculatingabreak-evenpointinyears.

Ifthespreadinprojectedreturnisstillclearlyinfavorofthebuycandi-date,followthroughwiththetrade.Ifnot,thenhumanexperiencecomesbackintoplayandyouhavetoask,“Howmuchconvictiondowehaveinourprojectedreturns?”Somefirmstaketheprocessabitfurtherwhentheprojectedreturnof thesecuritybeingconsideredforpurchase isgreaterthanthatofthesellcandidate:Theycalculateabreak-evenperiodinyears.Then they compare the break-even period with their historical averageholdingperiod,whichistypicallyderivedfromtheaverageturnoverrate.Ifthebreak-evenperiodisgreaterthanhalftheaverageholdingperiod,thetradeiswithdrawn.Forexample,ifthehistoricalturnoverrateofastrat-egyis25percent,thefirmassumesanaveragehistoricalholdingperiodoffouryears.Iftheanalystcalculatesabreak-evenperiodofthreeyearsforaparticularbuycandidate,thatsecuritywouldmostlikelybeeliminatedfrom further consideration for the immediate future. Other candidatesareconsidered,orthetradeisputonholduntilthereisamorefavorablemarketenvironmentandthetransactionhassuperioreconomicvalue.

Aportfoliomanagerwhousesthisstrategyandhaspresentedthevalueof its methodology at public conferences is Joanne Howard of Rosen-bergCapitalManagement(RCM).5Thesecuritybreak-evenanalysisbyHowardandherassociatesstartsbyanalyzingthetaxcostofsellingthe


FIGURE11.2 SecurityBreak-EvenAnalysis

CURRENTINVESTMENT NEWINVESTMENT

Company Xerox Cisco

Ticker XRX CSCO

SharesOwned/ToBuy 3,900 2,413

Cost/Share 18.46

CurrentPrice 46.13 58.00

CurrentMarketValue 179,888 139,970

CapitalGainsTaxrate 37%

Tax$Paid 39,918

After-taxProceeds 139,970

Assumptions

3–5YearGrowthRate 10.00 30.00

CurrentRel.P/E 0.66 1.50

TargetRel.P/E 0.70 1.60

Conclusion:

YEARSTOBREAK-EVEN 2


Pre

tax

retu

rns

($)

600,000

500,000

400,000

300,000

200,000

100,000

0

OldInvestment

NewInvestment

Years

1 2 3 4 5

Sourc

e:

JoanneH

ow

ard

/Rose

nberg

Capit

alM

anagem

ent


existingsecurity(seeFIGURE11.2).Intheexample,sellingXeroxatthecurrentpriceof$46.13willgenerateataxcostof$39,918onthesaleofapositionof3,900shares.Thetaxcostisachievedbytakingintoaccountthedifferenceinthecostbasisandcurrentmarketvalueandapplyingtheclient’staxrateof37percent.Obviously,thisisatradeforapositionheldlessthanayearandsubjecttotheshort-termcapitalgainstaxrate.ThereasonthetradeisbeingconsideredisthattheiranalystbelievesCiscohasavastlysuperiorestimatedgrowthrateof30percent,ascomparedwithXeroxat10percent.However,thetradeonlymakessenseifthecurrentpriceofCiscoislowenoughtoovercomethetaxbiteorcostwhenXeroxissold.Inthisexample,thebreak-evenorcrossoverpointisapproximately1.7years.Mostfirmsthatapplythistypeofanalysisbelievethebreak-evenpointforstocktradesneedstobeapproximatelytwoyearsorlesstojustifythetrade.Thisisjustonepartoftheselldecision-makingprocess,butitisanextremelyimportantonethatquantifiestheimpactoftaxes.Iftheanalystorportfoliomanagerfeelsstronglytheexistingholdingislikelytofallprecipitouslyinprice,thenthesecurityshouldsimplybesold.Thisisnotthetimetobetaxwiseandsecurity-outlookfoolish!Itisthistypeofmethodologythatcausesmanypractitionerstocalltax-awareinvestinganartform,ratherthananexactscience.Assimpleasthistypeofanalysisis, in theauthor’s experience thereare fewer than twodozenfirms thatemploythistypeofanalysis.Firmsfocusedonservingtheneedsoftheirtaxableclientsareembracingandrefiningthistypeofanalysistopositionthemselvesaselitetax-awarepractitioners.

The challenge with this procedure is you need to have an efficientportfolioaccountingsystemtokeeptrackofthenumeroustaxlotsacrossall thefirm’s taxable accounts of the same strategy.This example againdemonstrates the value of coupling tax-aware investing concepts withtechnology.

Wewilldiscuss tax-awarefixed income investing inchapter12,butSanfordC.Bernsteinisonefirmthathasautomateditsanalysisandtrad-ingfunctiontotheextentitcanquicklydetermineifablockofbondsitseesofferedforsaleonthe“Street”willaddincrementalvalueonanafter-taxbasisforeachandeveryoneofitsindividualtaxableaccounts,whiletakingintoaccounttheuniquetaxprofileofeachindividualrelationship.Whentax-awareprinciplesaremarriedwithtechnology,theresultscanbetrulyimpressive.Thatiswhythisnicheofinvestingissoexcitingtoday,aswehaveonlyencounteredthetipoftheicebergintermsofwhatcanbedone.

10 Beingcommittedtoafter-taxperformancestandardsandre-porting:After-taxreportingissimplytheicingonthecake.Firmsshouldattempttoprovideindividualclientswithbothpre-andpost-liquidation


returns,asbothofferusefulinformation,dependingontheneedsoftheclient.Moreover,iffirmshavegonetothisextremetopositionthemselvesaselitepractitioners,theyshouldattempttobrandtheirreport.ExamplesofaclientreportbyParametricPortfolioAssociatesandasampleAIMR-compliantafter-taxcompositereportaregiveninchapter7.

Inyearstocome,furtherelementsmaybeaddedtothelist.BeecherInvestorshasputinplaceoneofthemoreinnovativeinitiatives.Thisisafirmthattrulyendorsestax-awareinvestingprinciples,somuchsothatit has instituted fees basedon its after-tax results. If amanager cannotoutperformanETFortax-managedfund—whicharereadilyavailableal-ternatives—onanafter-taxbasis,thenhowcanitjustifychargingafee?Itcan’t,sowhyshouldn’ttaxableclientsinsistonpayingforresultsbasedonafter-taxresults?Thisisanareayouwilllikelyhearmoreaboutinthefutureandhopefullywillbecomemorecommonsothatitcanbeaddedtothelistoftax-awareelementsinthefuture.

There are three additional factorsmanagersneed to consider in themanagementofinternationalequityportfolios.Thefirstisthatnotallfor-eignstocksproducequalifieddividends,andU.S.domiciledaccountsandfundsare subject todividendwithholding taxes.Second, foreign stocksmustbeheldsixteendaysfortheinvestortoclaimacreditforthewith-holding taxes.The third factor involves additional taxes from currencyoverlaymanagement.Ifpossible,internationalmanagersemployingcur-rencyhedgingshouldbepositionedintax-exemptentities,sincethepro-cess is inherently tax-inefficient.Unless themanagercandemonstrateameaningfulalphathroughamethodicalprocessofcurrencymanagement,taxableaccountsarebetteroffemphasizingmanagersthatomitthisfacetofinternationalorforeignsecuritymanagement.

Anothermethodthatisgainingacceptanceismanagingbytaxablecli-entobjectivesversustax-exemptconsultantdemands.Inthepast,manag-erswere criticized if theydidnot transition accountsquickly tomodelportfolios that resulted inminimal returndispersionbetweenaccounts.Now taxable-account managers are taking the time to properly analyzethereturnpotentialofeachsecuritytheyinheritinconjunctionwiththecostbasis.Thisisamajorchangefromthemindlessprocessofimmedi-atelysellingallholdingsthatdonotconformtothenewmodelportfolio,regardlessoftheircostbasis.Iftheunrealizedcapitalgainsaresubstantial,tax-awaremanagersmaytakemonthsoryearsbeforeeliminatingtheposi-tionandwilltrytodosowhentherearelossesavailabletominimizethetaximpact.Also,evenwhenstartingwithcashportfolios,somemanagersareonlyfundingaportionoftheirtaxableportfolio,astheydonotwantto subjectnewclients to rapid tradingwhen somepositionsareon the


cuspassellcandidatesandwillbeeliminatedinthemonthsahead.Eachofthesepracticesservestheclient’sobjectivesratherthancateringtothewhims of tax-exempt account consultants. Further insistence by clientsandtheiradvisersofmanagingbyclientobjectivewillultimatelyleadtoenhancedwealthcreation.

Wehavediscussedthechancesthatactivemanagerswilloutperformpassiveportfolios.Toaddressthisissue,weextractalpha-statisticinforma-tionfromthePSNmanagerdatabase(seeFIGURE11.3).6

First,weneedtodeterminetheappropriatebefore-taxandbefore-feehurdle for an equity manager to be competitive. We create the hurdleby determining what is required to outperform the appropriate bench-mark,thatis,theQTAmanager’sexpectedreturn.AQTAmanagershouldoutperformthebenchmarkonanafter-taxbasisby1.3percentperyearwithnormalmarketvolatilityandunderthecurrentprovisionsofthetaxcode.(Theoutperformancewas1.5percentunderthetaxcodepriorto2003,whentaxratesonordinaryincomeandcapitalgainswerehigher.)Takingintoaccountthattheaveragemanagernotadheringtotax-awaremethodswilllikelyachieveatax-costratioof1.3percent,orloseanequalpercentagethatthetax-lossharvestingfirmwillgain,results inareturndifferential due taxes of 2.6 percent (1.3% + 1.3%).The difference infees,anotherformoftax,foractivelymanagedseparateaccountscanvarysignificantlybutisusuallyinarangeof0.5to1percent,dependingonthe

FIGURE11.3 Before-FeeandTaxAlphafortheTenYearsEndingDecember31,2003

PERCENTILERANKFROM“TOP”ASSETCLASS 10% 25% 50% N BENCHMARK

Large-CapCore 3.80 2.01 0.79 129 Russell1000

Large-CapValue 3.25 1.78 0.61 191 Russell1000Value

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

Sourc

e:P

lanS

ponso

rN

etw

ork

,S

eanW

hit

e


assetclassandsizeoftheassignment.Usingamid-rangeof0.75percentanda0.35percentannualfeeforQTAmanagerscreatesafeedifferentialof0.4percent.Addingthefeedifferentialof0.4percenttotheafter-taxperformancedifferentialof2.6percentresultsinahurdleof3.0percent.Again,thisisthealpha,ortheamountbywhichanequitymanagerneedstooutperformasuitablepassivebenchmarkbeforeheshouldbeconsid-eredaseriouscandidatetoservetaxableaccounts.Readerscanadjustthethreeinputvariablestoaccommodatetheirownoutlookfortaxefficiencyandfees,but thisapproachmakes thesearchprocessa simpler task,asit eliminatesmanyfirms that simplydonothaveaprocess inplace toachievethistypeofresultinthefuture.Asshownforthetenyearsend-ingDecember 31, 2003, managers had to be in the top10percent ofactivecoreandvaluemanagerstooutperformthe3.0percenthurdle,orbogey.Theinformationsuggeststhatmanagersinless-efficientsmall-capandinternationalmarketsdohaveachancetoachieveattractivereturnsonafter-taxbasis,butisthisinformationrepresentativeoftheactualex-perience investors encountered? Unfortunately, manager databases haveextremesurvivorbias:managersthatgooutofbusinessorstopsubmittingdataareexcluded.Additionally,marketersrarelysubmitdatatoamanagerdatabaseunlessthemanager’sinitialperformanceisatleastinthetophalfofmanagers.Also,wedon’tknowhowmanyofthemanagersshownareclosedtonewbusiness,whichiscommonwithsmall-capmanagers.Withtheexceptionofsmall-capgrowth,noneoftheequityclassesrepresenteddemonstrateameaningfulchanceofoutperformingonanafter-taxbasis.Forthereasonsmentioned,thelikelihoodthatthosemanagerswhodidoutperformthe3.0percenthurdle,willrepeatinthefutureisfarlessthantheinformationabovesuggests.

By applying the nontraditional tax-aware elements discussed above,eliteequitymanagerscaninfactachievecompellingafter-taxresults.Astheybecomemorecomfortableandcompetentintheprocessofexecutingtheelements,theydiscoverahighprobabilityofsuccess.Forequityman-agers,thealternativetoatax-awareportfolioisaconcentratedportfoliooftwentysecuritieswithgreateremphasisonalphageneration.Thosewhoemphasizeconcentratedportfoliosalongwiththetax-awareelementsarebeing sought out by the most discriminating taxable-account investorsandadvisers.Whileelitemanagerswhoembracethetax-awareelementsare emerging, they are still in short supply. If taxable investorswish toensuretherearelargenumbersofmanagerswhocanservetheirtaxable-accountneeds,theyhavealignthemselveswithadviserswhocanidentifymanagerswithcredibleprocessesandbecomelessdependentonhistoricalrecordsofperformance.Furthermore,asTadJeffreysuggests, long-terminvestorsmaybebetteroff ignoringtheconceptsofbenchmarkingand


trackingerrorandfocusonfactorsmorerelevanttobottom-lineafter-taxresults.7Asimilarissuethatinvestorsmustgrapplewithistheapproachof somemanagerswhomake large shifts tocashequivalentswhentheybelieveopportunities fromstocksare lessattractive.Theactionbyitselfistax-inefficient,disruptstheoverallassetallocationplan,andshouldbeavoidedunlessthemanagercanclearlydisplaythatoverlongperiodsoftimehehasproduced sufficient alpha to justify theprocess.Hopefully,theemphasisonprocessandonputtingtaxableclientneedsfirstwillulti-matelyprovethatcompellingresultscanbeachievedonbothabefore-andafter-taxbasis.

ChapterNotes

1. ParametricPortfolioAssociates,“ParametriconTaxes&Investing”(internalmarketingpresentation),Fall2001,2.

2. Muchofthediscussiononthepracticesofelitepractitionershasbeentakendirectlyorsummarizedfromtheauthor’sarticlewithSeanW.Egan,“EvaluatingandClassifyingTaxableAccountManagers,”JournalofWealthManagement(Fall2004):49–62.

3. IRSPublication550,InvestmentIncomeandExpenses(2003),http://www.irs.gov/publications/p550/ch04.html(accessedNovember5,2004).

4. FairmarkPressTaxGuide for Investors,http://www.fairmark.com (accessedNovember5,2004).

5. NewYorkSocietyofSecurityAnalystsPrivateWealthConference,NewYork,NewYork,July2001.

6. InformationcompiledbySeanWhiteofCTCConsultingfromthePSN(PlanSponsorNetwork)database,April2003.

7. RobertH.Jeffrey,“Tax-EfficientInvestingIsEasierSaidThanDone,”JournalofWealthManagement(Summer2001):9–15.

PracticesofEliteTax-Aware

FixedIncomeActiveManagers

149

Thus far,wehave focusedonequityportfolios.However,all thetax-awareelementspresentedhaveapplicationswithfixedincomeportfoliosaswell.Sincefixedincomemanagementisquantitative

in nature, it truly lends itself to tax-aware management.With taxableaccounts,after-taxhistoricalresultsforbondsaretypicallyabouthalforevenlessofwhattheyareforequities.

“BondManagement forTaxable Investors,”whichR.B.“Guy”Da-vidsonIIIwrotein1999,stillstandsastheseminalarticlepertainingtotax-awarefixed incomemanagement.1 In the article,Davidsonoutlinesthevalueoftax-lossharvestingforbondinvestors.Aswithequityportfo-lios,healsoshowshowtheopportunityfortax-lossharvestingwithbondportfoliosdissipatesovertime.Whenshort-termlossesoffsetshort-termgainsand long-term lossesoffset long-termgains,hedemonstrateshowtax-lossharvestingcanaddatleast0.5percentand0.8percentannuallyforperiodsuptotenyearsforten-andtwenty-yearmaturities,respectivelytothevalueoffixedincomeportfolios.Inaddition,headdressestheoften-ignoredsubjectoftakingprofitswithtaxablebonds.Whenthereisadropininterestrates,asweexperiencedfrom1981to2003,manyhigh-yieldbonds are priced at a significant premium to par value. Depending ontheoutstandinglifeormaturityofthebond,thereisabenefitinselling

A foolandhismoneyare soonparted. It takes creative tax lawsfortherest.

—BobThaves(“Frank&Ernest”)

C H A P T E R 1 2


thepremiumbondwitha10percent-pluscoupon,payingthelong-termcapitalgainstax,andthenreinvestingtheproceedsinanotherhigh-yieldbondwithamuchlowercouponatparvalue.Thisisfavorabletothetax-ableinvestor,sincethetaxonincomefromthecouponofthebondforinvestorsinthehighesttaxbracketisnowmorethantwicetherateofthetaxonlong-termcapitalgains.AsDavidsonpointsout,thereisalimittothebenefitofthistransaction,astherearefewerproceedstoreinvestaftertaxesarepaid.Whenthestudywasconductedin1999,thisopportunitypeakedwithten-yearmaturities.

Bondinvestingisconsideredtobeagameofinches,ascomparedwithfeetoryardsinstockinvesting.Dependingonthelevelofinterestrates,thedifferencebetweenagreatfixedincomemanagerandagoodormediocremanagermayonlybe0.25to0.75percentannually.Additionally,astheav-eragecouponofbondsoutstandingcontinuestofall,itbecomesmoredif-ficultforbondmanagerstoachieveattractiveabsolutereturns.Therefore,inalow-interest-rateenvironment,theenlightenedorelitetax-awarefixedincomemanagerbecomesevenmorevaluabletohisclients.Thischapterwilladdressthekeycharacteristicsoftax-awarefixedincomemanagers.

TheHierarchyofTax-AwareInvesting

(SupplementalElementsforFixedIncomePortfolios)

1 Knowsthataladderofmaturitiesisnotatax-awaresolution2 Iswillingtoenhanceafter-taxincomebutnottocausedetrimental

consequences3 Understandstheimpactofpremiumsanddiscounts4 Avoidsphantom-incomesituations,ifpossible5 Purchasesout-of-statemunicipalbondswhentheyoffer superior

after-taxreturns6 Purchasestaxablebondswhentheyoffersuperiorafter-taxreturns7 Takesadvantageofgoodthingshappeningtomunicipalbonds8 Understandsthatportfolioshavinglongeffectivematuritiesoffer

thegreatestpotential9 Canmanagebondportfoliossuccessfully forvarioustypesoftax

ableentities10 Understandshowtooptimizeportfoliosforthealternativemini-

mumtax

Eachelementwillbeexaminedtoprovideanunderstandinghowtheelitefixedincomemanagersextractvaluefromthebondmarketsonanafter-taxbasis.

PracticesofEliteTax-AwareFixedIncomeActiveManagers 151

1 Knowsthataladderofmaturitiesisnotatax-awaresolution:Iftheobjectiveistomaximizeafter-taxtotalreturn,aladderofmunicipalor tax-exemptbonds represents awillingness to acceptmediocrity.Un-fortunately,toomanyindividualsacceptthembecausetheyareinformedbondladdersarenotsubjecttopricevolatilityasarefixedincomemutualfunds.Allbondportfoliosaresubjecttopricesensitivityfromchangesinthegenerallevelofinterestrates!Moreimportant,bondladdersrepresentamissedopportunitycostfortax-awareinvestorsthatinsomecasescanexceedasmuchas1percentormoreinreturneachyear.UntiltheSECre-quiresbrokerstodisclosethefullcostoftradingfixedincomesecurities,astheydowithequities,bondladderswillunfortunatelycontinuetoflour-ishasinvestorswillremainunawareofthetruecostsofconstructingandmaintainingthem.Ifyounaivelypurchasemunicipalortax-exemptbondsandhold themtomaturity,you forgo tax-awareopportunities.Aswithequities,oneofthebestwaystoaddincrementalvalueisthroughtax-lossharvesting.Unlikethecasewithequities,doingthiseffectivelywithbondsrequires sizable, liquid positions that can be exchanged at a reasonablebid/askspread.Moreover,therearenuanceswiththetaxcodethatmaketax-lossharvestingmorecomplexforbonds,ascomparedwithequities.Theadvocatesof ladderscannotcompete inthisarenafortwoprimaryreasons.First,unlessamanagertradesaccordingtobest-executionprovi-sionsandpassesthecompletesavingsontotheircustomers,itisdifficulttoconductthetax-lossharvestingtradewithbondaccounts.Second,asyougothroughtheadditionalelementsoftax-awarefixedincomeinvest-ing,youcometotheconclusionthattheexperienceandskillsetnecessarytoachieveoptimalfixedincomeresultsrestswithalimitednumberofelitemanagers.

Thisdiscussion isoriented toward investorswith sufficient assets tofundalargeseparateaccountandthoseprofessionalsthatmanagethem.However, most individuals think of a fixed income mutual fund as analternativetoabondladder.Itisdifficulttojustifyfixedincomemutualfundswhen theaverage intermediatenationalmunicipalbondcategoryhasatwelve-monthSECyieldof3.4percentandtheaverageexpenseratiois1.03percent,accordingtoMorningstar.2Thismeansthefeesconsumealmostaquarteroftheyield!Thisdifficultyismagnifiedevenmorewithmoneymarketfunds,someofwhichhavehadtowaivetheirfeestoavoidhavingnoyield.Feesmatterwithfixedincomefundsandoverthelonghaulareamajorcontributortosuccessorlackthereof.Feesaloneshouldeliminatethemajorityoffixedincomemutualfundsfromconsideration.For example, cost-competitive fundshave expense ratiosof0.2percentorless,whereastheaveragefundhasafeeslightlygreaterthan1percent.Thisdifferenceof0.8percentaloneiswhatdifferentiatesafixedincome


managerwhoismedianperformerfromoneinthetopquintile.Ifyouarewithafundgroupwithmultiplefundofferings,youcanconductthetax-lossharvestingwithaphonecall,whichisasignificantadvantageovertheladder.Ifyoutakeadvantageofthisopportunity,itcanmorethancovertheexpenseratio.

2 Iswillingtoenhanceafter-taxincomebutnottocausedetri-mental consequences:Taxable-bond management is different than thetotal-return-focused environment of tax-exempt account management.Withtaxableaccounts,itisnecessarytobalanceboththeabilitytogener-atemeaningfulincomeonanafter-taxbasisandpriceappreciation.Estab-lishedfixedincomefirms,likeStandishMellon,devotesignificantresourc-estodeterminedailyhowtheycanachievethehighestafter-taxreturnsfortheircustomerswithoutsubjectingthemtorisksthatmayjeopardizeprincipal.These firms employ state-of-the-art systems and experiencedprofessionalswiththeexpertiseandexperiencetoconstructportfoliosthatgeneratemoreincomethanamarketproxyandthentodelivermorepro-tectionor appreciation, dependingon their outlook for changes in theoutlookfor interestrates,shapeoftheyieldcurve,andrelativevalueofvarioussectorstheydeemmostcompelling.Theirobjectiveistodeliverconsistent,above-benchmarkresultswithouttakingonunnecessaryrisk.Theyshouldbeexpectedtoaddvalue,butthereisalimitastowhatcanbeaccomplishedwithinthisframework.Fishermenhaveasayingthatyoucan’tcatchaten-poundbassifthepondisonlycapableproducingabassthatweighsfivepounds.Thisissotruewithfixedincomeportfolios,astheamountofupsideislimited,andinvestorsalltoooftenhaveanunre-alisticexpectation.Whenbondyieldsarelow,youcan’texpectmanagerstoadd1percentinperformanceunlesstheyaretakingonadditionalrisk.Foramanagerwhoiscontrollingrisk,asinthecaseofStandishMellon,themost investors shouldexpect toreceive in incremental return isap-proximately10percentofthecurrentyieldtomaturityofthebenchmarkportfolio.Therefore,ifmunicipalbondsyield4percent,anactiveman-agershouldbeabletoproduceareturnof4.4percentbeforefees.Therearetoomanyexamplesofhowinvestorshavelostnot1or2percentbut25percentormoreoftheirinvestmentorprincipalfrombondmanagers’reachingfortoomuchyield.Ifadditional incomeisbeingachievedbe-yondwhatisachievedbyamethodologythatStandishandothersemploy,youhavetoask,“WhatistheadditionalriskIamtaking,andamIbeingcompensatedforit?”

Additionalincomeoryieldcanbeachievedthroughemphasizingcer-taintypesofsecuritiesorbyemployingleverage.Atthesecuritylevel,themarketoffersadditionalincomeforabondthatiscallableorisoflessercreditquality.Callriskarisesfromnotparticipatinginmarketapprecia-


tionopportunitieswhen interest rates fallorbondsare taken fromyoubytheissuerwhenyouhavepurchasedthematapricegreaterthanpar.Creditriskreferstotheissuer’sabilitytopayinterestandrepayprincipalasscheduled.Whatmanyinvestorsfailtorealizeisthathighyielddoesnotnecessarilyresultinhighafter-taxreturns.Forthepasttwodecades,taxablehigh-yieldcorporatebondshavebeen issuedwithcouponsnear10percent,buttheaverageannualreturnaftertaxesondistributionsandsaleoffundsharesforhigh-yieldbondfundshasbeenapaltry2.08per-centand3.48percentfortenandfifteenyears(seeFIGURE12.1).Thisisevenafterfavorabledouble-digitreturnsin2003.

Asthefigureshows,municipalbondshavehadvastlysuperiorresults,ascomparedwithhigh-yieldcorporatebondsonanafter-taxbasisforthesimplereasonthatyouhavetoconsiderdefaultsaswellasincomeoryield.Onewaytomitigateriskisthroughdiversification.However,amajordif-ferencebetweentheequityandbondmarketsisthatdiversificationtypi-callybenefitsstockportfolios,butitcanbedetrimentaltohigh-yieldbondportfoliosbecausecertainsectorsarenotoriousfortheirhistoryofpersis-tent high default rates. High-yield managers who have been successfulmostlikelyrunconcentratedportfoliostoavoidweaksectors.Moreover,equitiestradeonformalexchangesandforthemostpartareliquid.U.S.Treasuriesareliquid,buthistoryhasshownthatyield-orientedbondsec-torsgothroughperiodsofilliquiditythatcanlastaquarterormore.

Manyclosed-endfixedincomemutualbondfundsemployone-thirdorsoinleveragetoboosttheirincomegeneration.Leveragingcanalsobecombinedwithpurchasinglonger-termmunicipalbondinstrumentsand

FIGURE12.1 After-TaxReturnsofHigh-Yieldvs.MunicipalBondFundsCategoryAveragesfromMorningstarPrincipia(ForPeriodsEnding6-30-2003)

ONDISTRIBUTIONS ONDISTRIBUTIONS ANDSALEOFSHARES

MORNINGSTARCATEGORY 5YEARS 10YEARS 5YEARS 10YEARS 15YEARS

High-Yield –0.62% 1.43% 0.27% 2.08% 3.48%

IntermediateNationa|

Municipal 4.52% 5.07% 4.50% 5.03% 5.74%

High-YieldMunicipal 3.49% 4.08% 3.77% 4.95% 5.84%

Sourc

e:M

orn

ingst

ar


shorting short-term taxablebond instruments. It isnotuncommon forsomeofthesebetstobemagnifiedeighttotentimesbyhedgefundsusingleveragetoachievetax-exemptincomethatmayexceedayieldof10per-centannually.Thismayallbefineforashortperiod,butthemanagermaynotbeabletosustainthestrategythroughaperiodofilliquidity,whichcanhappeneveryfiveyearsorsointhefixedincomemarkets.

When reportingyields to taxable investors, you should refrain fromquotingthemonagrossyieldbasis.

grossyield=tax-exemptbondyieldtomaturity/(1–taxrate) netyield=taxablebondyieldtomaturity×(1–taxrate)

Todemonstratethecalculation,let’sassumewehaveatax-exemptormunicipalbondwithayieldtomaturityof4.0percentandtheinvestorissubjecttothemaximumfederaltaxrateonordinaryincomeof35percent.Inthiscase,thebondhasagrossyieldof6.15percent(4%/[1–35%]).Ifataxablebondhasayieldtomaturityof6.0percent,itwouldhaveanetyieldof3.9percent(6%×[1–35%]).Unfortunately,thepracticeofquotingagrossyieldinmutualfundadvertisinggivesafalseimpression.Ifyoucompoundgrossyieldsandthenreducetheamountbyanappropriatepercentageoftax,youobtainagreateranswerthanifyoucompoundtheafter-taxyields.FirmsconformingtotheAIMRafter-taxreportingstan-dardsmustreportportfoliocharacteristicsonanetratherthangrosstaxbasis.Thestatement“Youcan’teatgrossyields”isoftenusedtohighlightthisissueandcertainlystrikesachordwithtax-awareinvestors.

3 Understands the impactofpremiumsanddiscounts:Whenabondisfirstissueditprobablyofferstheleastvaluetoinvestors,asthereis greatdemand forbondspriced atpar value.Retail investors likeparbondsbecausetheirmechanicsaresimpletounderstand.Tax-awarebondmanagersmostoftengotothesecondarymarkettohuntforvalue,butthismeansthebondmostlikelyisatapriceotherthanpar.Mostoften,tax-awaremunicipalbondmanagerspurchasebondsatapremiumtopar,because of a relatively obscure provision of the tax code known as thedeminimisrule.Priorto1993,whenyoupurchasedabondatadiscountandhelditmorethanayear,theaccretionoftheprincipalwastaxedattherateforlong-termcapitalgains.Sincethen,ifyouexceedthedemi-nimisamount,theaccretionistaxedatthemuchhigherrateforordinaryincome.Iftheamountisdeminimis,whichisdefinedasthemarketdis-countbeinglessthan0.25percentofthefacevalueofthebondmultipliedbythecompletenumberofyearstomaturity,thenthelong-termcapitalgainratestillapplies.Forexample,ifyoupurchaseabondwitharemain-inglifeoftenyearstomaturityat98,thediscountisconsideredtobede


minimis.However,ifyoupurchasedthebondatapriceof97.5orbelow,theaccretionissubjecttotheordinaryincomerate.Thisfeatureisespe-ciallyimportantwheninvestorsanticipateconductingatax-lossharvestingtradewhenbondpricespeakoryieldstrough,astheydidinthesummerof2003.Followingperiodslikethis,youwanttoholdaportfolioofbondspurchasedatapremiumratherthanatparvalueoratadiscount,becausewhenratesgraduallyincrease,themarketpricesinanadditionaldiscountwhenthebondstrendtowardthelevelatwhichdeminimistaxprovisionstakehold.Thiscausesdeeper-discountbondstoacceleratedownwardinprice.Moreover,itbringsintoquestiontheviabilityofthetax-lossharvest-ingtrade,becauseyouaremostlikelytakingalossatthelong-termcapitalgainsrateandyoudonotwanttopurchaseareplacementbondthatwillhaveaccretionsubjecttotheordinaryincometaxrate.Doesthismeanyoushouldtotallyignorediscountbonds?Notnecessarily,astherehavebeentimeswhendeep-discountbondsbecamesooversoldthatastutetax-awareinvestors couldextract compelling returns fromthemevenafterpayingtheoneroustaxontheannualaccretionamount.

Ifa tax-exemptbond ispricedatapremium,noamortization isal-lowed.However,thereductioninbasismustbeaccountedforwhenthebondissold.Thisfeatureneedstobecarefullyconsideredwhenanalyzingabondonanafter-taxtotalreturnbasis.Fortaxablebondspurchasedatapremium,theinvestorcanelecttoamortizethebonduntilmaturityornotamortizeandincludeitaspartofthecostbasis.Thishasoftencausedcon-fusionfor taxable investorswhopurchasecertainGovernmentNationalMortgageAssociation(GNMA)mutualbondfunds.Ifthefundelectednottoamortizehigh-couponbondspurchasedatapremium,itpaidoutahighlevelofincomeovertimeandthepriceofthefundgraduallyfelltoadjustforthetreatmentofthepremium.Inthiscase,thereisnofreelunch!Thisarrangementmakes littlesenseforaninvestorinahightaxbracket,asheendsuppayingtaxonthehighlevelofincomethatisnotoffsetbytheamortizedamountattheordinaryincomerate,andthenifheholdsthefundmorethanayearandsellsit(mostlikelyataloss),heonlygetsacreditatthelong-termcapitalgainsrate.Thisresultwasquiteprevalentwithfundsinthe1980s,whenbondscouldstillbepurchasedinthemarketplacewith10percentpluscoupons.Thekeytothiselementisthatbondmanagersneedtobeawareofhowinvestorsevaluatebondsfortaxnuancesandbeabletotakeadvantageofpricingdiscrepanciesanddislocationinthemarketwhentheycanaddvaluefortheirclients.

4 Avoidsphantom-incomesituations, ifpossible:OneitemthatperplexesindividualsisthepaymentoftaxonphantomincomecreatedbystrippedTreasuryzero-couponbonds.Thesebondscanbeidealforfund-ingspecificcashflowrequirements,as thezero-couponstructureavoids


reinvestment risk. In this case, the total rateof returnof thebondwillequal the yield to maturity, because semiannual coupon income is notreinvestedatdifferentyieldandpricelevels.Unfortunately,eventhoughthezero-couponTreasurydoesnotdistributeincome,investorsmustpaytaxontheamountofannualaccretion,orphantomincome.ThisproblemalsooccurswithTreasuryinflation-protectionsecurities(TIPS).TheseareTreasurybondsthatareissuedalower-than-marketcouponandtheirprin-cipalamountisincreasedmonthlybythepercentageincreaseintherateofinflation,asmeasuredbytheconsumerpriceindex.Therearetwowaysthiscanbeovercome.First,ChristineToddofStandishMellonnotesthatthephantom-income taxdoesnot apply to the zero-couponmunicipalbonds in theirportfolios.Second,Barclayshasdevelopedan innovativesolutionwiththeirTIPSiShareexchange-tradedfundofdistributingtheamountofprincipaleachmonthratherthanaccretingit.NowindividualinvestorsdesiringtoinvestinTIPshaveasufficientflowoffundstocovertaxpayments.Therearenowmunicipalinflation-protectedsecurities,orMIPS.Inthese,theprincipalamountisfixed,butthesemiannualcouponisadjustedforinflation.Atthisjuncture,bondmanagershavesomecon-cernswiththeseissuesbecausethereislimitedvolumeavailableandthesemiannualcouponpaymentsystemmissessomeoftheseasonalinflationpatternsthatareprevalentwithTIPS.3

5 Purchases out-of-state municipal bonds when they offer su-periorafter-taxreturns.Tax-awaremunicipalbondmanagersthinkofmaximumafter-taxversuspayingnotaxandarenotwedtopurchasingbondssolelyfromtheclient’sstateofresidence.Thereissomuchdemandforthebondsofhigh-taxstateslikeCalifornia,Massachusetts,Minnesota,andNewYorkthatlocalinvestorsoftenpayapremiumforthem.Whenthemarketgetsfrothy,theastuteinvestorwilllooktootherstates,wheredemandislower.Thiswillusuallytakethemanagertolow-taxstatesoroneofthesixstateswherelocalinvestorsmuststillpaytaxesonmunicipalbond incomefrombonds issued fromtheir stateof residence.Tomakemattersmorecomplex,therearestateslikeWisconsinwhereonlyapor-tion of municipal bonds are exempt from both federal and state taxes.Withcomplexityoftencomesopportunity.Therefore,managerscanof-tenpurchasemunicipalbondsatlevelscheapenoughthattheystilloffercompellingvalueafterpaymentofastatetaxontheirincome.Notonlydoesthispracticeservetoachievehigherafter-taxreturns,italsoleadstoamorediversifiedportfoliowithlesssensitivitytostate-specificeconomicorpoliticalrisk.WhiletheeconomicoutputofNewYorkorCaliforniaislargerthanthatofmanycountries,theybothhavehadtheirfairshareofbudgetaryconcernsoverthepasttwodecades,whichhaveputseverepric-ingpressureontheirbonds.


6 Purchases taxable bonds when they offer superior after-taxreturns:Tax-awarebondmanagerswillalsoconsidertaxablebondsforinclusion in the portfolio if the after-tax returns are more compellingthanthoseoftax-exemptbondalternatives.Thesimplestexampleofthisopportunitycanbeshownwithmoneymarketfunds.Justoutofcurios-ity,visitthewebsiteofafavoritelargemutualfundcomplex,checktheyieldsonitsnationaltaxablemoneymarketfund,andmultiplyby0.6toaccountforthetaxhaircut.ThencomparethisnumberwiththecurrentyieldonitsCaliforniamunicipalmoneymarketfund.Moreoftenthannot,afterpayingtaxes,theyieldonthetaxablemoneymarketfundwillbehigher.Doesthatmakesense?No,butitisamazinghowmanyinves-torsfromhigh-taxstateswillpurchasemunicipalbondproductstopaynotaxratherthanmaximizetheirwealthcreationandinvestonanafter-taxbasis.

Togainanunderstandingofthetaxtreatmentoftaxablebonds, in-vestors shouldbeaware thatTreasuryandGNMApass-through securi-tiesareconsideredtobedirectobligationsof theUnitedStatesandareexempt fromstate tax.Agency issuesbytheFederalFarmCreditBank,

FIGURE12.2 After-TaxYieldComparison

Before-TaxYieldtoMaturity

TAX-EXEMPT U.S. GOVERNMENT A-RATED MUNICIPAL TREASURY AGENCY CORPORATE

3.20% 4.00% 4.40% 4.80%

After-TaxYieldtoMaturity

FEDERAL TAX-EXEMPT U.S. GOVERNMENT A-RATED TAXRATE MUNICIPAL TREASURY AGENCY CORPORATE

10% 3.20% 3.60% 3.96% 4.32%

15% 3.20% 3.40% 3.74% 4.08%

25% 3.20% 3.00% 3.30% 3.60%

28% 3.20% 2.88% 3.17% 3.46%

33% 3.20% 2.68% 2.95% 3.22%

35% 3.20% 2.60% 2.86% 3.12%

Sourc

e:

Dougla

sS

.R

ogers


FederalHomeLoanBank,andSallieMaearealsoexemptfromstatetax.SincetheseagencyissuesofferapickupinyieldoverU.S.Treasuriesandareveryliquid,theyareoftenemphasizedbymanagerswhoincorporatethe“crossover”trade(crossingoverfromtax-exempttotaxablebondsandback again to achieve the highest potential after-tax returns) as part oftheoverallstrategytoenhanceafter-taxreturns.Onthesurface,thetradeappearstobequitesimple.Youjustselectthebondofferingthehighestpotentialafter-taxreturn.Toillustratetheopportunityforvalue,FIGURE

12.2showsbefore-andafter-taxyieldsforatax-exemptmunicipal,U.S.Treasury,governmentagency,andcorporatebondatthedifferentbreakpointsinthefederalmarginaltaxrates.

In reality,bondprices andyields changedaily, andfirms that applythecrossovertradeinasophisticatedmannerincorporatestatetaxratesaswell.Toachieveafter-taxtotalreturnsforcomparativepurposes,thefirmmayincorporateaninterestrateforecastortakeintoaccountinformationderived from the shape of the theoretical spot rate curve to determinethe impact of price movement over a defined time horizon.Tax-awaremunicipalbondmanagersincorporatethisinformationalongwithotherinformationbeforemakingbuyandselldecisions.Onefirmthatempha-sizesthistypeofstrategytoachieveitsvalue-addedpropositionisM.D.Sass.Throughelectronicapplicationsitcanmonitorthecurrentafter-taxpotentialofeverybond in its inventory. It receivesbidson itsholdingsfrommorethan200professionalsacrossthecountryhavingaccesstoitsinventory.This is especially advantageous for its performance; as men-tioned earlier, the retail side of the business will often pay a premiumforin-statebonds.Youmayask,“Dotax-exemptinvestorseverpurchasemunicipalbonds?”Astutetax-exemptbondmanagersdo,especiallywhentheyieldsapproach100percentofTreasuryyields.Thesemanagersrealizethat taxable investorswillcomeback intothemarketwhentheyrealizehowcheapmunicipalbondsare,withpricemovementsuperiortothatofequalmaturityTreasuries.

7 Takesadvantageofgoodthingshappeningtomunicipalbonds:AnotherelementthatpeoplemissthatMichaelBrilleyofSitInvestmentAssociatesshareswithhisclientsandprospectsis“Goodthingshappentomunicipalbonds!”Unliketaxablebonds,withwhichthebestthingthatcanhappenisperhapsacreditupgrade,municipalbondscanbepre-re-fundedorescrowedtomaturity.Whenratesfall,theissuermayestablishanescrowaccountandfundtheremainingcashflowsfromtheproceedsofU.S.governmentbonds.Whenthisoccurs,thebondsareupgradedtoAAA,causinganimmediateimprovementinprice.Also,thebondsmaybecomesubjecttoapremiumparcall,wherethebondswillbetakenoutat levels two to threepointsabovepar.Corporate sinking-fundbonds,


whicharebecomingincreasinglyrare,aretheonlytaxableissuesthatex-hibitsimilarfavorablefeatures.Anastutemoneymanagerwantstofocusonbonds that are likely tohave these favorable actionshappen ratherthan purchasing those bonds where the favorable actions have alreadyoccurred.

8 Understands that portfolios having long effective maturitiesoffer the greatestpotential:Mostbondprofessionals thinkof achiev-ing compelling returns as the ability toproduce superior risk-adjustedreturns.Thatisfineifyoulimityourselftotheconfinesofatradingdesk.Whatisignoredtoalargeextentwithtaxablebondportfoliosistheneedtomatchthehorizonofclientassetswiththeirliabilities,whichismoreofaretirement-planconcept.Foranindividualstartingacareer,thereisaneedforasafetynetandarisk-adjustedreturnorientationmakessense.However,ifahigh-net-worthfamilyhasarespectableestateplan,itcanbeconsideredtobeaperpetualorganization.Therefore,portfolioshavingalongermaturityordurationmakesense,especiallyifyoucantakead-vantageofthetax-lossharvestingtradewithmoreliquidsecurities.Thisdoes not mean you should immediately plunge into longer maturitieswheninterestratesarenearhistorical lows.However,overtime,asop-portunitiespresentthemselves,high-net-worthfamiliesespeciallywouldbefinanciallybetteroffextendingtheaveragelifeoftheirtaxablebondportfolios.Thisisespeciallytruewithmunicipalbonds,astheyarelesssusceptibletoFederalReserveactivity.UnlikeTreasuries,whereshorter-maturity issues offer greater yields than longer-term bonds, municipalbonds do not experience yield-curve inversions. The municipal bondyieldcurvemaintainsitshumpedshapewithapeakinyieldtypicallyinthefifteen-totwenty-five-yearmaturityrange.Therefore,investorscantakeadvantageofthehigher,persistentleveloftax-exemptincomefromthisportionoftheyieldcurveandgainsomeappreciationinpricewhentheirindividualbonds“rolldowntheyieldcurve”withtime.

9 Canmanagebondportfolios successfully forvarious typesoftaxableentities:Thepropertyandcasualtyinsuranceindustrypresentsadifferentsetofchallengesforthetaxable-accountbondmanager.Therearethreedistinguishingfactors.First,municipalbondincomeissubjecttoa15percenthaircut—meaning it is taxedata rateof5.25percent(35%×15%).Second,thepropertyandcasualtyinsuranceindustryissubjecttostatutoryreportingrequirements.Untilamanagercandem-onstrate competence with this additional layer of complexity, compa-nies and their advisers are usually unwilling to take them on.Third,the insurance companymay, from time to time, tap theportfolio forprofitswhentheyareavailable.Therefore,whenamanagertakesagain,hemayinfactbeworkinginthebestinterestsofthecorporation.This


thoughtprocesscanbequitedifferentthantheprocesswhereamanagermaywishtotakelossesanddelaytakinggainsforhigh-net-worthfam-ilyportfolios.Also,theprovisionsofvarioustaxcodesthatapplytothedifferent types of taxable account entities generally have a far greaterimpact on the day-to-day management of fixed income portfolios, ascompared with equity portfolios.While everyone should know aboutthe tax ramifications of trading a particular client portfolio, the fixedincomeprofessionalnavigating thesevarious typesofmarkets success-fullysoonfindshimselfalmostataxexpertoneach.Perhapsthatiswhybondmanagerswhostartedtheircareersoriginallyasaccountantsfindthisnichesorewarding.

10UnderstandshowtooptimizeportfoliosfortheAMT:ThebondmanagerneedstoexercisecautionwithcrossovertradingwhentheclientissubjecttotheAMT.4TheAMTisoftenreferredtoevenbyaccountantsas“theonetaxaccountantsdonotunderstand.”Anaccountanttypicallythinksofminimizing the taxbiteof a client,notnecessarilybeing tax-awarewhen itcomes to investments.This isagainacaseofoptimizingtheamountofdollarsofnetorafter-taxincome,ascomparedwithpay-ingtheleastamountoftaxes.Itisessentialthatthetaxable-accountfixedincomemanagermastersanunderstandingoftheAMT,asoftentimeshewillbetheonewhoinitiatesandcarriestheconversationasapartoforwhenworkingwiththemembersofthequalifiedtriumvirateoftax-awareserviceproviders(seechapter5).TheAMTcameaboutin1986andisaformoftheflattaxthatSteveForbessupportedinhiscampaignforthepresidency.FIGURE12.3liststheitemsthatmostoftencauseanindividualtobesubjecttotheAMT.5

Line42ofForm1040requirestaxpayerstocalculatetheirAMTac-cording to Form 6251. AMT income, or AMTI as it is referred to, iscalculatedby startingwithadjustedgross incomeandaddingbackcer-tainpreference items.Formarriedcoupleshavingmore than$175,000

FIGURE12.3 ItemsCausingtheAlternativeMinimumTax

Exemptions InterestonSecondMortgages

StateandLocalTaxes MiscellaneousItemizedDeductions

MedicalExpenses IncentiveStockOptions

Long-TermCapitalGains TaxShelters

Sourc

e:

Fair

mark

Pre

ss


inAMTI,multiplyby28percent and then subtract$3,500 to achievetheAMTtax.Forcoupleshaving less than$175,000 inAMTI,simplymultiplyby26percent.IftheAMTisgreaterthantheregulartaxdollaramount,theAMTapplies.Moreandmoreindividualsarefindingthem-selvespayingtheAMT,especiallysincethemaximumfederaltaxratehasbeenloweredfrom39.6percentto35.0percent.

Theincomefromasubsetoftax-exemptormunicipalbondsknownasprivateactivitybondsissubjecttotheAMT.Amunicipalsecurityisclassi-fiedasaprivateactivitybondifmorethan10percentoftheprivatebusi-nessactivityoftheissueorloanstonongovernmentalborrowersexceeds5percentoftheproceeds.AsFIGURE12.4,providedbyStandishMellon,shows,privateactivitybondsoffergreateryieldsthansimilar-maturitytax-exemptbonds.

Theyielddifferential in this chart is shown inbasispoints.Abasispointis1/100thof1percent.Thetrendsince2002makessense.Sincemore investors arebecoming subject to theAMT, there is lessdemandforprivateactivitymunicipalbonds.ForclientsnotsubjecttotheAMT,privateactivitybondsprovideasmallboostintax-exemptincomegen-eration and shouldbe considered.Amunicipalbondmanager canbetax-efficientbyavoidingprivateactivitybondsforclientssubjecttotheAMT. However, this simplistic approach typically does not provide anoptimaltax-awaresolution.

FIGURE12.4 HistoricalYieldDifferentialBetweenTen-Year-MaturityInsuredandAMTMunicipalBonds


Basi

sP

oin

ts

32

40

24

16

8

0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Sourc

e:

Sta

ndis

hM

ellon


AnoptimalapproachforclientssubjecttotheAMTrequiresmodel-ingtheallocationtotax-exemptversustaxablebonds.Adjustmentoftheallocationbetweenthetwotypesofbondscanmeaningfullyincreasetheclient’snet after-tax income,which is the tax-aware approach.To starttheprocess,weselectyieldsonrepresentativehigh-gradetax-exemptandgovernment agency bonds that have effective maturities similar to theportfolio’s.Forthisexample,thebondportfoliois$30millionandtheyieldonanappropriatemunicipalbondis3percent,whereasthetaxablebondisofferingayield4.5percent.Nextweconstructaspreadsheetthatincludestheitemsnecessarytoestimatetaxesandnetincomeforthein-vestoratboththeregulartaxrateof35percentandtheAMTrateof28percent,asshowninFIGURE12.5.

Inthefigure,westartwiththeamountoftaxablesecurityincomefromthebondportfolioandaddtoitotherincometocalculatetheadjustedgrossincome.Intheexample,thereis$0oftaxablesecurityincome,be-causetheportfoliohasa100percentallocationtomunicipalbonds.Weadjustthisamountfortheallocationtotaxablebonds(seeFIGURE12.6).

Sourc

e:Thom

as

Law

rence,D

ougla

sS

.R

ogers

FIGURE12.5 CalculatingtheRegularandAlternativeMinimumTax(MarriedCoupleWithAMTIGreaterThan$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

TaxRate 35% AMTTaxRate 28%

Tax $210,000 AMTTax $248,500

(AMTIx28%)–$3,500

Tax-ExemptIncome $900,000 Tax-ExemptIncome $900,000

NetIncome $1,290,000 NetIncome $1,251,500


Thenwesubtractitemizeddeductionstocalculatetheamountoftaxableincome.Tocomputetheregulartaxdue,wesimplymultiplybytheclient’staxrate,inthiscase35percent.Last,wesubtractthetaxfromthetaxableandtax-exemptincometocalculatethenetorafter-taxincome.

FortheAMTcalculation,webeginwiththetaxableincome,addbackthepreferenceitems,andthenmultiplybytheAMTrate.Sincethisclientismarriedandsubjecttothe28percentrate,wesubtractanother$3,500to achieve thedollar amountof thepotentialAMT.Thegreaterof theregulartaxorAMTamountapplies.Inthisexample,theAMTamountof$248,500isgreater,sotheindividualwouldhavetopaynoadditionaltaxwitha100percenttax-exemptbondportfolioandwouldfeelquitecontent.Moreoftenthannot,hisadviserswouldsay,“ItisunfortunatethatyouhavetopaytheAMT,butaslongasyoudon’tholdprivateac-tivitybonds,youhavedonetherightthingbecauseyouminimizedyourtax liability.”Iftheinvestortakesthistax-efficientadvice,hemissestheopportunitytoenhancehisnettaxableincomebyapproximately$30,000annually.Thiscanbeaccomplishedbyholdingaportfolioofslightlyless

Sourc

e:Thom

as

Law

rence,D

ougla

sS

.R

ogers

FIGURE12.6 AdjustingtheMixofTax-Exemptvs.TaxableBondstoOptimizeNetIncome

FIXED-INCOMEMIX REGULARTAX AMT%TAX % NET NETEXEMPT TAXABLE TAX INCOME TAX INCOME

100% 0% $210,000 $1,290,000 $248,500 $1,251,000

90% 10% $257,250 $1,287,750 $286,300 $1,258,700

80% 20% $304,500 $1,285,500 $324,100 $1,265,900

70% 30% $351,750 $1,283,250 $361,900 $1,273,100

60% 40% $399,000 $1,281,000 $399,700 $1,280,300

50% 50% $446,250 $1,278,750 $437,500 $1,287,500

40% 60% $493,500 $1,276,500 $475,300 $1,294,700

30% 70% $540,750 $1,274,250 $513,100 $1,301,900

20% 80% $588,000 $1,272,000 $550,900 $1,309,100

10% 90% $635,250 $1,269,750 $588,700 $1,316,300

0% 100% $682,500 $1,267,500 $626,500 $1,323,500


than60percentintax-exemptbondsandtheremainderintaxablebonds.Wecometothisconclusionthroughaniterativeprocessbyadjustingthemixofbondsin10percentincrementsandrecalculatingthetaxandnetincome,asshowninFigure12.6.Theshadedareainthelastcolumnhigh-lightshowgraduallyaddingtaxablebondstothemixincreasesafter-taxnetincome.Whiletheinvestor’staxishigher,soishisnetincome.

Holdinganymore thanapproximately40percent in taxablebondspushes the clientoutof theAMTandprovidesnobenefit.When theclientholds lessthan60percent intax-exemptbonds,thereeventuallycomesapointwheretheAMTnolongerapplies,hepaysanincreasinglyhigheramountoftaxes,andhisnettaxableincomecontinuestodrop,ashighlightedinthefourthcolumn.Therefore,itisextremelynaiveforamanagertosay,“Taxablebondsareabargainrelativetomunicipals,solet’smovethewholeportfoliointhatdirection.”AsFigure12.6shows,the municipal bond manager that works in a trading-room vacuumwithouttakingtheclient’suniquetaxprofileintoaccountshouldbeap-proachedwithahighdegreeofcaution.Thistypeofmodelingdoesnotrequireasophisticatedapproachbut,unfortunately,isalltoorare.Eachtaxableclientisdifferent,andthepractitionerdoingthistypeofanalysisshouldconsiderexpandingtheentriesunderadjustedgrossitems,item-izeddeductions,andpreferenceitemstogainabetterunderstandingoftheinteractionbetweenthekeyvariables.Thisexerciseshouldfacilitateahealthydialogueandmaycausetheclient’saccountanttosuggestaddi-tionalrecommendationspertainingtoincomegenerationandpreferenceitemsthatcanbeextremelyvaluableinthewealthcreationprocess.

Couplingmunicipalbondswithothersecuritiescanproduceinterest-ing tax-advantaged products. For years, firms like PIMCO and Metro-politanWesthavecombinedshort-durationbondtradingwithfuturestocreatebenchmark-plus-equityreturns.Thesametypeofstructurecanbedonewithmunicipalbonds in lieuof taxable short-durationbonds.Asuniquecombinationssuchasthesebecomemoreprevalent,wearelikelytouncoveradditionalelementsoftaxablefixedincomeinvestingthatwillcontinue to allow competent tax-aware bond managers to outperformladderedportfolios,afterfees,byameaningfulmargin.Besides,theoneserviceaninvestorshouldpayafeeforiscreditanalysisaimedatavoidingpotentialdefaultsituations.

Wehaveshownthatactivefixedincomeportfoliomanagementmakessensefortaxableaccountswhentax-awareelementsareemployed,butatwhatassetsize?Toanswerthis,wemustasktwoquestions.First,whatistheminimumnumberofbondsnecessarytoachieveadiversifiedportfo-lio?Mostpractitionerswouldanswertwenty,astheydonotwanttohaveanymorethana5percentexposuretoanyonecredit-sensitiveissuer.The


numbercouldbesmallerifsomeofthesecuritiesarefull-faith-and-creditobligationsoftheU.S.government.Second,whatisthesmallestsizeofbondtradethatcanbeconductedwithareasonableamountofliquidity?The answer varies according to the sector, but $250,000 is the mini-mumdollarpositiontoefficientlyconductthetax-lossharvestingtrade.Therefore,investorsshouldshyawayfromactivelymanagedportfoliosoflessthan$5million(20securities×$250,000persecurity)insize.Foramountsunderthisthreshold,fixedincomemutualfundsserveavalu-ablepurpose.Besides,withamutualfundyoucanconductthetax-lossharvestingtradewithasimplephonecallortwo.

For taxable-bond managers, establishing the hurdle is a differentprocess and the spread is narrower.Fees are similar for bondmanagerswhetherornottheyconducttax-lossharvesting.Inanycase,youshouldrealizethetax-lossharvestingtradealoneallowstheinvestortoobtainthemanager’sexpertiseforlessthancost,butthisisonlytrueforintermedi-ate-andlong-maturityportfolios.Ifthemanagerdoesnotofferanyofthetax-awareelements,heneedstohaveanalphaof+0.5percentannuallytobecompetitive.AsFigure11.3highlights,thisperformanceisinthetop25percent.Aswithequities,fixedincomemanagerswhodonotapplythetax-awareelementsareatameaningfuldisadvantagetothosethatdo.

ChapterNotes

1. R.B.DavidsonIII,“BondManagementforTaxableInvestors,”AIMRConfer-enceProceedings,InvestmentCounselingforPrivateClients,no.2(1999):59–68.


3. ChristineToddofStandishMellon,indiscussionwiththeauthor,November10,2004.

4. The author is extremely grateful for the input received from family officeexecutiveThomasLawrenceforhiscommentspertainingtothealternativemini-mumtax.

5. “TopTenThingsThatCauseAMTLiability,”FairmarkPressTaxGuideforInvestors,http://www.fairmark.com/amt/topten.htm,accessedJuly30,2004.


TheHedgeFundDilemma

167

There is no other place in the market today where the Chineseproverb above is more applicable than in the rapidly growinghedgefundarena,whereassetswillsoonexceed$1trillion.Inves-

torsinvestinhedgefundsfortwoprimaryreasons:tolowertheriskoftheirexistingholdingsortoseeksuperiorresultsfromothersourcesofreturn.Fortaxableinvestors,especiallyhigh-net-worthindividuals,thesearecertainlyworthwhileobjectivestopursue,butiftheresultsaren’tthereaftertaxesarepaid,evenso-calledgoodtradesarenotworththeeffort.

Bytheirverynature,mosthedge fundswillbenotoriously tax-inef-ficient.Doesthismeanthatinvestorsshouldignorethem?Absolutelynot,butiftaxableinvestorswishtopursuehedgefunds,theyshouldhaveanappreciationofthetax-awareopportunitiesthatareavailable.Thereisnosinglesolutionthatissuitableforallsituations.Therefore,itisparamountthat taxable investors and their advisers align themselveswithqualifiedindividualswhospecialize inunderstandingandsharinghowtonegoti-atetheserelativelyunchartedwaters.Thekeyistoseekindependentandobjectiveadvicethatisnotalignedwithaparticularproductorstrategy.Forexample,withouttheeducationtheauthorhasreceivedoverthepastseveralyearsfromBobGordonandTomBoczarofTwenty-FirstSecuri-ties,thischapterwouldhavebeendifficult,ifnotimpossible,toprepare.

Thosethatcandoagoodtradedon’twrangleovertaxes.

—OldChineseProverb

C H A P T E R 1 3


Thefirstthinginvestorsneedtounderstandisthathedgefundsutilizepartnershipaccounting.Thetaxstrategiesofthepartnershipoutlinedinthefund’sprivateplacementmemorandumshouldbecarefullyreviewed.TheresultsofthepartnershipflowthroughtotheinvestorsandarereportedonScheduleK-1.Therearecertaintaxapplicationsofpartnershipaccountingthatbothtax-exemptandtaxableinvestorsneedtobeawareof.

Sincehedgefundsoftenemployleverage,theycangenerateunrelatedbusinesstaxableincome(UBTI).Thisisofparticularconcerntocertaintrusts,charitableorganizations,andretirementplans,asUBTIcancauseallincomereceivedbytheentitytobetaxable.InvestorsconcernedaboutUBTIinvestintheoffshoreoffering,versustheonshoreoffering.Offshorehedgefundsarestructuredascorporations,andgeneratedividendincomenotsubjecttothetaxonUBTI.

Sincehedgefundsarepartnerships,onetechniquethatcanbeem-ployed to lower the tax bite of the fund is to make an asset-in-kinddistributionofassets,aswasdiscussedwithexchange-tradedfunds.InthecaseofanETF,thistypicallyinvolvesalargebasketofliquidsecuri-ties. However, there have been instances with hedge funds where thedistribution consisted of low-cost-basis securities that were extremelyilliquid.Itisonethingtoreceiveanarrayofliquidstocks,butitisquiteanother to receiveobscureprivateplacementsordistressed-debt issueswithlargebid/askspreadswherethereisnoorderlyexchange.Therefore,it is important for investorsandadvisers to investigatehowthehedgefund has executed past distributions, especially in challenging marketenvironments.

Perhapsthegreatesttaxissuecurrentlyofconcerntotaxableinvestorsisthedeductibilityofhedgefundexpenses.Hedgefundschargeafeeasapercentageofassetsmanagedandaperformance feebasedonresultsaboveapredesignatedhurdlerate.Atypicalfeearrangementis1percentofassetsand20percentoftheprofitsabovethereturnofabenchmarklikeT-bills.Hedgefundsoffunds,whichmanageabasketorportfolioof individual hedge funds, typically further charge 1 percent of assetsand10percentofprofits.Therefore, if ahedge fundor fundof fundsachievesagrossreturnintheneighborhoodof15percent,thefeescaneasilybe5percentormore.Likemutualfunds,hedgefundsreporttheirreturnsnetofallfees.However,ifthesefeesarenottax-deductibleatthehedgefundlevelandtheinvestorexperiencesanetreturnof10percent,hemayenduppayingtaxonareturnofapproximately15percent.Thisisachallengewithafundoffunds,becauseahedgefundneedstoclaimtraderstatustobeabletooffsetthefeesagainstexpenses.1Otherwise,inapartnership,expensescannotbeoffsetagainstincomeandarelistedsepa-ratelyontheK-1asamiscellaneousitem.Mostinvestorscannotusethese

TheHedgeFundDilemma 169

miscellaneousdeductions,astheydonotexceedthethresholdpercentageofadjustedgrossincomeneedtoqualifyforadeduction.Recentrulingsondaytraderssuggestthatthesefeesarenotdeductibleforcertainhedgefunds.Asthisbookgoestopress,thisistheoneissuetostayabreastof,asitcouldhaveasignificantimpactonhowtaxableinvestorsallocatetheirhedgefunddollarsinthefuture.Moreover,ithighlightstheimportanceof knowing the various approaches to enhancing the tax efficiency ofhedgefundinvesting.

Factorsthatinvestorsandadviserscanexploretoenhancetheafter-taxreturnsofhedgefundsare:

1 Taxefficiencyofexistinghedgefunds2 Significantownership3 Favorabletransactions4 Allocationfavoringhedgefundsthatofferthepotentialforhigher

after-taxreturns5 Placementofassetsinindividualretirementaccounts6 Investmentinanoffshorefund7 Privateplacementlifeinsurance(PPLI)policies8 Sharesofstockinacompanywhoseinvestmentportfolioconsists

of,orwhoseprofitsaretiedto,hedgefunds9 Hedgefundderivativeproducts10Derivativesonhedgefundindices

Separatelyorcombined,thesetentax-awarefacetsofhedgefundin-vestingcanservetoenhancethewealthoftaxableinvestors.

1 Taxefficiencyofexistinghedgefunds:ScheduleK-1canbeana-lyzed todetermine the relatively efficiencyof varioushedge funds.Thekeytothisprocessisyouneedseveralyearsofhistorybeforeyoucandrawmeaningfulconclusions,whichisnotalwayspossiblewithhedgefunds.Segregatinginformationbythetaxnatureofeachitemcanprovevaluable.Ifyouservethehigh-net-worthindividualmarket,youarelikelytohaveclients,especiallythosepayingthealternativeminimumtax,whomaynotbeabletotakeadvantageofcertaindeductions.

2 Significantownership:Perhapsthebestwaytodetermineifthehedgefundislikelytobetax-efficientistointerviewtheseniorprofession-alsinvolvedanddeterminehowmuchoftheirpersonalwealthisinvestedinthefund.Amanagerwhohasasignificantpersonalstakeinafundislikelytohaveadistinctlydifferentapproachtowardtaxconsequencesthananother manager with a minimal commitment.Tax-aware hedge fundsmayapplysomeofthesamemeasuresastraditionalmanagershighlightedinchapters11and12,but thenatureofhedge fund tradingwillmostlikelycausethemtofocusontheelementsofitem3.


3 Favorabletransactions:Thefollowingtransactionsareexamplesof how tax savings can be achieved in the daily management of hedgefundsthatTwenty-FirstSecuritieshassharedwiththepublic.2

a. Equitylong/shortfundsneedtobesixty-onedaysonthelongsideandforty-sixdaysontheshortsideforthequalifieddividendtobe taxedat15percent and the expense tobedeductedat35percent.

b. Whencashispartofamerger,holdingthetargetstockforatleastsixty-onedayswillcausetheamounttobetaxedatthemorefavorablerateforqualifieddividends.

c. Constructive-sale rules do not apply to fixed income transac-tions.Therefore, a trade that is short against thebox,whereyoushortthesameappreciatedsecurity,candeferthegain.Thistradealonehastremendouspotentialfordistressed-debtspecialists,whooftenachievesizableprofitsfrombondsthatappreciatesignificantlyinpriceafterbeingpurchasedforpenniesonthedollar.

d. Anothertradethathaswideapplicationistheuseofabroad-basedlistedoptionthatqualifiesforfavorabletaxtreatmentunderSection1256.Ifyouaregoingtoholdanindexproductfor lessthanayear,itmakessensetouseaqualifiedSection1256contract,becauseitissubjecttoablendedcapitalgainstaxrateof60percentlong-termand40percent short-term,oramaximumfederal taxequivalentof23percent.Whenheldatyear-end,thesecontractsaremarked tomarket and the costbasis is adjusted accordingly.Therefore,short-termtradingwithaSection1256contractinlieuofusinganindexfundorETFcansaveone-thirdintaxdollars.

Thesearesimplyasampleoftradesthatcanleadtotaxsavings.Thetax-awarehedgefundmanagersworkcloselywithtaxexpertswhospecial-izeinthisnichesotheycankeepabreastoftax-minimizationstrategies.Thehedgefundmanagersmustanalyzethetaximplicationsofthetradesthatcharacterizetheircorecompetencyandestablishprocedurestotakeadvantageofcertaintechniqueswhentheymakeeconomicsense.

4 Allocation favoring hedge funds that offer the potential forhigherafter-taxreturns:Generallyspeaking,nondirectionalhedgefundstrategiesthatemphasizeconsistentabsolutereturnshavelowerafter-taxreturnsthandirectionalhedgefundstrategies.Therefore,whenstrategiesareputthroughaportfoliooptimizationprocess,itonlymakessensethattaxable accountswill relyondirectional strategiesmore than tax-exemptcharitable organizations and retirement plans will. This is why advisersservingtaxableaccountstypicallyrecommendahigherallocationtoequitylong/shortfunds,ascomparedwiththevariousarbitrage-relatedstrategies.


5 Placement of assets in individual retirement accounts:Thiswouldbetheeasysolution.However,thetrulyaffluentinvestorsmayhavea very smallportionof theirwealth in IRAs.Also, you shouldkeep inmindthathedgefundsarelimitedtohowmuchtheycaninvestinquali-fiedretirementplanassets.

6 Investment inanoffshore fund:Like theIRA,thisoptionhaslimitedapplication,butitcanbemeaningfulandshouldnotbeignored.It applies primarily to investors inhigh-tax states. Inmost cases,U.S.individualswouldnotuseoffshore vehicles, as these entities are struc-tured as passive foreign investment companies (PFICs). As such, theirincomeandgainsaretaxedatordinaryincomerates.Thisisnotamajorconcernwithsomehedgefundstrategies,becausethebulkoftheirdistri-butionsareordinaryincome.InaPFICinvestment,taxispaidonyournetprofits,notgross,.Accordingtotaxexpertsinthisarea,PFICshaveseveraldrawbacks,oneofwhichisa5percenttaxondeferredincome.However,oneadvantageisthatordinaryincometaxandinterestchargesarenotincludedaspartoffederaltaxableincome.Sincethisiswhatmoststatesbasetheirtaxcalculationon,thisfeaturecouldprovidemeaningfulsavingsforindividualsinhigh-taxstates.Twenty-FirstSecuritiesoffersacalculatoronitswebsitetoallowinvestorstoanalyzeiftheoffshorealter-nativeissuperiortothetraditionalonshoreordomesticoption.3

7 Private placement life insurance policies: Revenue rulings in2003clarifiedtheinvestment-relatedissuespertainingtotheuseofhedgefundsastheinvestmentvehicleforPPLIpolicies.Toqualifyforfavorabletax status, insurancecompaniesare takingmeasures toensure thehedgefundoptionsaredeterminedbyapersonotherthanthecontractholder,preferablyanindependentparty,andoffering“insurance-dedicated”prod-ucts.4Asaresult,thereislikelytobeaproliferationofproductintheyearsahead,astherearethreedistincttaxadvantagestolifeinsurance:

❑ Buildingofprincipaltax-free❑ Abilitytomaketax-freewithdrawalsandloans❑ Avoidingtheestatetax

FirmsplanningtoenterthePPLIarenaareseekingtheexpertiseofin-dividualssuchasLeslieGiordaniofGiordani,Schurig,Beckett&Tackett,whospecializesinthisarea.Thisisanexampleofhowregulatoryknowl-edgeplaysakeyroleeveninindividualinvestorsituations.Skepticsbelievetheinsurancecompanieswillnotbeabletoattracttop-notchhedgefunds,whichwouldnotwanttobecomecaptivetoasingledistributionchannelorclientwheretheirfeestructuremaybebroughtintoquestioninfutureyears.Iftheseproductscanbelaunchedwithoutoutlandishfees,theben-efitsfromtaxefficiencywillmakethemanextremelycompetitivetax-aware


alternativethatwilldemandseriousconsideration.Asaresult,adviserswillbeforcedtodeterminewhichinsurancecompaniesofferthemostadvanta-geousproductsinresponsetoinquiriesbytheirtax-awareclients.

8 Sharesofstockinacompanywhoseinvestmentportfolioconsistsof,orwhoseprofitsaretiedto,hedgefunds:Oneinnovativewaytoap-proachthisprocessistostartanoffshoreinsurancecompany.Inlieuoftraditionalassets,thecompanywouldutilizehedgefundsfortheinvest-mentportfolio.Obviously,ithastobedonewheretheuseofhedgefundswouldsatisfyrisk-basedcapitalstandardsorsimilarprovisions.Whileyoucannot remove thecompany-specific risk, this is away toachieve indi-rect exposure to hedge funds in a tax-aware manner. Another exampleofhow investorscangainexposure tohedge funds ispurchasingsharesof a company like Man Group, an enterprise that derives profits fromthemanagementofalternativeinvestments.Thesearelessthanperfectlycorrelatedplaysonhedgefunds,buttheydodemonstrateinsightful,tax-awarethinking.

9 Hedgefundderivativeproducts:Playingoffinvestors’fearsfollow-ingthreedownyears inarowintheequitymarkets(2000to2002), itshould be no surprise Wall Street has responded with costly principal-protectednotes. Froma tax viewpoint, they are less than a satisfactorysolution,becausetheytypicallycombineafinancialderivativewithaU.S.Treasurystripsecurity.Therefore,theyaresubjecttothephantomtaxonaccretedincomedescribedinchapter12.ThenextstepbytheStreetwastoofferacalloptiononahedgefundoffunds.Thisproducthasreceiveda lackluster response,because thepremiumcharged for the tax-deferralmechanismis20to25percent,andmanybelievethestructurewillrunafouloftheconstructive-salerules.Anotherwaytolookatthisofferingiswhywouldaninvestorpaysuchahighpremiumforanoptiononahedgefundoffundswith5to7percentannualvolatility?Inthisscenario,theprobabilityofachievinganegativereturnoverfiveorsevenyearsisnearzero.Boththeaccountingprovisionsandthecostofthetaxdeferralorop-tionneedtobetightenedupbeforethesestructuresbecomemoreaccept-edbyastuteadvisers.BruceTavelandhisquantitativespecialistsatU.S.TrustCorporationhaveconstructedanalternativeworthconsideringthatproducesa similaroutcome.TheycombineaQTAstrategyhighlightedinchapter10withvariouscallandputoptionstotrulyaddressboththeclient’staxesandinvestmentneeds.

10Derivativesonhedgefundindices:Forinvestorsthatarelookingfortaxefficiencyandliquidity,thisisprobablythemostpromisingalterna-tivetoday.Therearenowinvestablehedgefundindicesavailabletoinves-tors.Asaresult,dealersareofferinginvestorssyntheticexposurethroughtheuseofderivatives.Structurednotesarenowbeingofferedwithweekly


liquidityinamountsaslittleas$50,000.Unlikecalloptions,taxexpertsbelieve thenotescanbeofferedwithout triggeringtheconstructive-salerulesthatconvertthereturnstreamintoordinary income.Therefore, ifheldmorethanayear,theywillbesubjecttothemorefavorablerateonlong-termcapitalgains.AsTomBoczarandMarkFichtenbaumpointoutin their article, “Making Hedge Fund Investing MoreTax-Efficient,” ahedgefundoffundswouldhavetoproducea4.8percentannualalphatomatchthereturnonaseven-yearnoteandtheunderlyingindexproduc-inga10percentreturn.5Evenifthefund-of-fundsinvestorcoulddeductexpenses, thealphahurdle is3.3percent.Therewillbe skepticsof thisstrategy,especiallythosewhoquestionthereturnsofahedgefundindexforvariousreasons.However,asinthecaseofHedgeFundResearch,theseareinvestableindiceswithunderlyingmanagers.Willthebestmanagersbepartoftheirprograms,andwilltheirreturnsdivergesignificantlyfromthe actual overall market, which nobody has yet been able to measurebecauseofallthedifficultiesinobtainingmeaningfulhedgefundperfor-mance?Onlytimewilltell,butwhatwedoknowisthatovercominga3or4percentalphainanyassetclassisanextremelyarduoustaskoveraseven-yearperiod,especiallyforhedgefundcategoriesthathavemoreuniformreturns,suchasconvertiblearbitrage.

Thischapterexplainedvariousoptionsavailabletohedgefundmanag-ers,advisers,andinvestorstolowerthetaximpactofthistax-inefficientnicheof investing.With the rapid growth expected forhedge fund in-vestinginthedecadeahead,therewillbenewandinnovativetax-awareapproachesworthconsideration.Inthemeantime,investorsareapplyingtax-aware solutions first to those niches of hedge fund investing wherethe alpha, or incremental return is limited, which follows the trend oftraditionalassets.Therefore,weshouldanticipatethecontinualevolutionof“optimal,”“coreandsatellite,”or“hubandspoke”tax-awarecustomhedgefundcombinationstomatchtheclient’staxprofileandtoleranceforrisk.

ChapterNotes

1. Robert N. Gordon, “Taxing Phantom Hedge Fund Profits: Here’s How toMakeSureYourClientsPayTaxesonWhatTheyMake,”OnWallStreet,August1,2004,http://www.keepmedia.com(accessedNovember13,2004).

2. RobertN.Gordon, “MakingHedgeFundsMoreTax-Efficient,” Journal ofWealthManagement(Summer2004):75–80.

3. Twenty-FirstSecuritiesCorporation,Newsletter(Summer2004).


4. LeslieC.GiordaniandAmyP.Jetel,InvestinginHedgeFundsThroughPrivatePlacementLifeInsurance,”JournalofInvestmentConsulting(Winter2003/2004):77–82.

5. ThomasJ.BoczarandMarkFichtenbaum,“MakingHedgeFundInvestingMoreTax-Efficient,”Monitor(July/August2004):31–35.

AmendingtheSearchProcessfor

Tax-AwareManagerSelection

175

Thebesttoolfortryingtogetagraspofthevariousnuancesofhowafirmorportfoliomanager,especiallyonewhotakeshisfiduciaryresponsibilityseriously,considerstheimpactoftaxeswhenmak-

inginvestmentdecisionsistheformalmanagerquestionnaire.Aquestion-naire—orrequestforproposal(RFP),asitisformallyreferredto—shouldnotbeissueduntilthesponsor,consultant,oradviserhashadtheoppor-tunitytodetermineashortlistofcandidatesafterconductingtelephoneorone-on-oneinterviews.Ifquestionsarethoughtoutinadvance,muchoftheinformationrequiredtomakeinformeddecisionscanbeobtainedearlyonintheprocessandshouldberecordedinanorganizedmannerforfuturereference.Constructinganefficientquestionnaireisanartformthat requires experience tomaster. It is an extremely importantpartofthe searchprocess, as by the varynatureof yourquestions youwill beestablishingtheexpectationsfortheinvestmentmanager.Therefore,youshouldattempttotailoryourquestionnaireaccordingtothemagnitudeandcomplexityoftherelationship.Alsorememberthatthequestionnairerepresentsyourorganizationandclient.Oneofthehighestcomplimentsyoucanreceiveiswhenamanagercallstoclarifyanissueandstates,“AfterreviewingyourquestionnaireInowknowwhyyourfirmhassuchanout-standingreputationinthetax-awareinvestmentmanagementarena!”

Ican’tmakeadamnthingoutofthistaxproblem.Ilistentoonesideandtheyseemright—andthenIlistentotalkfromtheothersideand they seem just as right, andhere Iamwhere I started.God,whatajob!

—WarrenG.Harding

C H A P T E R 1 4


Thequestionsyou list shouldbeorientedtowardthespecificassetclass the search is focusedon.Thischapteroffersadetailedquestion-naireforadomesticequitymanagersearch.Thequestionsrelateonlytothoseareaswheretaxescomeintoplay,astherearenumerousoutstand-ingsamplequestionnairesfortax-exemptaccountsthatcanbeobtainedfromotherbooksandwebsites.Sothinkofeachquestionofferedasasupplementtotheprocessforatax-exemptaccount.Thequestionnairewasdeveloped to cover indetail thevarious typesof taxable accountspractitionersmightservesothatitwouldbeofvaluetoallreaders.Thequestionsareorganizedaccordingtotopicalareasand listed ina logi-calprogression.Donotthinkthatyouneedtouseeveryquestion;thecompletelistofquestionsismostlikelyfarmorethanwhatisrequired,basedonthemagnitudeandcomplexityoftheclientsituation.However,tax-awareinvestingisemergingasanartininvesting,andprofessionalsoften interpret termsquitedifferently.Unlessyoucraftquestions thatare consistent with your manager-evaluation process, you will receiveresponsesthatwillforceyoutospendaninordinateamountoftimefol-lowinguptotrytogetattheactualcruxofthemanager’sprocess.Thisisespeciallytruewithhowmanagersaddressthewashsaleruleandexecutetax-lossharvestingtrades.Quitesimply,usethefollowingasasourceofquestionsthatcanbecherry-pickedtofocusontheneedsofthespecificassignment.

SupplementalTax-RelatedQuestionsforaDomesticEquityManagerSearchQuestionnaire

Organization

1 Howmanytaxableaccountsandassetsdoyoumanage?Pleasepro-videbreakdownsfortaxableandtax-exemptassetsforthefirmoverallandforeachstrategyyouemploy.2 What typesof taxable accountsdoyoumanage? (Checkall thatapply.) 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 Whatistheaveragesizeofyourtaxableaccountsineachcategorylistedabove?4 Whataretheproductsyourfirmrecommendstotaxableinvestorsandaretheylistedinthe_________reportingdatabase(s)?5 Pleaselistthenamesandtheprimaryresponsibilitiesofallinvest-mentprofessionals(portfoliomanagers,analysts,servicingpersonnel,traders,etc.)thatwillbeinvolvedinthemanagementofthistaxableaccountstrategy.Pleasealsolistthenumberofyearstheyhaveservedtaxableaccounts,thetypesoftaxableaccounts,thetimespentontax-able versus tax-exempt accounts, and their unique taxable accountqualifications,ifany.6 Whomdoesyourfirmutilizeforsecuritytaxexpertise,as itper-tainstotax-awareinvesting?7 Doesyourcompensationstructureincludeincentivesformaximiz-ingtheclient’safter-taxreturn?8 Whatisyournormalfeeschedule,andareyouwillingtoacceptaperformance-orientedfeearrangementbasedonafter-taxreturns?

Philosophy

1 Explainindetailyourfirm’sapproachtotaxableaccountmanage-mentandwhyit is likelytoproducecompellingafter-taxresultsforthisparticularportfoliostrategyinthefuture.2 Whatpercentageofoverall assetsdoyou typically recommendaclientallocatetothisstrategy?3 Doyourecommendthisstrategyasaprimaryallocationfortheas-setclass,orisitmosteffectivewhencoupledwithotherstrategiesthatmaybedifferent inthenumberofsecuritiesheld,style(value,core,growth),capitalization(large,mid,small,micro),sector(technology,healthcare,etc.),country,overlay,orotherconsiderations?4 Ifotherstrategiesarebeneficial,doyouhaveinternalofferingsyourecommendtocomplementthisstrategy,ordoyouseektheservicesofotherfirms(pleasenamethem)?

InvestmentMethodology

1 Doesthetaxableaccountstrategymodifyanexistingstrategyfortheimpactoftaxeswithinthefirm,orhastheproductbeendevelopedandmanagedsinceinceptionsolelyfortaxableaccounts(explainindetail)?2 Do you include the effective tax rate (consideration of federal,state,local,andothertaxrates)inyourmanagementforeachseparateaccountrelationship?3 Istaxefficiencyimprovedthroughanalysisofthetaximpactaspartofbuyandselldecisions,orisitbestdescribedasanoverlayprocess?


4 Pleaseaddressthefollowingelementsoftax-awareinvestingwithadetaileddescriptionofhowyouattempttoaddvaluewitheach: a. Extendingtheholdingperiod b. Dependingontheleveloftaxonincomeandlong-termcapital

gainsthatareineffect, incomeversuslong-termcapitalgainsorientation

c. Timehorizonandstep-upincostbasisatthetimeofdeath d. Tradingactivity

5 Whenlossesarepresentintheportfolio,doyouwaitforinstruc-tionbytheclientordoyouattempttoproactivelyharvestthem?6 Howofteniseachportfolioreviewedforpotentialtax-lossharvest-ingopportunities,andhowcantheclientauditthisprocess?7 Ifyouharvestalossatyourowndiscretionoratthedirectionoftheclient,doyoueverallowtheproceedstobeincashuntilitisinvestedatleastthirtydays?Ifso,pleaseexplainwhenandwhy.8 Doyouever“doubledown”onasecuritypositionbypurchasingadditionalsharesratherthenharvestingthelosswhenitfallssubstan-tiallyinprice?Ifso,pleasedescribewhenyouwoulddothisandhowyoumightattempttominimizethetaxconsequences.9 If you harvest losses and invest in something other than cash,whattypeofsecuritiesdoyouuse(e.g.,stocks,bonds,mutualfunds,exchange-tradedfunds,derivatives,etc.)?Explainthechallengeswithfuturepricemovementandtaxconsequencesofeach.10Doyouuseanyanalyticaltoolsorsoftwareprogramsthatcalculatethe tax consequences of a buy-and-sell decision before it is actuallyconducted?Ifso,weretheydevelopedinternallyorexternally,andhowdoyouadjustthemforaparticularclient’staxprofileandforchangesinthetaxcode?11Forconcentratedpositions,doyouassistintheanalysisoftax-lossharvestingstrategiestograduallyreducetheposition,exchangefunds,prepay forwards, collars, etc.? If so, what are your capabilities, andwhatdoyouchargefortheseservices?Willyoumonitorandmakeanongoingrecommendationfortheconcentratedstockposition(s)?12Doyouhavetaxableandtax-exemptaccountsusingthesameprod-ucts/strategiesyouoffer?Ifso,howdoyoutreatthemdifferently?13Canyourunthisstrategyaccordingtosociallyresponsiblecrite-ria?Ifyouhaveexperienceinthisarea,ifasked,whichcriteriawouldyou recommend a client consider and why? From your experiencewithsociallyresponsibleaccountsforthisstrategy,doesmanagingtheaccounts by applying thedesignated social criteria cause returns todifferfromthestandardbenchmarkorindex?


14Howmuchalphadoyouderivefromthetraditionalmeasures(sec-torallocation,securityselection,etc.),andhowmuchtaxalpha,ifany,doyoubelieveisreasonable?(Explainindetailandhighlightwithnu-mericalexamples,ifpossible.)Howwouldyoudemonstratethevalueadded (netof taxand fee alpha) against anappropriatebenchmark,mutualfund,orexchange-tradedfundonanafter-taxbasisoveranex-tendedperiodwhentaxesandfeesareaccountedforbyutilizingboththepre-andpost-liquidationafter-returncalculationmethodologies?15Describeyourriskmanagementprocessandcriteria,asappliedtotaxmanagement.16Whatdoesyourfirmdointhisstrategythatyoubelievetrulydis-tinguishesyouintaxableaccountmanagement(notwhatyoudodif-ferentlyfromyourtax-exemptaccountmanagement)?17Ifyouknowthemandateistomaximizeafter-taxperformance,isthereanythingyouwoulddomodifytoyourexistingstrategy?

Operations

1 Doyouraccount-openingproceduresincorporateapplyinginfor-mationpertainingtotheclient’staxprofileandreconcilingsecuritytaxlotsbeforetradingisallowedtobegin?2 Whoisresponsibleforthisprocess,andhowdoesthisindividualmaintainqualitycontrol?3 Doesyourportfolioaccountingsystemhaveatax-lotaccountingcapability?4 How often do you reconcile tax-lot positions with the custo-dian(s)?5 Whatisyourdefaultaccountingconvention?6 Canyourportfolioaccounting systemmaintainaccountingcon-ventionsotherthanaveragecostorfirstin,firstout(e.g.,highin,firstout;specificlotidentification)?7 Whodoyoubelievearethebestcustodiansfortaxableaccountcli-entrelationshipsandwhy?

Trading

1 Doyouuseanytrade-processingsystemsorsoftwarethatoffersadistinctadvantagewithtaxableaccounts?Ifso,wasitdevelopedinter-nallyorexternally,andhowdoyouadjustitforaparticularclient’staxprofileandfuturechangesinthetaxcode?2 Doyouattempttoharvestlossesdependingonwhetheritisadvan-tageousforaspecificaccountorforthecompositeoftaxableaccountswithinthesamestrategy?3 Doyouattempttoharvestlossesaccordingtoeachofthevarious


platformsyoumanage(separateaccounts,wrapaccounts,commingledfunds,mutual funds,etc.)orbysomeothermethod?Pleaseaddresshowyouprioritizetheprocessandhowyouhandlethechallengeofpotentiallybuyingasecurityforsomeaccounts,whilesellingthesamesecuritytoharvestlossesinothers.

After-TaxReporting

1 If yourfirm claims compliancewithAIMR standards,were youabletosatisfytheafter-taxstandardsfortaxableseparateaccountsandcompositesinJanuaryof2005?Ifnot,whendoyouexpecttobecom-pliantwiththeAIMRafter-taxreportingstandards?2 Whatsystemsandprovidersareyouutilizingtosupplyyourclientswithafter-taxreturns?3 Canyousupplyanindividualclientwithbothpre-andpost-liqui-dationafter-taxreturns?4 Ifyourfirmmaintainsafter-taxreportingcompositeinformation,pleasedescribethethoughtprocessthefirmgoesthroughtodeterminehowaparticularaccountisassignedtoacompositebyaddressingthefollowing: 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 Pleaseattachasamplereporthighlightinghowyoupresentclientswithafter-taxreturns.6 What is your approach toward after-taxbenchmarks, andwhichprimaryandsecondarybenchmarksdoyoubelievearebestsuitedforthisstrategy?7 Ifyoucannotprovideafter-taxreportingconsistentwiththeAIMRstandardspleasecompletethefollowingtableforarepresentativeac-count.Pleaseattachcustodialstatementsthatwereusedtocompletethetable.


Pleaselisttheanticipatedtaxratesthatwereappliedinrow10forthecalculationoftheestimatedtotaltax:

Taxableincome __._percent Qualifieddividends __._percent Short-termcapitalgains __._percent Long-termcapitalgains __._percent

AccountServicing

1 Doesyourfirmcreateforeachtaxableaccountaninvestmentpolicystatementorsimilardocumentthatincorporatestheuniquetaxprofileoftheclient?Areyouwillingtomeetwithotheradvisersinitially,andasrequiredinthefuture,togainanunderstandingoftheclient’stax

FIGURE14.1 TemplateforEstimatingAccountAfter-TaxReturn

YEAR1 YEAR2 YEAR3 YEAR4 YEAR5

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])

12 %After-TaxReturn

(1–11)

Sourc

e:

Dougla

sS

.R

ogers


profile?Ifso,whoisresponsiblefortheprocesswiththispotentialrela-tionshipandwhatarehisorherqualificationswithtaxableaccounts?2 How are adjustments made to the investment policy statementwhentheclient’staxprofilechanges?3 Howdoestheaccount-servicingprofessionalensurethatanalysts,portfoliomanagers,andtradersareincorporatingtheclient’staxpro-fileinthedecision-makingprocess?4 Howdotheclientsandtheiradvisersreceiveinformationthrough-outtheyearpertainingtorealizedcapitalgainsandlosses(bothshort-andlong-term)andunrealizedpositionsbothattheportfolioandse-curitylevel?5 Willyouapproachtheclientwithrecommendationswithregardtotax-awareinvestinginaproactivemanner,orwillyouonlyreacttotheclient’sdirection?6Doyouofferadditionalservicesthatmaybebeneficialtothetax-able investorbeyondtax-aware investment services, suchas the fol-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-planningservices7 Willyouallowtheclienttoconductasitevisit?8 Willyouprovidetheclientwithatleasttwotaxableaccountrefer-ences,oneofwhichhasterminatedtherelationshipwithyourfirm?

Oversight

1 Who has oversight responsibility beyond the assigned portfoliomanagertoensurethefirmisdoingwhatisnecessarytomaximizetheclient’safter-taxreturn?


2 Whatchecksandbalancesdoesthefirmhaveinplacetoensurethethirty-daywashsaleruleisnotviolated?3 Whatisyourphilosophytowardvariabilityofafter-taxreturnsfortaxableaccounts?4 Ifapplicable,whatdoyouconsidertobeanacceptablelevelofvari-abilityofreturnsforyourbefore-andafter-taxcompositereturnsforthesamestrategy?5 Isthereadifferenceinthetimeframeforinvestingatax-exemptversus taxableaccount for the samestrategywhenyoustartwithallcashequivalents?Ifso,pleasedescribeyourprocessindetail.6 Isthereadifferenceinthetimeframeforinvestingatax-exemptversustaxableaccountforthesamestrategywhenyouinheritaportfo-lioofexistingsecuritiesthathasanunrealizedcapitalgainsposition?Ifso,pleasedescribeyourprocessindetail.7 Isthereadifferenceinthetimeframeforinvestingatax-exemptversustaxableaccountforthesamestrategywhenyouinheritaport-folioofconcentratedpositionsoflow-cost-basissecurities?Ifso,pleasedescribeyourprocessindetail.

WhenyouissueaquestionnaireorRFP,berespectfulofthetimeandeffortrequiredoftheinvestmentmanagementfirmtocompletethedocu-ment.Dependingonthesizeandstructureofthefirm,theremayormaynotbesufficientresourcesinplacetoreturnapolishedproductinseveralweeks, but this typeof quick turnaround shouldnotbe expected. It isbest to allowfirms approximately twomonths to complete a tax-awarequestionnaire for twoprimary reasons.First, tax-aware investing is stillarelativelynewniche,andthequestionnaireprovokesmorethoughtfulanswersthanthestandard,cookie-cutterresponsesgiventothetraditionaltax-exemptaccountquestionnaire.Second,withboutiquefirms,don’tbesurprisedifagoodnumberofthequestionswillbecompletedbythein-vestmentprofessionalsratherthanbythemarketingstaff.Crafteachques-tiontoelicitaspecificresponse,andmakesureyouareavailabletoansweranyquestionsthemanagermighthave.

Unfortunately,whentax-awareinvestingcameintovogueduringthelatterhalfofthe1990s,thereweretoomanyinstancesofmarketinghype,withlittleornounderlyingtax-awareprinciplesbeingappliedinthedailymanagementofthestrategy.Withtheethicalchallengeswehaveenduredinsocietyingeneraloverthepastdecade,itissimplyagoodbusinessprac-ticetoinsistthatthefirm’scomplianceofficeroraseniorprofessionalsignoffontheresponse,indicatingithasbeenreviewedbyothersoutsidethemarketingdepartment,beforesubmittingittoyou.Youmayevenwishtotailoroneorseveralquestionsinamannerthatwillallowyoutodetermine


iftheprospectissimplytellingyouwhatyouwanttohearratherthanhowthefirmphilosophicallygoesaboutexecutingatax-awareprocess.Inoneinstanceintheauthor’spast,aninvestmentmanagementfirmeventooksomeofthequestionsandincludedtheminfuturemarketingmaterials,notrealizingitwassignalingitreallydidnotunderstandthetaxramifica-tionsofvarioustradingstrategiesonafter-taxtotalreturns.Obviousflagsthatyoushouldlookforintheresponsetoaquestionnaireare:

❑ Incompleteanswers,indicatingthefirmdoesnottakethepotentialassignmentseriously❑ Referencesonlytothetax-exemptaccountphilosophy,withoutad-dressingtheimplicationsoftaxes❑ Firmsthathave littleornotaxableassetsandinvestmentprofes-sionalswhospendmostoftheirtimeontax-exemptaccounts❑ Reference to “team approach” typically means standardization,whichisfinefortax-exemptaccounts,whereasmanagingtaxableac-countseffectivelyrequiresahighlevelofpersonalattentiondevotedtoeachrelationship❑ Immediatetransitioningofaccountstothefirm’smodelportfoliowithoutconsideringsubstantialembeddedunrealizedcapitalgains❑ Inexperiencedservicingpersonnelwhoprovideonlysalessupport,ascomparedwithexperiencedprofessionalswhoplayanintegralroleindevelopinginvestmentpolicyandthelike❑ Firmsthatconstructperformancecompositesthatdonotsegregatetaxableandtax-exemptaccountswithinthesamestrategy

As addressed in chapter3, achieving compelling after-tax results re-quirestime.Forseasonedaccountswithhighlevelsofunrealizedcapitalgains,theperiodfollowingtheassignmentofanewportfoliomanagercanbeextremelycostlytotheclient.Therefore,thestabilityoftheorganiza-tionanditsinvestmentprofessionalsisparamountwithtaxableaccounts.Sincemanyinvestmentmanagementfirmshavebeensoldoverthepastdecadeandothersaregoingthroughculturalchange,thoseresponsiblefortaxableaccountsmaywishtoincludespecialportfoliolock-upprovisionsintheircontracts.Thisisanotherreasoninsupportofpassiveorquantita-tivetax-awarestrategies,whichreduceoreliminatethepotentiallycostlyhumanfactor,fortaxableaccounts.

Thequestionsofferedaboveneedtobemodifiedforsearchesofassetclassesotherthandomesticequities.Itwouldbetoovoluminousto in-cludeaseparatequestionnaireforeachassetclass.Therefore,thefollowingquestionshavebeenpurposelylimitedtofixedincomeandinternationalequitytaxableaccountsandareintendedtosupplementthosealreadypre-sentedforadomesticequitymanagersearch.


SupplementalTax-RelatedQuestionsforaFixedIncomeTaxableAccountManager

SearchQuestionnaire

1 Pleaseexplainindetailthefirm’sphilosophyformanagingfixedincometaxableaccountportfolios.Besuretoaddressifyourobjec-tiveisto a. maximizeafter-taxtotalreturnorpayaslittletaxaspossible b. managetheportfoliointhecontextofanisolatedsingleaccount

or consider the interaction of multiple classes/portfolios andtheiroveralltaxramifications

c. manage the portfolio for the best risk-adjusted return or themaximumafter-taxlong-termsolution

2 Forthemunicipalbondportionofthetaxableaccountportfoliostrategy: a. Doyoupurchasebondsoutsidethestateoftaxdomicile?Ifso,

doyousetminimumormaximumportfolioallocationstoin-orout-of-statebonds?

b. Doyou favoranyparticularbond structures (premiums,dis-counts,callable,zero-coupon,etc.)astheyrelatetotheimpactonafter-taxreturns?Ifso,pleaseexplainindetail.

c. Whatisyourapproachtomunicipalbondssubjecttooriginalissuediscount(OID)andthedeminimisrule?

d. Whatisyourapproachtobondssubjecttothealternativemini-mumtax(AMT)?

3 Doesyourfirmbelieveithassufficientinternalexpertisetoassistclients and their advisers with issues pertaining to the AMT? If so,whoistheindividualmostqualifiedtoaddressthissubjectandwhatarehisorherqualifications?Ifnot,whomdoyougotoforthistypeofexpertise?4 Whatistheuniverseofsecuritiesforyourfixedincomestrategyfortaxableaccounts?5 Ifyouincludetaxablebondsinthemix,whatistheprocessyouemploytodeterminewhentheyareappropriatefortaxableaccounts,andwhoisresponsibleforthisprocess?6 Areanylimitsimposedontheuseoftaxablebonds?7 Ifyoupurchasetaxablebonds,doyourelyonyourmunicipalbondteamtomakeindividualsecuritybuyandselldecisionsoronyourtax-exemptaccountbondteam?8 Does yourportfolio accounting systemhandle amortization and


accretionofbondspurchasedatapremiumordiscounttoparvalueinconjunctionwithprovisionsofthetaxcodeappropriateforthetypesofclientsthatyouserve?Whataccountingmethodforamortizationandaccretiondoyouapplyandwhy?9 Given the way you manage fixed income portfolios for taxableaccounts,doyouenvisionthatthestrategy’safter-taxreturnwillbegreaterthantheafter-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 afixedincometaxableaccountportfoliodifferentlyfromyourexistingstrategyifyouknewthetimehorizonwasatleastthirtyyearsandtheobjectivewastomaximizelong-termafter-taxperformance?

Withfixedincomesearches,beextracarefulinyourcommunicationandaddtheterms“fixedincome”or“accounts”afterthewords“taxable”or “tax-exempt.”This will avoid possible confusion, because managerstendtothinkintermsofthetypeofbond,whereasclientstendtothinkofthetypeoftheaccount.Obviously,usingthephrase“municipalbonds”eliminatespotentialconfusion.

SupplementalTax-RelatedQuestionsforaInternationalEquityTaxableAccountManager

SearchQuestionnaire1 DoyoupurchaseprimarilyAmericandepositaryreceipts(ADRs)or“ordinary”sharesissuedinforeigncountries?2 Howdoesyourfirmhandlewithholdingoftaxesondividendsofforeigncompanyshares?3 Iscurrencymanagementpartofyourprocess?Ifso,isitdoneanydifferentlybetweentax-exemptandtaxableaccountstoaccountfortheimpactoftaxpayments,andhaveyouanalyzedtheimpactonafter-taxreturns?

Questionnairesarequitehelpful,butremembertheyarejustoneofthetoolsrequiredtoanalyzeamanager’spotentialforachievingcompel-lingafter-taxreturns.Forseparateaccountinvesting,thereissimplynoexcusefornotconductingasitevisit.Iftheinitialinterviewsandques-tionnairehavebeendoneproperly,thesitevisitshouldbeprimarilyanexerciseinconfirmingwhatyoubelievetobetrue.Arrangeyourvisitinadvance,andshareacopyofyourchecklistwithyourhost.Makesureyouhave theopportunity to speakwith individuals fromall pertinent


areasofthefirm.Priortoyourarrivalyoushouldcarefullycraftseveralquestionsthatyouplantoaskofeverydepartment.Ifthereisatax-awareprocessinplace,expecteveryoneyoumeettoknowhowthesubjectim-pactstheirareaofexpertise.Itiseye-openingwhenyoureceiveaques-tionnairebackthatappearstoindicatethefirmconsiderstaxesinmakinginvestmentdecisions,yetwhenyouinterviewananalystduringyoursitevisityouhear,“Idon’tknowwhatthemarketingpeopletoldyou,butwedon’tlookattheimpactoftaxeswhenrecommendingstocks.”Anothercuriosityiswheninitsresponsetothequestionnairethefirmhighlightsaparticularsystemthatassistsinmakingtax-awaredecisions,andyoufindduringthesitevisitthatalthoughthefirmdoeshavethesystem,noneoftheportfoliomanagersareactuallyusingit.Itwillbecomeobviousafteryouhavereceivedseveralquestionnairesandvisitedthefinaliststhattheelitetax-awarepractitionerswillprovideconsistentanswerstoyourques-tionsandfeelhonoredtorolloutandsharetheirdistinctiveapproachtotax-awareinvesting.


ChallengingTraditionalAssetAllocationMethods

P A R T F O U R

Don’ttaxyou.Don’ttaxme.Taxthefellowbehindthetree.

—RussellB.Long

189


ChallengesWithTraditional

InvestmentPolicyDevelopment

191

Withthegreatbullmarketofthelatterhalfofthe1990s,manyless-than-idealpracticespersistedandunfortunatelyhavebe-comealmostaccepteddoctrine.Thehighreturnsduringthis

period simply masked the lack of capability of the average adviser toserve taxable investors.These shortcomings start with the creation oftheinvestmentpolicystatement.Firmscanmaketremendousstridesinovercomingthesinsofthepastwhenservingtaxable-accountrelation-shipsbyadoptingthefollowingtax-awareprocedures:

1 Listingtheclient’sassetsbythetaxcharacteristicsoftheinvestingentity

2 Obtainingandreconcilingthecostbasiswithcustodialandman-agerstatementsofeachtaxlotforeachsecurityandfundheldbytheclient

3 Addressingwiththeclientwhatisrequiredtoachieveanoptimal,tax-awareinvestmentsolution,versususingquestionnairesfocusedontheclient’spersonalitytraits

4 Including and revising the investment policy statement for theclient’scurrentandprojectedtaxrates

5 Applying after-tax return and standarddeviations in the asset al-locationprocessbasedonreasonableassumptions,versushistorical,before-taxassumptions

Thinkingisonethingnoonehaseverbeenabletotax.

—CharlesF.Kettering

C H A P T E R 1 5

192 ChallengingTraditionalAssetAllocationMethods

6 Applyinganasset allocation tool that isdifferent than thefirm’sstandardsolutiontoaddressanuniqueclientsituation

7 Avoidingtheuseof“cookie-cutter”assetallocationoptionsbasedonhistoricalriskprofiles

8 Ensuring 401(k) presentations include the need to incorporatefundsoutsidetheemployer’splaninthedecision-makingprocessforoptimaltax-awarepositioning

9 Reviewing themagnitudeofamanager’sunrealizedcapitalgainspositionbeforeterminatingthemanager

10Establishingappropriateminimumandmaximumallocationrang-esaroundthestrategictargetallocationpercentagethatincorporateabalancebetweenriskmanagementandtaxefficiency

Unfortunately,many inexperiencedpractitioners fall short inoneormoreoftheseprocedures.Alltoofrequently,thecosttotheclient issogreatthatitfarexceedsthefeetheadviserchargesorthevalueadded.Withitem10,youdon’twanttobesotax-sensitivethatyoufail tomaintaintheoverallriskprofileofthemixandavoiddecliningmarkets,butatthesametimeyoudon’twanttobeadjustingallocationstoassetclassesandmanagers/fundssofrequentlythatyougenerateexcessiveandunnecessaryshort-termgains.Thischapteraddresseswhatcanbedoneduringthecon-structionoftheinvestmentpolicystatementtoovercometheseshortfallsand provide the client with a meaningful tax-aware solution. Elementsmentionedabovenotdirectlyinvolvedwiththecreationoftheinvestmentpolicystatementlistedaboveareaddressedinotherchapters.

Theinvestmentpolicystatementservestodriveinvestmentdecisionsin accordancewith thedesiresof the client.Becauseof the importanceofitsrole,thepolicystatementneedstoincludekeyelementsofthetax-awareprocessthatarenotpartofthetax-exemptaccountprocessutilizedforpensionplansandcharitableorganizationstobeeffectivefortaxableinvestors. The investment management process includes the followingstandardsteps:

1 Analyzeexistingholdingsandneeds2 Developtheinvestmentpolicystatement3 Presenttax-awareallocationandpositioningsolutionsforconsid-

eration4 Selectmanagersandimplement5 Monitorandreviseholdings

Youcaneasilytellpeoplewhodonothaveaworkingknowledgeoftaxable accountswhen they reverse steps2 and3,which represents theprocedureusedtomanagetax-exemptaccounts.Withtaxableaccounts,

ChallengesWithTraditionalInvestmentPolicyDevelopment 193

it is impossible todevelopanoptimal solution,unlessyouget therebyluck,withoutconsideringtheentitiesavailableforinvestmentandthetaxcharacteristicsthatapplytoeach.Therefore,alargeportionoftheinvest-mentpolicy statement fora taxableaccount shouldbecompletebeforeyouinserttheacceptablerangesforthestrategictargetallocationintheirappropriatelocationinthefinaldocument.

Beforeworkontheinvestmentpolicystatementcanbegin,theadvisermostknowthecurrentpostureofallassets,bothtaxableandtaxdeferred,listedaccording to their respective entity.An investment entity canbepersonal taxable assets, a 401(k) plan, defined-benefit retirementplan,individualretirementaccount,educationplan, insurance,varioustypesoftrusts,andsoon.Theentitieslistedshouldbedrivenbyclientneeds.Understandingandincorporatingthecharacteristicsofeachentityises-sentialtoachieveanoptimalsolutionthataccountsforfeesandtaxes.

Whenanadvisertakesonanewrelationship,itisnotuncommontofind theclienthasfinancial assetswithmore thanoneproviderorcus-todian.TheinventorysheetinFIGURE15.1showsaformatthatcanbeusedforpersonaltaxableassetswhenonlytraditionalassetsareemployed.Thelisthereislimitedtomajor,traditionalassetclasses,butitshouldbedesignedinamannertoaccommodatetheclient’scurrentassetclassesandthosethatmaybesuggestedtofurtherdiversifythemix,suchasTIPSandthevariouscategoriesofalternativeinvestments.

Obviously,additional inventorysheetsshouldbecreatedforeachoftheentitiesinvolved.Thelistshouldbeasshortoraslongasneededtoaddress the client’s complete financial picture. Using a Microsoft Excel

FIGURE15.1 ClientAssetInventorySheet(PersonalTaxableAssets)

ASSETCLASS PRODUCT $MARKETVALUE $COSTBASIS

CashEquivalents

Tax-ExemptorMunicipalFixedIncome

DomesticLargeEquities

DomesticSmall-/Mid-CapEquities

InternationalEquities

RealEstate(REITs)

Sourc

e:

Dougla

sS

.R

ogers


spreadsheetratherthanapreprintedformisrecommended,asspacecanbeexpandedorcontractedtoaccommodateallentrieswithease.Tosavetime,anorganizationshouldconstructtheformusingnomenclaturecon-sistent with that used in all functional areas of the firm. For example,domesticstockscanbecategorizedinvariousacceptablewaysbycapital-izationand/orstyle,butitshouldbedoneconsistentlytoavoidconfusingtheclientbyhavingonenomenclaturefortheinitialquestionnaire,assetallocation,andpolicystatementandyetanotherinthereportingpackage.Consistencywiththedeliverablesshowsthatafirmhasawell-thought-outprocessandpaysattentiontoqualitycontrol.

Oneofthebiggestmistakesanadviserorclientcanmakeistoallowtradingtobeginwithanewmanagerbeforeestablishingthecorrectcostbasisof each securitywith thecustodian.Acomplete reconciliationofeachandeverytaxlotshouldbeconductedanddiscrepanciesresolvedbe-foretradingisallowedtobegin.Ifthisisnotdone,someonewillhavetospendaninordinateoftimetoresolvethesituationlater.Thecustodian’sstatementshouldserveastherecordofchoicewiththemanager’sreportserving as abackup,but this isnot always the case.There are still in-stancestodaywherecustodiansdonothavetax-lotaccounting.Withoutaccuratetax-lotaccountinginformationitisdifficult,ifnotimpossible,fortheadvisertomakesagerecommendationsthatwilllowertheclient’staxbite.

FIGURE15.2representsthetypeofinformationthatisrequiredforeachtax lot.Before entertainingnewmanagers forhire, a solidunderstand-ingofthepotentialtaxconsequencesofterminatinganexistingmanager

FIGURE15.2 SampleHoldingsReport

PURCHASE PURCHASE TOTALSECURITY DATE SHARES PRICE COST

CompanyA 3/15/2004 500 $28.50 $14,250.00

11/2/2003 300 $31.75 $9,525.00

10/27/2003 200 $25.50 $5,100.00

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

Sourc

e:D

ougla

sS

.R

ogers


needstobeestablished.Iftheexistingmanagerhasasubstantialunrealizedcapitalgainsposition,itmaytakeanexcessiveamountoftime,ifever,tobreakevenorgetaheadwiththenewmanager.Thisisthesametypeofanalysis that is conductedbyelite tax-awareequityandbondmanagersbeforetheysellanexistingsecurityposition(seeFIGURE11.2).

Determininganappropriateriskprofileisthemostcriticalelementoftheprocess,asitdrivestheremainderofthesolution.Itisalsotheelementthat requires themosteducationandexperience todoproperly.Unfor-tunately,untilclientsexperienceabearmarket,theytrulydonotknowwhattheirthresholdisforriskorthepainoflossofwealth.Theadvisershouldhighlightatleasttwoconcepts:First,ittakesfarmoretorecoupaloss,asFIGURE15.3demonstrates,thanmanybelieve.Whileitiseasytoplay“Mondaymorningquarterback”andpointtotheInternetstockbubble,themarketenvironmentof2000to2002doesprovideinvestorswithsomelevelofsobrietytowardrisk.Gainandlossarenotsymmetri-cal.AsFigure15.3shows,ifyoulose90percentofyourassets,ittakesa900percentgaintobreakeven!Whereasthelosscanoccurquickly,a900percentreturntypicallyonlycomesaboutbycompoundingresultsoverseveraldecadesormore.

Second, investors fail to realize thatwith greater volatility, youneedmorereturntoachievetheresultsofmoreconsistentperformers.InFIGURE

15.4,therearetworeturnseries:AandB.Bothachieveanaveragereturnof10percentoverfive years.However, look at thedifference indollarsbetweenseriesAandBattheendofthefifthyear.SeriesBendsupwith$506less.Thisiscapturedinthegeometricreturn,whichwillalwaysbelessthanorequaltotheaveragereturn.Themorevolatilethereturnseries,thegreaterthegeometricreturnwillbebelowthearithmeticreturn.

FIGURE15.3 Risk

GAINREQUIRED LOSS TORECOUPLOSS

10% 11%

25% 33%

50% 100%

75% 300%

90% 900%

Sourc

e:D

ougla

sS

.R

ogers


After-tax returns are less volatile than before-tax returns, especiallywhentax-awareprinciplesareapplied.Thisisespeciallytruewithnegativereturns,becauseyoureceiveacreditfortheloss.Iftax-lossharvestingisapplied, small ornegativebefore-tax returnswill be less than the after-taxreturns.Therefore,ifmanagersembracetax-lossharvesting,theycanachievehigherreturnsforthesamelevelofriskidentifiedusingbefore-taxassumptions.

FIGURE 15.5 lists the annual total return each profile mix achievedduringthetwenty-five-yearperiodending2003.Duringthistime,interestratesrosetodouble-digitlevelsin1981andthengraduallydeclinedforthenexttwenty-twoyears.Asaresult,equitiesbenefitedfromanupwarddriftintheirvaluation,asrepresentedbyhigherprice-to-earningsratios.Itshouldbenosurprisethatthegreatertheallocationtoequitiesforagivenprofilemix,thegreatertheannualreturnforthisanalysis.Theperiodalsohadmeaningfulvolatility,asthethree-yeardeclineintheequitymarketsfrom2000to2002issecondonlytotheexperienceoftheGreatDepres-sionofthe1930s.Itisthisrecentexperiencethathascausedinvestorstorefocustheirattentionontheconceptofrisk.

Figure15.5giveshistoricalresultsdependingontypicalindustrypro-filemixes.Itiscommontousefourprimaryclientprofilemixes:aggressive,moderate, conservative, and risk-averse.All equity andallfixed-incomeprofilemixesareaddedhereforcomparativepurposes,buttheymayormaynotbeusedinactualpracticewhencommunicatingwiththeclient.Inthisexample,theall-equitymixisablendbycapitalization,whereasthe

FIGURE15.4 TheImpactofVolatilityonCompoundReturns

YEAR SERIESA $10,000 SERIESB $10,000

1 16.0% $11,600 20.0% $12,000

2 18.0% $13,688 28.0% $15,360

3 2.0% $13,962 –10.0% $13,824

4 12.0% $15,637 14.0% $15,759

5 2.0% $15,950 –2.0% $15,444

AverageorArithmeticReturn 10.0% 10.0%

GeometricReturn 9.8% 9.1%

Sourc

e:D

ougla

sS

.R

ogers


all-fixed-incomemixcombinesbondsandcashequivalents. In the fourprimaryprofilemixes,theequityandfixedincomecomponentsareadjust-edbyincrementsof15percentstartingwith80percentequitiesforanag-gressivemix.Theresultsinthefigurearederivedfromthequarterlyreturnhistoryof theS&P500 stock,Russell 2000 stock,MSCIEAFE stock,LehmanBrothersAggregatebond,andCitigroupthree-monthTreasury-billindices.Thekeyhereistoemphasizethemeasurementsofriskforeachprofilemixwiththeobjectiveoftheclientidentifyingacomfortzonewithonerepresentativeprofileandinitiallevelofstandarddeviationtobeginthemoredetailedanalysistofollow.

Forthosemorecomfortablewithstatisticalmeasures,thestandardde-viationstatisticandSharperatioworkwell.TheSharperatiomeasurestheamountofincrementalreturnabovearisk-freerateofreturn(U.S.Trea-surybills)comparedwiththeamountofrisktaken([returnofportfolio–risk-freerate]/standarddeviation).ItwasoriginallycreatedbyWilliamF.Sharpe,thewinnerofthe1990NobelPrizeinEconomics,ashebelievesinvestors shouldonly takeonrisk if theyareamplyrewardedbeyondaguaranteed rate of return.AsFigure 15.5depicts, from theperspectiveofrewardperunitofrisk,theallfixedincomemixistheleastattractive(0.39Sharperatio).Theallfixedincomeprofilemixhasa40percentcashequivalentscomponent,soalowSharperatioisexpected.Fixedincomesecuritiesandcashequivalentsarenotasvolatileasotherassetclasses,buttheyarelikelytoproducejustaslightpremiumoverthegeneralrateofinflationoverthelongterm.Addingequitiestothemixdoesimprovethe

FIGURE15.5 ProfileMixReturnandRiskInformation(forthe25yearsEnding2003)

ANNUAL STANDARD DOWN SHARPE

PROFILEMIX TOTALRETURN DEVIATION LOWYEAR DRAWDOWN YEARS RATIO

AllEquity 13.42% 16.68% –20.41% –41.57% 5 0.41

Aggressive 12.90% 13.66% –14.52% –30.66% 5 0.46

Moderate 12.25% 11.45% –10.33% –22.07% 4 0.49

Conservative 11.54% 9.37% –6.11% –12.76% 3 0.53

Risk-Averse 10.77% 7.51% –1.87% –7.20% 2 0.55

AllFixed-Income 8.38% 4.54% –0.09% –4.72% 1 0.39

Sourc

e:D

ougla

sS

.R

ogers


trade-offbetween risk and return, and it is interesting tofind the risk-aversemixwouldhavebeentheoptimalmix(0.55Sharperatio)forthetrulyrisk-sensitiveinvestor.

StandarddeviationandSharperatioinformationisniceforanalyzingrisk-adjustedreturns,butitdoesnothitattherealpainofpotentiallylos-ingmoney.Forthisrequirement,thelow-yearreturn,drawdown(greatestpeak to trough),andnumberofdownyearsaremorevivid.Thedraw-downstatisticisverycommonlyusedinalternative-investmentanalysis,andisgainingawiderfollowing.Usingseveraldifferentmeasuresjustin-creasesthechancethatatleastonewillresonatewiththeclient,whichistheultimategoaloftheeducationportionoftheexercise.

One must be careful with risk analysis based on historical returns,becausethetimeframeislimited.Unfortunately,meaningfulbenchmarkinformationreflectiveofspecificassetclassesisonlyavailablebeginningin the late 1970s.This challenge becomes even greater whenTIPS oralternativeinvestmentsareincludedasspecificassetclasses.Fortunately,theexperiencesof2000to2002forstocks,1994and1999forbonds,1998forhedgefunds,andvintageyear1999forprivateequity/venturecapitalallowinvestorstogaininsightintothepotentialpainofatumultu-ousmarketenvironment.Educationpertainingtoriskprofilingisimpor-tantbecauseitsetsthetoneforallactivitiestofollow.Additionally,manyadvisersdonothave sufficientexperiencewithalternative investments,anduntilrecentlyyoungprofessionalshavenotmanagedthroughtoughmarketenvironments.

Advisersoftenusequestionnairestohelpensureaconsistentapproachisusedacross thepracticewitheachclientandto fulfillcompliancere-quirements.Questionnairescanbeexcellenttoolsiftheyservetoeducatetheclientandestablishreasonableexpectations,buttheycanbeacrutchforfirms that donothavequalifiedpractitioners capable of communi-catingeffectivelywith sophisticatedclients.Moreover, theultra-affluentoftenfindquestionnairesinsulting,especiallythosethatfocusonperson-alitytraits.Thesetypesofquestionnairesmaybeabletotelliftheclientisperhapsconservativeoraggressivebynature,buttheytypicallyofferlittlemorethanentertainmentvalue.Theobviousexampleisaninvestorwhoisconservativebynature.Anadviserfollowingthisconceptwilloftenpres-entamixsoconservativethepotentialreturnswillbeinsufficientfortheinvestortomaintainarespectablelifestyleduringretirementaftertakinginflation, investment expenses, and taxes into account.Likewise, entre-preneursmostoftentakeanaggressivepostureintheirbusinessdealings,butafteramassingtheirhard-earnedfortunestheyaremostoftenseekingtopreservetheirwealth.Regardlessofwhattypeofquestionnaireisused,anexperiencedprofessionalstillneedstostepinandbeabletocoachthe


clients and at times protect them from the characteristics of their ownpersonality.

Organizationsshouldprovidesufficienteducationfortheirstafftoen-surethatinexperiencedindividualsdonotusequestionnairesasacrutchwhen attempting to solve taxable-account scenarios with mechanical,cookie-cutter solutions solely for operational efficiency and compliancepurposes.Theseshortcutsaretypicaloffinancialplannersofferingsolu-tionsbasedonwhattheclientorsponsoriswillingtopay.Withthesetypesofsolutionsyouonlygetwhatyoupayfor.Fortunately,therearequalifiedpractitionerswithin thefinancialplanningandconsultingcommunitiesthatrefusetofallintothistrapanddoapplyaknowledgeableskillsettoachievefavorableresultsfortheirclientsforareasonablefee.

Thefollowingisanoutlinethatcanbeusedtocreateaninvestmentpolicystatementthatwillincorporatethekeyelementsoftax-awarein-vesting.

ElementsofaTax-AwareInvestmentPolicyStatement

1 Purposeormission:Outlineinsimpletermswhatistobeaccom-plished.

2 Background a. Source of wealth: Describe the source with the objective of

showingrespect—forexample,corporate sourceof funds, familywealth,currentemployment,oraconcentratedstockposition.

b. Evolutionoftheprocess:Listkeyeventsandteachingpoints. c. Education:Addresstheexperienceoftheindividuals involved

intheprocessandhoweducationwillproceedinthefuture.Also,highlightlicensingorcertificationrequirements,ifany,toserveincertaincapacities.

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.Discussinteractionwiththeothermembersofthequalifiedtriumvirate.

c. Accountant: Mention how reports will be presented and theprocessforinteractingwithothermembersofthequalifiedtrium-virate.

d. Estateattorney/trustee:Outlineauthorityandhowrecommen-dationsaretobepresentedaspartofthequalifiedtriumvirate.


e. Custodian:Describehow related issueswill bepresented andwhetherandhowoftenarepresentativewillneedtobepresentatmeetings.

f. Managers:Theirspecificinvestmentcriteriashouldbelistedasaseparateappendixforeachstrategy.

g. Authorityfortheadvisertoactbetweenmeetings:Acriticalitemthatcreatesflexibilityandtrustifsufficientproceduresareoutlinedandadheredto.

4 Risk profile or tolerance: Include a quantitative measure—forexample,“astandarddeviationof__percent,asrepresentedbyre-turnsachievedbya__/__percentblendofstocksandbondsoverthe__-yearperiodfrom____to____.

5 Goalsandreturnobjective(s):Discussthesenetoffeesandtaxes,asappropriate.

6 Strategictargetallocation a. Methodology: Include a brief statement describing the proce-

dureanddocumentitsapprovalbytheinvestor.Acopyoftheex-erciseandanotehighlightingthefinaldecisioncanbeincludedasanappendix.

b. Strategictargetallocation:Insertatablehighlightingthealloca-tiontoeachassetclassbyentity.

c. Acceptablerangesandrebalancingmethodology:Userangesthatare tight enough to maintain the general risk profile but looseenoughtoensurethatthefrequencyofrebalancingdoesnothaveanoverwhelmingnegative impacton taxefficiency.Themethodforcalculatingthebandsorrangesshouldbeexplained.

d. Commitment of funds and approach to tactical opportunities:If therelationshipstartswithahighportionofcashequivalents,determine a timetable for the commitment of funds and add itas an appendix. For taxable accounts, items like high-yield andnon-hedged international fixed income assets may be tacticallyemployed, especially if there is a tax-deferredentity available forpositioning.

e. Frequency:Formallyreviewassetclassassumptionsannuallytoaccountforrevisionstotheadviser’seconomicandmarketoutlook.Revisittheexercisewhentheinputvariableswillcauseameaning-fulmodificationtothestrategictargetallocation.

7 Constraints a. Entities i. Organization:Dependingonthecomplexity,thismayinclude

anorganizationalchart,especially ifmultiplegenerationsare in-volved.Thekeyistohighlightrelationshipsandflowoffunds.


ii. Parameters:Discuss the tax implications, term,possibilityforvaluationdiscounts,priorityofdistributions,anddeduct-ibilityof feesandexpenses,especiallywitheachtypeof trustandretirementplan.

b. Timehorizon:Thiscanbediscussedundereachentityorbytheoverallrelationship.

c. Distributionorspendingpolicy:ThismayincludeadiscussionregardingmattersliketheUniformPrincipalandIncomeAct.

d. Taxes:Listcurrentfederal,state,andlocalrates,alongwithanyanticipatedchanges.

e. Prohibitedinvestmentsorsocialinvestingcriteria:Includealist-ingof restricted stockdue to employment relationships andanysocialinvestingcriteriatheclientdesires.

f. Liquidityrequirements:Thiscanbestatedquitesimplyasaper-centageofassetsorrequireamoreelaborateplanwhenprivateeq-uityandventurecapitalareinvolved,whichmaybeincludedasanappendix.

g. Currencyofchoice:ThisitemisespeciallyimportantwithclientslivingoutsidetheUnitedStates,whichmayrequirehedgingvari-ousportfolios.

8 Operational a. Proxyvoting:Statewhetherthemanagers,theclient,oramem-

berofthequalifiedtriumviratewilltakeonthistaskandwhatpa-rameterstofollow.

b. Trading/commissions:Describeindetailanyvariationfrombest-executiontradingpractices.

c. Securitieslending:Forlargeportfolios,thismaybeasourceoffundsworthdiscussingwiththecustodian.

9 Monitoring a. Frequencyof reportsandmeetings:Quarterlymeetingsare the

normforlargeclients,buttheycanbelessfrequentwithseasonedrelationships. Meetings should be scheduled after quarter-endprocessingwhendetailedreportsareavailable,unless“flash”sum-maryreportswillsuffice.

b. Measurement i. Benchmarksandpeergroups:Clearlystatethebenchmark

andpeergroupuniverseforeachassetclass. ii. After-taxreporting:Includeadiscussionofanyothermea-

suresbesidesthepre-liquidationafter-taxreturn,ifrequired.10Approval:Asaminimum,theclientandtheadvisershouldsignanddatetheinvestmentpolicystatement.Itmaybedesirableforothermembersofthequalifiedtriumviratetosignthedocumentaswell.


There is no perfect length or amount of detail for the investmentpolicy statement.Afirmmaywish tohave a lengthydocument that itkeepsonfileandanexecutivesummarythatisincludedinthequarterlyreportingmaterials.Itisagoodpracticetostarteachmeetingbyaskingif there isanyneedtoconsiderrevisingthepolicystatement.Thus,thedocumentshouldbedynamic,ratherthanstatic.Changescanbemadeintheoriginaldocumentorbylistingtheminanappendix.Appendicesshouldprovidetheflexibilitytorespondtoadditionalrequirementsanddetailwhenrequired.Formutualfundsandpartnerships,thereisaformaldocumentforeachinvestmentstrategy.Thisisnotthecaseforseparateaccountmanagers.Ratherthanhaveeachadviser inthefirmcraft indi-vidualinvestmentcriteriaforeachmanagerposition,thisprocessshouldbecentralizedwithintheresearchstafftoachieveconsistencyandkeepthecriteriawheretheycanbeeasilyaccessed.Thiswillsaveagreatdealoftimeandagainhighlightthefirm’sorganizationandattentiontodetail.

Thetypeofoptimizationtooluseddependsontheamountofassetsandtypeofsituationyouaremodeling.Forexample,amean-varianceoptimizationmaybequitesuitableforanultra-high-net-worthfamily.Withthistool,thepractitionercansharewiththefamilytherangeofpossibleoutcomesovervarioustimehorizonsandtheprobabilityofnotmeetingadesiredreturnobjective.Thevalueoftheoutputcanbeen-hancedwithmethodslikeMonteCarlosimulation,whereasmanyasathousand iterationsaremodeled toprovidea feel for likelyoutcomes.These types of solutions are becoming more prevalent as the cost ofcomputermemorydrops.

If thereturngoal isnotmet, thefamilymayhavetoadjust itsstyleof livingorphilanthropicactivity.Another tool that incorporates asset/liabilitymatchingismoreappropriateforcriticalfundingissues,suchasforeducation.Inthiscase,ifthereturngoalisnotmet,theconsequencesarelikelytobefarmoresevere.Therefore,ratherthannaivelyapplyingagivensoftwarepackage,theadvisershouldfirstaskwhattoolismostap-propriateforthenatureofthetaxable-accountscenario.

In the example of the high-net-worth family, the policy statementshouldattempttoidentifyasuitablelevelofriskasmeasuredbythestan-darddeviationofreturns,whereaseducationfundingismoreorientedtoachievingadesiredrateofreturn.Thecurrentyieldtomaturityofagov-ernment-sponsoredzero-couponbondwithamaturitydateequaltothetimewhenfundswillbeneededeliminatesreinvestmentriskandprovidesaguaranteedprincipalamount.Therefore,oneormoreyieldsfromzero-couponbondscanbeenteredintoaprogramorspreadsheettodeterminetheleveloffundingrequired.

Oneareathatisoftenoverlookedistheimpactofrebalancingtomain-


tainthedesiredstrategictargetallocationontheafter-taxreturnsoftaxableaccounts.Aminimumandmaximumpercentageallocationisestablishedforeachassetclassinanefforttoadheretoabuylow,sellhighapproachandcontroltheriskofthemixintheprocess.Quiteoften,practitionerssimplypullapercentageoutoftheairtoestablishtherangeswithoutapplyinganyserious thought to theprocess.Themagnitudeof the ranges for taxableaccountsshouldstrikeabalancebetweenmaintainingaprudentriskprofileandavoidingexcessivemovementofassetsthatwillleadtosubstantialcapi-talgainsrealization,especiallygainsthatareshort-terminnature.Ifoneassetclassdropsfarbelowitscost,youmaywanttoselltheexistingpositionandharvesttheloss.Inthemeantime,theproceedsfromthesaleshouldbeheldinasuitablealternativeforthirtydaystoavoidviolatingthewashsalerule.Exchange-tradedfundssatisfythisneedwell.Thenthisamount,alongwiththeadditionalfundsrequiredtoachievethestrategictargetallocation,canbeinvestedinthelong-termstrategyofchoice.

As Jeffrey Horvitz points out in his article, “The Implications ofRebalancingtheInvestmentPortfoliofortheTaxableInvestor,”thereisnoperfectmethodforestablishingoptimalrangesortriggerpointsfortakingaction.1However,healsooffersamethodemployedbytax-awarepracti-tionersthatcanreducepotentiallyfrivolousrebalancingbytakingintoac-counttheprojectedvolatilityofeachassetclass.Toaccomplishthis,deter-mineasuitablemultipleofthestandarddeviationandthenmultiplyitbythestrategictargetallocationpercentage—forexample,1,1.5,or2timesthestandarddeviationofeachassetclass.Thisisoneareaoftax-awarein-vestingthatwouldbenefitfromadditionalresearch.Unfortunately,thereisnoformulaavailabletodeterminetheoptimalfactorthatwilltakeintoaccountvariablessuchastheinvestor’staxprofileandthetimehorizon.Todemonstratehowthiscanbedone,FIGURE15.6wascreatedbytakingtheafter-taxstandarddeviationassumptionsfromchapter16andapplyingafactorof1.5toachievethe+/–factororpercentagethatisappliedtothestrategictargetallocationtoachievetheminimumandmaximumpermis-siblepercentageallocations.

Theone exceptionwhere youmightnot apply themethodologyofFigure15.6iswithcashequivalents,becausetheremaybeagenuineneedtomaintainaliquidityreserve,10percentinthefigure.Sointhisexample,10percentisenteredastheminimumrangeforcashequivalents.

Althoughagreatdealhasbeenwrittenaboutpayoutordistributionpolicyforcharitableorganizations,thissubjectmatterislessunderstoodwithhigh-net-worthfamilies.Thechallengewithhigh-net-worthfamiliesis that members of the family grow exponentially with each successivegeneration,whilethegrowthinassetsislinear.Therefore,sometimeaftertheoriginalfortunehasbeenachieved,unlessfamilymemberscontinueto


beeconomicallyproductive,theywillsoonsignificantlydilutetheamountoffundsavailabletomembersofsuccessivegenerations.Toillustratethisconcept,wewilluseanamountequaltothecurrentannualestateexclu-sionof$2millionastheinitialamountofcorpus.Thefundsareinvestedinabalancedmixof65percentlarge-capdomesticstocksand35percentfixedincomesecurities.Thehistorical10.4percentgrossreturnforlargecompanystocksisappliedtodomesticstocks,and80percentofthehis-torical5.4percentreturnforintermediategovernmentsisusedtoachieveareturnof4.3percentfortax-exemptbonds.2Thenweapplytheaveragefeeandtax-costratiofortherespectiveMorningstarcategorytoachievenet returnsof7.8percent for common stocks and3.2percent for tax-exempt bonds.This results in a blended rate (net of fees and taxes) of6.2percent.Applyingthehistoricalrateofinflationof3percentleavesarealreturnofonly3.2percent.Therefore,historically,ifafamilyinvestedinatypicalmixofmutualfundsandachievedaveragereturns,distribu-tionshadtobe3.2percentorlesseachyeartomaintainrealgrowthinassets.Thisestimateisconservative,becausefeespaidtotheadviser,estateattorney,andaccountantarenotincluded.

FIGURE15.7wascreatedusingdistributionratesof3,2,and1percentannuallyinrealterms.Theavailableamountperfamilymemberfallspre-cipitouslywiththegrowthinthenumberofindividualswitheachsuccessivegeneration(thirtyyears).Itisnowonderyouhearstoriesaboutwell-knownwealthyfamilieswherecurrentgenerationsreceiveonlyapittanceinannual

FIGURE15.6 CreatingthePermissibleRangeforEachAssetClass(1.5+StandardDeviation)

AFTER-TAX STRATEGIC STANDARD TARGET +/– MINIMUM MAXIMUMASSETCLASS DEVIATION ALLOCATION FACTOR RANGE RANGE

DomesticEquity 15.3% 45.0% 10.0% 35.0% 55.0%

InternationalEquity 19.1% 15.0% 5.0% 10.0% 20.0%

Tax-ExemptFixed-Income 3.5% 20.0% 2.0% 18.0% 22.0%

RealEstate(REITs) 12.0% 10.0% 2.0% 8.0% 12.0%

CashEquivalents 0.5% 10.0% 1.0% 10.0% 11.0%

100.0%

Sourc

e:D

ougla

sS

.R

ogers


financialsupportascomparedwithearliergenerations,especiallyifthoseearliergenerationshadlavishlifestyles.Byapplyinghistoricalassumptionsandaveragefeeandtax-costratioinformationfromMorningstar,youfindyouwillneedtodistributesomewherelessthan1percentofassetsannuallyifyouwantfuturegenerationstobenefitequally.Theonlywaystoimproveonthisscenarioaretohopeforlowerinflation,haveamoreaggressiveassetmix,achievehigherreturns,paylowerfees,and/orlowerthetaxbite.Con-trollinginflationisoutsidethecontrolofadvisersandinvestors.However,byutilizingafter-taxassumptionsintheassetallocationprocess,allocatingasset classes andmanagers/funds according to the characteristicsof eachentity, tax-aware equity manager positioning, and identifying tax-awaremanagers/funds,thetaxableinvestorcanimproveperformanceby1.3to2.5percentannually,dependingonthestructureoftherelationship.3

Tax-awaremanagersachievetheexposuretotheunderlyingassetclassandattempttocreatealphabycombiningtheirtraditionalpracticesandtax-awaremethodsthatlessenthetaxbiteorturnthestrategyintoanet-lossgenerator.Fees and taxes canbothbe controlledby tax-awareprac-titioners and their clients. For this exercise, fees and taxes amounted to2.2 percent annually.This percentage can be reduced to as little as 0.6percentbyusinglower-costtax-efficientmutualfundsorexchange-tradedfunds,foranimprovementinnetannualperformanceof1.6percentalone!Therefore,combiningthesesavingswiththeotherthreeelementsoftax-awareinvestingcaneasilyproduceresultsthatareconsistentwiththeclaimofa2.5percentannualenhancementinperformancemadebymanytax-awarepractitioners.Ithasonlybeentenyearsorsosincethesefeatureshavebeguntoreceivetheattentiontheydeserve.Thebottomlineis,iffamilieswishtomaintaintheirfinancialdynasties,theyneedtotakeseriouslyatax-awareapproachtoinvesting.

Managingatrustwasrelativelysimpleinthepast,whenallyouhadtodowaspayoutincome.Previously,trustshavehadtwotypesofbeneficia-ries:incomeandprincipal.Oftentheirinterestswerenotaligned,aswhenonebenefitsitisusuallytothedetrimentoftheother.TheUniformPrin-cipalandIncomeAct(UPIA)allowsgreaterflexibilitywithtrustdistribu-tions.Perhapsthisactcameaboutbecauseincomebeneficiarieswerecom-plainingaboutlowerdistributionsasaresultofloweryields.Fortunately,morestatesareamendingtheirrulestoallowforaportionofgainstobeallocatedaswell.Thischangeinmethodologyissimilartothedistributionorspendingpoliciescharitableorganizationsadopt.Theonlydifferenceis the distributions are taxable to the beneficiary.Therefore, the UPIAheightenstheimportanceofthetrusteeormembersofthequalifiedtri-umvirate,asnowtheyareinvestingfortotalreturnwithtaximplications.Thetrusteenowneedstodeterminewhatlevelofdistributionisjust.As


aresult,wealthyfamiliesarenowtakingthetimeandefforttoconductelaborateafter-taxassetallocationandcashflowexercisestodetermineapayoutratiothatwillbeequitabletoboththeincomebeneficiariesandtheremaindermen.Atleastforthebeneficiariesinvolvedintheprocess,itistotheirbenefitthatthequalifiedtriumvirateadherestoatax-awareprocess,becauseiftheyhavetopaytaxesontheprincipaldistributionsitismuchmore favorable to account for them at the long-term capital gains ratethanattheshort-termrate.Thisprocessjusthighlightshowimportantitistobeabletoworkwithmembersofthequalifiedtriumviratewhocancomprehendandapplythevariousfacetsoftax-awareinvesting.

Theinvestmentindustryhasevolvedtoapointwheretax-awarecon-ceptscannowbeappliedinamoresystematicanduniformmanner.How-ever,todosorequiresaplan,andthereisnobetterplacetoarticulatewhatis required than in the investmentpolicy statement.Therefore,puttingforththeeffortduringthecreationoftheinvestmentpolicystatementwilldrivetheremainingtaskstoensureatax-awareapproachcanbeachieved.

FIGURE15.7 HowtheLevelofDistributionAffectstheWealthofFutureGenerations

NO.OF 3%DISTRIBUTION 2%DISTRIBUTION 1%DISTRIBUTION PEOPLE ANNUAL $DISTRIBUTION SPENDING $DISTRIBUTION SPENDING $DISTRIBUTION GENERATION LIVING DISTRIBUTION PERMEMBER DISTRIBUTION PERMEMBER DISTRIBUTION PERMEMBER

$60,000 $40,000 $20,000

1 2 $60,114 $30,057 $40,476 $20,238 $20,438 $10,219

2 4 $63,516 $15,879 $57,041 $14,260 $38,307 $9,577

3 8 $67,238 $8,405 $81,342 $10,168 $73,373 $9,172

4 16 $71,178 $4,449 $115,996 $7,250 $140,535 $8,783

5 32 $75,349 $2,355 $165,414 $5,169 $269,177 $8,412

6 64 $79,764 $1,246 $235,884 $3,686 $515,573 $8,056

7 128 $84,438 $660 $336,378 $2,628 $987,511 $7,715

8 256 $89,386 $349 $479,684 $1,874 $1,891,445 $7,388

9 512 $94,624 $185 $684,042 $1,336 $3,622,812 $7,076

10 1024 $100,169 $98 $975,463 $953 $6,939,014 $6,776


ChapterNotes

1. JeffreyE.Horvitz,“TheImplicationsofRebalancingtheInvestmentPortfoliofortheTaxableInvestor,”JournalofWealthManagement(Fall2002):49–53.

2. IbbotsonAssociates,Stocks,Bonds,BillsandInflation2003Yearbook(Chicago:IbbotsonAssociates,2003).

3. J. Richard Joyner, “Tax-Efficient Investing: Can It Add 250 Basis PointstoReturns?” Journal of InvestmentConsulting vol.67,no.1 (Summer2003):82–89.

FIGURE15.7 HowtheLevelofDistributionAffectstheWealthofFutureGenerations

NO.OF 3%DISTRIBUTION 2%DISTRIBUTION 1%DISTRIBUTION PEOPLE ANNUAL $DISTRIBUTION SPENDING $DISTRIBUTION SPENDING $DISTRIBUTION GENERATION LIVING DISTRIBUTION PERMEMBER DISTRIBUTION PERMEMBER DISTRIBUTION PERMEMBER

$60,000 $40,000 $20,000

1 2 $60,114 $30,057 $40,476 $20,238 $20,438 $10,219

2 4 $63,516 $15,879 $57,041 $14,260 $38,307 $9,577

3 8 $67,238 $8,405 $81,342 $10,168 $73,373 $9,172

4 16 $71,178 $4,449 $115,996 $7,250 $140,535 $8,783

5 32 $75,349 $2,355 $165,414 $5,169 $269,177 $8,412

6 64 $79,764 $1,246 $235,884 $3,686 $515,573 $8,056

7 128 $84,438 $660 $336,378 $2,628 $987,511 $7,715

8 256 $89,386 $349 $479,684 $1,874 $1,891,445 $7,388

9 512 $94,624 $185 $684,042 $1,336 $3,622,812 $7,076

10 1024 $100,169 $98 $975,463 $953 $6,939,014 $6,776

Sourc

e:D

ougla

sS

.R

ogers


DevelopingAfter-TaxAssetClass

Assumptions

209

At the Association for Investment Management and Research(AIMR,nowtheCFAInstitute)conventionin2003,economistPeterL.Bernstein shared fourkeypoints thathe thought rep-

resented inflection points in the investment management industry.”1Bernsteinbroughttotheforefrontpracticesthathavebeenacceptedininvestmentpolicydevelopmentalmostwithoutquestionforthebetterpartof thirtyyears.Whilebearmarketsarepainful, theexperienceof2000to2003broughtoutmanyoftheillsthatBernsteinandothershadbeenquestioningforsometime.Hisproclamationregardingthe“deathofthepolicyportfolio”couldnothavebeenbettertimed,asitplayedtoamore-than-receptiveaudience.

Following a thought process to similar Bernstein’s,William Jahnke,inhisnoteworthyarticle,“DeathtothePolicyPortfolio,”appropriatelyattackstheinvestmentconsultingcommunityforitsmisrepresentationofstudiespertainingtotherandommarkethypothesisandtheimpactofas-setallocationonfuturereturns.2Jahnkehighlights,“ThereisnothinginMarkowitzmean-varianceoptimizationorinSharpe’scapitalassetspric-ingmodeltoindicatethattherandom-walkmodelsuggeststhathistoricalreturnsshouldbeusedinforecasting.”Additionally,clientshavebeentoldforyearsthatthestatictargetallocationdictatesmorethan90percentof

[American tax laws] are constantly changing as our elected rep-resentativesseeknewwaystoensurethatwhatevertaxadvicewereceiveisincorrect.

—DaveBarry

C H A P T E R 1 6


futurereturns,asaresultofthefindingspresentedin“DeterminantsofPortfolioPerformance,”byBrinson,Hood&Beebower(BHB).3Whileassetallocationisimportant,asJahnkepointsout,properinterpretationoftheresultssuggestsstatictargetallocationexplainsabout50percentofthefuturereturnoveraten-yearhorizon.Thisestimateisfortax-exemptaccounts,sowhentaxesareincluded,thepercentagethatshouldbeattrib-utedtostaticallocationshouldbeevenless.ThedifferencebetweentheBHBstudyandJahnke’sanalysisishowtheR2measurementisapplied.

RonaldSurz,DaleStevens,andMarkWimerhavepointedoutthatwhiletheBHBstudyhasbeenmisinterpreted,amuchsimplerapproachprovidesvaluableinsight.4Theybelievethefocusshouldbeonthemag-nitudeofthedifferenceinthereturnoftheactualportfoliomixandtheinvestmentpolicyweightedbenchmarkreturn.Anexampleofanactualreturn of 9.01 percent versus a policy return of 10.11 percent demon-stratesthattheinvestmentpolicyportfoliorepresents112percent(10.11/9.01)of theperformance.Since thepolicyportfolio return is a com-binationofpassiveportfolios, theactualportfoliomixreturn isaresultofthethreeprimaryeffects:sponsor,manager,andcosteffects.Fortax-exemptandtaxableaccounts,thefirsttwoeffectsarethesame.However,fortaxableaccounts,thetaximpactisanadditionalcostthatrangesfrom–0.5to–2.5percent.Ifweappliedthemid-rangeof–1.5percenttotheexampleabove,thepolicyportfoliowouldexplain135percent(10.11/[9.10–1.50]).What thismeaningful, simplistic approachhighlights ishowdifficult it is for taxableaccounts tooutperformthepassivepolicyportfolio.However,thetaskisnotinsurmountable,andinfact,informedtaxableseparateaccountpractitionerscanachieveabetterratiothantheirtax-exempt accountpeers.What follows in chapters16 through18 aresolutionstocommonmistakesmadewithtaxableportfoliosandsolutionstonarrowthegaporexceedthereturnofthepassivepolicyportfolio.

Unfortunately,thereisanaiveaudiencetodaythatstillbelievesusinghistoricalreturnstocalculateastatictargetmixwithoutstrategicadjust-mentsisthepropermethodforallocatingclientfunds.Whenmarketsaretradingatvaluationlevelssubstantiallydifferentfromhistoricalaverages,usinghistoricalassumptionsleadstoanill-advisedsolution.Inthespringof2000,adviserswhoutilizedhistoricalreturnsweresubjectingtheircli-entstothegreatestequityexposureeveratpreciselythewrongtime,be-causeoftherobustreturnsofthe1980sand1990s.Reversionbacktothenormormeanisapowerfulforce,andwhenthingsgetoutoflinethereisanaturalperiodofcorrection.Whiletheexacttimingofthesepointsisdifficult topredict, these long-termevents are anythingbut random.Thisisevidentbythe–0.85correlationbetweenreturnsofa60percentequity/40percentfixedincomemixcalculatedbyRobArnottwhencom-

DevelopingAfter-TaxAssetClassAssumptions 211

paringthepreviousandfollowingten-yearperiods.5Thestrategicingredientorelementthatincorporateshowtheworldis

likelytochangeoftengetsconfusedwithtacticalallocationorquicktim-ingmechanisms.Strategicrevisionsaremadegraduallyandmethodically.Liketaxes,financialmarketsandtheelementsthatinfluencethemchangeovertime.Historyisrifewithexamplesofmilitaryleadersfailingtoadjustfor change while their conquerors applied one or more strategic initia-tivestodefeatthem.Tosimplyacceptadefeatistattitudeandclingtoaportfolioallocationthatnolongerrepresentsrealitymakeslittlesense,butithappensalltoooften.Unlesshistoricalreturnsarerepresentativeofthefuture,usinghistoricalreturnsissimplyasigntheadviserorfirmsimplyisunwillingtodevotethetimeandenergynecessaryordoesnothavetheintellectualcapitaltojustifyitsfee.

YogiBerraoftheNewYorkYankees,theholderoftenWorldSeriesrings, supposedly said amongother things, “Predicting is verydifficult,especiallywhenitinvolvesthefuture.”Forecastingisdifficultbutitshouldnot be neglected, and when done in a rationale, systematic manner itservestheclients’bestinterests.Fortaxableaccounts,forecastingshouldalsoincludetheexpectationforchangesinthetaxcode.Remember,Berraalsosaid,“Itain’tover’tilit’sover!”TheuseofYogiBerraasanexampleisintentional.Theanswersclientsreceivefromadvisers,afterbeingsub-jectedtoreturnsofportfolioscreatedfromhistoricalreturnassumptionsduringthelastbearmarket,havehadthemtwistingtheirnecksandshak-ingtheirandheadsjustliketheAFLACduckafterasessionwithBerraatthebarbershop!

Threeprimaryinputassumptionsarerequiredforeachassetclassinorder to conduct a mean-variance allocation optimization exercise: theprojected return, the standard deviation of returns, and the correlationcoefficientbetweeneachassetclass.Modifyingbefore-taxassumptionstoconvertthemtonet-of-tax-and-feeassumptionsatfirstappearssomewhatdifficult,butitcanbedonewithrelativeeaseifasystematicapproachistaken.Specificstepsrequiredinclude:

1 Identifysuitableassetclasses.2 Determinethebefore-taxassetclassreturnassumptionstoinclude

theappreciationandincomecomponentsofreturn.3 Calculatetheclient’santicipatedtaxprofile.4 For the appreciation component of return, estimate the capital

gainsrealizationrateforeachassetclassandthepercentagesubjecttoshort-versuslong-termcapitalgainstreatment.

5 Fortheincomecomponentofreturn,identifytheportionofin-comethatistaxable,isaqualifieddividend,oristax-exempt.

6 Applyanappropriatefeeschedule.


7 Adjustthebefore-taxstandard-deviationassumptionsfortheim-pactoftaxes.

Thepurposeofthischapteristoprovidethemostbasicapproachtodeterminingafter-taxassetclassassumptions,sothatitwillapplytothewidestaudiencepossible.Thus,ifareader’scurrentassetallocationsoft-warepackagedoesnotincorporatetheimpactoftaxes,asimplespread-sheetcanbecreatedandmodifiedasappropriatetocreatethenecessaryinputvariables.

The assumptions are not intended to be static, as this would be asfaultyasapplyinghistoricalassumptions.Itisfrequentlyasked,“Howof-tenshouldassetclassassumptionsberevised?”Theyshouldbeformallyreviewedonanannualbasis,asmostprofessionalcertificationprogramsincludethisprovisionintheircodeofethicsorsimilardocuments.How-ever,keyeconomicandpoliticaleventsshouldinstigatemorefrequentre-view.TheeconomicimpactoftheeventsofSeptember11,2001,andtheeffectsofthecutsindividendandcapitalgainstaxratesin2003arejusttwoexamplesofeventsthatshouldhavecausedpractitionerstogobacktothedrawingboardandreviewtheirassumptions.Manyfirmssatisfythisrequirement with a quarterly review of asset-class assumptions by theirinvestmentpolicycommittee.Theassumptionsshouldalsobemodifiedwhen clients go through a major change in their tax profile, especiallythosethatarecreepingintothealternativeminimumtaxzone.

1 Identify suitableassetclasses:First,youneedtodeterminethepermissibleassetclassestheclientwishestoconsiderorthelistthefirmdesirestomaintainforgeneralpurposes.Theapprovedlistshouldbede-terminedduringinitialcommunicationwhenobtainingtheinformationnecessarytoconstructthepolicystatement.Thereisafinelinebetweenofferingeducationandtakingdiscretionovertheassets.Advisersneedtobecarefulthattheydonotexceedtheauthorityinherentintheirparticulartypeofplatform.Theadvisermaybeastrongadvocateoftheemergingmarkets,buttheclientmaybeunwillingtotoleratethevolatilityoftheassetclass.Asaresult,thediscussionshouldfocusonthesesevenprimaryassetclassesandinflation:

1.Domesticequity2.Internationalequity3.Tax-exemptfixedincome4.Realestate(REITs)andotherhardassets5.Hedgefunds6.Privateequity/venturecapital7.Cashequivalents8.Inflation


Mostfirmsmaintainamoreextensive listofassetclassassumptionsdrivenbythenatureoftheirclients.Also,refinementscanbemadewithinthebroaderassetclasses.Forexample,taxablebondsmaybeincludedanddomesticequitycanbefurtherdelineatedintolarge-andsmall/mid-capcomponents.

2 Determinethebefore-taxassetclassreturnassumptionstoin-cludetheappreciationandincomecomponentsofreturn:Whende-terminingassetclassassumptions,itisbesttofamiliarizeyourselfwiththefollowingelements:

❑ Historical returns, standard deviations, and correlation coeffi-cients

❑ Therealreturnpremiumforeachassetclassinexcessofthehistori-calrateofinflation(3percent)

❑ Economic,demographic,andpoliticaltrendsthatarelikelytohaveameaningfulimpactonfuturereturns

❑ Projectedcorporateearnings❑ Relativevaluationofeachassetclass❑ Projectedrateofinflation

Afirmcangoaboutestablishingassetclassassumptionsbyvariousac-ceptedmethodsthatincorporatevaluationtechniquesinabuilding-blockmethod.The key is to employ a method the firm can support and itsservicingpersonnelcaneasilyexplaintoclients.Theimportanceofestab-lishingassumptionsissuchthatfirmsgenerallyrallythebestintellectualresources toprovidemeaningful input into theprocess.For the sakeofbrevity,hereisaverysimplemethodtodemonstratehowthiscanbedoneevenwitha“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,thedifferentialsuggestsinflationof2.6percentoverthenexttenyears,ascomparedwiththe3percentaveragesince1926.6Thoughitissimple,thismethodutilizesinformationfromthoseinthemarketwhoarecom-mittingsignificantcapitalbasedontheiroutlookforinflationandfutureinterestratelevels.

Theinflationassumptioncanbeappliedtoachieveaprojectedyield-to-maturity for amunicipalbondof similarmaturity, for instance,fiveyears.First, take the inflation assumption and add to it an appropriatepremiumabovetherateofinflation.Historically,thismeasurehasbeenapproximately2.4percent.Thissuggeststhefive-yearTreasuryislikelytoyield5percent(2.6%+2.4%)inthefuture.Sincehigh-grademunicipalbondstypicallytradeatayieldof80percentofTreasuries,weachievea


yieldestimateof4percent(5%×0.80).Withthecurrentyield-to-matu-rityforintermediate-maturitybondsat3percent,theaveragebondinthemarketistradingatasignificantpremiumtoparvalueat108.45andasofDecember31,2004,hadanaveragecouponof5.75percent.7Whentheaveragebondinthemarketistradingatameaningfuldifferentialfrompar(100)thebond’stotalreturnprojectionshouldincludeanappreciationordepreciationcomponentofreturn.Thisisespeciallytrueforadviserswhorelyontheirassetclassassumptionsforclientincomeprojections.Forex-ample,atthebeginningof2005,iftheclientelectedtoreceiveallincomethenthecurrentpayoutwouldbeequaltothecurrentaveragecouponof5.75percent,butwithbondstradingwellabovepartherewouldbemean-ingfulerosionofprincipal.Thistypeofexerciseisespeciallyimportantforhigh-yieldcorporatebondafter-taxassumptions,asthetaxconsequencesofpremiumsanddefaultsshouldalsobetakenintoconsideration.

Onemethodofaddressingtheseconcerns istocalculatetheaverageyield-to-maturityandamountofamortizationoraccretionofthepremi-umordiscountofthebenchmarkfixedincomeportfoliooverthetimehorizonoftheassetclassassumptions,forexample,tenyears.Tomakethesecalculations,wemustalsoknowtheremaininglifeormaturityoftheaver-

FIGURE16.1 EstimatingtheAverageCoupon

YEAR YTM FLOW AVERAGECOUPON

1 3.06% 14.79% 4.83%

2 3.16% 14.79% 4.58%

3 3.26% 14.79% 4.39%

4 3.36% 14.79% 4.24%

5 3.46% 14.79% 4.12%

6 3.55% 14.79% 4.04%

7 3.65% 14.79% 3.98%

8 3.75% 14.79% 3.95%

9 3.85% 14.79% 3.93%

10 3.95% 14.79% 3.93%

AverageCoupon 4.20%

Sourc

e:

Dougla

sS

.R

ogers


agebondinthebenchmarkportfolio,whichinthiscaseis6.76years.InFIGURE16.1,theyield-to-maturity(YTM)foreachyearistheav-

erageversusthebeginningorendingYTM.Bytaking intoaccountthegradualadjustmentinthebenchmark’saveragecoupon,wecanestimatetheaveragecouponflow(4.20percent).Nextwecalculatetheannualad-justmentinprice.Intheexample,bondsarepricedatapremiumtoparvalue,sotheaverageannualamortizationwilloffsettheaveragecouponamountjustcalculatedtoachieveanestimateofaveragetotalreturn(seeFIGURE16.2).

Whenwesumtheaveragecoupon(4.20percent)andimpactofamor-tizationforbondstradingatapremiumtoparvalue(–0.81percent),wereachanestimatedannualtotalreturnof3.39percent.

JeremySiegelpointsoutthatonaverage,stockshavehistoricallytradedat14.8timesearnings,andwhenyoutaketheinverseofthisnumberyoucomeupwith6.8percent,whichisclosetotherealreturnpremiumfordomesticstocks.8AsofNovember2004,theprice-to-earningsratiobasedonoperatingearningsisapproximately18($1,185/$65.75).Therefore,thecurrentestimateoftherealreturnpremiumfordomesticstocksis5.5percentbythisapproach.Sinceourestimateforinflationis2.6percent,

FIGURE16.2 CalculatingAnnualChangeinPricePremium

YEAR AMORTIZATION FLOW AVERAGEPRICE PRICECHANGE

1 1.25 14.79% 106.13 –2.32

2 0.91 14.79% 104.45 –1.68

3 0.66 14.79% 103.23 –1.22

4 0.48 14.79% 102.35 –0.89

5 0.35 14.79% 101.70 –0.64

6 0.25 14.79% 101.24 –0.47

7 0.18 14.79% 100.90 –0.34

8 0.13 14.79% 100.65 –0.25

9 0.10 14.79% 100.47 –0.18

10 0.07 14.79% 100.34 –0.13

AverageAmortization(–)orAccretion(+) –0.81%

Sourc

e:

Dougla

sS

.R

ogers


thenominalreturnestimatefordomesticcommonstocksis8.1percent.Returnsfortheremainingassetclassescanbederivedbasedontheircur-rentvaluationrelativetothesetwoprimaryassetclasses.Forexample,atthisjuncture,REITsarepricedatanevenhigherpremiumthandomesticequitiesandshouldbeawardedanappropriatediscount.FIGURE16.3liststheassumptionsthatwillbeemployedthroughouttheremainderofthechapter.

Thekeyistoeducateclientsandmanagetheexpectationofwhatthefutureislikelytobringandhowbesttopositiontheiroverallmixofassets.Alongwiththetotalreturn,theappreciationandincomecomponentsofreturnaregiven inFigure16.3.This isnecessary,becauseour taxcodehasdifferenttaxratesthatapplytothevarioustypesofappreciationandincome.Aswasshownwithtax-exemptincome,theincomecomponentshouldrepresenttheaverageoftheperiodratherthanwhat iscurrentlyavailableinthemarket.Thereisnosingletimeperiodfortheanalysisthatisperfect.Thisexerciseassumesaten-yearprojection.Thetimehorizonoftheanalysisshouldbeestablishedaccordingtotheneedsoftheclient.Anappropriatetimehorizonforanucleardecommissioningtrustmaybetwenty-fivetofortyyears,whereasforaretireeitmaybemuchshorter.

3Calculate the client’s anticipated tax profile: Before we beginanalyzing the impactof taxeson thebefore-tax returnassumptions,weneedtodeveloptheanticipatedtaxrateprofileoftheclient.Inthisex-ample,ourclientissubjecttothemaximumfederaltaxrates(35percent),

FIGURE16.3 ComponentsofReturn

ASSETCLASS BEFORE-TAXRETURN APPRECIATION INCOME

DomesticEquity 8.1% 6.1% 2.0%

InternationalEquity 8.3% 6.8% 1.5%

Tax-ExemptFixed-Income 3.4% –0.8% 4.2%

RealEstate(REITs) 7.0% 3.3% 3.7%

HedgeFunds 9.0% 6.5% 2.5%

PrivateEquity/VentureCapital 13.0% 13.0% 0.0%

CashEquivalents 2.4% 0.0% 2.4%

Inflation 2.6%

Sourc

e:D

ougla

sS

.R

ogers


a5percentstatetax,anda1percentlocaltax.Usingtheformulaforan-ticipatedtaxratesfromchapter7,weobtainthefollowingrates: Ordinaryincomeandshort-termcapitalgains 38.9% Qualifieddividends 20.1% Long-termcapitalgains 18.9%

Thesetaxratesareappliedwhenappropriatetoachievetheafter-taxreturns.Theexampleshowstaxratesfor2004.However,tobeconsistentwith themethodused todetermine asset class assumptions, it is also aworthwhile exercise to consider applying a forward-looking element totheclient’saverageprojectedtaxprofile.Forexample,asofthiswriting,ordinaryincome,stockdividend,andcapitalgainstaxratesareatthelow-estlevelseverinthepost–WorldWarIIera.However,withlargebudgetdeficits,manybelievetaxlevelswillrevertbacktothe39.6percentrateonordinaryincomeand20percentrateoncapitalgainsforwealthyindividu-als.Therefore,youcoulduseblendedratesforthefederaltaxonordinaryincomeof37.3percent([35%+39.6%]/2)onordinaryincome,17.5percentonlong-termcapitalgains([15%+20%]/2)and27.3percent([15%+39.6%]/2)oncommonstockdividends,ifsodesired.Similaranalysiscanbeappliedtostateandlocaltaxratesaswell.

4Fortheappreciationcomponentofreturn,estimatethecapitalgainsrealizationrateforeachassetclassandthepercentagesubjecttoshort-versus long-termcapitalgainstreatment:Fortheapprecia-tioncomponentofreturn,therearetwofactorsthatinfluencetheimpactoftaxes.Firstisthecapitalgainsrealizationrate(CGRR).Forthisexerciseonly,theCGRRisdefinedasthepercentageoftheappreciationcompo-nentofreturnthatgeneratesataxableevent.Thisshouldnotbeconfusedwiththeportfolioturnoverrate,whichisbestsuitedformeasuringtrans-action or commission costs versus tax implications.The CGRR mightalsobecalledthenettaxableturnover,andsomepractitionerscallittheeffectiveturnover.Thenextstepistotakeintoaccountthepercentageofshort-versuslong-termcapitalgains.Fromthisinformation,thetaxim-pactfortheappreciationcomponentofreturncanbecalculatedforeachassetclass,asFIGURE16.4shows.

TheCGRRisshownherepurposelyasanegativevalue.Thenegativesignisappropriateifthemanagersbeingconsideredhaveafter-taxreturnslowerthantheirbefore-taxreturns,whichistypicallythecase.However,quantitativetax-awareequitymanagersdiscussedinchapter10andmu-nicipalbondmanagerswhoemphasizetax-lossharvestingdogeneratepre-liquidationafter-taxreturnsgreater thantheirbefore-taxreturns.Whenemployingthesetypesoftax-awaremanagers,theCGRRpercentagecanbeapositiveentryashighas+5percentto+15percent,dependingonthe


timehorizonoftheexercise.Asdiscussedinchapter11,tax-lossharvestingismostproductiveduringtheearlyyearsofanaccountrelationshipthatisfundedwithcash.Therefore,thelongerthetimehorizon,thelowerthepercentageshouldbeforthispositivecontributiontotheportfoliomix.Somefirmsevenlistthesemanagersasseparateassetclassestodetermineanappropriateequity“coreandsatellite”allocation.

5 For the income componentof return, identify theportionofincomethatistaxable,isaqualifieddividend,oristax-exempt:Thetaxcalculationfortheincomecomponentofreturnisrelativelystraight-forwardbutsubjecttothreedifferenttaxrates,asshowninFIGURE16.5.If the client is also subject to the alternative minimum tax, additionaladjustmentsmaybenecessary.

TheareathatisleastspecificisthepercentageofREITandinterna-tionalstockdividendseligibleforqualifieddividendtaxtreatmentatthemorefavorable15percentrate.Coordinatingwithmanagersandcallingcompanytreasurersaresometimesnecessarytoacquirethisinformation.

6 Apply an appropriate fee schedule: Now that the tax conse-quencesfrombothcomponentsofreturnarecalculated,feescanbein-cludedtoderive thereturnsafter taxesand fees foreachassetclass (seeFIGURE16.6).

Thefeeestimatesshownaboveareforseparateaccountmanagers,andforpartnershipsinthecaseofhedgefundsandprivateequity/venturecap-ital.Inthisexample,aconservativeapproachwastakenbyassumingthe

FIGURE16.4 EstimatingtheTaxImpactoftheAppreciationComponentofReturn

ASSETCLASS APPRECIATION CGRR SHORT-TERM LONG-TERM TAX

DomesticEquity 6.1% –20% 25% 75% –0.3%

InternationalEquity 6.8% –20% 25% 75% –0.3%

Tax-ExemptFixed-Income-0.8% –2% 10% 90% 0.0%

RealEstate(REITs) 3.3% –20% 25% 75% –0.2%

HedgeFunds 6.5% –80% 80% 20% –1.8%

PrivateEquity/

VentureCapital 13.0% –0% 0% 100% –0.2%

CashEquivalents 0.0%–100% 100% 0% 0.0%

Sourc

e:D

ougla

sS

.R

ogers


feeswerenotdeductiblefortaxpurposes.Whenusingmutualfundsandmodeling forcertain trust structures, feesmaybeoffset against incomeandshouldbeaccountedforappropriatelyintheprocess.Inthecaseofmutualfunds,youcanforgothefeeanalysisandsimplyconducttheexer-cisenetoffees,whichisthemethodforreportingmutualfundbefore-andafter-taxreturns.

Eachestimateshouldberepresentativeofthetypesofseparateaccountmanagers, funds, andpartnerships theclient is likely tohold.Youmaywishtoapplyauniformfeeforeachassetclass—say,forexample,ifyouarecharginganall-infeearrangementthatwouldberepresentativeofawrapprovider,whichonaverage is1.75percent. Ifaconsultant is em-ployed,youmayalsowishtoaddthatfeetothemanagerfeeforeachassetclass.

Onearea that isabitchallenging isestimating fees forhedge fundsandprivateequity/venturecapitalpartnerships.Thetypicalstructureof1percentofassetsand20percentofprofitsaboveahurdleratecausesasub-stantialdifferencebetweengrossandnetresultsevenbeforeconsideringtheimpactoftaxes,andtheadditional1percentofassetsand10percentofprofitschargedbyafundoffundsonlyaddstothecomplexityofthecalculation.

7 Adjustthebefore-taxstandarddeviationassumptionsfortheimpactoftaxes:Manyfirmsstarttheprocessbytakinghistoricalstandard

FIGURE16.5 EstimatingtheTaxImpactoftheIncomeComponentofReturn

ORDINARY QUALIFIED TAX-EXEMPT

ASSETCLASS INCOME INCOME DIVIDENDS INCOME TAX

DomesticEquity 2.0% 0% 100% 0% –0.4%

InternationalEquity 1.5% 10% 90% 0% –0.3%

Tax-ExemptFixed-Income 4.2% 0% 0% 100% 0.0%

RealEstate(REITs) 3.7% 90% 10% 0% –1.4%

HedgeFunds 2.5% 80% 20% 0% –0.9%

PrivateEquity/

VentureCapital 0.0% 0% 100% 0% 0.0%

CashEquivalents 2.4% 100% 0% 0% –0.9%

Sourc

e:D

ougla

sS

.R

ogers

deviationsandadjustingthemslightlyfortrendsinthemarket.Forexam-ple,mostrecently,domesticstockreturnshavebeenlessvolatilethantheirhistoricalaverage.Iftheadviserbelievesthiswillbeapersistenttrend,thenanappropriateadjustmentisinorder.Withafter-taxreturns,itisassumedthattaxesarepaidquarterly,sincethistypeofanalysistypicallyappliestoclientsfilingquarterly estimated taxes.Therefore, you can reviewquar-terlyreturnsandfocusonthevariationintheappreciationcomponentofreturntocomeupwithareasonableadjustmentfactor.After-taxstandarddeviationsarelowerthantheirbefore-taxcounterparts,becausewithap-preciation, taxesarepaidonrealizedgainsandcreditsaccumulate fromrealized losses.This leads toa smoother, lessvolatile returnstream.Forequitiesthereisabouta10percenthaircut,orreductioninvolatility.Withtaxablebondsandsomehedgefundstrategies,thetaxhaircutapproachesthetaxrate,sincethemajorityofthereturnistaxable(seeFIGURE16.7).

Last,tohaveall theinformationnecessarytoconducttheoptimiza-tionexercise,correlationcoefficientsbetweentheassetclassesarerequired(seeFIGURE16.8).This is theoneareawheretherereally isnoneedtomakeanadjustment,because the tax impactcausesonlyminutediffer-encesbetweenbefore-andafter-taxassumptions.Asaresult,mostfirmsthatuseafter-taxassumptionssimplyrelyontheirbefore-taxcorrelationcoefficientassumptions.

FIGURE16.6 ReturnAssumptionsAfterFeesandTaxes

RETURNAFTER

BEFORE-TAX AFTER-TAX FEESAND

ASSETCLASS RETURN TOTALTAX RETURN FEES TAXES

DomesticEquity 8.1% –0.7% 7.4% 0.60% 7.5%

InternationalEquity 8.3% –0.7% 7.6% 0.70% 7.6%

Tax-ExemptFixed-Income 3.4% 0.0% 3.4% 0.30% 3.1%

RealEstate(REITs) 7.0% –1.5% 5.5% 0.70% 6.3%

HedgeFunds 9.0% –2.7% 6.3% 2.10% 6.9%

PrivateEquity/

VentureCapital 13.0% –0.2% 12.8% 2.90% 10.1%

CashEquivalents 2.4% –0.9% 1.5% 0.20% 2.2%

Sourc

e:D

ougla

sS

.R

ogers



Aswithanyoptimization,reasonableconstraintsmustbeputinplaceforeachassetclasstopreventa“cornersolution.”Acornersolutionoccurswhen the optimizer selects a preponderance of one or two asset classesthatsimplydonotrepresentaprudentrecommendation.Thiscaneasilyhappenwhenhedgefundsareincludedinthemix,becauseoftheirlowvolatilityandcorrelationswithotherassetclasses.Alwaysrememberthattheexerciseshouldbebasedonwhatisreasonable,asthisisanartformratherthananexactscience.

Onceyouruntheoptimizationwithafter-taxassetallocationassump-tions,youare likely to face threeoutcomes.First, sinceafter-tax returnandstandarddeviationassumptionsarelowerthantheirbefore-taxcoun-terparts,youshouldexpecttheefficientfrontiertoslopedownandtotheleft(seeFIGURE16.9).

Second, the after-tax portfolio will shift from tax-inefficient hedgefunds to more tax-efficient private equity/venture capital, as comparedwiththenormalbefore-taxmix.Thisiswhyconsultantsinthehigh-net-wortharenaoftenrecommendahigherpercentageoftax-inefficientnon-directionalstrategiesinfoundationsandlesstax-onerouslong/shortequitystrategiesfortheirfamilies’taxableaccounthedgefundrequirements.

If you adhere to the concept of speaking to clients in terms of be-fore-taxvolatilityorstandarddeviation,theoptimalafter-taxsolutionwill

FIGURE16.7 StandardDeviationAssumptionsAfterFeesandTaxes

BEFORE-TAX STANDARD AFTER-TAX STANDARD DEVIATION STANDARD

ASSETCLASS DEVIATION ADJUSTMENT DEVIATION

DomesticEquity 17.0% 90% 15.3%

InternationalEquity 20.5% 93% 19.1%

Tax-ExemptFixedIncome 3.6% 98% 3.5%

RealEstate(REITs) 16.0% 75% 12.0%

HedgeFunds 8.0% 70% 5.6%

PrivateEquity/

VentureCapital 32.0% 95% 30.4%

CashEquivalents 0.5% 95% 0.5%

Sourc

e:D

ougla

sS

.R

ogers

mostlikelyincludemoreequityandfewerbondsthanthebefore-taxmix.Thisoccursbecauseyouattempttotargetthesamelevelofriskbyapply-ingless-volatileafter-taxstandarddeviationassumptions,asFigure16.7indicates.Therefore,thirdandlast,whenyoucompareefficientmixesfortheafter-taxandbefore-taxsolutions,theafter-taxefficientmixgeneratesasuperiorsolutiononanafter-taxreturnbasisfortheequivalentlevelofrisk.Theamountofthevalueaddedtypicallyrangesfrom0percenttoperhapsashighas0.7percent,dependingonthereturnassumptionsandthemixofpermissibleassetclasses.

Whenproperlyapplied,useofafter-taxassumptionsintheassetclassoptimizationprocess isoneofthefourkeyelementsintheconsultativeprocessthatcanleadtosuperiorafter-taxresults.Thediscussionherewaspurposelymaintainedatabasiclevelsothatwhenpractitionersencountersophisticatedallocationsoftwareincorporatingtaxes,theywillbefamiliarenoughwiththeapproachandterminologytomakeinformeddecisions.More important, software applications have their strengths and limita-tions,andtax-awarepractitionersneedtohavetheexperiencetoensurequantitative tools arebeingproperly employed to thebenefitof clientswithtaxableaccounts.

FIGURE16.8 CorrelationCoefficients

1 2 3 4 5 6 7

1.00 0.76 0.14 –0.15 0.55 0.78 –0.16

1.00 0.22 0.27 0.53 0.70 –0.28

1.00 0.12 0.29 0.12 –0.13

1.00 0.31 0.58 –0.19

1.00 0.52 –0.20

1.00 –0.22

1.00

AssetClass

1 DomesticLarge-CapEquity

2 InternationalEquity

3 Tax-ExemptFixedIncome

4 RealEstate(REITs)

5 HedgeFunds

6 PrivateEquity/VentureCapital

7 CashEquivalents

Sourc

e:D

ougla

sS

.R

ogers


ChapterNotes

1. PeterL.Bernstein,“Overview:AFifthPointofInflection,”PointsofInflection:NewDirectionsforPortfolioManagement,CFAInstituteConferenceProceedings,2004,1–5.

2. William Jahnke, “Death to the Policy Portfolio,” inThe InvestmentThinkTank:Theory,StrategyandPractice forAdvisers,editedbyHaroldEvenskyandDeenaB.Katz(Princeton,NJ:BloombergPress,2004),17–37.

3. GaryL.Brinson,RandolphHood,andGaryL.Beebower,“DeterminantsofPortfolioPerformance,”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-,andten-yearindexinformation.

8. JeremyJ.Siegel,“TheLong-RunEquityRiskPremium,”PointsofInflection:NewDirectionsforPortfolioManagement,CFAInstituteConferenceProceedings,2004,53–62.

FIGURE16.9 ShiftintheEfficientFrontierforTaxesandFees


FrontierBeforeTaxesandFees

EfficientFrontierAfterTaxesandFees

Risk(StandardDeviation)Percent

Ret

urn

Perc

ent

Sourc

e:D

ougla

sS

.R

ogers



WhytheStyleBoxHurts

TaxableInvestors

225

Theschematicthatweinvestmentprofessionalsare introducedtoduring our formative years categorizes equity managers accord-ingtotheaveragemarketcapitalizationofcommonstocksinthe

modelportfolioandthestylemethodologyemployedtoselectthem.1Em-ployingmultipleequitymanagersfortaxableclientsaccordingtothispro-cessleadstonothingmorethan“overpricedentertainment,”assuggestedbyDavidSteinofParametricPortfolioAssociates.2Unfortunately,tradingby portfolio managers to maintain capitalization and style purity leadsto premature and unnecessary realization of capital gains. Additionally,whenanexcessivenumberofmanagersareemployed,themanagerstendtocomeinatthehighendoftheirindividualfeeschedulesratherthanallowingaccesstosliding-scalevolumediscountswhenjustafewmanag-ersareutilized.Fortaxableaccounts,whenitcomestodeterminingtheoptimalnumberofequitymanagers,theruleofthumbis“Lessisbetterthanmore!”

Concreteguidelinesforsegmentingcommonstocksaccordingtomarketcapitalization do not exist; more precisely, they differ from provider toprovider.Themeanandmedianmarketcapitalizationcanbequitediffer-ent.Forexample,theS&P500stockindexcurrentlyhasameanmarketcapitalizationof$90billion,ascomparedwithamedianof$10billion.

Because of the income tax, a penny saved ismore than a pennyearned.

—JefferyL.Yablon

C H A P T E R 1 7


ThemeanmarketcapitalizationintheRussell1000,MidCap,and2000indicesare$80.2billion,$6.2billion,and$0.9billion, respectively forthe large-, middle-, and small-capitalization segments of the domesticstockmarket.Thesevaluescanshiftdramatically,dependingontheav-erageprice-to-earnings ratioof stocksand investmentbankingactivity.3

Corporatetransactionsinvolvinginitialpublicofferings,companiesgoingprivate,mergers,andtakeoversinfluencethecompositionofthevariousmarketindices.

Attemptingtocategorizeandbenchmarkmanagersaccordingtotheirpurchaseandsalemethodologycanbechallenging,asmanagersmayem-ployeclecticapproaches.Managersselectingstockswithagrowthorien-tationtypicallyseekcompanieswithsuperiorearningsgrowthandcor-respondinglyhighprice-to-earnings(P/E)orprice-to-book(P/B)ratios.Ontheotherhand,valuemanagersattempt to identify stocks thataretradingat adiscount toothers and typicallyhavea lowerP/EorP/Bmultiple than theoverallmarket.A“core”or a “blend” strategy sim-plycombineselementsofboththevalueandgrowthstock-selectionmethodologies.

FIGURE17.1illustratesthetraditionalequitystyle/capitalizationgrid.Over theyears, the tax-exempt-accountconsulting industryhasem-

phasized style/capitalizationpurity to create ahighdegreeof focus andspecialization, as there is an accepted belief this eliminates overlap andcreatesthemostpotentialforsuperiorreturns.Itistakensoseriouslythatmanagersareoftenterminatediftheydrifttoofarawayfromtheirper-

FIGURE17.1 TraditionalEquityManagerStyle/CapitalizationGrid

Figure17.1Rogers

Value Core Growth

Large

Middle

Small

Sourc

e:D

ougla

sS

.R

ogers

WhytheStyleBoxHurtsTaxableInvestors 227

ceivedcategory.Whilethismaybenefittax-exemptaccountinvestors,itworkstothedetrimentofthetaxableinvestor.

Thefrictionalcoststotaxableinvestorscomeinthreeways.Thefirstcostassociatedwithmaintainingstylepurity is thecostof trading.Theothertwocostsarefarmoresignificantandinvolvethepaymentoftaxesonrealizedcapitalgains.Thisoccurswhenasecuritymustbesold,be-causeachangeinpricecausestheP/EorP/Bratioorthecapitalizationofasecuritytobeinconsistentwiththemanager’sstyleorcapitalizationdesignation.

Tohighlightthecostofrigidstyleadherence,wewillinvestigatethecapital gains realization history of severalVanguard index funds.Thefundsusedinthisexerciseareintendedtodemonstrateteachingpointsandnottosuggestarecommendationfororagainsttheirpurchaseinthefuture.Sinceweareapplyinginformationfrommutualfunds,thecostspresentedshouldbeconsideredasthemostconservativewaytoestimatewhat investorsonaverageare likelytoexperience.Withtheexceptionofredemptionactivity,theonlytimestocksintheportfolioaresoldiswhenthe index isadjusted,or“reconstituted.”There isanothereventthatcancauseataxabletransaction:themergeroftwofirmsconductedon a cashbasis, versus an exchangeof shares.Therefore, the costs in-volvedareinmostcasesfarlowerthanwouldbethecaseifactiveman-agerswereemployed.MutualfundcapitalgainsgenerationinformationistakenfromMorningstarPrincipiatohighlighthoweasilythistypeofanalysiscanbedone.4

First,wewillexaminetheimpactthatadherencetomarketcapitaliza-tionparametershasongeneratingcapitalgainsandtaxes.Thechallengeoccurs when the sponsor reconstitutes the indices and eliminates themostsuccessfulstocksinsmall-andmid-capportfolios.Tomaintaintheintegrityoftheindexportfolio,themanagersellsstocks,whichusuallyresultsinsubstantialgains.Whensmall-andmid-capstocksriserapidlyincapitalization,aswithtechnologyissuesduringthe latterhalfofthe1990s,theindiceshavethepotentialtoproduceshort-termcapitalgainsthataretaxedatthehigherratesforordinaryincome.Thischallengeisnot a factorwith large-capportfolios, as there isnoneed to remove along-termconsistentgrowthstock,suchasGeneralElectric.Therefore,weshouldexpectbothsmall-andmid-capindexportfoliostogeneratemeaningfulcapitalgainsinordertomaintaindesiredmarketcapitaliza-tioncriteria.ThecostofthisphenomenonisshowninFIGURE17.2usinginformationtakenfromMorningstarInvestmentDetailReportsfortheVanguard500,Mid-Cap,andSmall-Capindexfunds.Allcapitalgainsdistributionshavebeenadjustedtoreflecta$100investmentatthebe-ginningoftheyear.


Fiveyearsofinformationisshown,astheVanguardMid-CapIndexFundbeganinMay1998.Moreimportant,usinganaverageofthefiveyearsgivesamoreaccurateportrayalofwhattoexpectinanyoneyear,asthebullmarketuptothespringof2000hadamuchgreaterimpactoncapital gains generationwhencomparedwith thebearmarket that fol-lowed.Asexpected,adherencetomarketcapitalizationparametershasatremendoustaximpactwithsmall-andmid-capindexportfolios.Fromataxstandpointalone,itisreasonabletolumpsmallandmiddlecapitaliza-tion together to create a small/middle-capitalization category. A typicalequityallocation—orinthiscase,afundallocation—of70percent500Index,20percentMid-CapIndex,and10percentSmall-CapIndexwiththe resulting capital gains is compared with theVanguardTotal Stock

FIGURE17.2 ImpactofCapitalizationonCapitalGainsRealizationDistributionper$100Investment

VANGUARDFUND/BENCHMARK 1999 2000 2001 2002 2003 AVERAGE

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 WeightedBlendCapitalGainsRealizationVersusTotalMarketDistributionper$100Investment


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

Sourc

e:M

orn

ingst

ar,

Dougla

sS

.R

ogers

Sourc

e:

Morn

ingst

ar,

Dougla

sS

.R

ogers


MarketIndexFund,whichattemptstoreplicatetheoveralldomesticeq-uitymarket(seeFIGURE17.3).

Thecapitalgainsdistributionofthetraditionalblendthatconsultantsandadvisersfortax-exemptaccountsusetoconstructclientportfoliosre-sultsinmorethanfourtimestheamountofcapitalgainsgenerationthatholdingthemarketportfolio,asrepresentedbytheVanguardTotalStockMarketIndexFund!Itshouldbenotedthatthetwoexamplesrepresentabest-casescenario,becausetheprimarysourceofcapitalgainsrealizationisfromtradingactivityconductedasaresultofreconstitutingtheunderly-ingindexofthefunds.Withactivemanagement,thecomparativeresultswouldmostlikelybefarmoredramatic,sincemanagerswouldhavead-ditionaltradingactivitywhensellinglessattractivestocksforthosetheybelievewilloffersuperiorreturnsinthefuture.

Thesecondfactorpertainstothetradingactivityrequiredtomaintainaparticularbuy-and-sellstockmethodologyorstylethatresultsinundesir-ablecapitalgainsandtaxes.Inthefollowingexample,wewillanalyzeresultsfromVanguard’svalueandgrowthstyleindexfunds(seeFIGURE17.4).

Cautionshouldbetakenincomparingtheresultsofthestyleindicesbycapitalization,becausethelarge-capfunds(1992)werecreatedsixyearsbeforethesmall-capseries(1998).Therefore,theyhadmoretimetoac-cumulateanunrealizedcapitalgainposition.However,whatthefundsdoshowisthatbuy-and-holdgrowthismoretax-efficientwhenmeasuredby

FIGURE17.4 ImpactofStyleonCapitalGainsRealizationDistributionper$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

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

Sourc

e:M

orn

ingst

ar,

Dougla

sS

.R

ogers


thedollaramountofcapitalgainsgeneratedbyafactorofapproximately4to1.Forthisperiodofanalysis,Vanguardemployedtheindexinforma-tionfromS&P500/Barra,butithasrecentlyswitchedtoanewmethod-ologycreatedbyMorganStanleyCapitalInternational.5Barracategorizesstocksasbeingvalueorgrowthaccording to their relativeP/Bratio,asstudieshavedemonstratedthatthismeasureismorestablethantheP/Eratio.6Whenindicesarereconstituted,stockssoldfromavalueindexport-folioarelikelytohaveappreciatedsignificantly,causingtherealizationofmeaningfuldollaramountsofcapitalgains.Fromataxview,evenwithindex funds, the value-stock selection methodology represents more ofatradingstrategyratherthanabuy-and-holdpropositionthatwillallowcapitalgainstocompoundtax-freeuntil realized.Ontheotherhand,astockremovedfromagrowthindexislikelytohavebeenexperiencingadecliningpriceandmayhaveminimalappreciation,orpossiblyevenbesoldataloss.Whenlossesoccurwithtaxableaccounts,orinthisexampleanindexfundportfolio,theyoffereconomicvaluebecausetheywillulti-matelybeusedtooffsetaportionofrealizedcapitalgains.

Anotherfactorthathascontributedtolowertaxefficiencyforvalue-orientedportfolios is thatdividendswere taxedat theordinary incomeratebefore2003.

FIGURE17.5showsthatthevaluestyleconsistentlyhasahigherpayout

FIGURE17.5 IncomeofStyleofBenchmarkStyleFundsDistributionper$100Investment

VANGUARDFUND/BENCHMARK 1999 2000 2001 2002 2003 AVERAGE FEE

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

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

Sourc

e:

Morn

ingst

ar,

Dougla

sS

.R

ogers


individends,asexpected.Using2002asanexample,forevery$100in-vested,aninvestorsubjecttothemaximumfederaltaxrate(38.6percent)wouldhavepaid$0.65($1.69×38.6%)intaxesfordividendsdistributedfromtheValueIndexFund,ascomparedwith$0.34($0.87×38.6%)fortheGrowthIndexFund.Manyseparateaccount investorscannotoffsetfeesagainsttaxableincomewhenfilingtheirtaxreturn.Therefore,togainanaccurateportrayalofthetaximpactofdividendsfromtheinformationinFigure17.5,theyneedtoaddbackthefeetofindthegrossdividendyield.Sointhelastcolumn,thefeeorcostper$100investedisshownforeachVanguard fund.During thisfive-yearperiod, theexpenses for anyofthefundsshowndidnotvarybyanymorethan$0.01.Aseparateac-countmirroringtheVanguardValueFundwouldhavehadagrossyieldof$1.92($1.69+$0.23).Therefore,forseparateaccountsholdingtheindexportfolio,thedifferenceintaxpaymentsforthevalueandgrowthstyleswouldbe$0.74($1.92×38.6%)and$0.42($1.10×38.6%),respectively.Asyoucansee,ifthefeeforseparateaccountmanagementwasnotsub-stantiallylower,themutualfundformatmayofferthetaxableinvestoran advantage from a tax standpoint, but the separate account formatdoeshaveanadvantageofprotectinginvestorsfromtheadverseimpactofshareholderredemptionactivity.

Combining the impact of portfolio rebalancing and dividend yielddampens the value style’s after-tax returns.7Therefore, growth-orientedindexportfoliosareinherentlymoretax-efficientthanthosewithavalueorientation.Anexceptiontothisgeneralruleiscorporateaccounts,whichbenefitfromtheexclusionof70percentoftheirdividendincomefromtaxation.Inthesecases,stocksthatpayhigherdividends,likepreferreds,mayoffersuperiorafter-taxreturns.

Thedilemmawiththetraditionalstylematrixcanbesolvedinoneoftwoways.Thefirstmethod,forseparateaccounts,istoemployastruc-tureotherthanthetraditionalthree-by-threematrix.Thesecondmethod,whichpertainstomutualfunds,istoutilizeafundvehiclethatisnotvic-timizedbycapitalizationgainsgenerationfromperiodicreconstitution.

Thereareseveralequityallocationmodelsthatconsultantsandinves-torswhomanagetaxableassetscanemploytolessenunnecessarycapitalgainsgenerationandpaymentoftaxes.First,let’sexaminemodificationstothetraditionalthree-by-threematrix.Alogicalevolutionisthe“modi-fiedtraditional”model.Inthismodel,thecoreandmid-capmanagerposi-tionsareeliminated.Additionally,small-capmanagersareallowedtoholdtheirwinnerslongerbytakingonasmall/mid-capmandate,andlarge-capmanagersareallowedtodipdowninmarketcapitalizationwithperhapsasmuch20percentofassets.

Theobviousintentionofthemodifiedtraditionalmodelistoreduce


capitalization-andstyle-orientedtradingandlessenthedragonafter-taxperformance.However,forlargeportfolioswhereseparateaccountmanag-ersareemployed,thereisanadditionalbenefit.Areductioninthenumberofseparateaccountmanagersfromperhapsninetofourwillmostlikelyleadtoloweroverallmanagementfees,whichisalsoaformoftax.Thisprocessworksbestwithelitetax-awaremanagers,especiallyforthelarge-capitalizationvalueandgrowthmandates.Oneproceduretheconsultantorsponsorcanemploywhileservingasthequarterbackoftheprocessistosuggestatransferofstockthathasrisenincapitalizationfromasmall/mid-capmanagerforanequaldollaramountofcashfromalarge-capmanager.Thisassumesthatthelarge-capmanagerfindsthestockofthecompanyinquestion tobeapurchaseor long-termholdcandidateandhascashavailable.Themodifiedtraditionalmodel isappropriateforclientswhowishtohavetheopportunitytopotentiallyoutperformanindexportfolioonanafter-taxbasisandarenotcomfortablewithaquantitativetax-awareapproachtoequitymanagement.

A compelling alternative to the modified traditional approach de-scribed above is the “all-capitalization/style-specific”model (see FIGURE

17.6).Withthismodel,theportfoliomanagerisallowedtoselectstocksaccordingtohisparticularstyle(valueorgrowth)fromacompleteuni-verseofsecurities,whichmayberepresented,forexample,bytheRus-sell3000ortheWilshire5000stockindices.Thereareveryfewactivemanagersthatofferall-capitalizationvalueorgrowthproducts.Withtheadoptionofthetraditionalequityallocationmodeloverthepastthirtyyearsorso,firmsgraduallydroppedtheseproductsandfocusedonstyle/capitalization-specificstrategies.However,withgrowinginterest intax-awareinvesting,all-capitalization/style-specificportfoliosareexperiencingarenaissancewithinformedinvestorsandadvisers.Theadvantageofthe

FIGURE17.6 ModificationstotheTraditional3x3Matrix

Large

Middle

Value Core

ModifiedTraditional

Growth Value Core

All-Capitalization/Style-Specific

Growth

Sourc

e:

Dougla

sS

.R

ogers


all-capitalization/style-specificmodelisthatitallowsinvestmentanalystsandportfoliomanagerstotakealong-termapproachtoinvesting,sincetheyarenotforcedtosellsmall-andmid-capstocksthathavehadsignifi-cantappreciationiftheystillbelieveitisbeneficialtoholdthem.Theworstthing that can happen with the all-capitalization/style-specific model is,forexample,ifthegrowthmanagersellsacompany’sstockatashort-termlossand thevaluemanagerpurchases itwithin thirtydays,negating thebenefitofthelosssale.Itiscriticalthattheconsultantorsponsorensuresthattimelycommunicationbetweenthetwomanagersismaintainedforalltradingactivitythatresultsinlosses.Thisisoftendonebyfacsimileor,evenbetter,bye-mailbeforethetradebeingconsideredisactuallyexecuted.

Thenexttypeofstructureinvolvesusingaquantitativetax-awareport-folio strategyor coupling itwith less tax-efficientproducts.These strate-gies,coveredindetailinchapter10,emphasizeconstructingaportfoliotoreplicatethebefore-taxperformanceofadesignatedstockindexandthenactively trading togeneratenet losses thatcanoffsetgains inotherport-folios. It is extremely difficult to manage small portfolios profitably in atax-aware manner, since taking taxes into account is likely to result in amorelabor-intensiveprocess.Thus,theall-capitalization/all-style,or“wholestock”modelisespeciallybeneficialforseparateaccountassignmentswithatotalequityallocationfrom$500,000to$3millionorgreater.8Perhapsoneof theexcitingdevelopmentsonthehorizonfor taxableaccounts is thecreationoftheall-capitalization/all-styletax-awareglobalequityportfolio(seeFIGURE17.7).

FIGURE17.7 All-Capitalization/All-StyleQuantitativeTax-AwarePortfolio

Figure17.7Rogers

Large

Middle

Small

Value Core Growth

Sourc

e:

Dougla

sS

.R

ogers


Astuteadvisersattemptingtomaximizeafter-taxreturnsusethequan-titative tax-aware approach where the odds of outperforming an indexare the least attractive and selectively place activemanagerswhere theybelievetheyhavethepotentialtoproduceanalphaof3.0percentorbet-ter.Therefore, thenext logicalextension is tocombine thequantitativetax-awareapproachwithsmall-orsmall/mid-capmanagers,asshowninFIGURE17.8.

ThisexamplerepresentsanS&P500quantitativetax-awarecorewithsmall/mid-capvalueandgrowthmanagers,buttherearemanysolutionsthat are equally attractive.For example,youcouldhaveaRussell1000quantitative tax-awarecorewithanactivelymanagedRussell2000coresmall-capportfolio.Additionally, insteadof oneor two small- or small/mid-capmanagers,youcouldusethree,dependingontheamountofassetsyouareworkingwithandtheminimumaccountsizemanagersarewillingtoaccept.FIGURE17.9,againfromBarclays,showsthepercentageofactivemanagerswhohaveunderperformedtheirrespectiveindicesonarespec-tivebasis.Sinceclosed fundsarenot includedandthedata suffer fromsurvivorbias,thispictureismorefavorablethanreality.However,itdoesshowwhereitmakesmostsensetomakeyouractivemanagementbets.9

Also,therecanbeaseparateaccountforthequantitativetax-awarecoreandmutualorexchange-tradedfundsforthesmall-capallocation(s).Thekeyhereisnottofall intothetrapofthetax-exemptindustryanddrivesomepreconceivedformatornumberofmanagers.Becreativeandsimply

FIGURE17.8 CombiningAll-Capitalization/All-Style(QuantitativeTax-AwarePortfolio)WithModifiedTraditionalPortfolio

Figure17.8Rogers

Large

Middle

Small

Value Core Growth

Sourc

e:D

ougla

sS

.R

ogers


dowhatmakessensewiththestrategiesandproductsyouhaveavailable!Takingthisprocesstothelogicalextremeresultsinthe“optimal”tax-

awareequityallocationmodel.Itisthecurrentragewithtax-awareconsul-tantsandadviserstoday,asitbringstogetherthemostcompellingfeaturesofvarioustypesofmanagers.Thismodelisalsoknownasthe“core-and-satellite”or“hub-and-spoke”approachtodomesticequitymanagerposi-tioning(seeFIGURE17.10).10

FIGURE17.9 PercentofActiveManagersUnderperformingtheIndex(from12/31/93to12/31/03)

VALUE(%) BLEND(%) GROWTH(%) BEFORE AFTER BEFORE AFTER BEFORE AFTER

TAX TAX TAX TAX TAX TAX

Large-Cap 86 98 82 95 67 88

Mid-Cap 71 91 51 89 60 84

Small-Cap 45 81 22 43 18 34

Note:Pastperformance isnoguaranteeof future results.All total returns reflect10-year annualized

figures.FundsarecategorizedbyMornigstarobjective.

FIGURE17.10 OptimalTax-AwareDomesticEquityManagerAllocation

Figure17.10Rogers

Large

Middle

Small

Value Core Growth

Concentrated

Active Active

Concentrated

QuantitativeTax-AwareCore

Sourc

e:B

arc

lays

Glo

balIn

vest

ors

Sourc

e:

Dougla

sS

.R

ogers


In the optimal model, the quantitative tax-aware allocation receivesthemostsignificant leveloffundingandservesasthecoreorhub,sur-rounded by satellites or spokes.The satellites or spokes may be small/mid-orsmall-capmanagersorconcentratedmanagersthattypicallyholdtwenty or fewer securities.The reduction in nonsystematic or security-specificriskdiminishesasstockportfoliosholdmorethantwentysecuri-ties.11Byholdingthisnumberofsecuritiesor fewer,managershavethebestchanceofobtaining3.0percentplusoutsizedreturnsthroughaselectnumberofideastheyhaveconvictionin.Theymayholdsomeofthesamesecuritiesinthespacethecoremanageroccupies.Ifthisisaconcern,thencoremanagercanbeprecludedfrompurchasingthesecuritiesheldbytheconcentratedmanagers.Additionally,youshouldnotbeconcernedaboutthelackofdiversificationofaconcentratedmanager,asthecorepositionisalreadyanchoringtheoverallmix.Theconcentratedapproachcanap-plytobothlarge-andsmall-capallocations,andsomefirmsevenincludeequitylong/shorthedgefunds.

Thequestion for thepractitioner is:Howmanymanagers should Ideployandwhatshouldtheallocationtothevariouscomponentsbe,es-peciallythequantitativetax-awarecore?Theallocationstothelarge-andsmall/mid-capitalizationequitycomponentscanbedeterminedthroughthenormalassetallocationoptimizationprocessusingafter-taxassump-tions.Thetwopercentagescanthenbeaddedtogetherfortheoveralldo-mesticequityallocation.Byadjustingtheweightsofthecoreandsatellite

FIGURE17.11 InformationRatio,After-TaxAlpha,andTrackingErrorbyAllocationtotheTax-ManagedCore

0%

Aft

er-

Tax

Info

rmati

onR

ati

o

Aft

er-

Tax

Alp

haa

ndT

rackin

gE

rror

AllocationtoTax-ManagedCore

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

.50

.45

.40

.35

.30

.25

.20

.15

.10

.05

.00

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

After-TaxInformationRatio

After-TaxAlpha

TrackingError

Figure17.11Rogers

Sourc

e:

Cliff

ord

H.

Quis

enberr

y,J

r.,

“O

pti

mal

Allocati

ono

fTaxa

ble

Core

andS

ate

llit

eP

ort

folioS

tructu

re,”

Journ

alof

Wealt

hM

anagem

ent

(Sum

mer

20

03

):1

8–2

6.


componentsforagivenbase-casescenario,CliffordQuisenberryofPara-metricPortfolioAssociates illustrates inFIGURE17.11 that theafter-taxinformationratiopeakedwithapproximately62percentallocatedtothequantitativetax-awareportfolio.Inthiscase,theafter-taxinformationisdefinedas“theportfolio’safter-taxalphaoverthetrackingerror.”12

Applying the information in the figure suggests allocating approxi-mately60percenttothecoreand10percenteachtotwosatellitesandtwosmall/mid-orsmall-capitalizationmanagerswouldproduceanattrac-tiveportfoliomixtodelivercompellingafter-taxresults thatadequatelyrepresentseachof thenine styleboxes.Thus, themixofmanagersandfundscaneasilybedonewithfiveorfewermanagers.Insomecases,theremaynotbeasubstantialfeesavings,asconcentratedandhigh-alphaman-agerstypicallycharge1percentormoreandmayevenapplythetypical1percentoffeesand20percentofprofitperformancetypicalofhedgefunds.However,thenetresultshouldcreatethepotentialformuchhigherreturnsafterallfeesandtaxes.ThegraphcreatedbyParametricillustratesoneapproachtodeterminingtheoptimalpercentageforthecorealloca-tion. Consultants and advisers may wish to create their own proprietymethodtodemonstratetheirfirm’sdistinctivecompetence.

Thekeytodevelopingahigh-performingmixofdomesticequityman-agersonanafter-taxbasis iswhat JeanBrunel refers toasavoiding the“murkymiddle”(seeFIGURE17.12).13

FIGURE17.12 MovingAwayFromtheMurkyMiddle:ACore-and-SatelliteApproach

Tax

eff

icie

ncy

Tax-efficientcore Highvalue-addedsatellites

Portfolioactivitylevel

Figure17.12Rogers

Sourc

e:

JeanL

.P

.B

runel,“

AT

ax-

Eff

icie

nt

Port

folioC

onst

ructi

onM

odel,”

Journ

alof

Wealt

hM

anagem

ent

(Fall2

00

1,

43

-49

.


The murky middle consists of the vast majority of equity portfoliomanagers, who simply have little or no chance of outperforming thebenchmarkonafter-taxbasis.Therefore,tax-awarepractitionersnaturallyfindcomfortinallocatingtotheextremesthatconsistofacoremanageremphasizingthetax-lossharvestingstrategyononeendof therangeofchoicesandhigh-alpha-generatingstrategiesontheother.

Thesecondwayinvestorscanreducethetaxdragfromadherencetospecificdomesticequitystyle-boxallocations is toseekan investmentve-hiclethatdoesnotsufferfromthereconstitutionoftheindex,asdomutualfundsandseparateaccountmandates.Fortunately,exchange-tradedfundsservethispurposewell,especiallythoserecentlydevelopedbyBarclaysinconjunctionwithMorningstar.14Asdescribed inchapter9, the in-kindtransfer allows exchange-traded funds to minimize the tax impact toinvestors, and in certain market environments eliminate it altogether.Sincemostreconstitutionsareannouncedinadvance,portfoliomanagersofexchange-tradedfundscanbeginacquiringsharestoensureanorderlytransitionoftheportfoliotothenewallocation.TheMorningstarmeth-odologyofstyle/capitalizationindexconstructionincorporatesthefactorslistedinFIGURE17.13.

The reason these are listed here is the nine iShare portfolios or ex-change-tradedfundsareconstructedinawaytominimizetheproblemwithoverlap.Toaddresstheconcernwithoverlap,Morningstarappliesamethodofcontrolcalled“ownershipzones.”Thisallowsinvestorstocreatemixesofportfoliosandfundswiththeconfidencethattheywillnotendupwithanundesirablepercentageallocationtooneormorestyle/capitaliza-tionblocks.Moreover,theycandosowiththeiSharesMorningstarfundsandindexesinawaythatishighlytax-efficient.Additionally,althougha

FIGURE17.13 iSharesMorningstarIndexMethodology

VALUEFACTORS GROWTHFACTORS

Price/ProjectedEarnings50.0% Long-TermProjectedEarningsGrowth 50.0%

Price/Book 12.5% HistoricalEarningsGrowth 12.5%

Price/Sales 12.5% SalesGrowth 12.5%

Price/CashFlow 12.5% CashFlowGrowth 12.5%

DividendYield 12.5% BookValueGrowth 12.5%

Sourc

e:

Morn

ingst

ar,

Barc

lays

Glo

balIn

vest

ors


brokeragefeeischargedtopurchaseandsellthem,annualfeesrunfromonly0.2to0.3percentannually,dependingonthespecificproduct.

TheMorningstariSharesindexmethodologyismoreintunewiththewaythemixofportfolioholdingsfortaxableinvestorsshouldbeconstruct-ed,as comparedwith theRussellmethodology,whereapproximately30percentoflarge-capstocksareownedbyboththeRussell1000ValueandtheRussell1000Growthindices.This isfinewithpensionorcharitableaccountsportfolioswheretaxesarenotaconsideration,asyouoftenfindrelativevalueandgrowth-at-a-reasonable-price(GAARP)stylemanagersholdingmanyofthesamestocks.However,taxableaccountsshouldavoidpairingthesetypesofmanagers,astheirtradingoftenviolatesthethirty-daywashsale rulenegating thevalueof sellinga securityata loss,andwhenyoucombinethetwoyoutypicallyhavelittlemorethananexpen-sivemarketportfolio.Moreover,highalphaismoreoftenassociatedwithmanagersthatadheretodeeporextremestyleemphasis.

Thecoreportionof the“optimal”portfoliodoesnothave tobeanindex-orientedproducttobeeffective.Therearemanagerswhoattempttousethebefore-taxapproachtheyhavemasteredforadecadeormoreand now apply a tax-loss harvesting overlay to their process. Althoughtheirbefore-taxreturntrackingerrorwillbegreaterthantheirindex-basedpeers,thisisnecessaryforthemtocreateadesirablebefore-taxalpha.Iftheycansuccessfullyachievebothabefore-taxalphadrivenfromsecurityallocation and security selection and an after-tax alpha from tax-lossharvesting,theinvestoristheultimatebeneficiary.Familyofficesareusingthis typeofapproachtohighlightthatwhattheyoffer isunique inthemarketplaceandreallyallowstheirmanagerstofocusonlong-termresults,rather than being subject to the ridiculous pressures of the tax-exemptconsultingcommunitywhichwantsthemtopigeonholetheminoneoftheninestyle/capitalizationboxes.Moreover, this typeofapproachandtax-efficientexchange-tradedfundscanallowthemanagertomigratetooroverweighttheportionsofthematrixtheyfeelhavetheopportunityforsuperiorlong-termreturnsbasedonvaluation.Forexample,DonPhillipsofMorningstarrelatedataBarclaysiSharesconferencethatasofthefallof2004,small-capvaluehasoutperformedlarge-capgrowthoverthepastfiveyearsbyperhapsthewidestmargininthemodernhistoryofthemar-kets.15Thisoutperformancewillnotlastforever.Therefore,ifyouacceptacontrarian’sapproach,theall-capitalization-and-styletax-awaremanagercangraduallyshifthisportfoliostyleandcapitalizationtoareaswiththegreatestreturnpotential.AnotheralternativeisusingMorningstariShares,sincetheyareextremelypure instyleandcapitalization,allowingtheadvisertouseaminimalamountofdollarstoachievethedesiredalloca-tion.Thisisthetypeoftacticalredeploymentofassetsthatcanbeexecuted


inatax-awaremannerbasedonsoundprinciplesandjudgment.Insummary,efficientlyallocatingequitymanagersfortaxableaccounts

initiallyappearstobeamorecomplexprocessthanwithretirementplansoreleemosynaryorganizationswheretaxesarenotafactor.However,withexperience,itbecomesasimpleandnaturalprocessofdoingwhatisneces-sarytoachievethehighestafter-taxreturnpossible.Bytakingintoaccountthe following factors, taxable investors benefit by adopting innovativeequityallocationmodelsthatsuittheirclient’sneeds:

❑ Establishingthetotaldollaramountoftheequityallocation❑ Reducing thenumberof equitymanagers employed tominimize

unnecessarycapitalgainsandtaxesbyadoptinganallocationmodelother than the three-by-three matrix developed for tax-exemptaccounts

❑ Positioningaquantitativeortraditionalmanagerwithafocusontax-lossharvestinginthecoreposition

❑ Deployingtraditionalmanagerswheretheyhavethegreatestprob-abilitytosucceed

❑ Emphasizing concentrated or high-alpha-generating portfolios,especiallyinefficientmarketniches

Elitepractitionersareembracingandwillcontinuetorefineandofferinnovativetax-awareequityallocationmodels,becausetheyrepresentanareaoftheinvestmentmanagementprocessthattrulyhasthecapabilityofenhancingthetaxableclient’sultimatewealth.

ChapterNotes

1. Muchofthediscussionontax-awareequitymanagerallocationhasbeentakendirectly or summarized from Douglas S. Rogers, “Tax-Aware Equity ManagerAllocation:APractitioner’sPerspective,”JournalofWealthManagement(Winter2001):39–45.

2. DavidM.Stein, “EquityPortfolioStructure andDesign in thePresenceofTaxes,”JournalofPortfolioManagementvol.4,no.2(Fall2001):37–42.

3. Barrow,Hanley,Mewhinney&Strauss,“BenchmarkReview,ThirdQuarter2004,”listingFactSet,S&P/Barra,andRussellasreferences,September30,2004.


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.


8. R. M. Ennis, “The Case for Whole Stock Portfolios,” Journal of PortfolioManagement(Spring2001):17–26.

9. BarclaysGlobalInvestors,TheBasicsofiShares,marketingdocument,March2004.

10. JeanL.P.Brunel,“AssetLocation:CaseStudyofaCriticalVariable,”Invest-mentCounselingforPrivateClientsIII,AIMRConferenceProceedings,2001,18-27;JeanL.P.Brunel,“ATax-EfficientPortfolioConstructionModel,”JournalofWealthManagementvol.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,”JournalofWealthManagement(Fall2001,43-49.

14. BarclaysGlobalInvestors, iSharesMorningstarSummary,marketingdocu-ment,June2004.

15. DonPhillips,“TheNewSchoolofInvestingIsHere,”presentationatBarclaysGlobalInvestorsConference,Chicago,October14,2004.


C H A P T E R 1 8

PositioningAssetsbytheTax

CharacteristicsoftheEntity

243

Positioningassetsbythetaxcharacteristicsoftheentityisacriticalstep in the logical progression of managing assets in a tax-awaremanner.Thisstepfollowsderivingafter-taxassetclassassumptions,

discussedinchapter16,andworksintandemwithequitymanagerpo-sitioning,explainedinchapter17.Oncethisstepiscomplete,managersandfundscanbeefficientlyassigned,whethertheyaretax-efficientornot.Thischapterexplainstheprocessatalevelwhereitcanbegraspedbyread-ersofalldegreesofsophisticationandexperience.

Proficiency at tax-aware location requires an understanding of thevariousentitiesthatinvestorsarelikelytoencounterwhendealingwiththeirpersonal situationorwhenpractitionersareworkingwithtaxableclients.Entitiescanbebrokendownintothefollowingmajorcategoriesforindividuals:

1 Taxableassets2 Tax-deferredretirementplans3 Individualretirementplans4 Educationplans5 Insuranceproducts6 Socialsecuritybenefits7 Trusts

Introduce a wise and efficient system of taxation, and life andenergywillpervadethecountry.Withoutsuchasystem,itwillsinkintogeneralandfatalparalysis.

—AtlanticMagazine


Mosttaxablecorporatesituationstypicallyapplyasubsetoftheaboveconsisting of taxable corporate assets, insurance products, and varioustrustsestablishedtoservespecificrequirements.

Asimplefoundationofkeyelementsofthetaxcodeasitappliestoin-dividualsisalsonecessarytotax-awarepositioningofassets.Thetaxcode,asitappliestoreturnsonfinancialinstruments,isextremelycomplex.Ittakes timeand substantial effort for the taxable accountpractitioner toobtainalevelofunderstandingsufficienttodealcomfortablywithclientsituations.Thisproblemmanifestsitselfprimarilyfortworeasons.First,taxratesevolveforindividualsecuritiesandproductsastheyarecreated.Second,thetaxcodeisorganizedbythecharacteristicsofthetaxpayingentity—forexample,anindividual,corporation,orpartnership.Plus,tax-relatedinformationisoftenpresentedintermsthatonlyaccountantsandattorneysfeelcomfortablewith.Inthischapter,wehighlightafewsimpleconceptsandoutlinethehistoryoftaxesonincomeandcapitalgainsandtheimpactofthemostcommonratesofthepost–WorldWarIIeraonthenetreturnofinvestments.

Theappendixliststhetopfederalincometaxratesonregularincomeandcapitalgainssince1916.Thetopincomerateisalsooftenreferredtoasthemarginaltaxrate,whichmaydiffersignificantlyfromanindivid-ual’saveragetaxrate.FIGURE18.1showsthefederaltaxratescheduleformarriedcouplesfilingajointreturnforincomeearnedin2004.

Applying the schedule to various levels of taxable income shown in

Sourc

e:C

CH

Tax

Law

Edit

ors

,2

00

4U

.S.M

ast

er

Tax

Guid

e(

Chic

ago:

CC

H,

20

03

).

FIGURE18.1 ScheduleY-1:MarriedFilingJointlyandSurvivingSpouse(toNearestDollar)

TAXABLEINCOME BUTNOT %ON OFTHEOVER OVER PAY + EXCESS AMOUNTOVER

$ 0 to $ 14,300 $ 0 10% $ 0

$ 14,300 to $ 58,100 $ 1,430 15% $ 14,300

$ 58,100 to $117,250 $ 8,000 25% $ 58,100

$117,250 to $178,650 $22,787 28% $117,250

$178,650 to $319,100 $39,979 33% $178,650

$319,100 to $86,328 35% $319,100

PositioningAssetsbytheTaxCharacteristicsoftheEntity 245

FIGURE18.2demonstratesthattheaveragetaxrateistypicallyfarlessthanthemarginal,ortop,taxrate.1

Thedifferencebetweenthemcanbesubstantial,especiallywhenthefirstincrementonincomeisnottaxed,asisthecasefor2004uptoanincomelevelof$14,300.Thisconceptisquitesimplebutoftenignored.Thereasonthispointismadeismoststudiesapplythemaximumfederalrate ineffect fortheyearofthereturntoachieveaworst-casescenario.Yourowntaxrateortheaveragetaxrateofyourclientsmaydiffersignifi-cantlyfromthetaxratesappliedinaparticularstudy.Therefore,itmaybenecessarytomodifytheconclusionofaparticularstudytoaccommo-datethecircumstancesofaspecificsituationifanothertaxrateismoreappropriate.

Oftentimes,thetaxpayerisalsosubjecttostateandlocaltaxes.Taxesbyforeigncountriesmayalsocomeintoplay.Theseadditionaltaxesarealsoimportantandshouldbeaccountedforintheanalysisforaspecificcli-ent.Inadditiontotheneedsofindividuals,taxableaccountmanagementprofessionalsmayalsoservetheneedsofvariousformsoftrustsestablishedforthepurposeofestateplanning,propertyandcasualtyinsurancecom-panies,nucleardecommissioningtrusts,settlementtrusts,andnonprofitvoluntary employeebenefit associations (VEBAs).For corporate-relatedfunds and property and casualty insurance companies, the maximumfederal tax rate of 35 percent is phased in once a certain threshold ofincome is received.Short- and long-termcapital gains areboth subject

Sourc

e:I

RS

Schedule

Y-1

(P

roje

cte

d2

00

4)

FIGURE18.2 MarginalVersusAverageTaxRate

TAXABLEINCOME MARGINALRATE PROJECTEDTAX AVERAGERATE

$ 10,000 10% $ 0 0.0%

$ 50,000 15% $ 6,785 13.6%

$ 100,000 25% $ 18,475 18.5%

$ 150,000 28% $ 31,957 21.3%

$ 200,000 33% $ 47,025 23.5%

$ 300,000 35% $ 80,025 26.7%

$ 500,000 35% $149,643 29.9%

$1,000,000 35% $324,643 32.5%


tothe35percentrate,buttheymaybeeligiblefora“dividends-receiveddeduction”of70percent.Forpropertyandcasualtyinsurancecompanies,municipalbondincomeisgenerallytaxedat15percentofthemaximumfederal tax rate,or5.25percent.Assets in thequalifiednucleardecom-missioningtrustaretaxedat20percent,ascomparedwith35percentinthenonqualifiedtrust.Theareaofestateplanningbringsinanadditionallevelofcomplexity,asanalysisoftaximplicationsmayincludethecom-ponentsofafter-taxreturnfromeachassetclassbeingconsideredinthemix, the tax characteristics of the typesof trustbeing considered, timehorizoncashflowandavailabilityof funds,andanypotentialvaluationdiscountforcontributingassetstothetrust.Withtax-deferredaccountsandinsuranceproducts,anyreductionintaxableincomefromthecon-tribution,withdrawal penalties imposedon earlywithdrawals, the leveloftaxondistributions,andwhetherdistributionswillbetaxabletotheestateareextremelyimportanttotheanalysis.Anyofthesetopicscouldandhavebeenthesubjectin-deptharticlesbythemselves.Therefore,itisclosetoimpossibleforanyoneinvestmentprofessionaltobecompletelyknowledgeableabouteveryfacetofthetaxcodeandestateplanningandtheimpactofeachonthevarioustypesoftaxableaccounts.However,withexperiencecomestheabilitytoasktherightquestionsandtoknowtoturntoqualifiedexpertswhenindoubt.

For individuals, estate taxes make the planning process even morecomplicated.TheEconomicGrowthandTaxReliefReconciliationActof2001affectedchild-related,educationandtuition,retirement-plan,andestate andgift taxprovisionsof the tax code.Themajor aspectsof theestateandgifttaxprovisionsareshowninFIGURE18.3.

Theprovisionsshownaboveclearlyhighlighttheimportanceoftax-awarepractitioners’beingcognizantnotonlyofcurrentprovisionsofthetaxcodefortheclientstheyservebutalsoofchangeslikelytotakeplaceinthefutureandhowthesemaybeaffectedbytheeconomicandpoliti-calclimate.

Toestablishanunderstandingofaclient’staxprofileforaparticulartaxableentity,thetax-awarepractitionershouldseekanswerstothefol-lowingquestionsfromtheclientorhisadvisers.

Generalquestions:1 Whatarethetypesoftaxableentitiesthatneedtobeanalyzed?2 Whataretheapplicablesectionsofthetaxcodethataddresseach

specifictypeoftaxableentity?3 Is this situation subject toanyadditional statutoryor regulatory

guidelines?4 Intheanalysisofthesituation,shouldtheclient’sorentity’smaxi-

mumoraveragetaxrate(s)beapplied?


5 Isthetaxableentitysubjecttostateandlocalrates?Ifso,whataretheapplicablerates?

6 Arethereothertaxesthatmustbeconsidered,suchasforeignwith-holdingtaxes?

7 Whenalltaxcomponentsareconsidered,whatistheentity’seffec-tivetaxrate?(Thereisusuallyadeductionforstateandlocaltaxesonfederaltaxreturns.)

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?

FIGURE18.3 EconomicGrowthandTaxReliefReconciliationActof2001

CALENDAR TOPESTATE/ ESTATE/GSTTAX GIFTTAX

YEAR GIFTTAXRATE EXEMPTION EXEMPTION

2001 55% $ 675,000 $ 675,000

2002 50% $1,000,000 $1,000,000

2003 49% $1,000,000 $1,000,000

2004 48% $1,500,000 $1,000,000

2005 47% $1,500,000 $1,000,000

2006 46% $2,000,000 $1,000,000

2007 45% $2,000,000 $1,000,000

2008 45% $2,000,000 $1,000,000

2009 45% $3,500,000 $1,000,000

2010 Repealed — $1,000,000

2011 55% $1,000,000 $1,000,000

Sourc

e:In

tern

alR

eve

rnueS

erv

ice


7 Whenapplicable,howwilldistributionsbetaxed?8 Ifthereisashortfallwithintheentity,whatimpactcanthishaveon

therequirementforadditionalcontributionsorthedollaramountofdistributions?

9 Whatistheneedforfunds,andhowarewithdrawalslikelytoaffectpotentialcapitalgainsrealization?

10Does the possibility of the alternative minimum tax need to beconsidered?

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,orwhathastobedonetoensureataxableeventisnottriggered?

6 Atwhatrate(s)arewithdrawalstaxed?7 Ifyouhavemorethanonemoretax-deferredentityasanoption,

doanyofthemhaveabeneficialestate-planningfeature?Ifso,whatisthevalueofthisbenefit?

Tax-related information canbeobtained throughdetailedquestion-naires,conversations,orexaminationofprevioustaxreturnfilings.Thereisnomethodthatisbest,asitdependsontheamountoftimetheclientiswillingtodevotetotheprocess,accesstomembersofthequalifiedtrium-virate,andtheexperienceofthetax-awarepractitioner.Typically,juniorprofessionals depend on detailed documentation and analysis, whereasseasonedprofessionalsmaycometothesameconclusionrelyingmoreontheir communication skills andpast experience.Themethodutilized isnotallthatimportantwhatdoescountiswhethertheadvisercapturesalltherelevantinformation,actsinthebestinterestsoftheclient,andcom-municateseffectively.

Laterinthechapter,PORTAX,themostsophisticatedcommerciallyavailablesoftwarefortaxableaccounts,ismentioned.Thisparticulartoolisidealforcomplexsituations,especiallyhigh-net-worthfamilies,wheremultiplegenerationsandvarious typesofestate structuresare involved.However,amuchsimplerapproachwillbeusedtohighlightthevalueofpositioningassetsbythetaxcharacteristicsoftheinvestingentity.Youdo


nothavetobeafamilyofextremewealthoralargetaxablecorporationtobenefitfromthiskeystep.Sinceanyonethatearnsincomeiseligibletofundanindividualretirementaccount,almosteveryonecanbenefitfromthisstepoftax-awareinvestmentmanagement.

Intheexamplethatfollows,wewillstartwithascenarioofanindi-vidual investor with three entities: a 401(k) plan, an IRA, and taxablepersonal assets.Readersmay evenwish to follow alongwith their ownpersonalsituation,astheyarelikelytocomeupwithasolutionthataddsenoughvaluetopayforthetextmanytimesover.

Theprocedureforpositioningassets/investmentvehicles(funds,sepa-rateaccounts,partnerships,andsoon)inatax-awaremannerincludesthefollowingsteps:

1 Listexistingfinancialassetsaccordingtotheirentity.2 Conduct an optimization of all financial assets using after-tax

assumptions.3 Analyze theprojected alpha and tax-cost ratio or relativewealth

measureofeachinvestmentvehiclebeingconsidered: a. 401(k) b. IRA c. Taxableassets4 Useaniterativeprocessto: a. Utilizethemostcompellingandtax-inefficientchoicesofthe

401(k). b. Positiontax-inefficientchoicesnotavailablethroughthe401(k)

intheIRA. c. Usethepersonaltaxableallocationassetstofundtax-efficient

vehicles,especiallyequities.

Using a systematic approach simplifies the tax-aware positioningprocess.

1 Listexistingfinancialassetsaccordingtotheirentity:Tobegintheexercise,theinvestororadvisersimplyneedstotakeaninventoryoftheexistingassets,asinFIGURE18.4.Inthisexample,thethreeentities—401(k),IRA,andpersonaltaxableassets—arelistedascolumnheadings.Thedollaramountoftheholdingwithineachenteredisenteredaccordingtoitsprimaryassetclassormajorsubcategorydesignation.Thisallowsforthecalculationofpercentagesbyentityandforthereviewoftheoverallpositioning.Intheexample,thetotalamountofassetsis$100,000.

The example in Figure 18.4 is very typical of naive asset allocationandlocationdecisionswhentaxesarenottakenintoaccount.Theforty-year-oldinvestordecidedona60percentequity/40percentfixedincomeallocation after hearing an adviser make a presentation at an employee


401(k)meeting.Sincetheadviserrecommendedallocatingaccordingtothe investor’s remaining timehorizon, the ruleof thumbof100minuscurrentagewasappliedtodeterminetheoverallequityallocationorinthiscase60percent(100–40yearsold).Additionally,theinvestorthoughtitwasprudenttoplace10percentofassetsincashequivalentsasasafetynet.Later,a10percentallocationtorealestateinvestmenttrustswasrecom-mendedforthemix,usingfundsfrompersonaltaxableassets,resultinginanoverallallocationof35percenttofixedincomeandcashequivalents,55percenttoequities,and10percenttoREITs.Sincetheinvestorisusingmutualfunds,allinvestmentsoutsidethe401(k)adheretoareasonable$2,000minimuminvestment.

Bynotbeingtax-aware,theinvestorhasmissedoutonseveraloppor-tunitycostsorpotentialsavings.Critical locationerrorsinthisexampleinclude:

1 Attemptingtoadheretothesamestrategictargetallocationacrossallentities.

2 Placinga liquidity reserveof cashequivalents in tax-deferredac-

FIGURE18.4 SampleClientFinancialAssetsInventory

TAX-DEFERRED PERSONAL 401(K) IRA TAXABLEASSETS TOTALASSETS

ASSETCLASS $AMOUNT % $AMOUNT % $AMOUNT % $AMOUNT %

CashEquivalents $ 5,000 10.0% $ 1,500 10.0% $ 3,500 10.0% $ 10,000 10.0%

IntermediateFixed-Income $15,000 30.0% $ 4,500 30.0% $ 5,500 15.7% $ 25,000 25.0%

DomesticEquity $22,500 45.0% $ 7,000 46.7% $10,500 30.0% $ 40,000 40.0%

Large-CapCore $ 7,500 15.0% $ 2,500 16.7% $ 0 0.0% $ 10,000 10.0%

Large-CapValue $ 5,000 10.0% $ 0 0.0% $ 5,000 14.3% $ 10,000 10.0%

Large-CapGrowth $ 5,000 10.0% $ 2,000 13.3% $ 3,000 8.6% $ 10,000 10.0%

Small-CapValue $ 2,500 5.0% $ 0 0.0% $ 2,500 7.1% $ 5,000 5.0%

Small-CapGrowth $ 2,500 5.0% $ 2,500 16.7% $ 0 0.0% $ 5,000 5.0%

InternationalEquity $ 7,500 15.0% $ 2,000 13.3% $ 5,500 15.7% $ 15,000 15.0%

RealEstate(REITs) $ 0 0.0% $ 0 0.0% $10,000 28.6% $ 10,000 10.0%

Totals $50,000 100.0% $15,000 100.0% $35,000 100.0% $100,000 100.0%


countswhenitisnotlikelytobeafactorforatleasttwentyyears.3 Holdingassets thatproducehigh taxable income in taxableper-

sonalfundsratherthanintax-deferredentities.4 Funding value-oriented equity strategies with personal taxable

assets funds andplacing indexor buy-and-hold growth-orientedfundsintax-deferredentities.

5 Using a total of twenty-one fundpositions to achieve the targetallocation,whichpresentsanadministrativeorlogisticalchallengejusttokeepupwiththeflowofinformation.

These types or mistakes are very typical, but costly. Over the pastfive years, academic research in this area has confirmed that individualhouseholdsandinvestorshavenotbeendiligentbyplacinghigh-taxable-income-generating asset classes and products in tax-deferred accounts.2Forexample,theinvestorisbetterofffinanciallyholdinganequityindexfund in a taxable account and taxable bonds in a tax-deferred accountinmostinstances.Partofthereasoninvestorsmayholdahighamount

FIGURE18.4 SampleClientFinancialAssetsInventory

TAX-DEFERRED PERSONAL 401(K) IRA TAXABLEASSETS TOTALASSETS

ASSETCLASS $AMOUNT % $AMOUNT % $AMOUNT % $AMOUNT %

CashEquivalents $ 5,000 10.0% $ 1,500 10.0% $ 3,500 10.0% $ 10,000 10.0%

IntermediateFixed-Income $15,000 30.0% $ 4,500 30.0% $ 5,500 15.7% $ 25,000 25.0%

DomesticEquity $22,500 45.0% $ 7,000 46.7% $10,500 30.0% $ 40,000 40.0%

Large-CapCore $ 7,500 15.0% $ 2,500 16.7% $ 0 0.0% $ 10,000 10.0%

Large-CapValue $ 5,000 10.0% $ 0 0.0% $ 5,000 14.3% $ 10,000 10.0%

Large-CapGrowth $ 5,000 10.0% $ 2,000 13.3% $ 3,000 8.6% $ 10,000 10.0%

Small-CapValue $ 2,500 5.0% $ 0 0.0% $ 2,500 7.1% $ 5,000 5.0%

Small-CapGrowth $ 2,500 5.0% $ 2,500 16.7% $ 0 0.0% $ 5,000 5.0%

InternationalEquity $ 7,500 15.0% $ 2,000 13.3% $ 5,500 15.7% $ 15,000 15.0%

RealEstate(REITs) $ 0 0.0% $ 0 0.0% $10,000 28.6% $ 10,000 10.0%

Totals $50,000 100.0% $15,000 100.0% $35,000 100.0% $100,000 100.0%

Sourc

e:D

ougla

sS

.R

ogers


of tax-exemptbonds in theirpersonal taxable assets isdueprimarily toprecautionaryinvestmentbehavior.Sincetax-deferredinvestmentsarein-tendedtobelong-terminnature,havingasufficientliquidityreserveinsuch“sleep-at-night”securitiesandfundsascashequivalentsandshort-termbondsisunderstandable.

2 Conductanoptimizationofallfinancialassetsusingafter-taxassumptions:Inchapter16,aprocedureforestimatingafter-taxreturnassumptionswaspresented.Conductingtheassetallocationoptimizationoranyotherfinancial-planningexerciseonanafter-taxbasisisessential,otherwisethepractitionerislikelytoachieveinaccurateresultsormislead-ingconclusionsthatwillbedetrimentaltowealthcreation.Continuingwiththeexamplefromstep1,calculatethebefore-taxstandarddeviationfortheoverallmix.Thenidentifyanefficientmixusingafter-taxassump-tionsforthesamelevelofrisk.Thisservesasafocalpointtoensuretheclient’s desired level of risk is maintained. In almost all cases, the newportfoliowillhaveagreaterallocationtoequitiesandahigherafter-taxreturn.Thisexercisecanbedonewithanyassetallocation/optimizationsoftwarepackagethatallowstheusertoadjustthethree inputvariables

FIGURE18.5 CriticalInformationforEntityLocation

401(K) IRA PERSONALTAXABLEASSETS TAX-COST TAX-COST TAX-COST UNREALIZED

ASSETCLASS ALPHA RATIO ALPHA RATIO ALPHA RATIO CAP.GAIN

CashEquivalents 0.0% 0.8% 0.0% 0.8% 0.0% 0.8% 0%

IntermediateFixed-Income 0.3% 2.0% 0.3% 2.0% 0.3% 2.0% 2%

DomesticEquity

Index/TM/ETF 0.0% 0.4% 0.0% 0.2% 0.0% 0.2% –5%

Large-CapCore 1.0% 1.5% 1.0% 1.5% 1%

Large-CapValue 2.0% 2.0% 2.0% 1.8% 2.0% 1.8% 15%

Large-CapGrowth 1.0% 1.5% 3.0% 1.0% 3.0% 1.0% –15%

Small-CapValue 4.0% 2.0% 4.0% 2.0% 4.0% 2.0% 30%

Small-CapGrowth 3.0% 2.0% 5.0% 1.5% 5.0% 1.5% 3%

InternationalEquity 2.5% 2.0% 3.0% 1.8% 3.0% 1.8% 12%

RealEstate(REITs) 2.0% 3.0% 2.0% 3.0% 20%


(returns, standard deviations, and correlation coefficients for each assetclass).Fortheremainderoftheexercise,insteadofa55percentequity/35percentfixed/10percentREITsallocationwewillassumethenewafter-taxefficientmixis60percentequity/30percentfixed/10percentREITs.

3 Analyze the projected alpha and tax-cost ratio or relativewealthmeasureforeachinvestmentvehiclebeingconsidered:Inthisexample,mutualfundsaretheinvestmentvehicleofchoice.Byresearch-ingMorningstarPrincipiaandanalyzingtheavailablefundsinthe401(k)andthoserecommendedforinvestment,wecanlisttheestimatedalphastatistic,tax-costratio,andthepercentageoftheunrealizedcapitalgainsforeachoptioninatemplatesimilartotheoneusedtoinventorytheini-tialassets(seeFIGURE18.5).

Inlieuofthetax-costratioorrelativewealthmeasure,youcanalsousetheleveloftaxableincometoconducttheanalysis.Theadvantageofthetax-costratioisitprovidesamorecompletepictureontaximplicationsofthefundoption,sinceitaccountsforthetaxfromcapitalgainsrealizationaswell.Additionally,thisexampleusesmutualfundsversusseparateac-counts.Therefore,theclientislikelytobemorefamiliarwiththetax-cost

FIGURE18.5 CriticalInformationforEntityLocation

401(K) IRA PERSONALTAXABLEASSETS TAX-COST TAX-COST TAX-COST UNREALIZED

ASSETCLASS ALPHA RATIO ALPHA RATIO ALPHA RATIO CAP.GAIN

CashEquivalents 0.0% 0.8% 0.0% 0.8% 0.0% 0.8% 0%

IntermediateFixed-Income 0.3% 2.0% 0.3% 2.0% 0.3% 2.0% 2%

DomesticEquity

Index/TM/ETF 0.0% 0.4% 0.0% 0.2% 0.0% 0.2% –5%

Large-CapCore 1.0% 1.5% 1.0% 1.5% 1%

Large-CapValue 2.0% 2.0% 2.0% 1.8% 2.0% 1.8% 15%

Large-CapGrowth 1.0% 1.5% 3.0% 1.0% 3.0% 1.0% –15%

Small-CapValue 4.0% 2.0% 4.0% 2.0% 4.0% 2.0% 30%

Small-CapGrowth 3.0% 2.0% 5.0% 1.5% 5.0% 1.5% 3%

InternationalEquity 2.5% 2.0% 3.0% 1.8% 3.0% 1.8% 12%

RealEstate(REITs) 2.0% 3.0% 2.0% 3.0% 20%

Sourc

e:

Dougla

sS

.R

ogers


ratiothanwiththerelativewealthmeasurepresentedinchapter8.Thereare limited investmentchoices inmost401(k)plans,andthe

fundselectionsavailablemaynotbeamongthebestintheirrespectivecat-egories.InFigure18.5,thedomesticlarge-capandsmall/mid-capgrowthequityfundsarelesscompetitivethansimilaroptionsofferedintheIRAandpersonaltaxableassetsentities.Thisiscommon,aswecaninvestinabroaderuniverseoffundswiththeIRAandpersonaltaxableassets.Inthisexample,theonlyrestrictionisfundsopentonewinvestmentandthosewillingtoacceptaminimuminvestmentof$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,thepercentageofunrealizedcapitalgains,isimportanttoavoidinvestingintoapotentiallysignificanttaxliability.Ifatax-efficientexchange-traded,in-dex,ortax-managedfundhasameaningfulunrealizedcapitalgainsposi-tion,itusuallyisnotamajorconcern.However,thesamecannotbesaidofactivelymanagedfundsnotknownforfocusingontaxefficiency.

4 Useaniterativeprocesstopositionthemostcompellingandtax-inefficientchoices inthe401(k); tax-inefficientchoicesnotavailablethrough the 401(k) in the IRA; and tax-efficient vehicles, especiallyequities, in the personal taxable assets: The target allocation, dollaramountineachentity,andthedesiredliquidityreservearerequiredbeforestartingtheiterativeprocess.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%

Theclienthasdecidedtheamountoftheliquidityreserveshouldbeequalto10percentofassets,andthefundsavailableineachentityis50


percenttothe401(k),15percenttotheIRA,and35percenttopersonaltaxableassets,withatotalamountagainof$100,000(seeFIGURE18.6).Theliquidityreserveneedstobesatisfiedbeforetheiterativeprocessbe-gins.Forsimplicity,wearegoingtoassumeallthepersonaltaxableassetsarebeingheldincashequivalentsandwedonothavetoconsiderembed-dedunrealizedcapitalgains.Previously,cashequivalentswereassignedinequalpercentagestoallthreeentities,buttheyshouldn’tbeusedintax-deferredentitiesbecausetheywouldbesubjecttoa10percentpenaltyifwithdrawnbeforeage59½.Therefore,step1inthetableistoallocate10percent,or$10,000,tocashequivalentsintaxablepersonalassets.Notethetax-costratioislistedat0.8percent,whichtakesintoaccountthepro-jectedreturnfromchapter16fortaxablecashequivalentsandthemaxi-mumfederaltaxrate.Wecouldjustaswellhavestatedamunicipal-bondcash-equivalentreturnand0percentforthetax-costratio.Whichtypeofmoney-marketfunddoesnothavetobedecideduntiltheimplementa-tion phase. At this time, we can ascertain if additional taxable incomemightplacetheclientinahighertaxbracketandwhichfundoffersthemaximumafter-taxreturn.FIGURE18.7(seepage258)differsfromFigure18.6,inthatithighlightsthestepsinvolvedinthe“worstcase–bottomup”and“bestcase–topdown”iterativeapproach.Somepeoplearecomfort-ablewiththetableformatofFigure18.6,whereasothersfindthe“bottomup/topdown”approachofFigure18.7issimplertoworkwith.Stillothersstartwiththebottomup/topdownapproachandthenlisteachstepinthetable.Thepointisthereisnothingmagicorsacredhere.Simplydowhateverworksbestforyouandyourclients.

In step 2, we look for the asset class with the highest potential taximpact.ThisiseithertaxableintermediatefixedincomeorREITs.Inthiscase,REITshaveahighertax-costratio,sowewillapplythisassetclassfirsttotheIRA,wherewehavethebenefitoftaxdeferralandavailability.Wenowturn to thebestcase–topdownselection. In this instance, theobjective is to place the most tax-efficient equity option in the taxablepersonal 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 the401(k) and save the remaining$5,000oftheIRAtochoicesthatgeneratehigheralpha,whichmightnotbeavailableotherwise.

Theiterativeprocesscontinuesuntilallfundsareaccountedfor.When using the iterative tax-aware positioning approach, interna-

tionalequityisquiteoftenthelastassetclasstobeallocated.Thisoccursbecauseitsrelativetaxefficiencyisbetweenthetax-efficientextremesof

tax-managedfundsandETFsononeendandtax-inefficienttaxablefixedincomeontheother.Whenthetaxablepersonalassetsarenear50percent,youshouldinvestigatewhethertheinternationalfundutilizesacurrencyoverlay strategy, as that would increase the tax-cost ratio. Internationalfundsthathedgecurrencypricemovementarebestsuitedfortax-deferredentities,andthismayinfluenceyourselectionofaparticularfundorfinalplacement.

TheexamplepresentedinFigure18.7isquitesimpleand,withexperi-ence,canbedoneinlessthanfifteenminutes.Assimpleasitis,position-ingbythetaxcharacteristicsof theentitiesandassetclasses/investmentvehiclesprovidesthefollowingmeaningfuladvantages:

1 Itachievestheoveralldesiredallocationandreducesthenumberofholdingsbyone-halformore—fromtwenty-onetoeleveninthisinstance.

2 Itusesaliquidityreserveonlywhereitmakessense.


FIGURE18.6 IterativeTax-AwareAssetPositioningProcess—TableFormat

TAX-DEFERRED TAX-DEFERRED PERSONAL 401(K) IRA TAXABLEASSETS TOTALASSETS

ASSETCLASS STEP# $AMOUNT % $AMOUNT % $AMOUNT % $AMOUNT %

CashEquivalents 1 0.0% 0.0% $10,000 28.6% $10,000 10.0%

FixedIncome 4 $20,000 40.0% $ 0 0.0% 0.0% $20,000 20.0%

DomesticEquity $17,500 35.0% $ 2,500 16.7% $25,000 71.4% $45,000 45.0%

Index/TM/ETF 3 $ 0 0.0% $ 0 0.0% $10,000 28.6% $10,000 10.0%

Large-CapCore $ 0 0.0% $ 0 0.0% 0.0% $ 0 0.0%

Large-CapValue 8 $10,000 20.0% $ 0 0.0% 0.0% $10,000 10.0%

Large-CapGrowth 5 $ 0 0.0% $ 0 0.0% $10,000 28.6% $10,000 10.0%

Small-CapValue 6 $ 7,500 15.0% $ 0 0.0% 0.0% $ 7,500 7.5%

Small-CapGrowth 7,9 $ 0 0.0% $ 2,500 16.7% $ 5,000 14.3% $ 7,500 7.5%

InternationalEquity 10,11 $12,500 25.0% $ 2,500 16.7% 0.0% $15,000 15.0%

RealEstate(REITs) 2 $ 0 0.0% $10,000 66.7% 0.0% $10,000 10.0%

Totals $50,000 100.0% $15,000 100.0% $35,000 100.0% $100,000 100.0%


3 It positions high-taxable-income-generating tax-inefficient assetclasses in tax-deferred entities and funds taxable personal assetswith investments thathave thepotential to generatemeaningfullong-termcapitalgains.

4 It ensures higher-capital-gains-generating value-oriented strate-gies arepositioned in tax-deferred accounts,whilebuy-and-holdgrowth, index, tax-managed, and exchange-traded funds occupypersonaltaxableassets.

Thissimpleexampleappliestoanyinvestorwitha401(k)plan,IRA,andpersonaltaxableinvestments.Inthesamplescenario,35percentoftheassetsaretaxable.Byreadjustingthelocationofthemix,thetaxbitewasloweredfrom$569to$295foranimprovementof$274eachyear.Thesedollaramountswereachievedbytotalingthetaxbite(tax-costratio×dol-laramountofinvestment)foreachoftheequityandREITpositionsin

FIGURE18.6 IterativeTax-AwareAssetPositioningProcess—TableFormat

TAX-DEFERRED TAX-DEFERRED PERSONAL 401(K) IRA TAXABLEASSETS TOTALASSETS

ASSETCLASS STEP# $AMOUNT % $AMOUNT % $AMOUNT % $AMOUNT %

CashEquivalents 1 0.0% 0.0% $10,000 28.6% $10,000 10.0%

FixedIncome 4 $20,000 40.0% $ 0 0.0% 0.0% $20,000 20.0%

DomesticEquity $17,500 35.0% $ 2,500 16.7% $25,000 71.4% $45,000 45.0%

Index/TM/ETF 3 $ 0 0.0% $ 0 0.0% $10,000 28.6% $10,000 10.0%

Large-CapCore $ 0 0.0% $ 0 0.0% 0.0% $ 0 0.0%

Large-CapValue 8 $10,000 20.0% $ 0 0.0% 0.0% $10,000 10.0%

Large-CapGrowth 5 $ 0 0.0% $ 0 0.0% $10,000 28.6% $10,000 10.0%

Small-CapValue 6 $ 7,500 15.0% $ 0 0.0% 0.0% $ 7,500 7.5%

Small-CapGrowth 7,9 $ 0 0.0% $ 2,500 16.7% $ 5,000 14.3% $ 7,500 7.5%

InternationalEquity 10,11 $12,500 25.0% $ 2,500 16.7% 0.0% $15,000 15.0%

RealEstate(REITs) 2 $ 0 0.0% $10,000 66.7% 0.0% $10,000 10.0%

Totals $50,000 100.0% $15,000 100.0% $35,000 100.0% $100,000 100.0%

Sourc

e:D

ougla

sS

.R

ogers


thepersonaltaxableassetsfortheinitialandrecommendedsolution.Thisisaboostinoverallperformanceof0.27percent($274/$100,000)alone.Plus,wehavemovedthefixedincomeallocationtothe401(k),wherethereturnsoftaxablebondscancompoundonatax-deferredbasis.

Thissamethoughtprocessappliesregardlessofthe levelofcomplexity.You can easily add columns for additional entities, and rows for assetclassessuchashedgefundsandprivateequity.Thisapproachprovidesasatisfactoryapproachtotax-awarepositioningfor99percentoftheassign-mentsfinancialplannersandconsultantstakeonforindividualinvestors.However,forultra-affluentclientswhohavenumeroustrustsacrossthreeormoregenerations,asystemthathasthecapabilitiesofPORTAXises-sential toachievemeaningfuloutput for furtheranalysis.PORTAXhastheaddedbenefitofincorporatingthecharacteristicsofeachentityandcashflowsintothefuture.Spreadsheetscanbeusedtoreplicatethispro-

FIGURE18.7 UsingBest-andWorst-CaseApproachIterativeTax-AwareAsset-PositioningProcess

TAX-COST GAINSTEP 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)

3 FixedIncome $20,000 0.3% 2.0% 401(k)

2 RealEstate(REITs) $10,000 2.0% 3.0% IRA

WorstCase–BottomUpS

ourc

e:D

ougla

sS

.R

ogers


cessinconjunctionwiththeafter-taxefficientsolutionfromtheoptimiza-tionsoftware,butitisacumbersomeprocessatbestandsubjecttohumanerrorbecauseofthevolumeofcalculationsinvolved.Whentheanalysisbecomes this complex, coordinationwith themembersof thequalifiedtriumvirate becomes more critical.The tax characteristics of each trustshouldbecoordinatedwithboththeaccountantandtheestateattorney.Moreimportant,iftheestateattorneydoesnotunderstandtheconceptoftax-awarepositioningofassets,youwillwastealotoftimerunningasset-locationsimulationsandwillhavedifficultyachievingconsensusonanoptimalsolution.

Whenaddressingthissubjectforthefirsttime,itishelpfultohaveafinancial-planning text for reference.There are about a dozen favoritesusedbycollegeprofessors.Thekeyistofindonethatworkswellforyourneeds.Aparticularlygoodone isPracticingFinancialPlanning forPro-fessionals,bySidMittrawith JeffreyKirkmanandGeorgeSeifert.3 It isextremelywellorganizedandthorough,whichsavesyoutimewhenthereisaneedtoaddressasubjectthatyoudonotdealwithonadailybasis.Sincethisareaofexpertiseissovast,itisdifficulttokeepupwithchangesdrivenbynewandinnovativeinvestmentproductsandtechniquesofeachnicheoftaxableaccountinvesting,aswellasthecontinualchangesinthetaxcodeandestate/regulatorymatters.

Toachieveanoptimalsolution,thepractitionermustaddresselementsunique to the type of taxable account investing, such as an individual,corporatefund,propertyandcasualtyinsurancecompany,nucleardecom-missioningtrust,medicalretirementtrust,andsoon.Whatfollowsisabrief discussionof key elements for investing for individuals.This areawaschosentodemonstratewhatisrequiredforthemajorityoftheread-ingaudience.Forthosepractitionersservinginotherareas,thisdiscussionshouldserveasanexampleofthecomplexitytheyarelikelytoencounter.

1 Taxableassets:Figure18.1showstheamountoftaxmarriedcou-plesweresubjecttoin2004,basedontheirlevelofincome.Therearefouradditionalitemsthatarekeyfortax-awarestrategy:gifting,federalestateexclusionamount,maritaldeduction,andstep-upinbasisatthetimeofdeath.

Currently,ahusbandandwifecaneachannuallygiftupto$11,000freeoftaxtoanyonetheychoose.Separately,duringtheirlifetimes,theycanmakeupto$1millioningiftsfreeoftaxes.Oneimportantstrategywithgiftingistotransfer$1millioninwealthtootherswheretheincomeandappreciationonthegiftedamountwillbesubjecttoalowertaxrate.

WiththeEconomicGrowthandTaxReliefReconciliationActof2001,thehighesttaxratesonthegiftandtheestatetaxbecamethesame,asFig-ure18.3shows.Fortaxyear2004,thetoptaxratewas48percentand


willdeclineto45percentfrom2007to2009.Theestatetaxisrepealedin2010,andthentherepealisreversedin2011withthetaxratesrevertingback to the2001 levelof55percentunlessCongress takesaction.Theexclusion amount for the estate tax is $1.5million in2004 and2005,increasesto$3.5millionin2009,andrevertsbackto$1millionin2011if, again,Congressdoesnot takeaction.Since theestate tax is amajorconcern,thereislikelytobemeaningfulchangetotheexistingprovisionssometimeduringthesecondtermoftheBushadministration.

Theunlimitedmaritaldeductionprovisionofthetaxcodeallowsforthetransferofassetsfreeofthegiftandestatetaxtothesurvivingspouse.Thiscanbeaccomplishedbythespousehavingcontrolofthepropertyorthroughalegalstructure,suchasaqualifiedterminableinterestproperty(QTIP)trust.

Thestep-upinbasiscurrentlyappliestoappreciatedpropertyorse-curitiesatthetimeofdeath.Thisfeatureprovidestheflexibilitytoreal-locate to other asset classeswithout generating substantial capital gainstax. Exchange funds are structured to take advantage of the step-up inbasis.Aconcentratedlow-cost-basisstockpositionistransformedintoawell-diversifiedportfolioofstocks.Thebeneficiaries,therefore,receivein-dividualstockspositionswherethecostbasisofeachsecurityequalsthemarketvalue.In2010,theprovisionsofthestep-upinbasisarelimitedto$3millionforthesurvivingspouseandanadditional$1.3millionforanybeneficiariesforatotalof$4.3million.Therearemanynuancesofthetaxcode,butthesearethefourmajorelementsthatapplytoindividualtaxpayersandshouldbetakenintoaccountwithanytypeofanalysisorplanning.

Keyquestionsrelatedtotheclient’spersonalassetsare:❑ Is the individualmakingannual gifts andhas the exclusionbeen

utilized?Ifnot,isthereanybenefittodoingthissoonerthanlater?❑ Whatistheanticipatedsizeofthetaxableestate?❑ Isitadvantageoustotakeadvantageofthemaritaldeduction,or

shouldaportionofassetsremaininthedecedent’sestate?❑ Whatarethelikelyestateexclusionamountandtheprojectedrate

oftaxonassetsexceedingthisamount?Haveotherlegalstructures(trusts)beeninvestigatedtolessenthetaxburden?

❑ Whatistheplanafterthestep-upincostbasis?Willthissuggestamajorshiftinthefamily’sstrategictargetallocation?

2 Tax-deferredretirementplans:Withtheexceptionoftheultra-affluent,thesetypesofentitiesoftencomprisethebulkofanindividual’sfinancialassets.Theycanbebrokendownintotwobroadcategories:de-fined-benefitanddefined-contributionplans.


Thedefined-benefitplanisalsoreferredtoasanemployerplan.Inthiscase, thecorporationguaranteescertainbenefits toqualifiedemployees.Anappropriateassetmixisdevelopedtakingintoaccountthecharacter-isticsoftheworkforceandthecostsofbenefitsoffered.Returnsgeneratedbythemixattempttomatchorexceedarate-of-returnobjectiveknownastheactuarialassumption.Mostrecently,defined-benefitplansoffinan-cially less-than-stablecompanieshavecomeunderpressure,becausetheactuarialassumptioninsomecasesnolongerreflectsreality.Sinceinterestratelevelshavefallendramaticallyandequitieshavebeenathighvalua-tionranges,assumptionsof8.5percentto9.0percenthaveanextremelylowprobabilityofbeingachieved.Akeyelementofdefined-benefitplansisthatfundingcontributionsbythecorporationtotheplan,uptocertainlevels,aredeductiblefromtaxableincomeandtheirappreciationistax-deferreduntiltheemployeeelectstoreceiveadistribution.Morecommontoday,especiallyforyoungeremployees,aredefined-contributionorindi-vidualretirementplans.Themostfamiliaristhe401(k)plan,ora403(b)planforanonprofitorganization.FIGURE18.8showstheamountthatcanbecontributedtoa401(k)bytheemployeewithanadditionalcatch-upprovisionforindividualsagefiftyandolder.4

TherearealsoKeoghplansfortheself-employedthatallowforfund-ingupto$42,000.Withdefined-contributionplans,theemployeeratherthan the corporation is responsible for determining the amount of thecontributionandmaking specific investmentelections.Foreverydollartheemployee setsaside, there is a reduction in theamountof reportedincomefor taxpurposes.Corporationstypicallymatchaportionof theemployee’scontributionuptoadesignatedlimit.Thesetwofavorablefea-turesalmostalwaysmakefundingthe401(k)planessentialandmaketheplanitselfthemostcompellingalternativeofanyentityoption.AstudybyStephenHoranfoundthe401(k)ispreferredoverthetax-deductibleIRAaslongastheemployermatchestheemployeecontributions.Additionally,theindividualisalwaysbetteroffwhendroppingfromthe28percentto

FIGURE18.8 AnnualEmployee401(k)ContributionLimits

YEAR CONTRIBUTIONLIMIT AGE50+CATCH-UP

2005 $14,000 $4,000

2006* $15,000 $5,000

*Indexedforinflationafter2006.

Sourc

e:

Inte

rnalR

eve

nueS

erv

ice


15percenttaxbracketuponcontributingtothe401(k)foranyinvestmenthorizonandforemployeematchingaslowas5percent.5

Other common types of defined-contribution plans include moneypurchasepension,profit-sharing,stockbonus,andemployeestockowner-shipplans.Keyquestionsformodelingretirement-planentitiesinclude:

❑ Whatportionoffundscontributedtotheplan,ifany,arededuct-iblefromincomefortaxpurposes?

❑ Doestheemployermatchanyoftheemployee’scontribution?Ifso,whatarethelimitsoftheemployermatching?

❑ For defined-benefit and defined-contribution plans that are theprimary responsibility of the employer, can the asset mix of theplanbedeterminedandincorporatedintheanalysis?

❑ Willdistributionsbesubjecttotaxatanyotherrateotherthantherateforordinaryincome?

❑ Havealltheeligibilityandvestingrequirementsbeensatisfied?Ifnot,whatistheirimpactandarethereanypenaltiesthatmustbeconsidered?

❑ Istheviabilityoftheplaninquestion?

3 Individualretirementplans:Individualretirementplansorac-counts(IRAs)areeligibletoanyonethathasearnedincome.Individualcontributionlimitsandcatch-upprovisionsareshowninFIGURE18.9.6

TherearetwotypesofIRA:traditionalandRothIRAs.ContributionscanbemadeuptoageseventyforeachtypeofIRA.Theprimaryadvan-tageof theRothover the traditional isdistributionsarenot taxed.ThetaxableportionofthetraditionalIRAdistributionissubjecttotaxattheordinarytaxrate,buttheinvestormaybeeligibleforafullorpartialde-ductionforthecontribution.Thedeductionsphaseoutin2005formar-riedcouplesfilingjointlythathavetaxableincomeof$70,000to$80,000.

FIGURE18.9 AnnualEmployee401(k)ContributionLimits

YEAR CONTRIBUTIONLIMIT AGE50+CATCH-UP

2005 $4,000 $500

2006–2007 $4,000 $1,000

2008* $5,000 $1,000

*Indexedforinflationafter2008.

Sourc

e:

Inte

rnalR

eve

nueS

erv

ice


Therearephase-outprovisionsfortheeligibilitytoparticipateinaRothIRA.Formarriedcouples,therangeis$150,000to$160,000.

InvestorseligibleforbothshouldtakethetimetoanalyzewhichtypeofIRAisbestsuitedfortheirpersonalsituation.Individualscanconductthe analysis themselves, using spreadsheetswithpresentor future valuecomputations.Fortunately,calculatorsareavailableontheInternettoal-low investors to determine which IRA is most advantageous for them.Lookforasitethatwillrequestthefollowinginformation:

❑ Contributionamount(s)❑ Currentandprojectedageatretirement❑ Expectedrateofreturnontheinvestmentportfolio❑ Currentandprojectedmarginaltaxrate❑ Marital statusandeligibility toparticipate inanemployer-spon-

soredretirementplan

InadditiontotheitemssuggestedaboveforcomparingthetwotypesofIRAs,youwillneedthedollaramountdesiredtobeconvertedandtheportionthatwasnottax-deductible.

Asgeneralrulesofthumb,researchconductedbyStephenHoran,Jef-freyPeterson,andRobertMcLeodsuggestsconvertingfromatraditionalIRAtoaRothIRAismostadvantageouswhen:7

❑ Theconversioncanbeconductedoptimallybypayingtaxconse-quenceswithnon-IRAassets.

❑ Thereisalongtimehorizon.❑ Theexpectedreturnishigh.❑ Theindividualwillbeinalowertaxbracketatretirement.8

Oneofthekeyelementsoftax-awareinvestingisthenecessitytokeepaccurate records.This is especially truewithdetermining the amountof theIRAcontributionthat isdeductible.IRSForm8606shouldbefiledfornondeductibleIRAs.AnothergoodhabittogetintoistoavoidmixingrolloverassetswithIRAsfundedthroughannualcontributionswhenchangingemployers.Theaccountingcanconsumeaninordinateamountoftimeandeffortandcreatearealheadacheinthefuturewhenyouattempttodeterminewhatportionofdistributionsyoualreadypaidtaxeson.

4 Educationplans:Individualshavefourprimaryoptionsforfund-ing education:529 savingsplans,Coverdell education savings accounts(education IRAs), UTGM/UTMA custodial accounts, and taxable ac-counts.Muchoftheliteraturethathasbeenprepareddoesnotcomparethefirsttwoalternativeswithtax-efficienttax-managedfundsorETFsinthetaxableaccount.Therefore,caremustbeexercised inmakingbroad


categorizationsof529plansoreducationIRAs,butthereisnodenyingthat 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.TheeducationIRAorCoverdelleducationsavingsaccountislimitedtofamilieswithadjustedgrossincomeupto$220,000anda$2,000an-nualcontributionperbeneficiary.The529collegesavingsplansarenotlimitedby individual’s adjustedgross incomeand feature amaximumcontributionperparticipantof$294,000.Asaresult,529plansareex-tremely popular with parents and grandparents capable of contribut-ingasubstantialamountoffunds,especiallywhenthecontributionscanqualifyasgiftsup$22,000annuallyforjointfilers.Additionally,couplescancontributeupto$100,000onceinfiveyearsandnottriggerthegifttax.There are also 529 prepaid and independent plans. Some of theseplanshaverecentlycomeunderpressureduetoconcernsaboutthefederalbudgetandthelessthanfavorablereturnsfromthefinancialmarketssincethebeginningof2000.

Earningsof the variousplans are tax-deferred. If funds areused forpurposesotherthaneducation,theyaretypicallysubjecttoa10percentpenalty.Likesomanyfacetsoftheindividualtaxcode,529plansarealso subject to sunset provisions in 2010. From an investment view-point529plansandeducationIRAsmake sense if the student isagetenor less.However, someeducationplans includecertainrestrictions,like which academic institutions qualify, that should considered beforeinvestinginthem.

5 Insuranceproducts: Increasingly, themostcontroversial typeofinvestingentityisthedeferredvariable-rateannuityforthesimplereasonthatwiththeevolutionofthetax-efficienttax-managedfundsandETFs,thereislessandlessreasontoownonewhenusingtraditionalassetclassesas theunderlying investment.However, salesactivityoftenexceeds$50billionannually,becausetheseproductsaresoldtoinvestorswhoareun-awareofthebetterreturnstheycouldgetfromtax-awarechoices.

There are two aspects thatmakedeferred annuities less competitivethan tax-awareproducts: fees and taxabledistributionsbeing subject tothe ordinary income tax rate. An annuity has several layers of fees. Asmentionedearlier,feesareaformoftax.Annuitieshaveadeathbenefit,butinterestinglyenough,thecostofthisbenefitgenerallyhaslittletodowithage.Whenthisfeeiscoupledwiththeunderlyingfundmanagementfee,totalfeestypicallyequal2percent.Fortunately,thereisaselectgroupofdiscountvariable-annuityprovidersthatofferproductswithtotalfeesintherangeof0.4to0.6percent.This isavast improvementover theaveragehigh-costalternative,butthisisstilltwotimestoasmuchassixtimes higher than the fee for a tax-efficient alternative mutual fund or


ETF.Fundsinvestedinavariableannuitybenefitfromcompoundingonatax-deferredbasis,butthetaxableportionofthedistributionistaxedatthehigherrateforordinaryincome.Ifyouhaveanequitymutualfundastheunderlyingoption,youareinessenceconvertingthelong-termcapi-talgainsportionofreturnintoordinaryincome,whichmakesnosense.Whenyouanalyzetax-managedfundsorETFsthathavelittleornocapi-talgainsgeneration,youconcludethatinmanycasesyouaregettingthetax-deferralmechanismofanannuityatafeeof0.2percentannuallyorlessandtheappreciationistaxedatthemorefavorablerateforlong-termcapitalgains.Additionally,ifthemarketisinitiallyunfavorable,youcanconducttax-lossharvestingtradeswithfundsheldinpersonaltaxableas-sets, which you cannot do with an annuity.This feature is not alwaysrelevantifthetax-managedfundhasasteeploaduponthesaleofshareswhenthetradeislikelytobeconsummated,whichwouldmostlikelybeinthefirstfiveyearsofownership,ifever.

One truebenefitof the annuity contract is that in about a thirdofthestates,annuitiesareprotectedfromcreditors.Foraphysicianwhosepersonalwealth ispotentially subject topatientmalpracticeclaims, thisfeature has genuine value.The one exception where the structure mayprovebeneficialfordeferredannuitiesiswithhedgefunds.Manyhedgefundstrategiesachievetheirreturnsthoughactivetradingthatgeneratesahighamountofshort-termcapitalandgeneratesincomesubjecttothehigherordinaryincometaxrate.Therefore,thetax-deferralmechanismismorevaluablethanwhentheinvestmentoptionisanequityindexfund,forexample,astheinvestmentisalreadyrelativelytax-efficient.

Studiesofvariableannuitiesoftencomparetheresultsachievedbytax-ablebondsheldinsideandoutsidetheannuity.Theprojectedreturnofthetaxablebondheldoutsidetheannuityisreducedbyataxhaircutre-flectingapotentialclient’santicipatedtaxrate.Theproblemwiththistypeofanalysisistheindividualsconductingthesestudiesoftendonotrealizeisthattax-exemptormunicipalbondsdonotgeneratereturnsequivalenttothehaircutforthemaximumfederaltaxrate.Typically,anintermedi-atebond indexwillgenerate returnsequal toapproximately70percentoftheindex,versus60percentaswouldbesuggestedifthefixedincomemarketswereperfectlyefficientonatax-arbitragebasis.Sothemunicipalbondusuallycarriestheday,unlessabondoflowercreditratingisusedinsidetheannuity.

6 SocialSecuritybenefits:Thiselementisusuallyavoided.Itislist-edherebecausesomefinancialplannersconsiderSocialSecuritybenefitsinthefinancialplanningprocess.SinceSocialSecuritybenefitshavetheirownsetoftaxramifications,theycanbetreatedasaseparateentity.Youreligibilityforfullbenefitsdependsontheyearyouwereborn.Ifdesired,


youcanbeginreceivingSocialSecuritybenefitsasearlyasagesixty-two,butyourbenefitswillbereduced.Also,thereisaformulatodeterminethelevelofeligibilityifyouelecttoreceivebenefitsatanagebetweensixty-twoandwhenyouarefullyeligible.SinceSocialSecurityispartiallytaxableincome,theremaybeanadvantagetotimingthedistributiondependingonotherpersonalfactorsifacouple’sincomeisgreaterthan$32,000.Ad-ditionally,dependinghowclosethecoupleisto$32,000,theplannerorsoftware solutionmaysuggestagreaterallocationto tax-exemptbonds,sincetheincomegeneratedisnotincludedinadjustedgrossincomeonthefederaltaxreturn.

7 Trusts:Trustscanaccommodateavarietyofplanningobjectives.Atrustisverysimplyalegalagreementunderwhichassetsareheldandman-agedbyonepersonforthebenefitofanother.Thetrusteeistheindividualresponsibleformanagingandadministeringthetrustassetsinaccordancewith theprovisions of the legal document.There aredifferent types oftrustsdesignedtosatisfyspecificobjectives.Theyareoftenidentifiedinterms of their relationship to the trustor’s (also commmonly called thedonor,grantor,orsettlor)life,aslivingortestamentarytrusts.Revocablelivingtrustsare typicallycreatedtoavoidtheprobateprocess,althoughtheyhavenoeffectonestatetaxesowed.Anirrevocablelivingtrust,whichcannotbealtered,mayhelpreduceincomeorestatetaxesbytransferringassetsduringthetrustor’slifetime.Testamentarytrustsarepartofthewillandbecomeeffectiveuponthetrustor’sdeath.Theirpurpose is tocon-serveortransferwealth.Sinceawillcanbechangedpriortodeath,thetestamentarytrustmaybechanged.Commontypesoftruststheprofes-sionalservingtaxableaccountsislikelytoencounterinclude:

a. MaritalorQTIPtrustb. Grantortrustc. Irrevocablelifeinsurancetrustd. Charitableleadandremaindertruste. Generation-skippingtrust

Othertypesofvehiclesthataresimilarintermsoftheirintendedpur-posearefamilypartnershipsandprivatefoundations.Inthefamilypart-nership,membersof the family canessentiallypool their resources andgain access to investment vehicles at a reasonable cost thatmaynotbeotherwiseavailable.Privatefoundationsallowfamiliestotransferhighlyappreciatedassetswhileobtainingacreditupto30percentofthetotalmarketvalueofthesecuritiesdonated.

Ifgainsandincomearenotdistributedtothebeneficiaries,thenthetrustmustapplyataxaccordingtothescheduleinFIGURE18.10.

Sincereachingthehighestfederaltaxcomesquickly,trusteesaregener-


allymotivatedtodistributeincomeandrealizedgainstothebeneficiaries,wheretheymaybetaxedataratelowerthanifintheyremaininthetrust.Obviously,investmentvehiclessuchastax-managedfundsandETFsthathaveahistoryofnotmakingrandomcapitalgainsdistributionscanbeoftremendousvalue,asitgivesthetrusteegreaterfreedomofchoiceindeterminingonhowtomanagedistributionsinatax-efficientmanner.Forexample,itismuchmoredesirabletosellaportionofanETFknowingtheproceedswillbesubjecttolong-termcapitalgainstreatmentthantoreacttoactivemanagersthatmayrandomlydistributegainssubjecttothehigherrateonshort-termcapitalgains.

Coordinationwithmembersofthequalifiedtriumviratebecomesex-tremelyimportantwhenattemptingtoestablishpayoutpolicy,especiallywhen certain charitable trusts are subject topriorityofdistribution ac-cording toordinary income, short-termcapital gains, long-termcapitalgains,andlastlytax-exemptincome.Thiscoordinationbecomescriticalasitmaydictatewhetherornotyouconsiderhedgefundsinthemix.Hedgefundscanservetoreduceoverallvolatilityandenhancetheprobabilityofachievingatargetreturnobjective,buttheyalsogenerateahighlevelofordinaryincomeandshort-termcapitalgainsthatmaybeadversetotheclient’soveralltaxprofile.Trustorestateplanningcanbeextremelycom-plex.Whentrustsareproperlymanaged,theycantrulyproducefantasticresults for all parties involved. However, when trusts are structured bytakinglibertieswithestate-planningtechniques,thetaxcode,orreason-ableinvestmentexpectations,theycanproduceresultsthatarelessthandesirableorevendetrimental.Thefollowingquestionsareprovidedinthe

Sourc

e:

CC

HT

ax

Law

Edit

ors

,2

00

4U

.S.

Mast

er

Tax

Guid

e(

Chic

ago:

CC

H,

20

03

),p.3

0.

FIGURE18.10 IncomeTaxRateScheduleforUsebyEstatesandNongrantorTrusts—2004

TAXABLEINCOME BUTNOT %ON OFTHEOVER 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

$9,550 – $2,468.50 35% $9,550


hopethat investorsandmembersof thequalifiedtriumviratecanavoidsomeofthecommonpitfalls.

❑ Isthetrustpropertyorassetssubjecttothemaritaldeduction?❑ Areopportunitiesavailablebygiftingbeingutilized?❑ Isthebestusebeingmadeofthemaritaldeduction?❑ Howwillthestep-upinbasisbeaccountedfor?❑ Willthevalueoftrustassetsbeincludedinthedecedent’sestate?❑ Doestrustincomehavetobedistributedannually?❑ Is thevalueof the trust assets included in the surviving spouse’s

estate?❑ Istheprojectedreturnonthetrust’sassetsrealistic?❑ Are thephilanthropic intentionsof the familybeing satisfied,or

aretheysogenerousthetrustormayhavedifficultymaintainingadesiredlifestyleinthefuture?

❑ Whatimpactdoesthestructureofthetrusthaveonthepotentialuseofspecificassetclasses,styles,andmanagertradingstrategies?

❑ Whenall fees(investment,custody,tax, legal,andsoon)areac-countedfor,canyoustilljustifythetrust?

❑ Does the trustee have an understanding of tax-aware investingprinciples and the ability to communicate effectively with othermembersofthequalifiedtriumvirate?

Questionsspecifictotax-awareanalysisandpositioninginclude:❑ Whatisthetermofthetrust?❑ Will incomebedistributedasordinary incomeorqualifieddivi-

dends,betax-exempt,orbesubjecttotheAMT?❑ Whatistheprojectcapitalgainsrealizationrate,andhowitismea-

sured for each fund/manager/partnership involved? What is theanticipatedsplitbetweenshort-andlong-termcapitalgains?

❑ What feesneed tobeaccounted for in theprocess, and towhatextentaretheydeductible?

❑ Whenassetsarecontributedtothetrust,aretheyeligibleforavalu-ationdiscount?

Considering the tax characteristics of each entity in theoverallmixcanaddmeaningfulvalueonanafter-taxbasis.Thespecificamountofincrementalreturn,whencomparedwithnaiveassetlocationthatutilizesthesamepercentageofeachassetclassacrosseachentity,dependsonthetaxcharacteristicsoftheentitiesinvolved,thedollarscontributedtoeachofthem,theavailableuniverseoffunds/managers/partnershipseachentitycanfund,andthetaxprofileoftheinvestororclient.Whiletheexercisetoachieveatax-awaresolutionmayatfirstappearcomplex,withexperience


itbedoneefficiently.Existingoptimizerscanbemodifiedtoachieveeffi-cientportfoliosbasedonreasonableafter-taxinputassumptions.Usinganiterativeprocesswillallowpositioningofinvestmentvehiclesthatarebestsuitedforthetaxcharacteristicsofeachentity.However,themostcom-plexsituationswillrequiresophisticatedsoftwaresolutions.Thebottomlineisthattax-awarepositioningbythetaxcharacteristicsofeachentityinvolvedcanaddconsistent,positiveresultsandshouldnotbeoverlookedbypractitionerswhentaxableaccountsandentitiesarepartoftheoverallassetmix.

ChapterNotes

1. CCHTaxLawEditors,2004U.S.MasterTaxGuide(Chicago:CCH,2003),28.

2. JamesM.PoterbaandAndrewA.Samwick,“TaxationandHouseholdPort-folioComposition:USEvidenceFromthe1980sand1980s,”NBERWorkingPaper,1999.

3. SidMittra, Jeffrey J.Kirkman, andGeorgeH.Seifert,Practicing FinancialPlanningforProfessionals(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,“AnAnalysisofNondeductible IRAContributions andRoth IRAConversion,”Financial Ser-vicesReview(1997),243–256.

8. StephenM.Horan,“AReexaminationofTax-DeductibleIRAs,RothIRAs,and401(k)Investments,”FinancialServicesReview(2001),87–100.


TheRoleofSystemsSolutionsin

Tax-AwareInvesting

271

Gradualimprovementinsystemstechnologyisallowingpractitio-ners to gain the information required to make more informedinvesteddecisionswhentaxesareafactor.Fifteenyearsago,the

generalconsensuswasthefirstaccountstohavethesophisticationtoad-dresstherequirementsoftax-awareinvestingwouldbethelargestaccounts.Thiswastrueforaboutadecade,but inthepastfiveyearsthemajorityof technology spendinghas shifted fromserving the largest accountsona stand-alonebasis tocreatingplatforms tohandle largenumbersofac-counts.Thereasonforthisshifthastodowiththeeconomicsofsoftwaredevelopment.Itisfarmoreprofitableforasoftwarefirmtotakeonasingleassignmentwithadeep-pocketedproviderthantoriskspendingthetimeandefforttomarkettolargetaxable-accountrelationshipsthataredifficulttoreach,wantacustomsolution,andinmostcasesareunwillingtopayareasonablepriceforthedeliverable.

There have been two noteworthy cases of attempts at platform de-velopmentthathighlighttherisksandpotentialforsuccess.ThecaseofmyCFO is an example of “a bridge too far.”There was a noble visionwithsufficientfinancialbacking,butthedeliverablefellshortofexpecta-tion.Ontheotherhand,LockwoodwasabletosecuretheexpertiseandexperienceofindustryveteranJayN.WhippleIII,thefounderofSecurity

Systemsof taxationneednotachieve the ideal.But the fact thattheConstitutiondoesnotdemandpurereasonandissatisfiedbypracticalreasondoesnotjustifyunreason.

—FelixFrankfurter

C H A P T E R 1 9

272 TheRoleofSystemsSolutionsinTax-AwareInvesting

APL,anddemonstratehowimprovementsinthefunctionalityofthebackoffice could lead to a scalable solution.Lockwoodwas acquiredby theBankofNewYorkin2002,whichprovideditwithatechnology-drivenplatformthatofferstax-awarestrategiesandafter-taxreporting.Thesuc-cessachievedbyLockwoodsettherestoftheindustryinmotiontoachieveequalorgreatersuccessorelserisklosingmarketshare.

TheauthorisextremelyappreciativeofJamesHollisofCutterAssociatesandMattSchottofTowerGroupforsharingtheirexperienceandexpertiseintheareaofsystemstechnology.HollisandhisassociatesatCutterusethephrase“portfoliomanufacturing”todescribetheapproachtoplatformdevelopmentthatwrapprovidersareembracing.Portfoliomanufacturingisapplyingmethodsandprocedurestypicalofindustrialautomationtotheportfoliomanagementprocesstoachievescaleandgreaterefficiencies.As“just-in-time”inventorycontrolhashadaprofoundimpactontheauto-motiveindustry,portfoliomanufacturingischangingthewaypractitionersapproachthemanagementofaccountswheretaxeshavean impact.Theuseofportfolio-manufacturingsystemshasthreeimmediatebenefits.First,ifproperlydesigned,portfolio-manufacturingsolutionshavethecapabilityofdeliveringauniformtax-awareapproachacrossthepractice.Second,itallows for quality control and compliance checks throughout the entireprocess.Third,acustomsolutionisnowpossibletoavoidpotentialcon-cernsoverconflictswithRule3a4coveringunregisteredmutualfunds.Ifwrapaccountprovidersadheretothisrule,theydonothaveregisterundertheInvestmentCompanyActof1940.Thewrapindustryhasbeencriti-cizedbecauseinmostinstancesitsmanneroftradingisnodifferentthana mutual fund’s, and clients do not have access to a solution that trulysatisfiestheirspecificneeds.AsHollisstates,“portfoliomanufacturingal-lows for customization in an automated environment.”1This concept isnot adreamor vision.Portfolio-manufacturing solutions arebeingnowimplementedthatwillhaveaprofoundimpactonhowthemembersofthequalifiedtriumvirateinteractwithclientsinthefuture.Unlikethetrendinsystemssolutionsfortheultra-high-net-worthmarketthatattempttoovercomeaccountingchallengeswithpartnershipsanddirectinvestments,the portfolio-manufacturing systems are providing tax-aware investmentstrategyandafter-taxreporting.Itisimportanttodistinguishbetweenthetwodeliverables.Taxsolutionsarefavoredbyaccounting-orientedCFOsoffamilyoffices,whereasportfoliomanufacturingoffersafarmorecom-prehensive solution capable of delivering substantial investment benefitsaswell.Anindicationofthepotentialthatcanbeachievedwithportfolio-manufacturingsolutionsisTowerGroup’sbeliefthatitisonlyamatteroftimebeforevendorswilloffersystemstoaccommodatepositioningofman-agersbythetaxcharacteristicsofeachentity,asdiscussedinchapter18.

TheRoleofSystemsSolutionsinTax-AwareInvesting 273

TowerGroupestimatesthatwrapaccountswillgrowby18.5percentayearandtotalassetswillgrowfrom$458billionin2003to$1trillionin2007.2Asaresult,itsanalysissuggestsspendingontax-awareoverlaymanagementserviceswillgrowfrom$6.3milliontomorethan$230mil-lionoverthesameperiod.3Themoneyisbeingspentbecausefirmsbelieveit isabsolutelyessential tohaveaviable technologyplatformtoremaincompetitiveandmanagetheassetsofretiredbabyboomers.Onecommonhurdlethatalmostallofthemajorwrapprovidershavehadtoovercomeisreplacingormodifyinglegacysystemsthatdonothaveatax-lotaccount-ingcapability.As in thecaseofafter-tax reporting,nothaving tax-lotaccountinghindersthedevelopmentofportfoliomanufacturing.

Toachieveatax-awaresolution,manywrapprovidersareembracing“overlaymanagement.”Noknowledgeableinvestorcangiveseriouscon-sideration to traditional wrap platforms when their average fee is 1.75percent.This is simply toohigh ahurdle.Once astute investors realizewhattheyaregettingforthecost,theywilllookelsewhereforamorecost-efficientsolution.However,withoverlaymanagementthewrapplatformofferstheinvestorsignificantimprovementinriskmanagementandthepotentialtosaveperhapsasmuchas1percentannuallyintaxsavings.4Theoverlaymanagementprocessisadministeredbyaqualifiedspecialist,whooftenservesasbothanadviserandamanager.Theterm“specialist”isusedherepurposely,soasnottoconfusethefunctionoftheoverlayman-agementprocesswiththeroleofmoneymanagers.Theprocesscanbeac-complishedbyallowingtheindividualmanagerstocontinuetotradetheirportfoliosandretainresponsibilityfortheirspecifictaxlots,ortheycaninformtheoverlayspecialistofbuyandselldecisionsbasedonamodelaccount.Itisthelatterformatthatisgainingacceptance,asitallowsforgreaterflexibilityandeaseofmanagementbytheoverlayspecialist.Typi-cally,thistypeofarrangementisdoneatareducedfee,becausetheoverlayspecialistassumesoperationalcontrolforactivityacrossallthemanagersintheclient’smasteraccount.Thisprocessmayatfirstseemlikea“black-box”solutiontotheinvestor,butitallowsforenhancedriskmanagementandtaxoptimization.

Theoverlayspecialiststartstheprocessmuchasaninvestmentadviserwould—byassistingtheclientinestablishingastrategictargetallocation,selecting managers, and incorporating appropriate constraints. Thesedutiesoftheoverlayspecialistresembletheadviserfunction.Therespon-sibilitiesoftheoverlayspecialistmaybedifferentfromfirmtofirm,buttheobjectiveissimilar.Theideabehindoverlaymanagementistoallowtraditionalmanagerstofocustheirattentiononselectingthebestsecuri-tiespossibleandallowtheoverlayspecialisttoserveasthe“quarterback”oftheoverallprocesstooptimizeoveralltaxefficiency.Itshouldbeno


surprisethatsomeofthefirmsofferingquantitativetax-awareportfolios,such asParametricPortfolioAssociates, alsoofferoverlaymanagementservices.Otherwell-knownoverlaymanagementprovidersareCiticorpandPlacemark.Toassist themintheircraft, thefirmsmentionedmayemployanoptimizerprovidedbyAxioma,Barra,ITG,orNorthfield.Anoptimizerisemployedtomanagethedesiredtrackingerrorrelativetoabenchmark,thewaytaxlossesareharvested,andthetradingcosts.Theoptimizersareoftenmodifiedtoprovideadesiredcustomsolution.Theoptimizationtechnologymustinterfacewiththeportfolioaccountingandtrade-ordermanagementsystems,whichallowsfortradesfromnumerousaccountstobebatchedandtransactedinacost-effectivemanner.

Theoverlayspecialistplaysacriticalroleintheallocationofassetstoeachmanagersecurityoverlapanalysisacrossthemanagers,andtaxman-agement. Challenges can arise with overlay management. For example,onemanagermaybesellingasecurityataloss,whileanotheriscontem-platingpurchasingit.Ifnotchecked,thistypeofactivityhasthepossibil-ityof violating the thirty-daywash sale rule.Therefore,managersneedtoreceiveinformationtoalertthemtopotentialwashsaleviolations.Toovercome these typesof challenges, rules-based solutions are instituted.Thesemayaddressissuessuchasindividualsecurityconstraints,changesinthetargetallocation,contributionsandwithdrawalsfromtheaccount,timingofpurchasesandsales,differenttaxrates,stateofresidence,andthealternativeminimumtax.Somemoneymanagersareunwillingtoacceptlowerfeesandturntheirmodelportfoliosandtradingauthorityovertotheoverlayspecialist,especiallyifthestrategyfocusesonless-liquid,thinlytradedsmall-ormicro-capitalizationsecurities.Differentchallengesarisewithfixedincomesecurities,sincetheyaretradedinasecondarymarketratherthanonanexchangewithfullpricetransparency.

Whenyoucomparethe investmentmanagement industrywithoth-erfields, it isreallyinaprimitivetechnologicalstate.Therealbeautyofportfoliomanufacturinglies initspotentialtocompletely integrateandstreamlinethedevelopmentoftheinvestmentpolicystatement,assetal-location, account-opening procedures, accounting, and performance-reporting functions.This typeof start-to-finish seamless solution isbe-ingaddressedinvariouswaysbyfirmssuchasADVISORport,Smartleaf,SoftPak,Tamarac,Vestmark,andVistaAnalytics.Therearealsofirmsthatspecializeintradingandcompliancemodules,likeCharlesRiver,LatentZero,andLinedataLongView.Thesefirmsoffercompleteoutsourcingoranàlacartesolution.Thecostsavingsfortheadviserandthesolutionof-feredtheinvestorarefarsuperiortoanythingadviserscanpatchtogetheron their own.When manager recommendations and custom reportingtemplatesareincluded,theadviserhasthepotentialtobrandtheoverall


package.GettingthejobdoneoftenrequireshiringconsultingfirmslikeCutterAssociatesorTowerGroup just togainanunderstandingof thelandscapeandwhoiscapableofsolvingaspecificneed.

Portfolio-manufacturingplatformsarenotwithoutrisk.Failuretose-lecttherightprovidercanbeextremelycostlytocorrect,whichistrueofanycustodialorreportingplatform.Whilethequalityandscopeofthesesupplierscontinuestoimprove,theprimaryriskstotheadviserandtheinvestorarethefinancialhealthofthesupplierandthequalityoftheun-derlyingmanagers.

Advisersneedtohaveahighdegreeofconfidencethesoftwareprovid-erwillbeabletoevolveastheirbusinessmodelandtheindustrychange.Interesting technology plays are emerging daily, but only a few will beabletoachievethecriticalmassnecessarytoremainprofitable.Therefore,itisimportanttoevaluatenotonlythequalityofthedeliverablebutthefinancialwherewithalofthecompanyaswell.

Portfoliomanufacturingoffersthepotentialtodeliveracost-effectivesolution,buttheoverallperformanceofthemanagersintheprogramwillhavethemostimpactonclientretention.Outstandingperformancestillhasawayofovercomingothershortfalls,butiftheoverallperformanceafterfeesandtaxesisnotonaparwithacombinationoflesscostlytax-awaremutualandexchange-tradedfunds,theplatformswillprovetobenothingmorethancostlyentertainment.Therearefourmajorconcernswithmanagerselectionandretentionthatwillinfluencetheultimatesuc-cessofindividualwrapplatformsandthisnicheoftheassetmanagementindustryasawhole.

Efficienciesachievedbyportfoliomanufacturingaredrivenbyvolume.Therefore,thegreatest inhibitortoachievingcompellinginvestmentre-sultsisemployingmanagersinassetclasseswheretheabilitytogeneratealphadiminishesquicklywithan increase inassetsundermanagement.Onceadvisersandconsultantsrecognizethis,theresultingflowoffundsoften drives performance more than picking the right securities does.Quitesimply, ifasmall-capitalizationmanagertransactinginless-liquidsecurities receives ahigherproportionof funds than its respective assetclass,continualpurchasingofstocksinthemodelportfoliowillnaturallyleadtosuperiorperformance.Atsomepoint,managersreachalevelwherethetimerequiredtosellapositionbecomessogreattheonlywaytheycanaccomplishthetaskwithoutseverelyaffectingthepriceofthesecurityisthroughamergeroracquisitionbyanothercompany.Whenthispointisreached,orthemanagerexperiencesanoutflowoffunds,theperformanceofclientaccountsthatremaininvestedwiththefirmsufferaccordingly.

Toovercomethefirstchallengepertainingtoassetsundermanagementrequires that analystsbe able to identify emergingmanagerswith short


trackrecords.Seasonedanalystswithextensive industryexperiencewhocanevaluatemanagersonprocessandotherintangiblesversusquantita-tivemeasuresarenecessarytoaccomplishthistask.Unfortunately,mostfirmsshortchangetheirresearchfunction,andyounginexperiencedana-lystsbasetheirdecisionsprimarilyonquantitativescreensandmeasures.Therefore,thesecondchallengeistoconstruct,orfortheinvestortoiden-tify,aplatformthatbuildsarecommendedlistofmanagerswhofocusontheprocessesthatwillleadtosuccessratherthansuperficialperformance.

Thethirdchallengepertainstofees.Oncemanagersarefound,theyneedtobeconvincedthatbeingcaptivetoawrapplatformmakessense.Amanager’sreputationcanbedamagedthroughinvolvementinawrapplat-form,asdiscriminatingbuyerssimplywillnotdealwithfirmsthatyieldto theasset-gatherermentality.Moreover,other thandiversifyingacrossdistributionchannels,whyshouldsmall-capitalizationmanagersdiscounttheirfeewhentheyhavelimitedcapacity?Thefirmsthathaveanexclusiveofferingrealizetheydon’tneedtobendtofeediscountsandwon’t.There-fore,itisdifficulttomaintainthequalityoftherecommendedmanagerslistunlessfavorabletermscanbeextendedtothemostattractivefirms.Asflowstomanagershaveslowedoverthepasttwoyears,investmentman-agerswhohavenotreceivedmeaningfulflowsarenowlookingforwaystogracefullyexitwrapandquasi-wrapseparateaccountplatforms.Theyaresimplynotbeingpaidenoughtoovercometheintricaciesofperfor-mance composites, higher-than-anticipated servicing requirements, anddemandsforfeeconcessionsandloweraccountminimums.Tosucceed,theplatformprovidersneedtobewillingtooffermanagersreasonablefeesanddemonstratetheycanprovidemeaningfulflowsoffunds.Addition-ally,theyneedtohavetheoperationalefficienciesnecessarytorespondtomanagers’requestsforinformationinordertosatisfytheirfirm’sclaimofcompliancewithAIMRreportingstandards,ifdesired.Ifaninvestmentmanagerisgoingtohaveexposuretowrapaccounts,thenitisbestdonewithoneorafewcredibleproviderswherethemanagerwillhavegreatercontrol.Fortheplatformprovidertoofferarecommendedlistofmanagersofthemajorwrapmanagersjustincreasestheprobabilitytheinvestorwillreceivenomorethananexpensiveindexsolution.

Thelastandfourthchallengehastodowiththetransaction-orientedmentalityofretailbrokeragethatcanspillovertowrapplatforms.Whiletechnologymayprovide a viable solution, someone still needs to com-municatewithandeducatetheclient.Unfortunately,thereisstillapor-tionofthemarketthatapproacheswrapmanagerslikeindividualstocksandterminatesthemfartoofrequently.Thecostofchangingmanagersishighenoughinthetax-exemptarenabutisevenhigherwithtaxableac-countsthatmissthebenefitofcompoundingreturnstax-free.Thisisone


reasonwhythesophisticatedelementofthemarketavoidsrecommendingmanagerswhoparticipateinwrapassignments,astheydonotwanttheirportfoliovaluesinfluencedbythewhimsofthewrapmarket.

Tovaryingdegrees,thefourchallengesnotedcanbeovercome.First,theplatformneedstoadoptadefinedphilosophytodrivethedecision-makingprocessinamannerconsistentwiththecultureoftheorganization.Itshouldbenosurprisethatadoptingportfoliomanufacturingwillhaveameaningfulimpactonthecultureofthefirm.Sinceitisprocess-oriented,itwillnaturallydirectbehaviorinacompliance-orientedfashion.Forthebenefitsoftax-awareinvestingtotakehold,theoverlayspecialisttakesontheportfolio-constructionroletoachieveconsistency.Professionalsofthefirmwhohavehadthefreedomtostructureclientportfoliosaccordingtotheirownpersonalbiaseswillfindtheseplatformstoberestrictive.Unlesstheycanaccept thebenefitof the tax-awareapproachandrefocus theirattentiontowardeducation,sales,andservicingactivity,theywillbelesseffective than individualswho arenew to the environment anddonotcarrythebaggageofthepastwiththem.Thisisthesameprocedurebanksgothroughwhentheir internalportfoliomanagersmustadjusttoopenarchitecture platforms, as they soon discover clients place less value ontheirindividualsecurityselectionskillsthanontheoverallmanagementoftheprocess.

Amajorplusofportfoliomanufacturingistheabilitytodeliveraqual-ityperformancereport.Firmsarespendingmoreandmoreeffortontheperformancereport,astheyrealizeitistheonecommunicationtoolthatcandistinguishthefirm.Todosomayrequireobtainingtheservicesofother parties for pricing, security characteristics, benchmark and peer-groupcomparisoninformation,etcetera.Withportfoliomanufacturing,theseoutsidetoolscanbebroughtinasneeded,inacost-effectivemanner,toenhancethecontentofthereport.Flashperformancereportscanalsobecreatedtoprovidemoretimelyinformation.Innovativesolutionsarebeingappliedtocompressthetimebetweentheendofthereportingperiodandthedeliveryofthefinalreporttotheclient.Inparticular,consultantsareheldhostagetowaitingonpeer-groupinformationcompiledfromsep-arateaccountmanagers.Toovercomethischallenge,mutualfundreturnsarebeingused to create customcomposites,which are availablewithinseveraldaysaftertheendofthereportingperiod.Inmanyplatforms,us-ing separateaccount informationmakes little sense,becauseofaccountminimums.Ifyourclientsareinvestinginequitymanagersthatwillacceptminimumsof$500,000orless,whycomparethesemanagerswithapeergroup universe where 75 percent of the managers have higher accountminimums than the client is eligible for? Using mutual and exchange-traded fund information is actuallymore relevant,because it represents


theresultsofatrueinvestablealternativetotheseparateaccountmanagersavailableintheplatform.

Adoptingaportfolio-manufacturingapproachmakestheinvestorcli-entmoredependentontheplatformprovider.It isdifficulttoquantifythisbenefitindollarsandcents,butitisimmensefromaclient-retentionstandpoint.Portfoliomanufacturingfacilitatescreationofavarietyofre-portingdeliverablesthatcanbeautomaticallysentbyregularorelectronicmailthroughouttheannualandquarterlyreportingcycle.Forexample,thesystemcouldcreateacustomreportinNovembertoaddressyear-endtax issues.Duringthequarter,variousreportscanbesentatdesignatedintervalstokeepremindingthemofthebrand.Thiscapabilitycanservetoeducateclientsonadditionalproductofferingsthatcanrangefrominsur-anceproductstocommoditiesandhedgefunds.Theseadditionalproductofferings can increase revenue and enhance the profitability of existinginvestorrelationships.At thesametime,gradual systematicupwarden-hancementof theportfolio-manufacturingapproachmakesthe investorincreasinglydependentontheprovider.Ifacompleteintegratedapproachisachievedthroughportfoliomanufacturing,thelogisticsinvolvedsimplybecometooonerousfortheinvestortoevenconsidermovingtoanotherplatform.

Therearestilldoubterswhodonotbelieveitispossibletoachievetheidealinvestorexperiencethroughautomation.Attorneysespeciallyfinditdifficulttoacceptthattheircraftcanbecapturedthroughtechnology,astheyseeestateplanningasanartformthatdoesnotlenditselftoasystemssoftwaresolution.However,ifyouhavethenecessaryinputvariablesandthehumanmindcansolveaproblem,asystemssolutionispossible.Back-groundinformationcannowbeaggregatedandanalyzedinasystematicfashion.Alongtheway,advisersassisttheinvestorbysittingside-by-sidetoanalyzevariousoptions.Decisionscanbemadequicklyanddocumentscanbeprintedandsignedtosatisfycompliancerequirements.Moreover,systemssolutionshavethebenefitofcreatingalternativesolutionswithoutpersonalbias.Thisallowssolutionstobeconsideredthatanattorneymaypossiblyoverlook.Softwaredevelopersthatcancapturetheknowledgeofqualifiedaccountants,estateattorneys,andinvestmentprofessionalshavethepotential tocreatetax-awaresolutionsandpresent informationthatcanbeeasilyunderstoodbyallpartiesinvolved.Thisenhancedcapabilitywillchangetherolesofthequalifiedtriumvirate,asitsmemberswillnolonger need to spend an inordinate amount of time analyzing existingholdingsandpreparingalternativesolutions.Theseactivitieswillbedoneforthem.Intheportfolio-manufacturingenvironment,practitionerswillbeabletospendtheirprecioustimeonreviewingpotentialsolutionstoachieveoptimalresults.


Withthepropersecurity,thereisnothingstoppingtheadviserfromtaking theprocess to the investor’shomeoroffice throughtheuseofaportablecomputer.Thevirtual,Web-basedsolutionisalsoarealitythatwillsavetimeandallowfornearreal-timeaccess.Thistypeofaccesscanunfortunatelybeadouble-edgedsword.Technologyisgreat,butdailyac-cessoftenfacilitatestheday-tradingmentalitythatisdetrimentaltowealthcreation. Therefore, firms need to consider carefully how informationshouldberepresentedtoensureitisconsistentwithatax-awareapproachtoinvesting.

In thepast, retail andultra-high-net-worthplatformproviders havehaddifficultyestablishingcredibilitywiththeirclient investors,becausetheapproachtoplanning,investment,after-taxreturnreporting,andtaxreportingneedsisinconsistentfortheassetsoftheirtypicalrelationship.Inalmosteverycase,oneitemisgivenpriorityattheexpenseofothers,dependingonthedistinctivecompetenceoftheplatformprovider.Mas-tering portfolio manufacturing for the base-level investor client on theplatformestablishesasolidfoundationforfuturedevelopment.Thebasicsincludeitemsliketax-lotaccountingandamortizationandaccretionforfixedincomesecurities.Oncetheplatformmastersthedeliverableforthesimplestclientonitsplatformitcanbegintoallocatedevelopmentdollarstosolvetheneedsofclientsofincreasingwealth.Gettingthisrightputstheplatformproviderinanenviablepositionofbeingabletocaptureandretainasignificantportionofthevastbaby-boomermarketthatisgradu-allyrollingoveritsqualifiedemployerretirement-planassetstoIRAs.Theconsequencesofmissingthismacroeconomictrendaresoseverethatfirmsfeeltheymustcommitampleresourcestoprotectorenhancetheirexist-ingmarket share.Therefore, the emphasis onportfoliomanufacturingwill ensure that tax-aware investing and after-tax reporting receive theprominencetheydeserve.

ChapterNotes

1. JamesHollis,indiscussionwiththeauthor,July19,2004.

2. MattSchott,“DiscretionaryOverlayManagement:TheRoutetoNotsoSepa-ratelyManagedAccounts,”TowerGroupinternaldocument,2003,4.

3. MattSchott,“DevelopingScaleforManagedAccounts:AreOverlayProvidersSittingintheCatbirdSeat?”TowerGroupinternaldocument,2003,4.

4. RonPruitt,“AComprehensiveViewofAfter-TaxInvestingandTaxEfficiency,”SeniorConsultantvol.6,no.5(May2003):1–6.


Theregoesanothertax-awareinvestorlaughingallthewaytothebank!

—DouglasS.Rogers

S U M M A R Y

281

Tax-aware investmentmanagementreallyboilsdowntomasteringfoursimplesteps: 1 Utilizingafter-taxassumptionsintheassetallocationprocess

2 Allocatingassetclassesandmanagers/fundsaccordingthecharac-teristicsofeachentity

3 Tax-awareequitymanagerpositioning4 Identifyingtax-awaremanagers/funds

Atfirst,theymayseemcomplicated,butthrougheducationandex-perienceanyopen-mindedadviserorinvestorwhodesirestocapturetheopportunityforwealthcreationinherentintheprocesscanmasterthem.

Whiledevelopmentsof thepastdecadehave significantlyenhancedourknowledgeoftax-awareinvestmentmanagement,therearestillareasthatrequiresignificantresearch.Theseincludetopicssuchasdetermin-ing the precise range for rebalancing target allocations, accounting forunrealizedcapitalgainspositionsintheafter-taxreportingprocess,andportfolioattributionthatincludestheimpactoftaxesonsecuritybuyandselldecisions.Solving thesechallenges requires solutions thatmightbeasradicalas tax-aware investmentmanagementwasonlya fewdecadesearlier.

Thepoliticalwindsarecertaintochangethetaxcodeinthefuture.Whileratesmaychange,deductionsmaybeeliminated,andtruesim-plificationmayevenbeadopted,theprinciplesoftax-awareinvestmentmanagement will endure.The key for continued success of tax-awareinvestment management lies in education and the basic profit motiveinvolvedintheprocess.Educationregardingtax-awareinvestmentman-agementwillcontinuetogainmomentum,becauseyoungdegree-andcertification-seekingprofessionalswillsimplydemanditandseekuni-

versitiesandorganizationscapableofsatisfyingtheirthirstforknowledge.Theprofitincentiveisalreadyinplaythroughportfoliomanufacturing,andthespoilswillgotothosefirmscapableofdeliveringsystemstechnol-ogythatwillprovideaclearcompetitiveadvantageinthefuture.There-fore,theknowledgeandapplicationoftax-awareinvestmentmanagementisnolongeraluxurybutanecessityforfuturesuccess.

282 Summary

A P P E N D I X

TopFederalIncomeTaxRatesonRegularIncomeandCapitalGainsSince1916

283

TOPRATEAPPLIES TOMARRIED

TOPRATEON TAXABLE TOPRATE REGULAR INCOME ONCAPITAL NOTESON YEAR INCOME OVER GAINS CAPITALGAINSTREATMENT

1916 15.0% $2,000,000 15.0% Sametaxrateas

regularincome

1917 67.0% $2,000,000 67.0% Sametaxrateas

regularincome

1918 77.0% $1,000,000 77.0% Sametaxrateas

regularincome

1919–21 73.0% $1,000,000 73.0% Sametaxrateas

regularincome

1922 58.0% $200,000 12.5% Maximumrateof12.5%

1923 43.5% $200,000 12.5% Maximumrateof12.5%

1924 46.0% $500,000 12.5% Maximumrateof12.5%

1925–28 25.0% $100,000 12.5% Maximumrateof12.5%

1929 24.0% $100,000 12.5% Maximumrateof12.5%

Sourc

e:

Cit

izens

for

Tax

Just

ice,

May

20

04

TOPRATE APPLIESTO

TOPRATEON MARRIED TOPRATE REGULAR TAXABLE ONCAPITAL NOTESON YEAR INCOME INCOMEOVER GAINS CAPITALGAINSTREATMENT

1930–31 25.0% $100,000 12.5% Maximumrateof12.5%

1932–33 63.0% $1,000,000 12.5% Maximumrateof12.5%

1934–35 63.0% $1,000,000 31.5% Slidingexclusionof

70%>10yrs;0%<1yr

1936–37 78.0% $2,000,000 39.0% Slidingexclusionof

70%>10yrs;0%<1yr

1938–40 78.0% $2,000,000 30.0% Excl.50%>2yrs;

67%18-24mos;

0%<18mos;30%max

1941 80.0% $2,000,000 30.0% Excl.50%>2yrs;

67%18–24mos;

0%<18mos;30%max

1942–43 88.0% $200,000 25.0% Exclusion50%>6months;

25%maximum


25%maximum


25%maximum


25%maximum

1950 84.4% $200,000 25.0% Exclusion50%>6months;

25%maximum


25%maximum


25%maximum

1968 75.3% $200,000 26.9% VietnamWar10%surtax

forpartofyear

1969 77.0% $200,000 27.5% VietnamWar10%surtax

Sourc

e:

Cit

izens

for

Tax

Just

ice,

May

20

04

284 Appendix

TOPRATE APPLIESTO


1970 73.5% $200,000 32.3% Higherratephase-in;

VietnamWar5%surtax;

minimaltaxeffects

1971 70%/60% $200,000 34.3% Higherratephase-in;

50%toprateonearnings;

minimaltaxeffects

1972–75 70%/50% $200,000 36.5% 50%exclusion,minimal

taxeffects

1976–77 70%/50% $203,200 39.9% 50%exclusion,minimal

taxeffects

1978 70%/50% $203,200 39.0% 50%exclusion,minimal

taxeffects;

lateyearreduction

1979–80 70%/50% $215,400 28.0% 60%exclusion

1981 70%/50% $215,400 23.7% 50%or60%exclusion

transition

1982–86 50.0% $215,400 20.0% 60%exclusion

1987 38.5% $192,930 28.0% 28%maximumrate

1988–90 28%/33% seebelow* 28%/33% Realizedgains

taxedsameas

asotherincome

1991–92** 31.0% $84,300 28%(28.9%) 28%(28.9%)

(31.9%) maximumrate

1993–96** 39.6% $255,100 28%(29.2%) 28%(29.2%)

(40.8%) minimumrate

1997–2000** 39.6% $280,300 20%(21.2%) 20%(21.2%)

(40.8%) maximumrate

2001** 39.1% $297,350 20%(21.2%) 20%(21.2%)

(40.3%) maximumrate

2002** 38.6% $307,050 20%(21.2%) 20%(21.2%)

(39.8%) maximumrate

Sourc

e:

Cit

izens

for

Tax

Just

ice,

May

20

04

Appendix 285

TOPRATE APPLIESTO


2003–05** 35.0% $319,100 15%(16.1%) Capitalgainsrate

(36.1%) alsoappliesto

dividends

2006–07** 35.0% $338,525 15%(15.7%) Capitalgainsrate


dividends

2008** 35.0% $351,250 15%(15.4%) Capitalgainsrate


dividends

2009** 35.0% $360,050 20%(20.4%) Dividendsreturnto

(35.4%) regulartaxrates

2010 35.0% $369,050 20.0% AllBushtaxcuts

expireafter2010

2011on 39.6% $378,250 20%(21.1%) 20%(21.2%maximum

(40.8%) rate)

Notes: The definition of taxable income varied very substantially over the years.

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).

Sourc

e:

Cit

izens

for

Tax

Just

ice,M

ay

20

04

286 Appendix

ContinuingEducationExam forCFPContinuingEducationCredit andPACERecertificationCredit

EarnfivehoursofcredittowardyourCFPBoardcontinuing-educationrequirementaswellasPACERecertificationcreditbypassingthefollowingexamonlineatwww.bloomberg.com/ceandenteringcode1576TAX8.

AllthematerialhasbeenpreviewedbytheCFPBoardofStandards.Ifyouwishtofindout if thisbookandexamcanbeusedtofulfill theCErequirementforadifferentorganization,pleasecontactitsgoverningboarddirectly.

1. Fundsintaxableaccountsrepresentapproximatelywhatpercent-ageoftheworld’sliquidfinancialassets?A. 10percentB. 25percentC. 33percentD. 50percent

2. Which industry niche had the greatest initial impact on theevolutionofknowledgepertainingtotax-awareinvestmentmanage-ment?A. wealthyindividualsB. propertyandcasualtyinsurancecompaniesC. nucleardecommissioningtrustsB. medicalretirementtrusts

3. Which investment consulting firm had a significant impact onprocedurestomaximizeafter-taxresults?A. CallanAssociatesB. CTCConsultingC. RogersCaseyD. SEIInvestments

287

288 ContinuingEducationExam

4. The“fatheroftax-awareinvestmentmanagement”isconsideredbymanytobe:A. CharlesEllisB. PeterBernsteinC. Robert“Tad”JeffreyD. JohnBogle

5. Whichofthefollowingarticlespublishedin1993servedasthecatalystfortax-awareinvestmentmanagement?A.“OptimalStockTrading”byGeorgeM.ConstantinidesB.“IsYourAlphaBigEnoughtoCoverItsTaxes?TheActiveManagement

Dichotomy”byRobertH.JeffreyandRobertD.ArnottC.“DoAfter-TaxReturnsAffectMutualFundInflows?”byDanielBerg-

stresserandJamesPoterbaD.“RankingMutualFundsonanAfter-TaxBasis”byJoelM.Dickson

andJohnB.Shoven

6. Ayoungprofessionalaspiringtoobtainacomprehensiveeduca-tionfocusedontax-aware investmentcanachievesuchbyfocusingonthefollowingsource:A. OneofthemanyuniversitiesteachingfinancialplanningB. AnMBAsecuritiesanalysisprogramC. AprofessionalcertificationprogramD. Noneoftheabove7. Ithasbeenshownthatsecuritiesareefficientlypricedwhentaxesareconsidered.A. TrueB. False8. Securitytrading,asmeasuredbytheportfolioturnoverrate,canbeappliedtoachieveanaccuratemeasureofamanager’stax-efficiency.A. TrueB. False

9. Whichofthefollowingeventsledtothecreationofafter-taxreturnsformutualfunds?A. Mutualfundsdistributingcapitalgainsof$238billionin1999and

$326billionin2000B. TheMutualFundTaxAwarenessActof2000passingbyavoteof385

to2C. TheSECissuingaproposalforpubliccommentinMarch2000D. Alloftheabove

ContinuingEducationExam 289

10.Whataretheessentialfunctionsthatmustbeconsideredfortax-ableaccountstomaximizeafter-taxresults?A. InvestmentfunctiononlyB. InvestmentandtaxfunctionsC. TaxandregulatoryorestatefunctionsD. Investment,tax,andregulatoryorestatefunctions

11.Whenamutualfundreportsafter-taxperformance,theafter-taxreturn will always be less than the before-tax return for the sameperiodofmeasurement.A. TrueB. False

12.Atwhat time is the tax impactaccounted forwhencalculatingafter-taxreturns?A. AtthetimeofthetransactionordistributionB. AttheendofthemonthC. AttheendoftheyearD. April15ofthefollowingyear

13.Tocalculateafter-taxreturns,aseparate-accountmanagermusthave access to a system or custodian that has a tax-lot accountingcapability.A. TrueB. False14.After-taxreturnsaremandatoryforseparate-accountclientsforallfirmsclaimingcompliancewithAIMR/GIPSstandards.A. TrueB. False

15.Withtaxableaccounts,whatamanagerhasdoneinthepastcanhaveanimpactonfutureafter-taxperformance.A. TrueB. False

16.The consultant “capture ratio” (after-tax return/before-tax re-turn)isameasureofafter-taxreturnsthatworkswellinallmarketenvironments.A. TrueB. False


17.Thevalueofthecaptureratiocanbegreaterthan100percent.A. TrueB. False

18.TheMorningstartax-costratioformutualfundsisaderivationoftheAIMRSubcommitteeforAfter-TaxReturnReporting’s“relativewealthmeasure”forseparateaccounts.A. TrueB. False

19.Themutualfundwiththelongestperiodsinceinceptionofnotdistributingacapitalgainisthe:A. VanguardIndex500mutualfundB. StateStreetSPDRexchange-tradedfundC. VanguardTax-ManagedGrowth&IncomemutualfundD. Schwab1000Invmutualfund

20.“Tax-lossharvesting”isatradeconductedpurposelytoproducealossthatcanbeappliedtogainsintheexistingportfolioorotherportfolios,ordeferredinmostcasesforfutureapplication.A. TrueB. False

21.Sellingasecurityandinvestingtheproceedstemporarilyincash(knownasa“nakedtrade”)makessensefrombothaninvestmentandataxperspective.A. TrueB. False

22.Fromatax-awareinvestmentmanagementperspective,whenasecurityfallsinvalueitisbesttodoublethepositionandthenselltheoriginalpositionortaxlotwhenthesecurityreboundsinprice(knownasthe“doubledown”trade).A. TrueB. False

23.Thepreferredmethodfortakingalossistosellthesecurityatalossandtemporarilyreplaceitwithasimilarsecurityhavingslightlydifferentcharacteristics(knownasa“pair-wise”transaction).A. TrueB. False


24.A benefit of the accounting methodology for mutual funds, ascomparedwithseparateaccounts,isthatyoucannotdistributealosstoshareholders.A. TrueB. False

25.Investors can relyonexchange-traded funds that focuson spe-cificcountriestoobtainahighleveloftaxefficiency.A. TrueB. False

26.The tax-lossharvesting trade canaddpersistent tax alphaovertimeastheportfolioseasons.A. TrueB. False

27.Quantitative tax-aware portfolio strategies that emphasize tax-lossharvestingcanbemanagedtogeneratealpha(additionalreturn)frombothsecurityselectionandtaxmanagement.A. TrueB. False

28.Foraninvestortojustifyselectinganactivelymanaged,domesticlarge-capitalizationportfoliostrategyoverafirmthatappliesaquan-titative tax-aware methodology that emphasizes tax-loss harvestingoverthefirsttenyearsoftherelationship,theactivemanagerneedstoproduceanalphaorreturnabovetheindexofatleastwhatper-centagewhentheimpactoftaxesandfeesareaccountedfor?A. 0.5percentB. 1.0percentC. 2.0percentD. 3.0percent

29.Whenan individual investor is subject to thealternativemini-mumtax,aladderofnon-private-activitymunicipalbondswillpro-videanoptimalsolution.A. TrueB. False


30.Whenreportingyieldstotaxableinvestors,thebestpracticeisto“grossup”theyieldsfortax-exemptormunicipalbondssotheinvestorcancomparetheresulttoyieldofasimilar-maturitytaxablebond.A. TrueB. False

31.What can an adviser or consultant do to enhance the tax effi-ciencyofhedgefunds?A. LookforhedgefundswherethemanagerhassignificantownershipB. Ifpossible,locatethehedgefundinatax-exemptaccountC. IdentifyhedgefundderivativesD. Alloftheabove

32.To identify separate-account managers who practice tax-awareinvestment,youcan:A. purchaseoneofseveraloutstandingdatabasesavailabletothepublicB. requestthatmanagersprovidetheirAIMRafter-taxcompositewitha

minimumoftenyearsofhistoryC. askmanagersforreferencesratherthanconductasitevisitD. noneoftheabove

33.When selecting a municipal bond manager, you should avoidselectingamanagerwhopurchasesbondsoutsidetheclient’sstateofresidenceandtaxablebonds.A. TrueB. False

34.Theprimaryreasonwhydomesticlarge-capitalizationequityman-agersdonotshowtheirclientsafter-taxreturnsisthattheirchanceofoutperformingtheS&P500onanafter-taxbasishasprovedovertimetobelessthan15percentandtheywanttohidethisfromtheirclients.A. TrueB. False

35.Whenconductinganasset-allocationoptimizationexerciseforahigh-net-worthfamily,itisbestto:A. relyonbefore-taxreturnandstandarddeviationassumptionsB. conducttheoptimizationfortaxableandtax-exemptaccountssepa-

ratelyC. placevalue-orientedmanagerswith turnover ratesof approximately

20percentintaxableaccountsD. noneoftheabove


36.To maximize after-tax returns, hold indexed mutual and ex-change-tradedfundsinindividualretirementaccountsandbondsinpersonal,taxableaccounts.A. TrueB. False

37.ItmakessensetoconvertfromatraditionalIRAtoaRothIRAwhen:A. thereisashorttimehorizonbeforetheinvestorreachesage59½B. theexpectedreturnislowC. theindividualwillbeinalowertaxbracketatretirementD. alloftheabove

38.Dependingonthecomplexityofthetaxableclientrelationship,researchhasshownthatapplyingtax-awareinvestmentmanagementprinciples is likely toadd0.5 to2.5percentperyear inadditionalperformanceorsavings.A. TrueB. False

39.Whichof the following isnot anelement that can improve taxefficiency?A. utilizingafter-taxassumptionsintheassetallocationprocessB. allocatingassetclassesandmanagers/fundsaccordingtothetaxchar-

acteristicsofeachentityC. tax-awareequitymanagerpositioningD. whentheassetsarelargeenough,alwaysusingseparateaccountman-

agersratherthanmutualorexchange-tradedfunds

40.Theareathatwillhavethegreatestbenefittobabyboomersforimprovingthenetafter-taxreturnsoftheirretirementassetsis:A. lowercommissionsbydiscountbrokersB. agreaternumberofavailableexchangefundsC. asignificantimprovementinthetechnologicalandreportingcapabili-

tiesofinvestmentplatformsD. avastincreaseinthenumberofinvestmentpractitionersseekingpro-

fessionaldesignations

accountant’sratio,95–96,136

accountingconventions,roleof,68–71

ADVISORport,274

AIMR.SeeAssociationforInvestment

ManagementandResearch

alternativeminimumtax(AMT),64–65,

160–164

AmericanAcademyofFinancialManage-

ment,CharteredWealthManager

program,36–37

AmericanBankersAssociation(ABA),39

PrivateWealthManagementSchool,

36

annuities,deferredvariable-rate,264–265

AperioGroup,120

Arnott,RobertD.,6,22–23,26–27,30,

210–211

assetallocation

appreciationandincome,analysisof,

213–216

assetclasses,identifying,212–213

capitalgainsrealizationrate,217–218

correlationcoefficients,220–222

fees,estimating,218–219

historicalreturns,problemswith,

209–211

income,estimatingtaximpact,218

revising,212

standarddeviation,before-tax,

219–220

steps,211–212

taxprofile,calculatingclient’s,

216–217

yield-to-maturityandinflation,analysis

of,219–216

assets,categoriesof,243–244

assets,positioning

after-taxassumptions,useof,252–253

educationplans,263–264

individualretirementaccounts,

262–263

insuranceproducts,264–265

iterativeapproach,254–259

listingassetsaccordingtoentitytype,

249–252

retirementplans,tax-deferred,

260–262

SocialSecuritybenefits,265–266

stepsfor,249

taxableassets,259–260

tax-costratio,relativewealthmeasures,

analysisof,253–254

trusts,266–268

AssociationforInvestmentManagement

andResearch(AIMR),7,8,39,57,

60,61,77–78,209

AIMRPerformancePresentationStan-

dardsHandbook,77

averagecostaccounting,104

AXAGroup,137–138

Axioma,122,274

BankofNewYork,272

BarclaysGlobalFundAdvisors,106,107,

156

Barraindices,120,122,230,274

Beebower,GaryL.,210

BeecherInvestors,145

benchmarks,79–80,120

Bergstresser,Daniel,29

Berkin,AndrewL.,27

Bernstein,PeterL.,22,209

BernsteinTax-ManagedInternational

Fund,113

Berra,Yogi,211

Beyer,CharlotteB.,7,36

I N D E X

294

Boczar,Tom,167,173

Bodie,Zvi,34

Bogle,JohnC.,22,104,105

“BondManagementforTaxableInvestors”

(Davidson),149

bonds.Seefixedincomefunds

Brilley,Michael,158

Brinson,GaryL.,210

Brunel,JeanC.,42,237

Brunel,JeanL.P.,6,42

BrunelAssociates,6

Brusven,ArlandD.,4

capitalgains,after-taxreturnsand,14–16

capitalgainsdistributions,principlesfor

avoiding,103–104

capitalgainsrealizationrate(CGRR),

217–218

CapitalTrustCo.,5

captureratio,96

CertifiedFinancialPlanner(CFP),35

CertifiedFinancialPlannerBoardof

Standards,34

CertifiedInvestmentManagementAnalyst

(CIMA),35

CertifiedPublicAccountant(CPA),35

CertifiedTrustandFinancialAdvisor

(CTFA),35

CFAInstitute,22,209

CGMCapital,24–25

charitableorganizations,payoutordistri-

butionpolicyfor,203–205

CharlesRiver,274

CharteredFinancialAnalyst(CFA),

34–35,40

CharteredFinancialAnalystsInstitute,39

CharteredLifeUnderwriter(CLU),35

Ciccotello,ConradS.,42

Citicorp,274

Citigroupindices,197

clientassetinventory,193–194

clientcriteria,120

clientobjectives,servicing,145–146

client/providerrelationships,48,49–51,

139–140

clienttaxprofile,calculating,216–217,

246–249

Clinton,Bill,57,58

collars,129–130

conferences,listof,39–40

Constantinides,GeorgeM.,21,104

corporatesinking-fundbonds,158–159

correlationcoefficients,220–222

Coverdellplans,263,264

crossovertrade,158

CTCConsulting,5–6,118–119

custodians,121

CutterAssociates,272,275

Davidson,R.B.,III,149,150

“DeathtothePolicyPortfolio”(Jahnke),

209

derivatives,172–173

“DeterminantsofPortfolioPerformance”

(Brinson,Hood,andBeebower),

210

Dickson,JoelM.,6,25–26,30,103–105

Dietz,PeterO.,22

discretionaryarrangements,50

diversificationissuestoconsider,130–131

“DoAfter-TaxReturnsAffectMutual

FundInflows?”(Bergstresserand

Poterba),29

Dodge&CoxStockFund,15–16,98–99

dollar-costaveragingprograms,68

double-downtrade,137

EatonVance,129

EconomicGrowthandTaxReliefRec-

onciliationAct(2001),246,247,

259–260

educationplans,funding,263–264

educationprograms/requirements,fortax-

awarepractitioners,34–37

EmployeeRetirementIncomeSecurityAct

(ERISA)(1974),3

England,Mark,118,119

equityfunds,60,61

Index 295

296 Index

break-evenanalysis,142–144

elementsof,135

extendholdingperiodsandmonitor

capitalgains,136

focusontaxableaccounts,141–144

HIFOaccounting,useof,138–139

internationalaccounts,145

maintainlowturnover,136

performancestandardsandreporting,

144–145

supportstaff,useofqualified,139–140

taxableincomelevels,adjusting,136

tax-lossharvesting,136–138,140–141

tax-lotaccounting,useof,138

washsalerule,140–141

equityinternationalmanagers,questions

toask,186

equitymanagers

Seealsomanagers,styleof

questionstoask,176–184

estateissues

exchange-tradedfundsversustax-man-

agedfunds,109,110

quantitativetax-awarefundsversus

exchanged-tradedandtax-managed

funds,126–129

exchangefunds,129

exchange-tradedfunds(ETFs),80,

105–107

comparedwithquantitativetax-aware

funds,125–131

comparedwithtax-managedfunds,

108–113

Exchange-TradedFundsManual,The

(Gastineau),108

expenses,treatmentof,83

FamilyOfficeExchange(FOX),7–8,39

FederalFarmCreditBank,157

FederalHomeLoanBank,158

fees

assetallocationandestimating,

218–219

client/providerrelationshipsand,

50–51,52–53

impactof,18–20

portfoliomanufacturing,276

quantitativetax-aware,121–122

redemption,110

Fichtenbaum,Mark,173

FidelityMagellanfund,24–25

FidelityValue,26

FinancialAnalystsJournal,22

FinancialPlanning,40

FinancialPlanningAssociation(FPA),

39,40

FinancialResearchAssociates(FRI),39

FinancialServicesReview,42

first,in,firstout(FIFO)accounting,68,

69–70,71,104

FirstQuadrant,22,120,121,125,128

MonteCarlosimulation,117–118

529collegesavingsplans,263,264

fixedincomefunds,82

alternativeminimumtax,160–164

bondladders,problemswith,151–152

elementsof,150

insuranceindustry,159–160

maturitydates,159

municipalbonds,out-of-state,156

municipalbonds,upgradingof,

158–159

phantomincomeissues,155–156

premiumsanddiscounts,impactof,

154–155

returnsversusrisk,balancing,152–154

taxablebonds,157–158

fixedincomemanagers


questionstoask,185–186

401(k)plans,254–255,261–262

FranklinGrowth,26

FrankRussellCo.,22

Friedman,Gregory,6

full-liquidationmethod,85–86

GalaxyIISmallCompanyIndexFund,

103

Gastineau,Gary,108

GeneralElectricCo.(GE),122,124

Gilmour,Paul,7

Giordani,Leslie,171

Giordani,Schurig,Beckett&Tackett,171

GlobalInvestmentPerformanceStandards

(GIPS),85

Gordon,RobertN.,42,167

GovernmentNationalMortgageAssocia-

tion(GNMA)funds,155,157

Gratry&Associates,81

Greycourt&Co.,6

grossyieldbasis,154

Hamilton,Sara,7

HedgeFundResearch,173

hedgefunds

derivatives,172–173

examplesoffavorabletransactions,170

expenses,deductibilityof,168–169

individualretirementaccounts,171

investingincompaniesthatown,172

managerownershipin,169

nondirectionalversusdirectional,170

offshore,168,171

partnershipaccounting,168

privateplacementlifeinsurancepoli-

cies,171–172

reasonsforinvestingin,167

taxefficiency,169

Heebner,Ken,24

highin,firstout(HIFO)accounting,70,

104,138–139

high-net-worthinvestors,cateringto,5–6

holdingperiods,14–16,136

Hollis,James,272

Holton,GlynA.,15

Hood,Randolph,210

Horan,Stephen,261,263

Horvitz,Jeffrey,203

Howard,Joanne,142–143

“HowWellHaveTaxableInvestorsBeen

Servedinthe1980’sand1990’s”

(Arnott,Berkin,andYe),26–27

HTMLformat,91

IbbotsonAssociates,39

“ImplicationsofRebalancingtheInvest-

mentPortfoliofortheTaxable

Investor,The”(Horvitz),203

income,estimatingtaximpact,218

indexparticipationshares(IPS),105

individualretirementaccounts(IRAs),

171,254–255,262–263

inflation,assetallocationandanalysisof,

219–216

InformationManagementNetwork

(IMN),39

INGGroep,137–138

InstituteforPrivateInvestors(IPI),7–8,

39

WhartonSchoolPrivateWealthMan-

agementProgram,36

InstituteofCertifiedBankers(ICB),35,

39

InstitutionalInvestor,39

insuranceproducts,264–265

IntegratedWealthManagement(Brunel),

42

internationalequities,47,145

internationalmanagers,questionstoask

equity,186

InvestmentAdvisor,39

InvestmentCompanyAct(1940),272

InvestmentCompanyInstitute(ICI),26,

57

InvestmentCounselingforTaxableInves-

torsConference,8

InvestmentManagementConsultantsAs-

sociation(IMCA),WealthManage-

mentCertificateProgram,36

InvestmentPerformanceCouncil(IPC),

7,78

investmentpolicydevelopment

clientassetinventory,193–194

profilemixreturnandriskinforma-

tion,196–198

questionnaires,useof,198–199

riskprofile,195

steps,192

tax-lotaccounting,194–195

volatility,analysisof,195–196

investmentpolicystatements

charitableorganizations,payoutor

distributionpolicyfor,203–205

elementsof,199–207

Index 297

298 Index

optimizationtools,202

rebalancing,impactof,202–203

useof,47–48

Investments(Bodie,Kane,andMarcus),

34

InvestorEducationCollaborative,36

IRS,Form1099-DIV,72–73

iSharesindexmethodology,Morningstar,

238–240

iSharesMSCICanadaandSwedenETFs,

110

“IsYourAlphaBigEnoughtoCoverIts

Taxes?”(JeffreyandArnott),6,22,

25

ITG,122,274

Jacob,NancyL.,5,6,118

Jahnke,William,209–210

Jeffrey,RobertH.,6,22–23,30,104

Jennings,William,43

J.K.LasserProIntegratingInvestments

andtheTaxCode(Reichenstein

andJennings),43

JobsandGrowthTaxReliefReconciliation

Act(2003),12

JournalofPortfolioManagement,6,22

JournalofWealthManagement,42

Kane,Alex,34

Keoghplans,261

Kirkman,Jeffrey,259

Langstraat,Brian,118

LatentZero,274

LehmanBrothersAggregatebond,197

LinedataLongView,274

Lockwood,271–272

LotsoffCapitalManagement,128

Lynch,Peter,24

MainStayInstitutionalEAFEIndexFund,

103

Maister,DavidH.,49

“MakingHedgeFundInvestingMore

Tax-Efficient”(BoczarandFichten-

baum),173

managementselection,portfoliomanufac-

turingand,275–277

managers,styleof

Seealsotax-awaremanagers;typeof

all-capitalization/style-specificmodel,

232–233

analysisof,236–240

core-and-satelliteapproach,237–238

costsofrigid,227–231

modified,231–232

MorningstariSharesindexmethodol-

ogy,238–240

optimaltax-awareequityallocation,

235–236

problemwithcategorizing,226

quantitativetax-awaremodelcombined

withotherstyles,233–235

M&IBank,121

ManGroup,172

Marcus,AlanJ.,34

marketcapitalization,225–226

markettiming,137

McLeod,Robert,263

M.D.Sass,158

MetropolitanWest,164

Minck,JeffreyL.,80

Mittra,Sid,259

MorganStanleyCapitalInternational

(MSCI),120,197,230

MorningstarInvestmentDetailReport,

61–64,227

tax-costratio,63–64,97–100

MorningstariSharesindexmethodology,

238–240

MotleyFool,58

Moulton,Marc,6

municipalbonds,64–65

buyingbeforeupgraded,158–159

buyingout-of-state,156

mutualfunds,reportingafter-tax,57–74

MutualFundTaxAwarenessAct(2000),7

myCFO,271–272

nakedtrade,136–137

NationalAssociationofPersonalFinancial

Advisors(NAPFA),39,40

Index 299

NewYorkSocietyofSecurityAnalysts

(NYSSA),40

NewYorkUniversity

CertificateinWealthManagement,36

InstituteonFamilyWealthManage-

ment,40

NMSManagement,40

nondiscretionaryarrangements,50–51

NorthernTrustGlobalInvestments,121

Northfield,122,274

NuclearDecommissioningTrusts(NDT),

4,40

nuclearpowerplants,decommissioning,

4–5

offshorehedgefunds,168,171

operationalissues


agedfunds,109,110



funds,125,126–127

organizations,professional,39–40

Osprey,91

overlaymanagement,273–274

pair-wisetrade,137–138

ParametricPortfolioAssociates,86–89,

118–119,121,124,274

passiveforeigninvestmentcompanies(PF-

ICs),171

performancereporting,277–278

Peterson,Jeffrey,263

phantomincomeissues,155–156

Phillips,Don,97,239

PIMCO,164

AllAssetFund,22

PEAValueAFund,98–99

pipeanalogy,15–16

Placemark,274

PORTAX,6,248,258

portfoliomanagement.Seequantitative

tax-awardportfoliomanagement

portfoliomanufacturing,272

benefitsof,278–279

fees,276

managementselection,275–277

outsourcing,274–275

overlaymanagement,273–274

performancereporting,277–278

risks,275

wrapaccounts,272–273

post-liquidationreturns,12–14,59–60,

85

Poterba,James,29,80

PracticingFinancialPlanningforProfession-

als(Mittra,Kirkman,andSeifert),

259

pre-liquidationreturns,12–14,24,59

prepaidvariableforwards,130

Price,LeeN.,6–7,77,78,79,91

privateplacementlifeinsurance(PPLI)

policies,171–172

Pruyne,RobertE.,7,77

PSNmanagerdatabase,146–148

publications,listofprofessional,42–43

quantitativetax-award(QTA)portfolio

management

benchmarkselection,120

clientcriteria,120

comparedwithtax-managedand

exchange-tradedfunds,125–131

custodian,roleof,121

earlyexampleof,118–119

elementsof,119

fees,121–122

portfolioconstruction,120–121

portfoliosoftware,122

trackingerror,122–125

Quisenberry,Clifford,237

“RankingMutualFundsonanAfter-Tax

Basis”(ShovenandDickson),6,

25–26

realestateinvestmenttrusts(REITs),12,

136

rebalancing,impactof,202–203

Reichenstein,William,43

reinvestmentofincome,12

relativewealthmeasure,96–97

reporting,after-tax,144–145

300 Index

ResearchAffiliates,22

retirementplans,tax-deferred,260–262

returns

componentsof,12

pre-andpost-liquidation,12–14,24

riskprofile,195

Rittenour,RalphC.,Jr.,5,118

Rogers,DouglasS.,7,91

Rosen,JanM.,42

RosenbergCapitalManagement(RCM),

6,77,142

Russellbenchmarks,120

RussellMidCap,226

Russell1000,226

Russell2000,197,226

Russell3000,232

Ryan,Paul,68

Ryzewic,SusanRemmer,36

SallieMae,158

Sauter,GeorgeU.,104

Saxton,Jim,67–68

Scholes,MyronS.,21

Schott,Matt,272

Schwab,Charles,25,26,30

Schwab1000IndexFund,25,26,104,

105

SecuritiesandExchangeCommission

(SEC),7,57–60,78

SecurityAPL,91,271–272

securitybreak-evenanalysis,142–144

Seifert,George,259

separateaccounts,after-taxreporting,

77–92

Sharpe,WilliamF.,197

Sharperatio,197–198

Shoven,JohnB.,6,25–26,30,103–105

Siegel,Jeremy,215

Simpson,JohnD.,91

SitInvestmentAssociates,158

Smartleaf,274

SocialSecuritybenefits,265–266

SoftPak,274

softwaresystems.Seeportfoliomanufac-

turing

StagecoachEquityFundIndex,61

stand-alonesystems,89

Standard&Poor’s

DepositoryReceipt(SPDR),105

500stockindex,111–112,114,197,

225

standarddeviation,before-tax,219–220

StandishMellon,152,156

StandishSmallCapitalizationTax-Man-

agedEquityFund,113–114

StateStreetGlobalAdvisors,121

Stein,DavidM.,80,119,124,225

Stevens,Dale,210

stock,selling,130

“StockIndexMutualFundWithoutNet

CapitalGainsRealizations,A”

(DicksonandShoven),26,104

Surz,RonL.,80,210

Tamarac,274

Tavel,Bruce,172

taxableassets,positioning,259–260

taxalpha,81,104,117–118,133–134

tax-awareinvestmentmanagement

elementsof,51–54

evolutionof,3–8

tax-awaremanagers


equityinternationalmanagers,ques-

tionstoask,186

equitymanagers,questionstoask,

176–184

fixedincomemanagers,questionsto

ask,185–186

inquisitivenessand,37–40

knowledgeability/educationalrequire-

mentsand,34–37

passionand,41–43

patienceand,40–41

skillsneededby,45–54

traitsneededby,33

tax-costratio,63–64,97–100

taxefficiency


agedfunds,108,109

hedgefundsand,169


Index 301


funds,125,126

measuring,95–100

taxes

consequencesofsellingandbuying

securities,16–18

federalincomeratesonregularincome

andcapitalgains,283–286

impactoninvestments,11–20

tax-lossharvesting,104,117–118

double-downtrade,137

nakedtrade,136–137

pair-wisetrade,137–138

percentagebenefitfrom,80–81

washsaleruleand,140–141

tax-lotaccounting,138,194–195

tax-managedfunds

comparedwith exchange-traded

funds, 108–113

comparedwithquantitativetax-aware

funds,125–131

taxprofile,calculatingclient’s,216–217,

246–249

taxrates

calculatinganticipated,84

estateplanningissues,246

federalincomeratesonregularincome

andcapitalgains,283–286

marginalversusaverage,244–245

Todd,Christine,156

TowerGroup,272–273,275

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

UtilityPensionFundStudyGroup,4

Vanguard,22,120

500IndexFund,6,23–29,30,104,

110–112,227–231

Mid-CapandSmall-Capindexfunds

227–231

Tax-ManagedGrowthandIncome

Fund,58–59,61–64,105,

110–112

TotalStockMarketIndexFund,

228–229

Vestmark,274

VistaAnalytics,274

volatility,analysisof,195–196

WallStreetSecretsforTax-EfficientInvest-

ing(GordonandRosen),42

washsalerule,140–141

Whipple,JayN.,III,91,271–272

Wilshire5000stockindex,232

Wimer,Mark,210

WindermereInvestmentAssociates,6

WindsorFund,22,104

wrapaccounts,272–273

Ye,Jia,27

yield-to-maturityandinflation,analysisof,

219–216

zero-couponbonds,155–156

A B O U T B L O O M B E R G

BloombergL.P., founded in1981, isaglobal informationservices,news,andmedia company.Headquartered inNewYork, the companyhas salesandnewsoperationsworldwide.

Bloomberg,servingcustomersonsixcontinents,holdsauniquepositionwithinthefinancialservicesindustrybyprovidinganunparalleledrangeoffeaturesinasinglepackageknownastheBLOOMBERGPROFESSIONAL®service.Byaddressingthedemandforinvestmentperformanceandefficien-cythroughanexceptionalcombinationofinformation,analytic,electronictrading, and Straight Through Processing tools, Bloomberg has built aworldwidecustomerbaseofcorporations, issuers, financial intermediaries,andinstitutionalinvestors.

BLOOMBERG NEWS®, founded in 1990, provides storiesand columns on business, general news, politics, and sports to lead-ing newspapers and magazines throughout the world. BLOOMBERGTELEVISION®, a 24-hour business and financial news network, isproduced and distributed globally in seven languages. BLOOMBERGRADIO

SM is an international radio network anchored by f lagship

stationBLOOMBERG®1130(WBBR-AM)inNewYork.InadditiontotheBLOOMBERGPRESS®lineofbooks,Bloomberg

publishes BLOOMBERG MARKETS® magazine. To learn more aboutBloomberg,callasalesrepresentativeat:

London: +44-20-7330-7500NewYork: +1-212-318-2000Tokyo: +81-3-3201-8900

forin-depthmarketinformationandnews,visittheBloomberg

websiteatwww.bloomberg.com,whichdrawsfromthenewsandpowerof

theBLOOMBERGPROFESSIONAL®serviceandBloomberg’shostof

mediaproductstoprovidehigh-qualitynewsandinformationinmultiple

languagesonstocks,bonds,currencies,andcommodities.

DouglasS.Rogers,CFA,hasbeeninthefinancialservicesindustryfornearly two decades and is a leading authority on tax-aware investmentmanagement and after-tax reporting. He is a senior consultant andmanagingdirectoratCTCConsulting, founded in1981,which servesmorethanonehundredhigh-net-worthretainerrelationshipsencompass-ingmorethan$12billioninliquidfinancialassets.

Prior to joining CTC, Mr. Rogers served within the consulting in-dustry as a chief investmentofficer anddirectorof traditionalmanagerresearch,wherehehasimplementedtax-awarestrategyandcreatedopen-architecturemanagerplatformstoservehigh-net-worthfamilies.Hehasalso worked with property and casualty insurance companies, nucleardecommissioningtrusts,andmedicalretirementaccounts.

Mr.Rogersunderstands the taxable-account industry frommultipleperspectives,includinginvestmentpolicy,assetallocation,managersearchactivity, portfolio management, security analysis, and reporting. He isthe chairman of the AIMR Subcommittee for After-Tax PerformanceReporting,whichwasresponsibleforinteractingwiththeSecuritiesandExchangeCommissionontheafter-tax standards formutual fundsandmaderecommendationstorevisetheexistingseparateaccountstandardstotheircurrentform.

Mr.RogersisagraduateoftheUnitedStatesMilitaryAcademyandholds an MBA from Southern Methodist University. A nationally rec-ognizedspeakerandauthor,heisalsoaCharteredFinancialAnalyst.In2001,hereceivedtheannualPeterDietzAwardforthemostsignificantcontributiontothebodyofknowledgeinperformancemeasurement,forhisarticle“TheChallengesofAfter-TaxPerformanceReporting” inthespring2000issueoftheJournalofPerformanceMeasurement.

A B O U T T H E A U T H O R


Documents

Tax aware investment management: The essential guide