- Building tax-efficient portfolios remains a challenge for wealth advisers.
- Our analysis revealed that a hypothetical U.S. tax-aware portfolio would have historically outperformed a tax-agnostic one without incurring significant risks and turnover costs during our study period.
- Advisers can use sophisticated tools such as MSCI’s Barra® Open Optimizer to effectively build tax-efficient portfolios that account for important tax considerations, as well as other portfolio objectives.
With the U.S. tax filing deadline looming, many of your clients may be racing to complete their returns. Preparation for tax day, however, is a year-long effort, as taxes can be a large drag on portfolio returns and have a significant impact on long-term growth. Given the complexity of tax regulation, wealth advisers continue to grapple with the questions “How do taxes impact the realized returns of my client’s investment strategy?” and “How can I efficiently manage that impact?”
Advisers can look to answer these questions by avoiding current net gains, which are subject to taxes and reduce available capital,1 and by deferring taxes as long as possible to keep more money in a client’s portfolio, potentially compounding over time. If only it were as simple as it sounds; there are many nuances to building tax-efficient portfolios. In this blog post, we propose a rules-based way of doing so and analyze the benefits and trade-offs of such approaches.
Two Approaches to Managing Taxes
Advisers looking to build tax-efficient portfolios in separately managed accounts (SMAs) for clients can do so with primarily two approaches:
- Tax-aware: Reduce taxes by realizing losses to offset capital gains so that the net gain is minimized. The aim is to realize only enough losses as needed to offset gains, such that the net tax is zero. This approach tends to be better suited for those seeking passive implementation of tax efficiency.
- Tax-loss harvesting: Maximize losses to offset gains from other sources. The aim is to continue to realize losses beyond zero tax to get the maximum tax benefit. This approach tends to be better suited for those seeking active implementation of tax efficiency where advisers decide on the extent of losses needed to offset gains in other parts of their portfolio.
Realized Gains of Tax-Aware Vs. Tax-Loss Harvesting
For our study, we looked at the tax-aware approach, excluding dividend taxation and focusing on minimizing net gains for tax efficiency.
Building a Tax-Efficient Portfolio
For this exercise, we used MSCI’s Barra® Open Optimizer to build hypothetical, tax-aware optimal portfolios. The Optimizer has the capability to sell certain assets to generate losses and replace them with similar assets to retain the original portfolio attributes while accounting for tax considerations such as the Internal Revenue Service's 30-day wash-sale rule, tax liabilities from short- and long-term gains and trading rules such as first-in first-out.
For this analysis, we used the MSCI USA Index as the underlying universe, MSCI’s Barra® US Total Equity Market Model for Long-term Investors (USSLOW) together with MSCI's Open Optimizer and a set of constraints and assumptions.2 We built an optimal, tax-efficient hypothetical index-tracking portfolio with the primary goal of bringing taxes to zero and minimizing tracking error to the MSCI USA Index, rather than taking any significant bets away from the benchmark. We call it the tax-aware portfolio.
Throughout this analysis, we compared the tax-aware portfolio to a hypothetical “minimum tracking error (min TE)” tax-agnostic one that simply tracks the MSCI USA Index without tax considerations. We set up the tax-aware and min-TE portfolios starting in January every year between 2001 and 2018 with monthly rebalancing and three-year holding periods. For both, we first subtracted the tax incurred from capital gains at each rebalancing and then used the portfolio’s after-tax market value to calculate after-tax performance. We compared the two portfolios for active return, tax savings, total risk, active risk (tracking error) and turnover.
Increased Active Return
When we compared average annualized after-tax return, we observed that the tax-aware portfolio outperformed the MSCI USA Index, and beat the min-TE portfolio by an average of 43 basis points (bps) on an annualized basis. While our analysis showed a three-year holding period, we tested other periods from 18 months to 10 years and found the tax-aware portfolio historically outperformed over these periods as well.
In general, the after-tax min-TE portfolio also returned less than the index. This is as we expected because it is not a full index replication, and the investor cannot “take home” all the realized return due to taxes paid on capital gains from rebalancing.3
Average Annualized Returns of Hypothetical Min-TE and Tax-Aware Portfolios and MSCI USA Index
Data from Jan. 31, 2001, to Jan. 31, 2021. The annualized mean gross return (after accounting for capital-gains tax) displayed is calculated over the three years of each holding period.
Let the Dollars Speak
Looking beyond returns, we saw a significant difference in cumulative taxes paid. As shown in the exhibit below, the tax-aware portfolio resulted in zero taxes in most analysis periods, while the min-TE portfolio required taxes throughout — reaching as high as USD 800,000 one year from an initial portfolio of USD 10 million.
Total Tax Paid Per Year for Each Hypothetical Portfolio Over Its Lifetime
Data from Jan. 31, 2001, to Jan. 31, 2021, and assumes an initial portfolio of USD 10 million.
Tracking Total and Active Risk
Both the min-TE and tax-aware portfolios exhibited very similar levels of total predicted risk as MSCI’s Open Optimizer was able to efficiently build in tax efficiency without taking on any material risk. Here we also see the active risk, or tracking error, of the min-TE and tax-aware portfolios alongside average after-tax return differences. We observe that MSCI’s Open Optimizer was able to efficiently balance the objectives to minimize taxes and tracking error for the tax-aware portfolio.
Risk Comparison for Hypothetical Tax-Aware and Min-TE Portfolios
Data from Jan. 31, 2001, to Jan. 31, 2021.
Reduced turnover is an important byproduct of tax-aware portfolios, as it can be a key cost component that can impact passive implementation. Indeed, our hypothetical tax-aware portfolio had lower turnover — and lower trading costs — than the min-TE one. This is a benefit of MSCI’s Open Optimizer only selling assets and realizing gains when it found offsetting losses, which reduces the opportunity set of potential trades and makes them more efficient and less frequent.
Turnover of Hypothetical Min TE and Tax-Aware Portfolios
We report two-way annualized turnover. Data from Jan. 31, 2001, to Jan. 31, 2021.
Too Much of a Good Thing?
Advisers today can use several tools to build tax-efficient portfolios for clients. It remains critical, however, to evaluate the benefits and trade-offs of a rules-based, tax-aware approach, keeping other important portfolio attributes in mind.
1Net gains are calculated as realized capital gains minus realized capital losses, which arise when we sell assets.
2Constraints include: a maximum of 300 assets and +/- 5% weight deviation for each sector. Turnover is unconstrained to analyze the turnover implications of the tax-aware approach. We assume a long-term capital-gains tax of 15% (for assets held more than 12 months) and short-term capital-gains tax of 30% (for assets held 12 months or less). These tax rates can be easily changed. For example, it is common to set different tax rates for different asset groups.
3We did observe a decrease in index outperformance at the 10-year mark, which is consistent with industry literature, such as: Israel, R, and Moskowitz, T. 2010. “How tax efficient are passive equity styles?” AQR.