Capturing alpha – investment outperformance against its relevant benchmark – is immensely challenging. In fact, some studies show 9 out of 10 managers underperform their benchmarks. Yet, everyone from the largest asset managers to individual investors spend immense effort to find an edge that will yield even a tiny sliver of performance over a benchmark. And, the truth is, they are often overlooking a golden opportunity to retain significant gains from better tax management – as much as 24% for a single opportunity nearing long-term, as we’ll explain.
It’s surprising then that the discipline of tax alpha is often dismissed as somehow having less of an impact on real performance. But as we say:
‘It’s not what you make, it’s what you keep that matters”
In our view, tax savings add alpha to a portfolio that’s every bit as meaningful to the bottom line as alpha generated from investment return.
There has been much debate recently about the alpha generated by the most common tax management tactic, tax loss harvesting. Rather than join that debate, we’re going to focus on simple tactics with undebatable benefit.
Convergence of Regs and Technology
Most investors are familiar that Cost Basis Reporting is now a requirement for brokerages (and others), thanks to the passage of the Emergency Economic Stabilization Act of 2008 (EESA). To date, the primary reaction from brokerages has been simply to comply – a huge missed opportunity for their clients. Combined with the increasing sophistication of digital financial solutions, clients now expect to have all of their tax information at their fingertips.
This convergence creates an opportunity for brokerages. Not only should advisors showcase their mastery of a client’s entire portfolio, but the opportunity now exists for advisors to easily identify opportunities to manage investment taxes and provide clients with an easy to understand, complete picture of the impact of taxes on their portfolios. The same applies to brokerages for self-directed investors.
There are many tax management strategies that can yield alpha for investors. As a simple example, take the difference in short- and long-term tax rates. The area between the two rates represents potential tax minimization (and alpha) for any gain that is taken long-term versus short.
Source: Tax Policy Center and Citizens for Tax Justice
Let’s say the target benchmark is expected to have an 8% return. For an investor with net income of $200,000, a single trade that matched that target on a pre-tax basis would yield just 5.36% after-tax for a short-term trade. If that same trade were executed as long-term, the yield would be 6.8% – resulting in 144 points of tax alpha. From a purely after-tax performance perspective, this same investor would need to generate an 11.95% return on a short-term trade just to net 8%. If that same investment were taken long-term, the after-tax return would be 10.16% – generating 216 points of tax alpha. Not every trade presents this opportunity, but clearly the benefit at least warrants a vigilant awareness that most investors don’t possess.
Trump Tax Alpha Example
Let’s examine the value tax management (and awareness) can bring to clients in the context of the recently proposed tax reforms. Changes to the tax rates and brackets themselves represent tax “arbitrage” opportunities. First, understand that short, long term and top tier capital gains rates have continuously evolved dating back to 1916. Reviewing just the last 25 years, we see that as administrations changed, tax rates changed also. Generally, rates have moved lower under Republican administrations and higher under Democratic administrations. However, George H. W. Bush famously raised rates in 1992 and surprisingly Bill Clinton lowered the top rate on capital gains. George W. Bush lowered rates further but allowed the highest income tier rate to trend upward. Barack Obama raised all rates in 2012 creating the highest tax rate for regular income and the highest income tier in 25 years but even though he raised the top rate on capital gains, it remains below the highest level from the early 1990s.
The lesson for investors is that every administration brings change and that creates opportunity, whether rates are going up or down. For example, President Trump’s preliminary tax reform package proposes to eliminate the 3.8 percent Net Investment Income Tax created by the Affordable Care Act. The tax applies to investment income of taxpayers with a modified adjusted gross income of more than $200,000 for single filers and $250,000 for married couples filing jointly. Ending the Net Income Investment Tax would drop the effective capital gains tax rate for high earners from 23.8 percent to 20 percent. President Trump is also proposing to reduce the number of tax brackets. In particular, he proposes lowering the top tax bracket to 35% from 39.6%.
Source: Tax Policy Center and Citizens for Tax Justice
The implication here is that, in the period immediately prior to the new rates going into effect, there will be opportunities for investors to reduce the amount of tax paid on certain trades simply by deferring sales until after the new rates go into effect. Obviously, investors shouldn’t refrain from selling all securities until new rates take effect; but by identifying even just one or two high gain/loss trades to accelerate or postpone, an investor can generate a significant performance improvement.
The opportunity to retain significantly more gains from specific winning positions carries obvious allure. So why isn’t this a core strategy for more investors and advisors?
Primarily, there are two reasons. Before the Cost Basis Reporting regulations went into effect in 2011, any investor inquiry about cost basis received the standard, “consult a tax advisor” response from their broker. As of 2011, those same brokers are responsible for reporting cost basis to investors and the IRS, so access to the necessary data and the means to capitalize on it are now within reach. The second reason is that monitoring and sifting through large quantities of trading activity can be time-consuming and a distraction from other investment activities. To solve this problem, brokers need to provide investors and advisors access to tax management tools, like the ones we offer from Scivantage, to take the large array of data and synthesize it into actionable data.
We’ve only touched on a couple strategies to generate tax alpha. There are many more, which we’ll explore in a future post.
As Chief Commercial Officer, Tax & Analytics, Cameron Routh is responsible for the overall vision, leadership and management of Scivantage Maxit® and analytics products. Under his direction, Scivantage has developed the next generation of investment management applications, including pre-trade decision tools.