Neuberger Berman CDI™ clients have the option to fund their account from a combination of cash and/or in-kind transfers of existing equity holdings. When a client opts for an in-kind transfers, there are two important considerations:

  1. To what extent are the existing in-kind holdings consistent with the client’s investment objectives? We find that tracking risk is a good way to measure this.
  2. What is the tax implication of selling all or some of the client’s in-kind holdings? This is particularly relevant if rebalancing the in-kind securities will trigger capital gains.

Neuberger Berman seeks to make funding an NB CDI™ account seamless and carefully evaluates the tradeoffs between these competing considerations.

We have developed a detailed transition analysis report to illustrate the potential tax and tracking risk implications of transitioning assets in-kind. This allows the client to choose the more optimal transition strategy.

To understand the transition analysis report, we propose a hypothetical example where we assume that the client’s original portfolio has a value of $1.6 million and that the client has already selected an investment strategy that is the target for this transition. Hypothetical tracking error and capital gains outcomes for several funding scenarios are shown in the figure below.

The outcomes of each of these scenarios are as follows:

  1. Original Portfolio: The investor transfers $1.6 million in securities to a NB CDI™ strategy to fund the portfolio in-kind. In this case, the tracking error is estimated to be 6% compared to the target investment strategy. While this approach has a significant tracking error relative to the other three options, the investor avoids realizing any capital gains.
  2. Liquidation: All the securities in the investor’s existing portfolio are sold and the cash proceeds are used to fund the new NB CDI™ portfolio. In this scenario the investor would realize $600,000 in capital gains from liquidating their initial portfolio, and $1.6 million cash will be invested in the NB CDI™ portfolio. Here, the estimated tracking error to the target investment strategy would very low or zero, but this low tracking error comes with the highest tax cost.
  3. Hypothetical Low Tracking Error Portfolio: In this scenario, the investor realizes $300,000 in capital gains and the cash from that turnover is used to buy securities that are more aligned with the NB CDI™ target investment strategy. The remaining securities are held, preserving their unrealized gains. Here, the investor would experience a lower tracking error (about 0.5%) relative to the Medium Tracking Error Portfolio but would realize more capital gains. Because this portfolio has a higher cost basis compared to the Medium Tracking Error Portfolio, it has a higher probability of loss harvesting which in turn may lead to potentially higher tax alpha1.
  4. Hypothetical Medium Tracking Error Portfolio: Finally, in the fourth scenario, the investor realizes $50,000 in capital gains and the cash from that turnover is used to buy securities in the target investment strategy. Since the investor had less cash from realizing gains (compared to the Low Tracking Error Portfolio), the investor is not able to match the target investment strategy as closely, resulting in a hypothetical portfolio tracking error of about 1.5%. While the tracking error is higher than the Low Tracking Error Portfolio, this method realizes $250,000 less in capital gains. The investor effectively controls capital gains at the expense of a lower probability of loss harvesting. This approach typically requires a long-term investment horizon given the higher tracking error. By holding on to existing securities in your current portfolio, we seek to reduce the upfront tax liability of transitioning to your NB CDI™ tax managed strategy of choice.

While these are simplistic examples used to illustrate the tradeoffs between tracking errors and capital gains, our process is more complex, customizing each transition analysis based on the investor’s objectives and requirements. Our transition analysis reports also include additional metrics such as tax impact and potential transition tax savings to provide a more holistic perspective when considering how to transition a portfolio.

For more information on NB CDI™, please reach out to your Neuberger Berman representative.