When an investor funds a TaxM™ account, there are three broad options for how to do so:
- Transfer the securities in the original portfolio in kind to the TaxM™ portfolio (“Original Portfolio”)
- Sell their existing portfolio entirely and use cash to fund the TaxM™ portfolio (“Liquidation”)
- Target a specified tracking error for the TaxM™ portfolio relative to the selected benchmark. We offer low tracking error (0.5% to the benchmark) and medium tracking error (1.5% to the benchmark) portfolios, depending on an investor’s tracking error and capital gains preferences
To understand the tradeoffs between these various funding methods, we have developed a detailed transition analysis report to illustrate the potential impacts to an investor’s portfolio.
In this note, we seek to explain the broad outlines of the transition analysis report. Hypothetical tracking error and capital gains outcomes of the funding options listed above are shown in the figure below.
Hypothetical Example: Realized Gains vs. Tracking Error (TE)
Source: Neuberger Berman.
For each hypothetical scenario, we have assumed that the client’s original portfolio has a value of $1.6 million and has the same investable universe as the benchmark. The outcomes of each of these scenarios are as follows:
- Original Portfolio: The investor transfers $1.6 million in securities to a TaxM™ strategy to fund the portfolio in kind. In this case, the tracking error is estimated to be 6% compared to the benchmark. While this approach has a significant tracking error relative to the other three options, the investor avoids realizing any capital gains.
- Liquidation: All the securities in the investor’s existing portfolio are sold and the cash proceeds are used to fund the new TaxM™ 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 TaxM™ portfolio. Here, the estimated tracking error to the benchmark would very low or zero, but this low tracking error comes with the highest tax cost.
- Hypothetical Low Tracking Error Portfolio: In this scenario, the investor realizes $300,000 in capital gains and uses that cash to buy securities that are more aligned with the TaxM™ benchmark. The remaining securities are transferred in kind. 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 alpha.
- Hypothetical Medium Tracking Error Portfolio: Finally in the fourth scenario, the investor realizes $50,000 in capital gains and uses that cash to buy securities in the benchmark. Since the investor had less cash from realizing gains (compared to the Low Tracking Error Portfolio), the investor is not able to match the benchmark 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.
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 cost and potential transition tax savings to provide a more holistic perspective when considering how to transition a portfolio.
For more information on TaxMTM, please reach out to your Neuberger Berman representative.