We have written before about how tax-loss harvesting and other tax-managed equity strategies can create tax credits that investors can use to lower their capital gains and income tax liabilities. These tax credits are most often used to offset capital gains in a tax-managed equity portfolio itself—which is why many providers of these strategies report after-tax returns to show the value of active tax management. However, tax credits can also be used to offset gains made when investors sell other assets in their portfolios, and can be carried forward into future tax years.
We think the potential for tax savings is vastly underestimated. If an investor’s equity portfolio is not actively managed for tax efficiency, the investor is not only missing out on the additional tax credits that could be generated, the investor is also almost certainly unaware of the tax credits that may be passively generated by the stock liquidations in his or her portfolio strategy, because the portfolio manager may not be reporting post-liquidation, after-tax returns.
When a tax-managed strategy reports its after-tax returns under the Global Investment Performance Standards (GIPS), it uses the “Modified Dietz Method”:
After-Tax Return = (End Value − Start Value − Sum of Portfolio Flows − Realized Taxes) / (Start Value + Sum of Day-Weighted Portfolio Flows)
If we simplify this by assuming there are no portfolio flows, we get:
After-tax Return = (End Value – Start Value – Realized Taxes) / (Start Value)
Intuitively, we can see that if we minimize the value of realized taxes, which accrue with capital gains, the after-tax return will increase. One way to accomplish this is to create realized losses in the portfolio (or negative capital gains), which we can then offset against the overall portfolio’s capital gain.
Tax-managed strategies use market volatility to “harvest” those realized losses while meeting the same investment exposure and performance objectives as a normal equity strategy. For example, a tax managed strategy might invest in a representative proportion of an index that replicates the performance of that index with a tracking error around 50 – 100 basis points. Then the strategy would trade frequently, perhaps every two weeks, to swap securities that are at a loss with other securities that are similar enough to keep the overall exposure to the index the same. The aim is to maintain a tracking error within 50 – 100 basis points while realizing more losses on individual stocks than a typical investment strategy. Over the course of the month and year these realized losses can add up to a meaningful value that can be offset against the capital gain of the overall portfolio—thereby lowering the realized capital gains tax levied on the portfolio.
We can illustrate this point with a simplified hypothetical example . We invest $1m in an actively tax-managed equity strategy for 10 years. Let’s imagine that equity markets are unusually poor, returning 0% every year. Nonetheless, an investor that pays tax on this portfolio can use the tax-loss harvesting strategy described above to potentially generate a positive after-tax return from realized losses on individual stocks.
Figure 1. Pre-Tax And After-Tax Returns From A Hypothetical Tax-managed Strategy Over 10 Years
Source: Neuberger Berman. For illustrative purposes only.
What’s actually happening here? While the overall portfolio ends each year at the same value it started, during the course of that year the portfolio manager sells stocks at a loss. In the first year, for example, realized losses add up to $100,000. The $100,000 can be used to offset a capital gain elsewhere. We assume the highest U.S. Federal rate of tax, which is 40.8%: 37% short-term capital gains tax plus 3.8% net investment income tax. Therefore, this $100,000 of “tax credit” can offset 40.8% tax on a capital gain of $100,000, or $40,800. That savings of $40,800 is our after-tax return of 4.08% on our $1m portfolio investment. We call that “tax alpha.”
You’ll notice that the after-tax return diminishes over time, simply because the opportunity to sell stocks at a loss diminishes as losses are harvested and more and more stocks in the portfolio have their cumulative returns set back to zero. Nonetheless, over 10 years, this hypothetical strategy would have generated $269,875 worth of realized losses, which could have been used to save $110,109 of tax liabilities.
You may wonder which gains are being offset by these losses, given that the portfolio’s return was zero. This is an important point.
These “tax credits” don’t all have to be used to offset gains in the tax-managed strategy itself. Rather than thinking of them as part of the strategy, these “tax credits” can be thought of as credits sitting at a bank that we will call “Inland Revenue Bank.” Whenever you owe “Inland Revenue Bank” a payment, you can use the credit in the account at Inland Revenue Bank in your name to offset the payment. Unless you find a way not to owe “Inland Revenue Bank” any payments at all, these credits can be enormously helpful. They can be used to offset gains realized anywhere in your portfolio—from the sale of other investment securities, for example, or the sale of real estate. They can also be saved up for use in later years, when you have enjoyed a particularly large gain on capital, say, or when you are selling assets to prepare for retirement.
That is why the way an investor’s portfolio manager reports returns is important. Reporting on a standard strategy that is not actively managed to generate tax credits will generally show returns that are pre-tax but also pre-liquidation, as per GIPS requirements. That is understandable: most of such strategies’ after-tax returns would be lower, because they tend not to realize enough losses to offset the full tax liability. But even if they did realize a high enough value in losses, there is potentially no way an investor would know—the transparency into the potential tax credits generated just is not there.
By contrast, reporting on a strategy that is actively managed for tax efficiency does include reporting on after-tax, after-liquidation returns. That’s because, more often than not, “tax alpha” is positive, and it therefore shows the benefit of a tax-managed strategy to the client. But it also gives the investor transparency into the excess tax credits that the strategy has generated, which can be used to lower the tax liability of liquidations elsewhere in the portfolio. In other words, a good manager of a tax-managed equity strategy delivers two benefits to the investor: the tax credits themselves, and the reporting transparency that enables the tax credits to be used most efficiently, whenever and wherever they can be.
Active tax managers use a variety of strategies to extract realized losses, either long- or short-term. Some trade every few weeks, within reasonable parameters so the main portfolio exposure is not impacted, some trade short-term losses against long-term gains, some only harvest losses below a specific threshold, some actively trade to get dividends to fall under the Qualified Dividend Income threshold (which has a lower tax rate): there are many ways to improve a portfolio’s tax efficiency. We’ll cover some of this in our next blog where we will discuss how to optimize active tax management.