While most might not admit it, many wealth managers are drowning in their data lakes.
Calculating Value Add at Scale for Tax-Managed Accounts
In this post, we will explain what tax-managed separately managed accounts (SMAs) are, clarify terms relative to performance measurement for tax-managed SMAs, and the challenges faced by performance professionals in measuring and attributing performance.
After-Tax Returns
Investors who care about maximizing after-tax returns may sometimes consider using tax-managed SMAs as part of their portfolio strategy. Tax-managed SMAs are customized portfolios that seek to reduce the tax drag on investments by employing various tax-optimization techniques, such as loss harvesting, gain deferral, and tax lot selection.
Tax-Managed SMAs
Tax-managed SMAs are portfolios of individual securities that are tailored to specific investment objectives, risk tolerance, and tax situations.
Unlike mutual funds or exchange-traded funds (ETFs), which are pooled vehicles that have a single tax identity, tax-managed SMAs allow an investor to own the underlying securities directly and have more control over the timing and realization of capital gains and losses. This affords the opportunity to minimize tax liability and enhance after-tax returns.
Tax Alpha
Tax alpha is a measure of value created by the effective tax management of investments.
Tax-managed SMAs can generate tax alpha by implementing the following strategies:
- Tax-loss harvesting involves selling securities that have declined in value to realize capital losses that can offset capital gains from other sources, thereby reducing current tax bill. Tax-loss harvesting can also create tax assets that can be carried forward to offset future gains or income
- Gain deferral involves holding appreciated securities for at least one year to qualify for the lower long-term capital gains tax rate, rather than selling them and triggering the higher short-term capital gains tax rate. Gain deferral can also involve avoiding unnecessary turnover or rebalancing that could generate taxable events
- Tax lot selection: This involves choosing the most tax-efficient lots to sell when liquidating a position, based on the cost basis and holding period of each lot thereby minimizing realized gains or maximizing realized losses.
Calculating After-Tax Performance
Portfolio return: There are two ways to calculate after-tax returns: pre-liquidation and post-liquidation.
Pre-liquidation, after-tax returns assume that the portfolio is held until the end of the period, and only account for the taxes paid on the income and realized capital gains during the period.
Post-liquidation after-tax returns assume that the portfolio is sold at the end of the period, and account for the taxes paid on the income, realized capital gains, and unrealized capital gains during the period. Pre-liquidation after-tax returns are more relevant for ongoing tax management, as they reflect the tax efficiency of the portfolio during the holding period, and do not depend on the timing of the sale.
Benchmark Returns: After-tax benchmarks are reference portfolios that reflect the market or a target index, adjusted for the impact of taxes on the returns. They are important for assessing the value added by tax management and investment decisions.
Calculating after-tax benchmarks can be challenging, as it requires choosing an appropriate reference portfolio that reflects the investor’s risk and return profile, tax situation, and investment horizon, and accounting for the effects of portfolio turnover, dividend payments, corporate actions, and benchmark rebalancing on taxes. Moreover, it requires estimating the tax rates and tax liabilities of the reference portfolio, which may differ from those of the actual portfolio. The other challenge is doing this at scale when supporting many client reporting needs.
Conclusion
Tax-managed SMAs can be a powerful tool for investors who want to optimize their after-tax returns and achieve their long-term financial goals.
By using tax-efficient strategies, such as loss harvesting, gain deferral, and tax lot selection, tax-managed SMAs may generate tax alpha and reduce the tax drag on the portfolio.
However, measuring and comparing the performance of tax-managed SMAs requires using after-tax metrics and accounting for the investor’s individual tax situation. Therefore, investors should consult with their financial advisors and tax professionals before investing in tax-managed SMAs.
(The author Shankar Venkatraman, CFA, FRM serves as a vice president of performance measurement and client reporting for global asset manager American Century Investments, with headquarters in Kansas City, Missouri. He will be a speaker at FTF’s Performance Measurement & Client Reporting event on Feb. 29, 2024, at Etc. Venues, 601 Lexington Ave. in New York City.)
DISCLAIMER: The opinions expressed are those of Shankar Venkatraman and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
References:
https://www.investopedia.com/terms/a/after_tax_return.asp
https://www.investopedia.com/terms/r/returnoninvestmentcapital.asp
https://www.blackrock.com/us/financial-professionals/insights/tax-efficient-equity-investing
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