Relative to the index, the after-tax returns for an ETF can be lower. Due to tax regulations, asset managers are only able to distribute capital gains, but not losses, which many clients find difficult to understand. However, by applying active tax management to an index-based separately managed account (SMA), some managers have been able not just to track the index on a pre-tax basis, but also to beat it after taxes.
Kevin Maeda, CIO of Active Index Advisors® (AIA), a division of Natixis Advisors, has been one of the pioneers of this strategy over the past 16 years. He explained that AIA strategies have been able to outperform many ETFs by using an index-based SMA structure as a core portion of their equity portfolios.
“The primary use is for people using this as simply tax-efficient beta1,” Maeda said. “This can be worth a significant amount, especially if you’re compounding that over time.”
Utilizing Losses Against Gains
While AIA has a similar dividend yield2 in its portfolios to an ETF, the concept behind the strategy is to defer gains and realize losses before utilizing those losses to offset gains from other investments, or from capital gains distributions.
This is done through a quarterly loss harvesting process across the entire portfolio. Taking an adjustable threshold of about 5% short-term losses, depending on the client’s individual tax rates, AIA’s algorithms sweep the portfolio, selling loss-making stocks and buying other securities in their place.
If there are no gains to offset in that particular year, losses can be carried forward as a tax-planning tool. Maeda pointed out that if clients anticipate having a large gain some time in the future – for example, selling a business in five years’ time – managers can utilize this strategy by having realized losses in place to offset those gains.
“All we’re doing is taking advantage of the tax laws where we hold on to the winners as long as we can and sell off the losers,” Maeda said.
In total, AIA works with more than 2,400 accounts. Maeda cautioned that aspects of the strategy can be misunderstood by clients. “When we talk about loss harvesting, people ask if we are trying to pick losers. We’re not – we’re simply picking diversified portfolios which track the index and take advantage of stock dispersion. If losers are there, we’ll take advantage of them, and we simply try to keep the winners on paper as long as we can,” said Maeda.
Keeping Costs Low
To keep costs low, AIA typically holds around 150 stocks, depending on the portfolio. The team estimates that this results in around one-fifth of the transactional volume of their competitors, and it means that when using brokerage-based fees (rather than asset-based fees), trading charges can be significantly lower.
In order to maximize after-tax returns for individual investors, Maeda said that AIA’s approach does not utilize a model portfolio. This also gives clients the ability to add their own customization features to the account – a level of flexibility which has proven important, with at least half of the clients choosing to set some sort of tax constraint.
“Clients can set a budget for the amount of capital gains being raised,” Maeda said, adding “Then we’ll realize gains up to the budget and only realize more if they can be offset with losses. This gives the client very fine tax control, so there are no surprises. Then in the future we can discuss if they’re comfortable raising more capital gains to get the portfolio closer to the index, if it’s not transitioning fast enough on its own.”
In addition to tax constraints, many clients want further combinations of features such as socially responsible investing constraints. AIA subscribes to a range of screens, and Maeda said that there are two main ways to create a custom index for the client. Managers can apply negative screening to an index such as the S&P 500®3 and take out the stocks that a client doesn’t want, or alternatively choose proactive screening, building the portfolio using MSCI ESG4 ratings. “This is only possible because it’s non-model-based,” Maeda said. “You can’t buy this off the shelf, but you can build it here. Even if you have 100 clients with 100 different scenarios, we can build all of them because none of our accounts look alike anyway.”
Crucially, AIA has algorithms in place that automatically take care of the customization process, meaning that clients see no difference in fees between the default and custom options. However, manual intervention can take place in order to deal with conflicting constraints.
Transitioning Low Basis Portfolios
AIA index portfolios can enable tax-efficient portfolio transitions when transferring assets to a new portfolio manager. The problem with traditional options for transferring stock portfolios is that they do not always provide the flexibility for integrating existing holdings into a comprehensive portfolio solution, meaning that clients can be forced to liquidate assets. This then triggers substantial capital gains on the sale. To provide a less expensive and more tax-efficient route, AIA immediately loss harvests when positions are transitioned into its portfolios. This process will additionally sell off anything not in the index, before comparing the rest of the portfolio to the index. They will then target sector-neutral weights to detect whether sectors are overweighted and whether specific weights for individual securities are too large. After trimming those weights down, the proceeds are then invested back into the portfolio, with the aim of targeting sector-neutral weights and diversification across differently sized companies.
Concentrated Wealth Strategies
A more extreme version of this process can be applied to deal with concentrated stock positions, where clients holding concentrated stocks are reluctant to liquidate because of the resulting capital gains expenses. “There are two ways we work with this,” said Maeda. “If they fund the account with stock, they can give us a capital gains budget. We’ll build a portfolio around it and then loss harvest. So we’ll chip away at the concentrated stock until the client is OK to realize more gains.” The alternative is, over a finite timeframe, to dollar-cost average out of that position every quarter and into a completion portfolio. So it’s about gradually selling out of the stock and buying into the rest of the index to build diversification.
Maeda pointed out that the idea is simply to spread out the tax gains over multiple years instead of one, gradually building up a greater portion of the portfolio that acts as a loss-harvesting vehicle. The approach can be done flexibly with a portion of the client’s position at a time, rather than the whole position, in order to help them get over some of the psychological hurdles of the tax consequences. “It’s why we don’t recommend liquidating the portfolio then starting again, because all you’re doing is accelerating the taxes,” he said.
“If clients are using it as a core, they tend to reinvest in it over time. If you add more cash to it, you reset the basis, which allows you to get more loss harvesting. The harvesting does tend to diminish over time, but it never completely goes away because we are reinvesting dividends or we’re rebalancing the portfolio to keep it in line with the index.”
2 Dividend yield is the ratio of a company's annual dividend compared to its share price.
3 The S&P (Standard & Poor’s) 500 Index® is an index of 500 stocks often used to represent the US stock market.
4 The MSCI ESG Indexes are designed to support common approaches to environmental, social and governance (ESG) investing, and help institutional investors more effectively benchmark to ESG investment performance as well as manage, measure and report on ESG mandates.