“To investors, costs matter,” says Kevin Maeda, Chief Investment Officer for Active Index Advisors® (AIA), a division of Natixis Advisors. “Most people think about investment costs as commissions or advisory fees or expense ratios. But what they don’t think about are the tax costs on a portfolio, which can be greater than all those other costs combined.”
In fact, according to a Lipper Analytics study,1 taxes have been shown to reduce a portfolio’s returns by 1%–2% every year, significantly eroding what a client keeps. That means that a hypothetical annualized average stock return of 10% could drop to an 8% return after taxes are factored in. Compounded over time, that can add up to a powerful tax hit.
Taxing Consequences of Cuts
Even though federal tax rates were lowered for most taxpayers in 2018 via the Tax Cuts and Jobs Act, it wasn’t all good news for investors. Tax rates applicable to long-term capital gains and dividends did not change, and the cap on deductions for state and local taxes resulted in higher effective rates for many taxpayers.
Overall, taxes remain the largest expenditure for high income households – far outweighing any other cost, including housing. In short, taxes need to be more top of mind than ever and ignoring the toll they can take on a portfolio can be a costly and long-lasting mistake.
Smarter Approach to Indexing
One way to help maximize after-tax wealth is through an index-based separately managed account (SMA) that is specifically designed to help reduce the impact of taxes on returns. Also referred to as direct indexing, this type of SMA is an individually owned, customized portfolio that seeks to track index performance before taxes but outperform it after taxes. To accomplish this, portfolio managers actively look for tax savings opportunities across the portfolio on a quarterly basis, not just at year’s end. For example, they utilize tax loss harvesting techniques to sell securities that have lost value and bank those losses, which can then be used to offset gains in other parts of an investor’s portfolio. If there are no gains to offset in that particular year, losses can be carried forward to offset future gains in subsequent years. For example, Maeda says that if an investor anticipates having a large gain some time in the future – such as selling a business in five years’ time – managers can apply the loss carry-forward strategy by having realized losses in place to offset those gains.
“Index SMAs are a great way to add dimension and tax efficiency to high net worth portfolios,” Maeda says. “When we utilize our tax loss harvesting process in the AIA S&P 500® Strategy, we’re looking for stocks that are down based on when a client bought them. In this manner, we’re trying to help mitigate capital gains tax consequences and maximize the after-tax returns for each individual client.”
Top Household Expenditures for $200,000+ Households2
|1. Personal taxes||33.5%|
|3. Personal insurance/pensions||12.2%|
|8. Cash contributions||3.2%|
|9. Apparel and services||3.1%|
Three More Use Cases
Besides the primary use of maximizing after-tax returns, consider these other scenarios for when index-based, actively tax-managed SMAs are a smart choice.
- Transitioning accounts
Active indexing strategies enable tax-efficient portfolio transitions when transferring assets to a new portfolio manager. Often, with traditional transition methods, existing holdings cannot be integrated and assets must be liquidated, which can trigger substantial capital gains on the sale. To remedy this, AIA immediately loss harvests when positions are transitioned into its portfolios. This process continues by selling off anything not in the index before comparing the rest of the portfolio to the index. They also look to see if any sectors are overweighted, and whether specific weights for individual securities are too large. If so, they will trim down those weights and proceeds are then reinvested into the portfolio.
- Unwinding concentrated positions
Many times, investors who hold concentrated stocks are reluctant to liquidate because of the resulting capital gains expenses. But if the new SMA is funded with stock, the portfolio managers can build a portfolio around a capital gains budget and then tax loss harvest. This means they’ll slowly reduce the concentrated stock until the client is OK to realize more gains.
Alternatively, you can dollar cost average out of a concentrated position every quarter and into a completion portfolio. This way you gradually sell out of the stock and buy into the rest of the index to build diversification. This process spreads out the capital gains over multiple years instead of one, gradually building up a greater portion of the portfolio that acts as a loss-harvesting vehicle.
- Implementing ESG customization
Many investors want to go beyond tax-sensitive management and own a customized index that screens investments for environmental, social, and governance (ESG) constraints. AIA does this in two ways. Managers can align a client’s portfolio with their personal values by applying negative screening to an index such as the S&P 500 Index and removing the stocks a client doesn’t want (such as tobacco or gun stocks, for example). Or the portfolio managers can do proactive screening and build the custom index by using MSCI ESG ratings. Accounts can also be customized by investment styles, such as growth, value, or dividend tilts, or to screen for specific sectors, industries, or individual securities.
2 Sources: US Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey, 2015; AIA
Natixis Advisors L.P. does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions. This material is provided for informational purposes only and should not be construed as investment advice. There is no guarantee that objectives stated will be achieved. All securities are subject to risk, including possible loss of principal. Please read the risks associated with each investment prior to investing. Detailed discussions of each investment’s risks are included in Part 2A of each firm's respective Form ADV. References to performance are based on past performance, which is no guarantee of future results. This document may contain references to copyrights, indexes and trademarks that may not be registered in all jurisdictions. Third party registrations are the property of their respective owners and are not affiliated with Natixis Investment Managers or any of its related or affiliated companies (collectively “Natixis”). Such third party owners do not sponsor, endorse or participate in the provision of any Natixis services, funds or other financial products. Natixis Advisors, L.P. provides advisory services through its divisions Active Index Advisors® and Managed Portfolio Advisors®. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, L.P.