Taking a tax-efficient approach to the portfolio management process can help investors make the most of potential growth opportunities. Taxes on investments shouldn’t be an afterthought, particularly since it is possible for tax costs to exceed expenses associated with investment management or advisory fees.

Tax Management: Easier Said?
Managing for taxes is often easier said than done because it isn’t nearly as easy to measure tax-efficiency as it is to assess the other costs associated with a fund. Tax-efficiency metrics are typically only available on a historical basis, and it is important to evaluate the context of how particular results were attained. For example, are the metrics the product of a tax-efficient strategy? Or simply the result of being in the right place at the right time?

Taking an Accurate Measurement
Of the many ways to measure tax-efficiency, including tax alpha, most aren’t easy to calculate, have limited utility, or simply aren’t accessible to most advisors. But two widely available measures may be useful for assessing how efficient a particular fund manager has been with tax management: tax cost ratio and tax-adjusted returns. These metrics also provide the ability to compare funds to gain a better understanding of which might be more tax-efficient.

  1. Tax Cost Ratio
    A tax cost ratio compares after-tax returns to pre-tax returns and can be likened to a tax expense ratio. This measurement is designed to describe how much of a fund’s returns an investor pays in taxes. For example, a 1 percent tax cost ratio on a fund with a 10 percent pre-tax return would mean that the fund lost one-tenth of its returns in taxes. The lower the number, the higher the tax-efficiency.

    One potential limitation of tax cost ratios for actively managed funds is that superior active management before taxes may be associated with poor tax-efficiency, high tax costs, and thus a higher tax cost ratio, while inferior active management before taxes may end up being quite tax-efficient and have a lower tax cost ratio. This is because superior active managers may purchase and subsequently sell securities that have appreciated, while inferior active managers may have purchased and later sold securities that have performed poorly. Thus, while the tax cost ratio is important, it should not take precedence over total returns. Tax cost ratios can also vary depending on market movements.
  2. Tax-Adjusted Returns
    A fund’s tax-adjusted return provides context around the difference between what the fund returned on a pre-tax basis and what it returned on an after-tax basis. Notably, each investor’s tax situation is different. Equally important is the fact that tax-adjusted return figures may not include state or local taxes and may also assume that a fund is held for a specific period of time with no redemptions or contributions. While tax-adjusted returns aren’t representative of an individual investor’s returns, they may provide a rough measurement of how much of a fund’s returns are paid to taxes.
Consider the Fine Print Too
Once you’ve got a sense for a fund’s tax-efficiency, it’s a good idea to evaluate the manager’s stance on tax management by digging into the fund’s literature. It is important to investigate whether a manager is intentionally pursuing tax-efficiency as part of a deliberate strategy. And finally, because each individual investor’s tax situation is different, it’s wise to consult with a tax advisor to determine the utility of a particular tax strategy.
The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Diversification does not guarantee a profit or protect against a loss.

Tax loss harvesting is the selling of securities at a loss to offset a capital gains tax liability.

Natixis Investment Managers Solutions does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.

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