As humans we try to make sense of things. This is necessary for survival. We order, segment and compartmentalize things so that the we can move forward with our daily lives. While in many ways this is good and necessary, there are drawbacks to this. Too often, it ends up in a situation where we throw out the baby with the bath water as the phrase goes. Sometimes we need to take a step back and say, what am I missing?
Not all tax-managed solutions are created equal
The tax-managed space is one such area where we see this happen. There are a number of views investors and advisors have when it comes to a topic such as tax management. Many of them are potential positives, such as:
- It lowers my tax bill
- It helps me grow my after-tax wealth faster
- My money is working for me better and faster
- It’s not what you make, it’s what you get to keep
- Unfortunately for some, the topic of tax-management has some other, less than positive things come to mind:
- My returns might not be as good if I do this
- Tax-management means I have to give up something
- If I just run faster I can outrun the tax bill
Here's the thing. While all of the above items, good and bad, may be true at times or may be true with specific solutions, broadly placing everything in the same bucket and then negatively labeling is definitely limiting. It’s the equivalent of throwing out the baby with the bath water.
It’s about outcomes
At the end of the day, what is likely most important to an investor and advisor is does this fit the bill, and does it do what I need it to do? In a taxable account, this means two things: 1) did I get the return I need for this strategy to meet my goals, and 2) how do I keep most of the return in my pocket by potentially minimizing the drag of taxes?
Actual numbers: Pre-tax returns
Let’s take a look at the actual numbers. Table 1 shows the pre-tax returns side by side for two different asset classes. What is being displayed here, in order, is a comparison, first looking at U.S. large cap, followed by U.S. small/mid cap. The comparison shown is the Morningstar blend universe for each asset class, a tax-managed peer group of just blend managers, a tax-managed peer group consisting of blend, growth and value managers, and then the Russell Investments tax-managed fund for that specific asset class. The tax-managed peer group is a sub-group created out of the Morningstar universes by screening for the word tax in the fund’s name.
Pre-tax returns (as of December 31, 2020)
Performance quoted represents past performance and should not be viewed as a guarantee of future results. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Current to the most recent month-end performance data may be obtained by visiting https://russellinvestments.com.
Tax-Managed U.S. Large Cap Fund : Annual Total Operating Expenses: 0.95% Annual Net Operating Expenses: 0.92%*
Tax-Managed U.S. Mid & Small Cap Fund : Annual Total Operating Expenses: 1.29% Annual Net Operating Expenses 1.20%*
Source: Morningstar Large Blend, Morningstar Large Growth, Morningstar Large Value, Morningstar Small Blend, Morningstar Small Growth, and Morningstar Small Value universes. See disclosures at end of article for peer group methodology. Active Large Blend: US Fund Large Blend excluding ETFs. Active Small and Midcap (SMID) Blend: US Fund Small Blend and US Fund Mid Blend excluding ETFs.
What you can see here is, on a pre-tax basis over the last one, three, five and 10-year periods, having a focus on tax-management did not harm returns. In fact, both tax-managed peer groups listed here as well as the Russell Investments funds outperformed the Morningstar Blend universes in both asset classes! This hopefully dispels the myth that by having a focus on tax-management an investor is giving something up. Again, while there might be periods where performance results could fluctuate and move the tax-managed comparisons to negative, this clearly shows there is not necessarily a disadvantage being created for investors who choose to go down the tax-managed route.
Actual numbers: After-tax returns
In the second comparison shown here in Table 2, we mimic the periods, asset classes and constituent comparison of the first table, but instead place the focus on what the after-tax returns look like.
After-tax returns (as of December 31, 2020)
Performance quoted represents past performance and should not be viewed as a guarantee of future results. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Current to the most recent month-end performance data may be obtained by visiting https://russellinvestments.com.
Tax-Managed U.S. Large Cap Fund : Annual Total Operating Expenses: 0.95% Annual Net Operating Expenses: 0.92%*
Tax-Managed U.S. Mid & Small Cap Fund : Annual Total Operating Expenses: 1.29% Annual Net Operating Expenses 1.20%*
Source: Morningstar Large Blend, Morningstar Large Growth, Morningstar Large Value, Morningstar Small Blend, Morningstar Small Growth, and Morningstar Small Value universes. See disclosures at end of article for peer group methodology. Active Large Blend: US Fund Large Blend excluding ETFs. Active Small and Midcap (SMID) Blend: US Fund Small Blend and US Fund Mid Blend excluding ETFs.
Highlighted here, which should come as no surprise after seeing the results from the first table, is that the after-tax returns for the different constituent categories have a widened positive gap versus the overall Morningstar blend peer universes. Not only do the tax-managed peer groups maintain their more positive results vs. the Morningstar peer universe, they expand it on an after-tax basis! This further hopefully dispels the myth that by embracing tax-management you need to give something up. The reality shown here is that by embracing tax-management, you may gain something instead.
Even more impressive in this analysis are the outcomes generated with the two Russell Investments portfolios relative to both the tax-managed peer groups and the Morningstar peer universes. There is clearly a dispersion of returns across managers focused on tax-management. Through a strong tried-and-true investment process focused on generating both solid pre- and post-tax returns, the Russell Investments portfolio is able to set itself apart. Hence, not all tax-managed solutions are created equal.
Taxes need to be an investment consideration
Taxes are a cost when it comes to investments. The impact of taxes is a drag on a portfolio’s after-tax returns. In essence, it’s a fee of sorts—a government fee being applied to investment portfolios. We believe this is something that should be managed to both minimize its impact and maximize the after-tax return on investor experience.Tax-management should be a major consideration when constructing an investment portfolio for a taxable investor. Because at the end of the day, it’s not what you make, it’s what you get to keep.
Disclosures
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
This material is not an offer, solicitation or recommendation to purchase any security.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.
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This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.
Russell Investments Financial Services, LLC, member FINRA, part of Russell Investments.
Fund objectives, risks, charges and expenses should be carefully considered before investing. A summary prospectus, if available, or a prospectus containing this and other important information can be obtained by calling 800-787-7354 or by visiting https://russellinvestments.com. Please read a prospectus carefully before investing.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
*The Net Annual Operating Expense Ratio may be less than the Total Operating Expense Ratio and represents the actual expenses expected to be borne by shareholders after application of: (b) a contractual cap and reimbursement on expenses through February 28, 2021. These contractual agreements may not be terminated during the relevant periods except at the Board of Trustee's discretion. Details of these agreements are in the current prospectus.
Absent these reductions, the fund's return would have been lower.
Returns after taxes on distributions may be the same as returns before taxes for the same period if there were no
distributions for that period.
After-tax returns are calculated using the historical highest individual federal marginal income tax rates and the
3.8% net investment income tax, and do not reflect the impact of state and local taxes. After-tax returns depend
on an investor's tax situation and may differ from those shown. After-tax returns shown are not relevant to
investors who hold their Fund shares through tax-deferred arrangements, such as 401(k) plans or individual
retirement accounts.
If the Fund has realized capital losses, the return after taxes on distributions and sale of fund shares may be
higher than the return before taxes and the return after taxes on distributions. The calculation of return after taxes
on distributions and sale of fund shares assumes that a shareholder has sufficient capital gains of the same
character to offset any capital losses on a sale of fund shares and that the shareholder may therefore deduct the
entire capital loss
Tax-Managed U.S. Large Cap Fund
Tax-Managed U.S. Mid & Small Cap Fund
Tax-Managed U.S. Mid & Small Cap Fund
Russell manages a portion of the Fund’s assets to effect the Fund’s investment strategies and/or to actively manage the Fund’s overall exposures to seek to achieve the desired risk/return profile for the Fund.
Index-based strategies may cause the Fund’s returns to be lower than if the Fund employed a fundamental investment approach to security selection with respect to that portion of its portfolio.
Income from the Tax-Managed U.S. Large Cap Fund and the Tax-Managed U.S. Mid & Small Cap Fund are managed for tax efficiency and may be subject to an alternative minimum tax, and/or any applicable state and local taxes
For all Russell Investment Company Funds, a portion of the income and capital gains distributions made by Russell Investment Management, LLC (RIM) funds throughout a calendar year may be subject to special tax treatment at calendar year end. Such treatments may reduce taxes shareholders may experience; The after tax returns for the current calendar year are recalculated at the year end to account for this reduction and may become slightly higher than currently reported. For previous calendar years, tax reductions due to such treatments are reflected in the after tax returns of the funds.
For all Russell Investment Company Funds, cash equitization techniques are utilized with futures in order to approach a fully invested portfolio position and to earn "market-like" returns on the Fund's excess and liquidity reserve cash balances.
Large capitalization (large cap) investments generally involve stocks of companies with a market capitalization based on the Russell 1000® Index. The value of securities will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions.
Investments in small cap, micro cap, and companies with capitalization smaller than the Russell 2000® Index are subject to the risks of common stocks, including the risks of investing in securities of large and medium capitalization companies. Investments in smaller capitalization companies may involve greater risks as, generally, the smaller the company size, the greater these risks. In addition, micro capitalization companies and companies with capitalization smaller than the Russell 2000® Index may be newly formed with more limited track records and less publicly available information.
MORNINGSTAR CATEGORY DEFINITIONS:
US Fund Large Blend: Large-blend portfolios are fairly representative of the overall U.S. stock market in size, growth rates, and price. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of U.S. industries, and owing to their broad exposure, the portfolios' returns are often similar to those of the S&P 500 Index.
Large-growth portfolios invest primarily in big U.S. companies that are projected to grow faster than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries.
Large-value portfolios invest primarily in big U.S. companies that are less expensive or growing more slowly than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).
US Fund Mid Blend: The typical mid-cap blend portfolio invests in U.S. stocks of various sizes and styles, giving it a middle-of the-road profile. Most shy away from high-priced growth stocks but aren't so price-conscious that they land in value territory. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.
US Fund Small Blend: Small-blend portfolios favor U.S. firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks while others employ a discipline that leads to holdings with valuations and growth rates close to the small-cap averages. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.
Small growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).
Small value portfolios invest in small U.S. companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow)..
OTHER CATEGORIES DEFINITIONS AND CONSTRUCTION:
- To create the tax-managed peer groups, we screened for Funds in the Morningstar universes that had specific words/descriptors in their names (tax, tax managed, tax-managed, tax-mgd, tx-mgd, tax exempt).
- Tax-managed Large-Cap peer group of blend managers: we used the Morningstar Large Blend universe.
- Tax-managed peer group of Large Cap Blend, Growth, and Value Managers: we used the Morningstar Large Blend, Morningstar Large Growth and Morningstar Large Value universe.
- Tax-managed Small Cap peer group of blend managers: we used the Morningstar Small Blend universe.
- Tax-managed peer group of Small Cap Blend, Growth, and Value Managers: we used the Morningstar Small Blend, Morningstar Small Growth and Morningstar Small Value universes.
Income from funds managed for tax-efficiency may be subject to an alternative minimum tax, and/or any applicable state and local taxes.
Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Index return information is provided by vendors and although deemed reliable, is not guaranteed by Russell Investments or its affiliates. Due to timing of information, indices may be adjusted after the publication of this report.
Historical data shown not an indicator of future results. Other universes/indexes will produce different results.
Morningstar returns are not inclusive of sales charges.
The Morningstar categories are as reported by Morningstar and have not been modified. © 2019 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Investors should consult with their financial and tax advisors before investing.
RIFIS 23603