Tax-smart portfolio turnover: The good kind
Think back to your last doctor’s visit … were you screened for your cholesterol levels?
If you are of a certain age, after your regular checkup, your doctor gives you the results of your body’s good and bad cholesterol. While bad cholesterol is what everyone focuses on, it’s important to realize that your body does make good cholesterol that helps to lower the risk of heart disease.
If your cholesterol numbers were bad, what did your doctor tell you about how to reduce your bad cholesterol and improve the good? Perhaps some changes to your diet or exercise program?
Quarterly portfolio reviews are a little like a regular doctor’s visit for your clients’ investments. Conventional wisdom has relied on portfolio turnover as a starting point for screening investments, especially for non-qualified accounts. But just like cholesterol, there is good and bad portfolio turnover!
We mention this because you may have had some difficult conversations with clients about their Form 1099-DIV this year, which possibly felt a bit like the conversation you had with your doctor if your cholesterol numbers were poor.
The S&P 500 Index returned 26% in 2021, its third straight year of double-digit returns. But with all good news, there is always a little not-so-good news: it was also a banner year for capital gains distributions. The average capital gains distribution for U.S. equity mutual funds in 2021 was 12% of net asset value (NAV), the highest level in 20 years.
And for investors in non-qualified accounts, that likely led to a big tax bill in April.
Why is good portfolio turnover important?
Remember, capital gains aren’t always a product of strong market or fund level performance. Instead, they are determined by the sale of securities within a fund. Even when markets are down, the sale of a security can still generate a gain, for example, if the security had been held in the fund for many years and had appreciated.
There are many reasons why a fund, or a group of funds, may distribute capital gains in any given year. A significant downturn in the markets may require the fund to raise cash to meet redemption requests, resulting in the selling of stocks at a gain, depending on how long they’ve been held. Managers may shift their investment thesis to take advantage of new opportunities, causing them to sell positions they may have held for a long time.
No matter the reason, they all result in what’s referred to as portfolio turnover. Simply put, portfolio turnover is a measure of how quickly securities in a fund are either bought or sold by the fund's managers over a given period, typically annually.
Many investors believe that one of the most effective ways to create a more tax-efficient mutual fund is to reduce its turnover ratio. It is true that high turnover can increase trading costs, thus increasing the fund’s costs. And funds with high turnover are more likely to incur capital gains taxes.
However, some turnover may be due to a long-term investment strategy transitioning from one security to another after benefiting from years of deferrals. And the best turnover comes from tax loss harvesting activity in which offsets to realized capital gains are accumulated.
In the cholesterol example above, there is good and bad cholesterol, and we all have both. But it’s important to have more good than bad cholesterol. The same applies to turnover in a taxable portfolio. There will be a variety of turnover in most portfolios; but you generally want to see more good turnover vs. just bad turnover. Bad turnover generates lots of gains, including short term gains. Good turnover lowers the impact of trading activity and/or offsets gains with tax assets generated from loss harvesting activities.
You may have recommended to your clients that you screen their mutual funds based on portfolio turnover, with the aim of limiting capital gains taxes.
This is much like your doctor recommending you meet with a nutritionist.
Solving the tax problem is just not that simple!
How does tax-smart turnover work?
At Russell Investments, our tax-managed solutions deploy good turnover. With our active tax-management approach, we use tax-smart levers throughout the year in the form of tax-smart turnover.
Our process for tax-smart turnover is multi-faceted.
- It starts with embracing a long-term focused investment strategy. This allows us to minimize the occurrence of short-term gains and focus on long-term appreciation where investors get to benefit from deferred realization of capital gains.
- Throughout the year we are active and opportunistic in tax-loss harvesting—this activity nets us offsets (tax assets) in the form of an accumulated tax-loss carryforward. These tax assets help in reducing, minimizing, and in many years, eliminating capital gain distributions.
- Additionally, we take it to another level by carefully evaluating tax lots. By better utilizing tax-lot level accounting while trading activity occurs, we can minimize the cost of taxes of trading activity by more thoughtfully choosing tax lots at the time of trade.
- All these items in combination and more—call it Russell Investments thoughtful turnover strategies—allow us to avoid portfolio lockup (this is when a portfolio has mostly gains embedded in it and virtually any trade will generate a realized gain). By thinking about it and implementing turnover more thoughtfully, our investors are in a much better position to achieve improved after-tax results.
This is just one of the levers that we use to simplify the delivery of an after-tax outcome for investors.