Three typical approaches to tax-managed investing. And why they’re wrong.
We recently shared a podcast on the topic of tax-smart investing, with significant insights from my colleague Jon Eggins, senior portfolio manager for global equities. I found the content compelling and it inspired me to write this blog post, based largely on Jon’s thoughts:
If you’re an investor or advisor and not worrying about the tax drag on your taxable investments, you’re almost certainly paying the price. And you’re almost certainly paying a lot.
Think how hard you work to generate a few more basis points in return, for yourself and your clients. Then consider this statistic: Over the last five years ending December 2017, using the Morningstar universe of U.S. large-cap managers, 187 basis points—1.87%—was lost to tax drag. That’s an annualized number, not a cumulative one—almost two percent in lost performance, annually.
So, let’s give kudos to the investors and advisors who take on the tax problem. But let’s use caution when we look at the typical approaches—and their respective challenges—that try to offer solutions.
Three typical approaches:
- Traditional mutual funds. The most common method is the most dangerous for most investors—which is simply investing in traditional mutual funds. Standard mutual funds seek to beat the broad market benchmark and beat their peers, which is good. But they don’t actively try to manage the after-tax return. The tax drag on those solutions can be quite extreme. We call this the ostrich method, where investors put their heads in the sand. They don’t think about negative tax impacts until they get that annoying letter from their fund company in February or March, telling them how big of a check they have to write to the IRS.
- The passive approach. The second approach is to wave the white flag, admit that taxes are tough and you’d rather avoid paying them, and default to passive investment vehicles like ETFs. The good news is that ETFs, with low turnover and low fees, can get investors closer to a tax-smart approach without too much work. But most of these solutions fail to provide a silver bullet. They can be surprisingly tax-unfriendly. In 2017, the average passively-managed U.S. equity fund still had more than one percent in tax drag, based on Morningstar data for the year.1 One percent of missed returns for a year is still too much, in my opinion.
- Annual tax-loss harvesting. Investors who are tax-aware will often invest in a separately-managed account. Then, in November or December, they’ll scour their portfolio for potential tax-loss harvesting opportunities: looking for individual stocks that have gone down, to sell those and harvest a loss, in order to offset any gains in the period.The problem with this approach is that it requires substantial resources and focus to do it well. Investors can try to harvest tax losses themselves. Some also will do so with an asset manager that provides a separate account. But markets don’t always cooperate at the time when investors need them to. If you’re not looking at the portfolio every day, all year long, this approach may not work. If you waited until December in 2017, for example, it was kind of too late, because U.S. equity markets had run so hard with record low volatility that tax loss harvesting opportunities were few and far between. And, frankly, the effort and time required is too much for most investors.
Is there a better way?
Each of these approaches has upsides we don’t want to give up:- Tax-loss harvesting is still the best way to minimize tax payments, in our opinion.
- Passive investing is the least work. If it’s easy, investors are more likely to do it.
- And traditional mutual funds still provide access to the benchmark-beating potential that can come from active management.
- The unconstrained opportunities that come from finding the world’s best money managers, seeking to generate the best possible excess returns.
- And a tax-smart approach that executes every trade in a tax-smart way, all year long.
The upside of down days
Let’s assume your asset manager of choice is good at finding return opportunities. What would it take for them to also be good at a tax-smart approach? What’s required are serious trading capabilities, along with a mind shift in regard to down days. Let’s say there’s a segment—say U.S. energy stocks—that get hammered in the markets. Even though most of the investment world is sad, that’s when a tax-management team is typically excited, because that can be their time to shine. A skilled tax management team can take advantage of that downside event and incrementally tax-loss harvest in a way that doesn’t dramatically depart from the overall structure of the portfolio. They can make surgical adjustments at the margins, selling five basis points here and ten basis points there. If they have the resources, focus, and skillset to do that on a year-round basis, that allows an asset manager to harvest a meaningful amount of losses throughout the year and not be victim to the tyranny of a low-volatility, high-return December market. So, is all this worth the effort? Yes. We’ve already seen that below-the-surface tax costs can create a massive drag on long-run returns. For investors, avoiding such drag can help give them a greater chance of reaching their goals. For advisors, a focus on tax-smart investing can create significant differentiation from competitors. When it comes to investing, tax-smart is just plain smart.1 Based on arithmetic average of Morningstar’s Tax Cost Ratio for U.S. ETF Large Blend, U.S. ETF Large Growth, U.S. ETF Large Value, U.S. ETF Mid-Cap Blend, U.S. ETF Mid-Cap Growth, U.S. ETF Mid-Cap Value, U.S. ETF Small Blend, U.S. ETF Small Growth, U.S. ETF Small Value, U.S. OE Large Blend, U.S. OE Large Growth, U.S. OE Large Value, US OE Mid-Cap Blend, U.S. OE Mid-Cap Growth, U.S. OE Mid-Cap Value, U.S. OE Small Blend, U.S. OE Small Growth, U.S. OE Small Value universes as defined by Morningstar. Passive is defined as being an index fund as reported by Morningstar or part of an ETF Category. Data includes all share classes.