‍What are the three top benefits of using active tax management in a direct index SMA?

by Alex Papageorgis, head of quantitative investments

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Key Points:

• Taxes can be one of an investors’ biggest expenses and can take a big chunk out of their returns.
• Tax-aware investment management is the practice of considering a client's tax liabilities throughout the portfolio construction and management process to proactively maximize their after-tax returns. 
• This type of management becomes more important as an investors’ tax bracket increases.
• SMA investors own the individual equities in the underlying portfolio, meaning they are able to offset capital gains through the sale of investments that will produce a capital loss. 
• Tax-loss harvesting, tax-aware transitioning, and tax-aware withdrawals are three key benefits to tax-aware investment management. 

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What you earn is important — but what you keep matters more. One of the biggest ways to help your clients maintain and even enhance the performance of their portfolios is by using sound tax-aware investment management.

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What is tax-aware investment management? What are some of its biggest benefits? What does its management entail? Let’s explore.

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What is Tax-aware Investment Management?

Tax-aware investment management, also known as active tax management, is the practice of considering your client’s tax liabilities throughout the portfolio construction and management process to proactively maximize their after-tax returns. It can be particularly valuable for high-net-worth investors, given their oftentimes complex financial situations and tendency to be taxed at higher rates than their less-financially-endowed peers without strong tax management. In fact, more than half of high-net-worth individuals place greater emphasis on minimizing their tax burden during the investment decision-making process than in pursuing high returns without regard for the tax consequences.

As wealth advisers, it’s our fiduciary duty to act in our clients’ best interest and help them to advance their financial goals. Yet in the absence of a thoughtful tax strategy, high-net-worth investors may find themselves facing higher-than-necessary tax bills, impacting their investment returns in the longer term. 

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SMAs for Tax-aware Investment Management

At Ethic, we use separately managed accounts (SMAs) to create low-cost, index-tracking, and tax-efficient sustainable portfolios that align with clients’ overall portfolio allocation strategies while focusing on returns. 

SMAs are unique in that their holdings can be flexible, tax-optimized, and personalized to reflect the individual’s values and risk appetite — all while maintaining a low tracking error against the given benchmark. Crucially, unlike investing in ETFs or mutual funds, SMA investors actually own the individual equities in the underlying portfolio, meaning they are able to offset capital gains through the sale of investments that will produce a capital loss. And unlike when they invest into mutual funds, they’re also not beholden to embedded capital gains, which is when all investors in the fund share the tax liability for capital gains made each year. This holds true even when they haven’t benefited from any of those gains because they only bought into the fund in the latter part of the year.

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What does tax-aware investment management entail? 

Ethic’s personalized SMA portfolios make it easier for advisers to help their clients navigate the potential tax implications of a new investment strategy, engage in continuous tax management, and conduct tax-efficient withdrawals. Here’s a quick overview of the top three benefits: 

1. Tax-loss harvesting: An important part of any wealth adviser’s toolbox, tax-loss harvesting is the process of selling an investment that has declined in value in order to offset taxable gains in a portfolio. When implementing this strategy, it’s important to be mindful of a wash sale, which is a rule enacted by the Internal Revenue Service (IRS) that prohibits investors from repurchasing the investment they just sold — or one that’s considered “substantially identical” — for at least 30 days. 

2. Tax-aware transition: Some clients may wish to transition their portfolio to one that better aligns their personal values with their financial goals, but there can be tax considerations associated with liquidating a portfolio that has already accrued significant gains. Ethic’s direct indexing approach allows advisers to gradually transition a client’s positions over time, while identifying any overlap in holdings and determining the amount of taxable gains the client can absorb without deviating too far from benchmark exposure. 

3. Tax-aware withdrawal: Clients will likely wish to tap into the gains generated by their portfolios, particularly as they approach retirement. However, in the case of realized gain (i.e., when an asset’s sale price exceeds its original purchase price), there can be significant tax implications. Wealth advisers can help their clients to preserve their nest egg by establishing and maintaining a realized gain budget that can shield them from unnecessary tax surprises. 

The role of the adviser has expanded over the years, and it now entails much more than simply generating returns on investment. Clients may look to advisers for guidance when it comes to planning some of life’s biggest decisions, staying the course during emotionally charged times, ensuring that their personal values are reflected in their portfolios, and establishing their legacy for future generations. 

Investors also rely on advisers to demonstrate their value by successfully navigating the complexities of existing tax code and making sure money isn’t being left on the table. Advisers who familiarize themselves with tax-efficient direct indexing strategies could ultimately pay dividends in the form of more rewarding relationships with clients, who will almost certainly appreciate their proactive and personalized approach.

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Contact your relationship manager to learn more about how Ethic can help you and your clients build a direct indexing portfolio.

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Please see additional Tax-Loss Harvesting Disclosures here.

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