April 15th—Tax Day in America—often causes affluent and high-net-worth (HNW) investors to make major disbursements to the federal government. For individuals who make quarterly payments to the Internal Revenue Service, Tax Day rears its head in every season. Whether an investor endures the angst and, typically, cash outflow for federal taxes annually or quarterly, the individual’s public equity portfolio is frequently the source of significant capital gains. The wealthiest 1% of households hold more of their wealth in stocks than in real estate and cash combined,1 a situation that makes it especially important to assess the taxes associated with these large holdings. Due to caps on annual 401k and IRA contributions, it is also unlikely that wealthy investors have most of their equities in tax-deferred accounts. For these reasons, tax overlays can be very important to HNW clients.
Understanding holistic tax overlay, UMAs, and direct indexing
Before we discuss the implementation of and possible use cases for a holistic tax overlay, we need to define exactly what it is and how UMAs and direct indexing play in.
Holistic tax overlay
A holistic tax overlay is a discretionary, holistic tax management service applied to a client’s investment account. It is typically implemented with clients who want to have significant exposure to multiple equity SMA sleeves within one Unified Managed Account (UMA) account. This tax overlay enables advisors and investors to address holistic needs around tax management while minimizing the effects that client specific customization requirements have on their investment portfolios. The overlay is intended to be applied to the entirety of an investor’s taxable investable assets and manage portfolios to individualized investor tax budgets and circumstances.
Unified managed account (UMA)
A UMA is a managed account structure that allows for many diverse types of investment products to be held in a single custodial account. Each investment product within a UMA is assigned its own “sleeve.” The set of investment products and their target weights selected for the client’s UMA is called the “UMA Target Allocation Model.” In most cases, a UMA is traded by a centralized overlay manager to facilitate adherence to the client’s target allocation and appropriate rebalancing activities. The efficacy of tax management does vary by sleeve type.
Direct indexing
Direct indexing is a form of passive, or systematic, investing that enables direct ownership of the individual securities that compose a benchmark. Unlike a mutual fund or an ETF, it gives investors greater control over the portfolio and allows for tax-loss harvesting, customization around preferences, and other features. It is typically implemented by having the account initially invest in an optimized subset of the securities in an index, while also allowing for all securities in the index to compose a “buy list” when tax-loss harvesting is deployed. This allows the account to potentially “bank” losses while reinvesting proceeds in securities within that index. In a UMA, direct indexing works a bit differently. The direct indexing manager still optimizes the client portfolio using a subset of securities in an index. However, rather than having this subset of securities become a “buy list,” the subset becomes a model that is delivered to the overlay for use as a sleeve within a UMA. It can be included as a sleeve within a UMA, making it a potentially valuable component within a holistic tax management solution.
Implementing the holistic tax overlay
The overlay is coordinated by a centralized manager to accomplish these key tax objectives:
- Managing the account so that it is as close as possible to the target model from a risk perspective, as measured by tracking error
- Adherence to client needs through personalized tax management
- Diversifying concentrated portfolios in a tax-efficient manner
- Minimizing realization of net short-term capital gains
- Monitoring and generally avoiding wash sales
- Aiming to meet client-specific long-term capital gains tax budgets
- Reporting on the benefits of tax management at the client level
Why is having a centralized overlay manager trading all the taxpayer’s taxable securities important?
It allows the investor to have greater control of their tax obligations by managing all their taxable assets to a specific tax budget, while also adhering tightly to the desired portfolio allocation. The overlay manager can additionally coordinate the harvesting of losses at the time the investor needs or wants to generate them, rather than aggressively loss-harvesting when there are no gains to offset and potentially causing portfolio lock.
How should tax efficiency inform how we approach asset allocation for taxable accounts?
In taxable accounts, we should think about allocating to those vehicle and product types that provide the greatest flexibility from a tax management standpoint. The table below summarizes this concept. (Note that Fund Strategist Portfolios, or FSPs, are referenced in our table. FSPs are model-delivered, multi-asset class portfolios controlled by a single overall manager.)
| Product Type | Suitability for Tax Overlay | Typical Number of Model Holdings |
|---|---|---|
| Index-based Equity SMA | Very High | Very High (100+) |
| Actively-managed Equity SMA | High | High (30-60) |
| Strategic, Diversified FSP | Moderate | Moderate (10-20) |
| Style focused FSP | Low | Low (5-10) |
| Tactical FSP | Very Low | Very Low (1-10) |
| Individual Mutual Fund/ETF Sleeves | Very Low | Very Low (1) |
| Bond Sleeves, Advisor Sleeves, etc | None | N/A |
Finally, tax overlay implementation should consider the potential sources of alpha in a taxable portfolio. We believe these sources are:
- Security selection
- Sector allocation
- Factor exposures
- Tax management
Tax alpha is not widely recognized in the traditional financial literature, but that does not mean it should be ignored by industry practitioners. As the other three sources of possible alpha can be ephemeral or expensive to reach, tax alpha may become more important for investors and their advisors. This trend toward holistic portfolio management should only strengthen in the future, too. Ultimately, after-tax returns matter more than pre-tax returns.
Addressing tax overlay concerns
Due to the complexity of tax management for HNW portfolios, the use of an overlay may lead to questions and concerns.
Why harvest losses for tax purposes now, without gains to offset?
According to the Internal Revenue Service, "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss. If your net capital loss is more than this limit, you can carry the loss forward to later years.”2 This rule means that capital losses are valuable even when they are not immediately needed to offset capital gains from the same year. Losses harvested this year can be “banked” to reduce future taxes. An overlay that harvests losses in a year without capital gains is still useful. Still, the investor needs to understand that the usefulness is not “free.” Aggressive loss-harvesting introduces risk to the portfolio, resets the cost basis downward, and reduces portfolio management flexibility.
What is the opportunity cost of harvesting a loss?
Harvesting losses does have two consequences. The process can temporarily shift a portfolio away from the desired allocation, and it will lower the cost basis of the account. The wash sale rule places constraints on the timing of repurchasing securities recently sold for losses, which can affect the portfolio’s performance. As for the reduction in portfolio cost basis, this reset happens whenever a capital loss is booked. Depending on various market factors, and how aggressively losses are harvested, this process can cause portfolio lock.
What is a portfolio lock?
Portfolio lock occurs when losses are relentlessly and aggressively harvested until the portfolio has no further unrealized losses in the account, causing any trading in the account to result in a capital gain. This can make future tax-efficient portfolio management far more difficult. The key to avoiding portfolio lock is to harvest losses in a balanced manner. The approach to loss-harvesting should be driven by an individual client’s tax circumstances (the tax budget). The tax management process should not introduce unintended consequences by aggressively, and possibly blindly, loss-harvesting.
Spending more time on what matters
We view the use of a holistic tax overlay as an integral component of HNW portfolio management. The overlay should be viewed as another way to deliver account customization without the advisor making manual trades and juggling many tax rules. Conducting tax management on client accounts manually requires a lot of time and is prone to human error. An automated, holistic tax overlay service can bring tremendous efficiency to this process. Clients may appreciate the consistent and customized tax management from the overlay service, too. This opportunity for mutual benefit is why we view the use of a holistic tax management approach as a potential win-win service for both advisors and clients.
Help protect your clients' capital gains and make a difference in managing their portfolio at https://www.envestnet.com/tax-managed-overlay
