Diversification is a key tenet of our portfolio-management strategies. Portfolios are structured to contain securities that perform well in various economic conditions, and each investment has unique financial characteristics. Some are chosen to produce long-term growth, while others generate current income, protect against inflation, or offer stability during recessions. Placing each type of investment in the appropriate account type can help minimize and defer tax bills, allowing client funds to compound at the highest possible after-tax rate. For example, interest income is taxed at a client’s ordinary income rate, while dividends and capital gains may be taxed at lower rates. Therefore, certain fixed-income investments may be better off in tax-sheltered accounts, while growth-oriented investments can be better suited to taxable accounts as capital gains tax rates are lower, and taxes can be deferred for many years as value accumulates. Appropriate asset location can boost performance significantly on an annual basis.*
Tax-loss-harvesting strategies can also help maximize after-tax performance. Even in years when the market does extremely well, many individual stocks decline in value and can be sold to generate tax savings. In recent years, sophisticated loss-harvesting programs have become available to the individual investor. One such strategy is direct indexing. By holding individual stocks rather than an index fund, investors can combine the benefits of low-cost indexing with tax savings. Direct indexing improves on two problems with older tax strategies—timing of tax sales and deviations from market performance.
Historically, investment managers would sell losing investments at the end of each year, or quarter, to generate tax assets. A regularly scheduled program limits the ability to take advantage of price movements in the interim. Furthermore, after such a sale, the IRS mandates a waiting period before a security can be repurchased. If a stock or fund rebounds during that time, performance suffers. Managers attempt to reduce this risk by substituting similar securities during the waiting period. While these temporary replacements are sometimes adequate, many investments have no close substitute, leading to unwanted performance deviations.
Recently, relatively simple advances in technology have helped to mitigate these problems. Investors can now employ programs that recognize losses continually rather than at year’s end and utilize correlation analysis to swap baskets of securities rather than temporary one-for-one exchanges. This helps maximize the value of tax assets while keeping account performance within striking distance of overall market returns. Employing such a program offers even more potential to generate additional after-tax returns.**
Perhaps the simplest tax strategy we have employed in client portfolios is our use of exchange-traded funds over mutual funds where possible. As ETFs have proliferated, we can often find an appropriate strategy in an ETF wrapper, which is hugely advantageous from a tax perspective. Many investors have had the unhappy experience of receiving a capital-gains bill from a mutual fund that has actually declined in value. This is because a tax bill is generated when a mutual fund sells appreciated shares for cash—regardless of the gains achieved by the end investor! ETFs, in contrast, are able to transact in shares. This “in-kind” creation and redemption process shields ETF investors from capital gains taxes to a large extent.*** As a bonus, ETF fees are often much lower than mutual-fund expenses, keeping even more money in clients’ pockets.
As outperforming the market has become even more challenging over time, leveraging tax-efficient strategies has become more important in providing a reliable edge. By placing the right assets in the right accounts, systematically harvesting losses, and choosing tax-efficient investment vehicles, investors can minimize tax drag and enhance long-term performance. Advances in technology have made these strategies more accessible than ever, and the Fragasso Financial Advisors team remains committed to staying at the forefront of advances in portfolio management.
Investment advice offered by investment advisor representatives through Fragasso Financial Advisors, a registered investment advisor.
Sources:
*corporate.vanguard.com/content/dam/corp/research/pdf/revisiting_conventional_wisdomregarding_asset
**rpc.cfainstitute.org/research/financial-analysts-journal/2020/0 015198x-2020-1760064
***schwabassetmanagement.com/content/understanding-etfcreation-and-redemptionmechanismlocation.pdf