This article was originally published on February 1, 2016.
The entire investment industry is almost universally focused on pre-tax returns. While taxable investors are acutely aware of the taxes they pay, most investment managers make no effort to discuss their historical or targeted returns in an after-tax context. For high-net-worth taxable investors, the difference between pre- and post-tax returns is particularly wide; thus, it is our duty to take taxes into account when managing their portfolios. As stated in our fourth quarter 2014 InvestorView article, “BBH’s Approach to Manager Selection,” Brown Brothers Harriman (BBH) considers after-tax returns as a relevant metric for taxable investors. While the nuances of taxes mean that standardized, client-specific data on after-tax returns can’t always be reported, clients should demand tax-aware investment management from their private wealth managers. Beyond just tax-efficient investing though, for the best long-term outcomes, a fully integrated approach to taxes requires that portfolio construction decisions and advice on asset location be considered in light of a client’s tax circumstances.
Why Taxes Are Ignored
The complex, dynamic nature of the tax code and the challenging communication issues that taxes present to investment managers are the main reasons they are often ignored. Changing tax brackets present a significant impediment for managers to explicitly report after-tax results. Individuals drift between tax brackets over time based on income, and Internal Revenue Service (IRS) tax rules change with whichever direction the political winds are blowing. The highest marginal tax rate in the U.S. was 70% before President Ronald Reagan lowered it to 50% in 1983, 38.5% in 1987 and 28.0% in 1988.1 Currently, 39.6% is the highest rate, and there is a 3.8% surcharge on net investment income that applies to capital gains, dividends and interest income for certain investors. Tax code changes make targeting the highest after-tax returns on a forward-looking basis even more difficult. Both political parties appear to agree that a substantial rewriting of the tax code is necessary, but there is no consensus on what the new rules may look like. The optimal investment strategy for producing the highest after-tax returns can only be contemplated with perfect knowledge of future tax rates, which are anything but clear.
Taxes are also ignored because, as we will demonstrate, many of the more exotic or high-octane investment strategies that investment firms like to sell make little sense for taxable investors. As a recent Financial Analysts Journal article pointed out: “Raising client awareness about the tax penalty can prove challenging because of both the complexity of the subject and the pall it can cast on an otherwise exciting story for some of the most glamorous strategies.”2 Perhaps for these reasons, and because taxes are not relevant for many large, sophisticated investors (pensions, endowments, foundations and so forth), managers have collectively kept the topic of tax efficiency out of the mainstream.
Understanding the Nature of Gains
Tax-aware investing starts with understanding the tax treatment various types of investments receive. This can be a legal or technical distinction, such as the difference between dividends and capital gains, or strategy-specific, such as how portfolio turnover affects taxes. For most high-net-worth clients, the applicable federal income tax bracket is the highest marginal rate of 39.6%, and additional taxes push the estimated burden to 43.4%.4 Many state income taxes drive this rate past 50% – or even higher in high-tax states such as California or New York. Capital gains are taxed as ordinary income for holding periods shorter than one year and receive the favorable long-term rate of 23.8% if deferred longer than one year, making short-term capital gains particularly painful because of the roughly 20% tax savings available if deferred. Certain security types have additional tax rules associated with them. For example, short-selling gains are taxed at the short-term rate regardless of holding period. Considering these tax rates, it is easy to see why for return-seeking investments, most income-oriented or high-turnover strategies are unattractive on an after-tax basis. Interest income is taxed at punitively high rates, and high turnover stands in the way of the more beneficial long-term tax treatment.
BBH’s Approach to Taxes
Notwithstanding the challenges of factoring in taxes to the investment process, it is important to not let perfect be the enemy of good. While it is difficult to forecast the exact future of tax rates at both an individual and even policy level, there are reasonable assumptions that can be made, and factoring them in can lead to better long-term investment outcomes. Those assumptions include that long-term capital gains will continue to be treated advantageously and that complexity in the tax code will create opportunities for experts to add value through effective planning. This article discusses five ways in which BBH seeks to improve after-tax returns for our clients by taking into account those assumptions, including:
- Invest with managers and in asset classes that generate attractive after-tax results
- Limit manager turnover
- Make asset allocation changes selectively
- Structure investments in tax-efficient vehicles and accounts
- Use effective tax planning strategies
It’s also important to note that BBH partners collectively invest alongside clients, mostly in taxable accounts. We believe this creates an important alignment of interests with our taxable clients.
Manager Selection and Taxes
When it comes to finding tax-efficient managers within asset classes where the returns are weighted toward capital gains, turnover emerges as perhaps the most important differentiating factor. Beyond taxes, turnover is generally a negative for investment performance in other respects – bid-ask spreads, the market impacts of trading and brokerage commissions all mean that high-turnover strategies have the deck stacked against them. Coupled with these challenges, turnover’s tax impact puts many investment strategy types at an extreme disadvantage for taxable investors.
As a simple illustration, a pre-tax return of 20% composed entirely of short-term gains becomes an after-tax return of roughly 8.9% for a New York City resident in the highest tax bracket.5 A hypothetical strategy that held onto its gains just long enough to qualify for long-term tax treatment would only need to produce a pre-tax return of 11.7% to achieve the same 8.9% after-tax return. Furthermore, there are additional tax benefits to deferring the payment of taxes indefinitely and allowing gains to compound. In practice, it is quite difficult to beat the returns of a long-only manager focused on buying high-quality businesses and holding them for the long term, and thus it should not be surprising that strategies, including the BBH Core Select strategy, represent a large allocation in client portfolios.
The nearby graph illustrates a numerical example of the benefits of allowing capital gains to compound. For two hypothetical portfolios with the same 10% return each year, one that allows gains to compound for 10 years and then liquidates and another that does a full rebalance annually, we compare the resulting returns and ending wealth values. The buy-and-hold portfolio earns an after-tax return of 8.3%, whereas the annually rebalanced portfolio earns 8.0%. An original portfolio of $1 million would grow to be almost $53,000 larger in 10 years by allowing the gains to compound instead of paying taxes annually. Note that while the buy-and-hold portfolio outperforms over the long term, the recognition of taxable gains is lumpier, as a larger proportion of deferred gains builds in the portfolio over time. This is a known feature of this kind of investing, however, and we are focused not on the level of taxable gains in any one year, but on the long-term after-tax return.
We believe there are substantial advantages for investment managers that take a long-term approach beyond just the tax benefits of lower turnover. We seek to partner with those that are focused on generating attractive after-tax, after-fee returns, and our criteria steers us toward firms that will be more tax efficient over the long term. However, we are not focused solely on minimizing taxes and don’t expect our managers to be either. Certain managers will recognize short-term gains from time to time, and we factor that into our analysis when determining whether to partner with a firm and how large a position we recommend it be in clients’ portfolios. This is an important point to emphasize: while we appreciate managers that take taxes into account, it is crucial for the long-term compounding of wealth to put pure investment considerations first and not let the tail wag the dog. While the certainty of taxes makes them something to avoid whenever possible, successful investments priced above their intrinsic value6 can fall much more than the “loss” an investor would experience by paying taxes.
Which Asset Classes Present Problems for Taxable Investors?
When examining tax efficiency across asset classes, fixed income is perhaps the easiest to analyze. While the asset class is prized for its current income, the tax penalty is particularly onerous for taxable bonds and loans, and after-tax returns are especially low in the current low interest rate environment. Because of this, the municipal bond tax exemption7 means these instruments have an almost insurmountable advantage for high-net-worth taxable investors – a benefit that is even more valuable the higher an investor’s tax bracket. In today’s market environment, though, where we believe interest rate risk is significantly mispriced, medium- and longer-term municipal bonds are unattractive even on an after-tax basis. Alternatively, taxable bond strategies that emphasize price stability, such as the BBH Limited Duration strategy, play a more important role in taxable portfolios as we await a more attractive rate environment. In the long term, we expect laddered portfolios of high-quality municipal bonds to make up the majority of our investment grade fixed income allocations.
In the same category of less tax-efficient asset classes fall high-turnover equity strategies and many types of hedge funds. For example, macro or quantitative hedge funds are typically tax inefficient because of the assets they own (e.g., currencies and fixed income instruments) and how frequently they turn over portfolios. As highlighted earlier, many individuals and institutions want to invest in what are viewed as the more exotic and sophisticated alternative strategies, including hedge funds. However, they frequently fail to even evaluate what the after-tax results have been, let alone what they may be going forward. It is not always easy to evaluate past performance on an after-tax basis, as most managers do not report those results. When evaluating these types of strategies, BBH’s investment team goes to great lengths to get the necessary information to understand their past and future tax efficiency in order to properly compare them with other options. In certain cases, hedge funds make sense for taxable clients, and in some cases, a strategy may make sense for tax-exempt accounts, but we cannot make the case for taxable clients despite what may appear to be superficially high pre-tax returns.
Core real estate strategies, including some REITs,8 are tax inefficient because of the high income percentage in the total return. However, this can at times be mitigated by the fact that real estate can offer higher returns than, for example, investment grade public fixed income through capital appreciation and also provide diversification benefits to portfolios. Other real estate strategies, such as value-add or opportunistic strategies9 employed by private equity real estate players, have a substantial capital gains component and different levels of tax efficiency depending on specifics.
On the more tax-efficient end of the spectrum are low-turnover public equity strategies and asset classes such as private equity where the rapid buying and selling of private businesses is almost a nonstarter. For low-turnover public equity, vehicle considerations can make a difference. For example, investors in a private vehicle (such as BBH Wealth Strategies) can receive an individually calculated tax basis. Private equity is highly tax efficient since managers make investments over multiyear holding periods, which defers the payment of taxes, and the vast majority of returns typically come from these long-term capital gains.
In many asset classes, tax efficiency depends less on the technical distinctions regarding the asset class and more on the portfolio manager’s execution. For example, public equity can be the most or least tax efficient depending on turnover. Similarly, the term “hedge fund” implies almost nothing about how a strategy is managed. Multistrategy and event-driven hedge funds range from producing a preponderance of long-term capital gains to being entirely driven by income and short-term capital gains. The tax efficiency of long/short equity hedge funds depends on, among other things, how long-biased the manager is.10 Because shorting gains are taxed at ordinary income rates, market-neutral hedge funds, which may get a significant portion of their gains from shorting, are at a disadvantage. Long-biased managers have less of a headwind to overcome.
Importantly, just because an asset class is not tax efficient does not mean that there are not times when a manager within the asset class, or indeed the asset class itself, can be compelling for taxable investors. For example, high yield is relatively tax inefficient as an asset class; however, there have been times, such as 2011, when even after factoring in taxes a high-yield investment was compelling for taxable clients. In addition, while long/short hedge funds in general are not tax efficient, some managers can still generate attractive after-tax returns. In the end, the interplay between tax efficiency and expected returns is what matters. A strategy with a high probability of achieving a 20% return that generates one-third of that percentage from short-term gains/ordinary income is still preferable to one that produces a 10% return entirely from long-term gains.
Manager Turnover and Taxes
Just as we seek to identify managers that take a long-term approach to investing in their portfolios, we also have a long-term view in the hiring of individual investment partners. We conduct substantial due diligence and are highly selective in adding individual managers to portfolios in order to best position ourselves for a successful long-term partnership. Our objective is for our partnership with each manager to last decades, which in the investment management industry is highly unusual. Advisors often want to show clients good relative performance, even if a client was not invested with the manager during its periods of outperformance. This leads to frequent turnover and a very poor tax profile.
We understand that every manager – even a very good one – is likely to go through periods of short-term relative underperformance, and we are comfortable with that as long as we believe the firm continues to execute its strategy well. We believe that taking a long-term view rather than firing managers every time they underperform over the short term not only leads to better results, but also reduces the transactional costs, particularly taxes, associated with manager changes. A 2014 Vanguard study, which compared the results of a hypothetical buy-and-hold strategy with a performance-chasing strategy, confirms this.11
While we hope each relationship lasts for a long time, we monitor managers thoroughly to ensure they still meet our criteria and are executing in a manner consistent with our expectations. We have had to make manager changes in the past and will certainly do so in the future; however, we hope our thorough underwriting of each investment leads to the twin benefits of strong after-tax returns and fewer changes, which combined should create attractive after-tax returns for our clients.
It is important to note that we evaluate tax efficiency by looking over a multiyear period rather than in any single year. Because we invest with managers that take a long‐term approach and are more tax efficient due to their multiyear hold periods and limited turnover, over time those managers may build up long‐term unrealized gains. Therefore, a larger taxable gain could be recognized when there is a shift of assets from one manager to another. If, on the other hand, we invested with less tax‐efficient managers, we could recognize more taxable gains annually but would not have as large a gain when reallocating money to another strategy. Therefore, our approach of investing with long‐term‐oriented, tax‐efficient managers can result in a lumpier recognition of taxes in years like 2015, but over time, we believe, should lead to better after‐tax results, as the benefits of tax deferral at the manager level outshine the occasional few years of above‐average gains.
Tax-efficient investing places an increased burden on portfolio construction and asset allocation decisions. One consequence of investing with managers and in asset classes that are more tax efficient is that over time, portfolios can have substantial unrealized embedded gains, and any manager who compounds capital in excess of the portfolio’s return will represent an increasingly larger portion of the overall portfolio. This can make asset allocation changes challenging, as there are often material tax consequences associated with any selling or trimming decisions. These decisions are particularly difficult because they require a conscious decision to take a known tax cost for an unknown future benefit. It is therefore important to understand how BBH thinks about these tradeoffs.
In a multi‐asset class portfolio, there can be a number of reasons for deciding to recognize taxable gains in order to shift assets from one strategy or asset class to another. This may include rebalancing from a manager or asset class that has become too large a weight in portfolios, shifting assets out of an asset class that has become overvalued, replacing a manager that our due diligence suggests no longer meets our investment criteria or selling assets in one area in order to fund a very attractive opportunity that our investment team has identified in another. In each of these cases – and any time we make a change in our allocations – the decision is only made after careful consideration of whether the benefits to our clients’ long‐term risk‐adjusted, after‐tax returns outweigh the short‐term impact of taxes or transaction costs.
As a result of evaluating these decisions on an after-tax basis, we tend to make infrequent tactical changes to our asset allocation recommendations given the transaction costs associated with taxes. We prefer instead to invest the vast majority of our clients’ assets in strategies that we believe are appropriate over market cycles and do not attempt to time the market in a specific asset class. However, there are times when making a change makes sense, and while it is difficult to justify realizing taxes when the short term is prioritized over the long term, a long‐term view favors investment considerations over taxes when it comes to reallocating capital to new investments and managers.
Though there is ongoing debate in the investment community about the best way to manage an asset allocation or portfolio construction process for taxable investors, a method based on minimizing taxes alone with no regard for future investment returns or diversification is surely not the correct way. In reality, it usually comes down to timeframe: the longer the investment horizon, the easier it is to overcome the tax drag associated with reallocating capital.
Asset Location and Vehicle Structuring
Tax management has another important dimension to consider, as the presence of different account types with varying tax rules surrounding them heavily affects the ideal strategy; thus, asset location and estate planning are critical for taxable investors. Ignoring the various types of trusts for a moment, at a basic level, the availability of tax-deferred accounts such as an IRA or tax-exempt accounts such as a Roth IRA means that the taxable vs. tax-exempt portfolio management question is even more complex for many investors. Add to that the plethora of potential trust options that exist, and the problem of asset location compounds further. To deliver intelligent solutions in this area, BBH’s relationship managers collaborate with our wealth planners to provide custom advice.
There is no one-size-fits-all approach to asset location, and the best solution often differs greatly between clients. For example, advice on whether to hold tax-inefficient strategies such as fixed income or tax-efficient ones such as low-turnover public equity in an IRA depends on the types of accounts the client has to work with and the market environment. While fixed income is generally inefficient from a tax perspective, placing low-yielding bonds in an IRA provides little current benefit since there is little tax drag to eliminate. Placing equities in an IRA may seem counterintuitive, but depending on the turnover, the benefits of time deferral may provide substantial benefit. Thus, the ideal solution is as unpredictable as the future path of interest rates. There is no surefire strategy, but after laying out all of the options, clients can make educated decisions in partnership with their private wealth manager, even with imperfect information about the future.
Tax-aware investment management is a multifaceted problem that demands great care from advisors to high-net-worth private clients, yet it receives little attention from the investment community. While it is impossible to identify the perfect strategy in advance in light of imperfect information about future tax rates, market returns and even life circumstances, a multidisciplinary approach can yield benefits. With an integrated effort from BBH’s investment team, relationship managers and wealth planners, it is possible to partner with tax-aware investment managers and make informed decisions about asset location. Longtime InvestorView readers will note that our wealth planners have penned many articles in past issues addressing many of the most salient wealth planning considerations for taxable investors. Our investment teams remain committed to providing investment strategies for our taxable clients that take appropriate account of taxes. While far from the most important consideration, taking a tax-aware approach to investing can yield material benefits for clients over the long term.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2019. All rights reserved. 2019. PB-03195-2019-11-27
1 Source: Tax Foundation.
2 Source: Geddes, Patrick, Lisa R. Goldberg and Stephen W. Bianchi, CFA. “What Would Yale Do If It Were Taxable?” Financial Analysts Journal 71.4. July/August 2015.
3 Source: Internal Revenue Service.
4 While not accounted for here, the effective tax rate can be even higher if an allowance is made for the personal exemption and Pease provision phaseouts.
5 Estimated federal taxes of 43.4% plus state taxes of 8.82% and city taxes of 3.876%.
6 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
7 Congress allows the interest on most municipal bonds to be excluded from an investor’s taxable income. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
8 Real estate investment trusts. While REITs are efficient in some sense in that they can usually avoid corporate-level taxation, once paid to investors, their dividends and capital gains receive no favorable tax treatment.
9 Value-add real estate generally involves properties requiring capital improvements that have the potential to enhance value, whereas opportunistic real estate involves seeking the highest returns and is associated with assets that may be substantially underleased or overlevered or new assets that are not currently producing cash flow, among other high-risk/high-potential return areas.
10 Net exposures of greater than 50% are generally referred to as long-biased.
11 Source: Vanguard Research Note. “Quantifying the impact of chasing fund performance.” July 2014. https://pressroom.vanguard.com/content/nonindexed/Quantifying_the_impact_of_chasing_fund_performance_July_2014.pdf.