Strategies to help keep clients' dollars out of harm's way at tax time.

Separately managed accounts (SMAs) love to stress the significant advantages they offer to advisors and clients alike, one of which is customized tax management. But how many advisors really take advantage of the tax management aspect of customization? There are no hard and fast statistics, and opinions vary.
    Mark Pennington, partner and director of the Strategic Relations Group at Lord Abbett, offers this view of SMA tax management usage: "Let's just say half of the accounts in 'SMA-land' are in deferred types of accounts, such as IRAs or other retirement accounts not subject to taxation. So you just took approximately 50% of the universe away. If you say that 15% to 20% of the remaining half are actually initiating tax-loss selling, that's a huge percentage of accounts that are benefiting from this."
    According to an ING report on tax-loss harvesting, interest in tax management has grown since the 1990s as a result of the broad range of fluctuation in market values. With the added ingredient of the Alternative Minimum Tax (AMT) "creep," tax management may become a venue through which advisors can competitively increase their value.
    Today's more sophisticated investors are demanding more from advisors, including risk management, tax efficiency and greater attention to costs. Each of these management aspects affects portfolio performance, and in an environment of single-digit returns tax efficiency becomes a sharp focus.
    Advisors looking to compete using tax management as a customization tool should start now. By presenting tax management solutions to clients even before they ask for them, advisors raise their professional stature in the eyes of clients. Tax management services can also be used to attract new accounts. Simply put, the combination of SMAs and tax management services results in better service to clients and greater differentiation for advisors.

What's Special About Taxes And SMAs?

When it comes to special features of SMAs, tax management is often at the top of the list. Better control over assets, greater transparency of fees, a more holistic approach to client service, the ability to implement restrictions-these are all extremely valuable aspects of SMA advantages. But what makes SMAs special regarding tax management?
    There are plenty of mutual funds with a tax-efficient management focus. With SMAs, however, tax management becomes a proactive service to clients, not simply passive homage to the problem. Disposition of concentrated positions can be handled in a specifically tailored fashion; SMAs offer the flexibility of offsetting gains generated by other investment vehicles, not just within the SMA itself; and SMAs grouped in a multiple-discipline format can be monitored to guard against duplication of positions and to facilitate gain/loss realization across portfolios.
    Richard J. Gladney, senior vice president, managing partner and principal of the Gladney Consulting Group at Wachovia Securities, meets with clients on a quarterly basis, uncovering any new tax or other concerns in the process. "As an example," he cites, "I was recently discussing the performance of a client's portfolio and he mentioned that he was thinking of selling one of the companies he owns. So we immediately got his accountant on the phone to talk about any loss carry-forwards the client had already banked, when the sale of the company might occur and how that would affect his tax situation. All of that has a bearing on how we manage the money."

These are big advantages-advantages that allow advisors to optimize clients' tax situations, not just manage them. Optimization implies the perfect combination of strategies to create the ultimate tax efficiency for the client. But it really goes one step further-tax optimization truly focuses on a holistic solution considering the client's entire portfolio of investment vehicles, his or her tax liability from income, AMT, estate, and gifts, and investment-related decisions. It implies that taxes are a year-round and even a multiyear concern to add the optimal value for the client.

Taxes Aren't Just A Year-End Thing

Gladney emphasizes the importance of managing tax liabilities throughout the year, not just at year-end. "We find so many people wait until the end of the year to try to pull the trigger, creating activity that is not necessarily in their best interest from a money management perspective," he says. Gladney's team at Wachovia offers a special SMA tax management program called Masters in which multiple SMA managers receive overlay treatment from a tax management perspective. "If we want to take losses in one account, we can be certain that another manager we're using for that same client won't be buying those stocks within a 30-day period, which would violate wash sale rules and eliminate the tax benefit," he explains. "By having it all on one statement, they're looking at it as a whole package," explains Gladney. "A single, comprehensive view helps keep money and tax management consistent since the client sees what's going on in the entire account, not just in one segment. It takes the emotion out of the decision-making."

Taxes should never take precedence over general investment decisions, though. In the order ranking of investment management, tax implications are the result of good investment decisions, not the impetus for them. Managing accounts strictly from a tax management point of view is "like the tax tail wagging the investment dog, and can inhibit the active manager in accomplishing management objectives," says Pennington.
    Russell Parker, president and chief distribution officer with Active Investment Advisors in Boston, says, "Tax planning and tax-loss harvesting may be the single most important tax management strategy for the investor, and it should be an ongoing event. Gains and losses are generated throughout the year, whether or not they are realized, and the key for advisors-and, ultimately, their clients-is to manage the outcome. Short-term gains can offset present, large concerns for clients. For example, in the current housing boom, if a client sells a second home and realizes significant capital gains, short-term losses can be used to offset the tax liability if the client doesn't plan to reinvest the funds into another residential property. Such exceptional events benefit from the flexibility of SMAs to work in a core-satellite strategy to manage tax liability incurred from other investments."

"SMAs attract the best money managers in the world," says Gladney. "Many clients are involved in businesses or other investment properties in which they may have gains or losses. Because SMAs actually give the client individual stock ownership, we can look into their portfolios to offset some of the other gains they've accrued."
    In many respects, SMAs offer investors benefits that formerly were reserved for institutional clients. Since institutions, for the most part, don't have to deal with taxes, individual investors present a unique situation. This unique situation offers opportunities for advisors to create unique strategies for optimizing a client's tax exposure.
    Parker explains a new approach to indexing that enables advisors to customize tax management for clients. In this strategy, advisors can tailor an SMA to be tax efficient based on the client's individual needs by creating a customized index reflective of the client's exposure. "We're able to replicate an S&P 500 index, for example, with as few as 50 stocks and as little as $100,000, to help people manage a concentrated stock position with a low cost basis," explains Parker.
    The overall strategy of including indexed products inside an SMA offers investors after-tax returns, making tax efficiency a natural by-product. For example, if GM stock produces losses in a client's customized S&P 500 index replication, it can be sold to harvest the loss and be replaced with Ford to maintain the exposure to the automotive sector and produce tax-efficient returns for the index.
    With exchange-traded funds, one of the most common investment vehicles used to manage concentrated positions and coming under greater scrutiny, the SMA indexing strategy offers an attractive alternative. "We bring index-based solutions through active equity strategies where we follow certain indices," Parker says. "We also have an actively managed ETF portfolio, with each holding between five and 20 ETFs. In a world where single-digit returns loom for the foreseeable future, the emphasis on after-tax performance will be enormous."

ETFs are also used to "fill" the position left when tax loss harvesting is implemented, leaving the portfolio with cash, i.e. no market exposure, for the 30-day period required to satisfy wash sale rules. In such cases, ETFs offer cost-effective exposure to the portfolio that can help maintain investment objective consistency.
    Municipal bond SMAs offer another strategic alternative for tax management that may not be commonly considered. Many advisors believe it is difficult for individual investors to benefit from municipal bond SMAs with investment amounts smaller than institutional size, usually $10 million. "For a minimum of $250,000, our bond program offers proper diversification and can still buy blocks of $25,000 or higher, which is a minimal efficient execution level," explains Robert Schonbrunn, senior vice president of ING's portfolio management team specializing in SMAs. "SMAs are uniquely suited to efficient tax management," he says, "The big issue here is the flexibility to adjust to individual investors' tax problems, such as changes in tax rates, capital gains situations from year to year, and changes in residence."

ING's municipal bond strategies encompass a duration position, a yield curve position and changing sectors within the area, along with selecting individual issues suited to the client's situation. Advantages of municipal bond SMAs may be even greater for individuals than for institutions, in some cases. "If you have $300,000 on your own, you don't have many good alternatives. In SMAs, because of the ability to group orders and get better executions, individual investors are brought to a level that is somewhat competitive with a $10-million account," Schonbrunn explains.

Another advisor, Tim Pagliara, managing partner of Capital Trust Wealth Management, says tax management should be rooted in investment philosophy. "Warren Buffett has so many great lines, and one of them is, 'The best way to minimize risk is to think," he says. "You have to think and have long-term strategies because-by design-if you don't, the taxes will."
    Pagliara says people overemphasize the "short-term" mentality. How do you end up with a tax-efficient portfolio? According to Pagliara, it's by being a patient investor.
     "It's a thinking process, and it will cause you to be in conflict with your clients from time to time-you may even look a little stupid. But it's all about making good long-term decisions," he says. He gives the example of owning Merck stock in the early 1990s. If the client has held most of the stock purchased in the early '90s, he or she still has a profit in it. Rather than recognize a gain by selling it, the client can purchase more since the stock has dropped significantly in value. He continues, "If your account has grown over the years, (Merck) has become a much smaller percentage of your overall account than it was ten years ago." This suggests possible room in the asset allocation for adding to the position.

By holding companies for as long as eight years in some cases, Pagliara has greater flexibility with moving positions in and out of his clients' portfolios, and since there are no short-term gains to offset-only long-term ones that are subject to a lower rate-costs are kept low and returns are enhanced.