It’s more than presidential candidates on the ballot this month. This election season has also seen the specter of tax hikes—for instance, a possible increase in capital gains taxes to 28% and even a potential tax on unrealized gains.
Given those fears, advisors may want to consider a more proactive and continuous portfolio management approach, especially for clients with highly appreciated stock positions.
Great Lakes Advisors, a Chicago firm currently managing $18 billion, has come up with a series of model portfolios designed to provide year-round tax-loss harvesting and active portfolio management, according to Brad Hays, the company’s director of intermediary distribution, who spoke with Financial Advisor about the approach.
The model is called the “Disciplined Equity Tax Managed Strategies,” and includes three portfolios divided by equity cap sizes: an all-cap strategy, a large-cap strategy and a small-midcap strategy (that it calls “Skid-Cap.”)
Hays claims all three models are either beating their respective indexes or are nearly neck-and-neck with them. He said the Disciplined Equity Tax Managed All Cap strategy, launched March 1, 2004, had a one-year return of 33.18%, a three-year return of 20.44%, a five-year return of 15.65% and a 10-year return of 13.10% (gross of fees) in the third quarter. That compares favorably to its benchmark, the Russell 3000, which had a one-year return of 35.19%, a three-year return of 10.29%, a five-year return of 15.26% and a 10-year return of 12.83%.
The idea is that active management and rigorous year-round tax-loss harvesting can be woven into every trade decision and minimize “tax drag” when managers buy and sell stock during the most opportune times throughout the year.
On average, taxes cost investors up to 2% of their annual returns. This leaves a $1 million portfolio with $218,994 less over 10 years, according to LSEG, a financial services data provider.
At the same time, even a modest 1% outperformance from active management can have profound positive effects, LSEG found, which said such outperformance can add $104,622 to a $1 million portfolio over the same 10-year period.
Passive or direct indexing strategies, by comparison, are not designed to beat the benchmark after fees. Hays said Great Lakes’ actively managed approach gives investors an opportunity to outperform the benchmark using disciplined, adaptive models, while also harvesting losses throughout the year to efficiently manage tax implications.
The strategies are used by institutions and pension plans and are available to individual investors exclusively through advisors for 50 basis points or less, depending on the advisors’ overall assets with the firm. Investment minimums begin at $100,000, Hays said.
Accommodating Client Positions
One noteworthy aspect of the firm’s strategies is that they can accommodate positions a client was already holding. While the tax-managed strategies can benefit any investor, they can really help those who come to the firm with concentrated and low-cost-basis stock positions—people who are in need of diversification—as well as investors who need to change their investment objectives, style and cap exposures in a tax-efficient manger, he added.
He says many clients with such concentrated positions can be found in a place like New Jersey, “where many pharmaceutical employees accumulate stock over their careers. For example, a client who has worked at Pfizer for 30 years may seek a solution for managing that concentrated risk,” Hays said.
Clients are not required to liquidate all their positions, and holdings are not sold off simply because they are not in the one of the strategies’ models.
This leads to a solution that incorporates some portion of the client’s holdings with new securities that complement the portfolio and achieve the similar characteristics of the model, Hays noted.
“Our strategies can accommodate clients’ existing positions without automatically selling them to fit a benchmark or model portfolio,” Hays said. “We evaluate each position's return potential, tax consequences, and overall portfolio risk. We provide a transition analysis to show clients how we can improve their portfolio from day one—identifying what to sell, keep or add, along with the potential impact on risk, return and tax implications. Investors are mindful of costs, especially regarding capital gains, so we prioritize transparency there.”
If items must be sold, the firm makes sure realized gains are capped at 10% of the portfolio’s value at transition to the firm’s strategies.
The tax implications of realizing gains and losses (both long-term and short-term) throughout the year are factored into all trading decisions, Hays added.
At the same time, the firm monitors portfolio sales and purchases to make sure they’re not running afoul of wash-sale rules. This monitoring is fully automated within the account. The company also keeps cash for withdrawals while minding the tax implications and customizing the portfolios to reflect the clients’ tax brackets, he said.
The firm compares what would happen if the clients chose a Great Lakes transition strategy or sold all of their highly appreciated holdings at once.
Hays said active management is necessary to help clients targeting specific asset classes, limiting capital gains distributions and allowing portfolio customization and loss harvesting at the individual security level.