My years of studying techniques to manage the risk and tax exposure of investors’ portfolios have led me to an unhappy conclusion:
These techniques, applied to single accounts, taxable and tax-advantaged, seem sensible but ultimately produce unfortunate outcomes for many investors.
Frankly, it’s taxing my patience why the financial advice industry can’t get on board with multi-account management, which my experience and research show yields the best outcomes for investors throughout their lives.
How Single Account Management Falls Short
Many single-account risk management techniques derive from institutional practices designed to solve different investment problems. Single-account tax management techniques were developed from simplified end-of-the-year loss realization or rules of thumb for prioritizing the location of stocks and bonds in individual retirement accounts (IRAs) and brokerage accounts.
Examining closely several popular single-account management techniques reveals their inherent flaws:
• High-turnover stock and fund selection strategies promise exceptional returns but often deliver mediocre pretax returns and significant capital gains.
• Direct indexing and ESG (environmental, social and governance) strategies offer customization of diversified stock investments but often deliver mediocre gain and loss management and exclude the wrong stock sectors.
• Laddered bond and managed credit strategies offer exceptional tailoring and returns but often deliver high trading costs and taxes on interest.
• Alternative investments have a variety of return and risk characteristics but are almost always highly taxed. They require prioritization for inclusion and locating them in IRAs and brokerage accounts.
Unless advisors have clients’ authorization and the right technology to manage their portfolios in toto, they will inevitably slip into using single-account techniques. Those may prove lucrative in the short term. But aren’t you in this business for the long haul with your clients?
The Problems With … Stock And Fund Selection Strategies
Active stock funds significantly predate index stock funds. Advisors still recommend them because they can always find some outperforming funds in the last few years.
However, as Princeton economist Burt Malkiel documented many years ago in his classic, “A Random Walk Down Wall Street,” vanishingly few actively traded funds can overcome their higher fees, much less their distributions of short and long-term gains.
Portfolios of sector exchange-traded funds (ETFs) and stock selection strategies in managed accounts can modestly reduce taxes by harvesting unrealized losses. Most seasoned clients have lost patience with their advisors, who call their attention to a handful of tax losses that are swamped by taxable gains.
Some global equity niches with poor financial reporting and an absence of opportunities to short stocks may legitimately provide a low-turnover stock selection opportunity. Advisors may also recommend certain highly taxed strategies, like active stocks, to their clients with available “free” capacity in their IRAs.
… And Direct Indexing And ESG Strategies
Direct indexing and ESG strategies offer customization of diversified stock investments in slightly different ways.
Direct indexing refers to the purchase of individual stocks in proportion to their shares in a stock index. Because almost every important stock index is capitalization-weighted, individual stock allocations increase (or decrease) based on relative returns. Stocks with significant gains can be allowed to run or gifted to charity, and stock losses can be harvested.
Problem? You bet.
Except after bad market performance or with large contributions to the account, there are few significant opportunities to harvest losses after several years. Some stock indices are notorious for high turnover rates based on their inclusion criteria. Growth indices drop lower-performing companies, which often have losses or small gains. Value, small, and midcap indices drop higher-performing companies, causing an advisor to sell stocks with the most significant gains.
ESG strategies allow clients to deselect investments in industries they do not want to support. These sectors may have small market capitalizations, like gun manufacturers, or large capitalizations, like fossil fuel companies and defense contractors. However, clients may not appreciate the diversification reduction that results and later regret their preferences.
Advisors can present a risk-based argument for clients with restricted stock and options in their employers to avoid the sectors those employers are in and sectors in which clients have large legacy positions and significant unrealized gains.
These clients, then, have restrictions on their investment capacity. With the assistance of risk management software, advisors need to prioritize stock sectors and especially alternative assets.
Laddered Bond Strategies: Good for Institutions, Not Always Households
Laddered bond and managed credit strategies offer exceptional tailoring but apply specialized institutional bond strategies to households—sometimes inappropriately.
The highest priorities for households investing in bonds are:
• Selecting bonds with the appropriate tax status based on clients’ tax rates for government, corporate, national, and in-state municipals, as well as the available bond yields.
• Creating a cash brokerage account to accommodate easily anticipated cash flows.
Advisors are always looking for opportunities to engage prospects or reconnect with clients. Some rely on the sequential expirations of individual municipal bonds for such opportunities.
Advisors have better, more consequential things to discuss with their clients, like tax and risk management.
State municipal funds are available in most states with high income taxes and provide professional management at very low fees. Except under unusual market conditions, bonds do not offer significant tax-loss harvesting or gifting opportunities.
Finally, chasing higher yields, either with non-investment grade bonds or low-grade lending, is usually a loser’s game and perilous if investors are ignorant about the risk of default. That said, some households have a significant enough allocation to bonds to locate higher-yielding bonds in “free” capacity in their IRAs.
The Good And The Bad Of Alternative Investment Strategies
Advisors who enthuse over alternative investments should be forthcoming about their advantages and shortcomings:
Plus: Alternative investments seek higher expected returns and have different risks than those associated with stocks and bonds.
Minus: Alternative investments have significantly higher fees (to the benefit of brokerage firms and fund partners). They can also be difficult to redeem or liquidate.
Alternative investments will almost always rank high in priority for clients who hold significant restricted company stock and options and legacy stock positions with large gains. The tax characteristics of alternatives—they often distribute gains and interest income—mean their best location is in available IRA capacity.
Alternatives should never be presented as low-tax investments, even if they delay taxable income for several years.
Multi-Account Management Is For The Long Haul
Clients intuitively understand that their destinies shouldn’t be tied up in one single account or investment, but they don’t know what to do. They’re at a loss about how to generate thrust from many accounts to propel their financial rocket toward their goals and, ultimately, retirement.
You should not be reticent to recommend that clients roll up their many accounts to balance their investments' risk, cost and tax features. There are easy-to-explain advantages:
• A custom-managed account can have a custom benchmark, updated annually or after significant market moves. It can also be managed consistent with firm recommendations and policies and without inscrutable advisor discretion.
• A cash brokerage account can accommodate almost all cash needs.
• Company-restricted stock and options can be held in a separate brokerage account or relevant 401(k)s.
• Other IRAs can be rolled up for each household member to simplify required minimum distributions (RMDs) and voluntary retirement withdrawals for spending and Roth conversions.
Everyone understands the adage, “The right hand doesn’t know what the left hand is doing.” It’s worth investing your time in educating clients about the pitfalls of keeping multiple advisors and accounts on a string without coordinating their risk, cost basis and tax liabilities.
Paul R. Samuelson is the chief investment officer and co-founder of LifeYield.