Advisors and investors have long relied on tax-managed strategies and funds to handle assets (at least those residing outside of shelters like trusts, insurance policies and retirement accounts). But what happens inside these products when broad market indexes like the S&P 500 start the year by rising approximately 17% in six months?
Actually, nothing should change much. There’s still a lot of opportunity for tax management, according to Monali Vora, global head of quantitative equity solutions at Goldman Sachs.
“It’s true while market return has been strong, there is a lot of dispersion among the stocks in the market,” says Vora. “If you’re trying to take losses, there’s lots of availability to harvest losses in every market cycle because of that dispersion.”
As Vora examined U.S. large-cap returns through June 30, she says that 300 stocks had been held by Goldman Sachs year to date at a gain, while 203 were held as losses.
According to J. Womack, global head of investment solutions for SEI, most of the large-cap stock index returns for the year have come from the group called the “magnificent seven”: Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia and Tesla. These equities accounted for nearly three-quarters of the gain in the S&P 500, leaving plenty of room for the managers of tax-managed strategies to maneuver.
“It’s true that there are far fewer opportunities to harvest losses this year versus last year on a broad index level, but we have other circumstances and situations to consider, like when the client invested and where their positions are versus cost-basis levels as volatility has extended over the years,” says Womack.
So some things have stayed the same, yet tax management must change over time. There are new account and product structures, and new technology being brought to bear on assets in taxable accounts, allowing investors to find every possible opportunity for tax efficiency and to optimize money moves at every level.
For example, when Eaton Vance sells depreciated positions to harvest losses within tax-managed client accounts, it often reinvests the proceeds using new methods and technologies, says Brian Smith, head of the wealth strategies group at the Morgan Stanley subsidiary.
“If you stack-rank every lot in a portfolio from most appreciated to least, you can peel off portions with the least embedded cap gains and use those to fund direct-indexing portfolios, which you can start to use towards the objective of tax-loss harvesting from single-stock positions providing losses on a 1099,” says Smith. “Then, on the other extreme, looking at a portfolio’s most appreciated assets, we look towards more traditional strategies like exchange funds. So we can approach tax management from both sides using the least and most appreciated assets.” (Exchange funds are pooled vehicles allowing holders of concentrated securities to diversify their portfolio while deferring taxes on their capital gains.)
For now, firms like SEI, Eaton Vance and Goldman Sachs are using new technology, products and structures in a complementary manner with traditional tax-managed equity funds, but in the future tax-managed investing will look very different. For one thing, at the advisory level, tax management is no longer just about minimizing capital gains but also about mixing strategies for asset location, timing financial moves and taking advantage of changing tax policies.
New technology and product structures are also gradually diminishing the attractiveness of the traditional tax-managed equity mutual funds as investors favor tax management at the account level using separately managed and unified managed accounts (SMAs and UMAs), as well as more tax-efficient products like ETFs that can create and redeem shares more efficiently than traditional mutual funds. There are also more personalized solutions via direct- and custom-indexing.
“Is direct indexing going to replace everything?” Smith asks. “The way we think about it is that it’s intended to complement what you’re already doing or have conviction behind. If you want a large-cap manager to actively manage your allocation, go do that. Then you can complement your manager with direct indexing in small-cap or mid-cap stocks. You’re identifying and picking and choosing battles in asset allocation. That’s how we’re looking at building portfolios.”
But right now, direct indexing and managed accounts are too labor-intensive to offer to just anyone, says SEI’s Womack. For the strategies really to work in a cost-effective manner, minimums of around $400,000 to $450,000 are needed, and to feasibly serve clients with a mix of direct-indexing and active tax-managed solutions, SEI needs them to have at least $230,000 in their taxable accounts.
For most investors, a mutual fund is still the most accessible option for tax management. But Womack believes more tax-managed funds will move to the ETF structure in coming years.
“Also, a lot of providers are thinking about ways to bring minimums down to the point where you can get a relatively robust portfolio at $150,000 to $175,000,” he says. “You’ll continue to see the industry leverage new technology and ETFs on the asset side; active ETFs are one of the fastest-growing trends in the market right now. Everyone is also advancing their direct-indexing capabilities in different ways. Fidelity has an offering with a $5,000 minimum for retail that shows the potential for fractional shares in direct indexing.”
In a not-so-distant future, these technologies and product structures will converge to offer comprehensive tax management with low or no minimums at a fraction of the cost of the traditional tax-managed equity mutual fund, Womack says.
Despite a number of competing investor demands that have altered the fund and strategy space—products are now available representing every conceivable factor, personal value, interest and long-term financial goal—tax management will always remain relevant in the minds of investors and the end client, says Goldman Sachs’s Vora.
“We think all of these demands can be met simultaneously,” she says. “So if an investor wants income, value alignment and tax sensitivity, we can incorporate all of that into a portfolio within an SMA. It makes sense for investors to have the ability to personalize and customize their investments. Everything else being offered to them is curated to the consumer: Today, investing is no different. The commingled vehicle is migrating to the SMA where you can do all of those things.”