Tax-Aware Managers

The money management business, at least as a professional, thoughtful, disciplined activity, grew up in the institutional world. The overwhelming majority of competent money managers designed their investment strategies and disciplines for, and cut their teeth on, an institutional, nontaxable client base. Because those investors paid no taxes, tax considerations were never incorporated into the investment process. Meanwhile, most family investors were stuck in the trust company and private client backwaters, having their portfolios managed by individuals who were really salesmen or client relations people, not professional portfolio managers.

As families have become more sophisticated over time, they have naturally sought out more professional investment management for their portfolios. Unfortunately, this has taken too many families out of the frying pan and right into the fire. The reason is that the institutional money managers whose thoughtfulness and discipline appeal to sophisticated families are all too often money managers who don't pay the slightest attention to the tax consequences of their investment activities.

As the institutional business has stopped growing and, at the same time, become intensely competitive, many institutional managers have set their sights on wealthy families as a rapidly growing and hugely underserved market. Most, as noted, have simply sold their gross return performance, hoping that family investors will not take the trouble to convert the (often) attractive gross returns into the (usually) unattractive net-of-tax returns.

Some institutional money managers have actually modified their investment disciplines to incorporate tax considerations, but families should be wary of such managers for a whole host of reasons. Imagine, in general, a money management firm that has built up a respectable track record over the years by diligently pursuing a particular investment process. Then, simply because the manager wishes to gather assets more rapidly, the firm alters its investment process to incorporate strategies that are currently more popular with investors. Unsophisticated investors might be lured into engaging such a manager, but more experienced investors will look elsewhere. For one thing, the new process is unproven—engaging the manager would be almost like engaging a newly formed firm with no track record. But there is a more serious problem, namely, the cynicism of the change in the investment process. A firm that would engage in such an activity once is a firm that will engage in it again, and we should beware of doing business with such a firm.

Modifying a disciplined investment process to incorporate tax considerations may not seem like a cynical move, but all too often it is. Clearly, for example, the change in the investment process is being made solely to improve the firm's asset-gathering capabilities—namely, by appealing to a new market of affluent, taxable investors. More fundamentally, it will be a rare investment process that will work as well considering taxes as it does without considering taxes—simply layering a tax-aware element onto a process that never considered taxes is no different in principle from layering a value element onto a growth discipline.

To take a simple example, let's consider a momentum manager for whom rapid turnover is a fundamental aspect of its style. This firm buys stocks that have risen in price recently and sells them as soon as their price momentum slows down. As a result, some stocks may be held for only a few days or weeks. Virtually all of the gains generated by such a manager will be short term, taxed at high rates for a family investor. Adding to the process a tax overlay that requires stocks to be held for a full year (to receive long-term capital gains treatment) would be absurd. Such a modification of the process would, in fact, destroy it.

With many other investment styles and disciplines, the consequences of adding tax considerations may not be so obvious, but they are almost always serious. To ensure that tax considerations will make a meaningful and positive contribution to an investment process requires that tax considerations be an integral part of the process as it is being designed. Thus, for a money management firm to enter the market for taxable investors requires far more than simply reducing turnover or trying to harvest losses now and then. It requires the firm to design a new investment process from the ground up. This process will undoubtedly incorporate the disciplines of the firm's tax-exempt product and it will build on the firm's strengths. But the taxable investment product will be quite different from the tax-exempt product and the track record of the tax-exempt product will be largely irrelevant.

The point is that if a money management firm that has historically advised institutional investors wishes to advise taxable investors, the firm will have to make a very substantial investment in the project. This investment will include designing the product as a taxable product from the beginning, and will include building a significant track record with the product before it can be marketed widely or successfully to taxable investors.

Identifying Tax-Aware Managers

As noted earlier, for many years, managers—including, unfortunately, banks and brokerage firms whose primary clients were families—paid no attention at all to the tax consequences of their money management activities. More recently, managers have begun to pay lip service to the concept of tax efficiency, but managers who are truly tax-aware in their disciplines remain rare. As we look for tax-aware managers, some of the characteristics we should focus on include the following:

• Managers whose styles include low turnover. Notice, however, that low turnover is not, in and of itself, conclusive evidence of tax efficiency. For low turnover to translate into tax efficiency, without the employment of other techniques, the turnover must be extremely low, typically on the order of 10 percent. A manager whose turnover is 30 percent is likely to be no more tax efficient than a manager whose turnover is 100 percent. Nor is high turnover itself conclusive evidence of tax inefficiency. Consider a passive, tax-aware manager that is constantly harvesting small capital losses and using those losses to shelter gains elsewhere. Such a manager will exhibit very high turnover, but its activities will in fact be highly tax efficient. Thus, we will want to examine a manager's annual turnover, but we will need to examine it carefully and in context.
• Managers who are conscious of holding periods and who avoid incurring short-term capital gains whenever possible. Here the challenge is balancing investment gains against tax losses. Assume a manager buys a security with an anticipated holding period of 18 months and an anticipated price gain of 40 percent. If the company's performance falls apart early in the holding period, it will likely make sense for the manager to sell the stock, even if it results in a short-term gain. But if the performance falls apart in the 10th month of the holding period, it may pay the manager to hold on for another two months, because the lower tax may offset the price decline.
• Managers who aggressively offset losses against gains in an attempt to zero-out the tax liabilities of their buying and selling activity. Managers naturally tend to be very confident of their skill. But the fact is that few managers will generate enough alpha to offset the taxes they produce.³ Thus, a manager who is truly tax aware will be willing to take a loss on a stock, rather than stubbornly hold on to it hoping its price will recover. Such behavior may well hurt the manager's gross-of-tax returns, but it will leave far more money in its clients' pockets.
• Managers who manage tax lots. Institutional managers simply accumulate stock positions and then deaccumulate them, in no particular order. But a portfolio manager who works with taxable investors must be aware of the tax lots it holds. For example, as the manager is accumulating a position in Ford Motor, the manager might buy some lots at $51, some at $53.50, some at $56, and so on. When it comes time to sell, the manager needs to identify which tax lot he is selling in order to minimize the tax consequence of the sale.
• Managers who are willing to be flexible in reducing their clients' overall tax burdens. Imagine a manager who is sitting on significant gains in securities whose prices the manager thinks will continue to rise. The manager has no losses in the portfolio, so it can't shelter the gains if they are realized. However, the manager's client calls and asks the manager to realize the gains on those stocks because the client has losses elsewhere in his portfolio that will cover the taxes on the gains. Will the manager sell the stocks? He won't want to sell, of course, because he expects the stocks to continue to rise. But if he is truly a tax-aware manager he will indulge the client's wishes, knowing that the client's gain is more important than his own gross returns for the period.⁴ The same is true of a manager sitting on unrealized losses, who expects those securities to recover, and who has no offsetting gains in its portfolio. If the client has gains elsewhere in his portfolio, the client may ask the manager to realize the losses.

Of course, some desirable managers are engaged in strategies that are inherently tax inefficient—absolute-return-oriented hedge funds, for example. It would be counterproductive to insist that these managers somehow develop tax-efficient disciplines, because it is the very nature of their strategies to produce short-term gains and ordinary income. But the point is that when we have a choice between a manager who is tax aware and one who is not, we will almost always want the former, not the latter.