October 4, 2019Rich Turgeon

The Importance of Tax Alpha in Managing Portfolios

As we enter the fourth quarter and consider opportunities for the period ahead, leveraging “tax alpha” remains attractive regardless of the outlook, or time of year. Tax alpha is simply the difference between after-tax and pretax return in a portfolio relative to the benchmark, and is an important consideration in portfolio construction and ongoing portfolio management. The amount of annual tax alpha that accrues to one’s portfolio depends to some extent on market volatility but also the advisor’s ability to take advantage of loss opportunities, avoid gain realization and structure portfolios in a tax efficient manner. Tax alpha is generated through a combination of strategies that can add as much as 0.5 -1.0% annually in returns over the course of a business cycle¹. Below we highlight several strategies Wellspring utilizes throughout the year to not only minimize the impact of taxes on your portfolio, but also to generate higher and more consistent returns.

First, tax loss harvesting is a relatively easy and efficient means of generating tax alpha. During periodic reviews of your portfolio, Wellspring looks for opportunities to offset long-term capital gains with existing losses. Because we target specific correlation and concentration risks during portfolio construction, we expect some asset classes to rise when others fall. When recognizing a loss in a portfolio, Wellspring often uses the opportunity to reposition assets to previously agreed upon strategic ranges and toward more attractive, less expensive, faster growing segments of the market. Depending on our outlook, we either add to risk assets or lock in gains to the portfolio. Wellspring believes it’s important to review portfolios throughout the year for tax loss harvesting opportunities and not restrict these activities to just a year end exercise. Ongoing monitoring of asset performance inside a portfolio ensures that tax-alpha opportunities are fully realized and banked as they become available.

A second way of generating tax alpha is through tax-efficient placement of assets inside a portfolio. Tax-efficient placement means structuring a portfolio so that the funds and securities that generate taxable ordinary income and short term capital gains are held in tax-deferred accounts, such as IRAs or 401(k)s, and those that generate the least amount of such income are held in taxable accounts. This allows income to grow deferred from taxation, until it is either withdrawn or distributed from the portfolio. For example, high-yield corporate bonds and real estate are usually best suited for tax-deferred accounts since that income is subject to high ordinary income tax rates when earned. When held in a tax-deferred account, the annual income from these funds accumulates tax deferred and may be reinvested fully back into the portfolio. Alternatively, municipal bonds are considered one of the most tax-efficient of all asset classes, making them ideal for taxable accounts. Similarly, growth funds that pay little or no annual dividends and seldom generate capital gains are considered good candidates to place in taxable accounts.

In addition, tax alpha is optimized with Exchange Traded Funds (ETFs) when we structure your portfolio. We do not position your portfolio in an ETF without first knowing the fund’s expense ratio, but in addition we avoid buying an ETF without first understanding its tax cost ratio. An ETF’s tax cost ratio measures how much of a fund’s annualized return is reduced by taxes investors must pay on capital gain distributions. In general, Wellspring constructs portfolios using ETFs with de minimis tax cost ratios. Tax cost ratios can range from 0.25% to 1.50% of a fund’s annual returns, depending on turnover and the ETF’s mandate². The typical tax cost ratio of an ETF in a Wellspring managed portfolio ranges from 0.25 to 0.50%. ETFs that experience little or no turnover in the underlying holdings during the year tend to have low tax cost ratios. Alternatively, ETFs with large unrealized gains, low liquidity or high turnover could cost fund owners at tax time.

A final strategy Wellspring employs in managing portfolios is minimizing “tax drag”. The current long- term capital gains tax rates under the 2018 tax law are 0%, 15% and 20%, depending on your overall income tax bracket. Tax drag can occur when an investor sells one fund and incurs a tax obligation, then invests the after-tax proceeds in an alternative fund under the assumption the appreciation in the new fund will more than offset the reduction in portfolio value as a result of the tax liability. In some cases, the reduction in the portfolio’s value from the tax exceeds the return potential of the new investment, resulting in tax drag. When evaluating the impact of tax drag on portfolios, Wellspring assesses whether the expected return of the new fund adequately compensates for the tax liability due as a result of disposing of the fund already held. If not, we normally will pass on that trade.

Effective management of tax alpha accrues to the benefit of portfolios over time and should be considered at every step of the financial planning, portfolio construction and management processes. Being mindful of how to continuously use these strategies can have a compound effect on income and ultimately the value of your portfolio. At Wellspring, we have an ongoing focus toward opportunities throughout the year to generate and bank tax alpha.

Roseen, Tom, “Taxes in the Mutual Fund Industry - 2010,” Lipper, a Thomson Reuters company.
J.D. Peterson, P.A. Pietranico, M.W. Riepe, and F. Xu, “Explaining After-Tax Mutual Fund Performance.” Financial Analysts Journal, Vol. 58, No. 1 (January/February 2002).