This podcast focuses on tax-aware transition planning, what it is, and how it may benefit investors who wish to transition their portfolios as their goals change over time. To discuss are Manju Boraiah, Senior Portfolio Manager & Global Head of Systematic Fixed Income, and Kandarp Acharya, Senior Portfolio Manager for Multi-Asset Solutions.

 

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Marilyn Johnson: I’m Marilyn Johnson and you are listening to On the Trading Desk®.

In this podcast, we’re focusing on tax-aware transition planning, what it is, and how it may benefit investors who wish to transition their portfolios as their goals change over time.

Our guests today are Manju Boraiah, Senior Portfolio Manager & Global Head of Systematic Fixed Income, and Kandarp Acharya, Senior Portfolio Manager for Multi-Asset Solutions. Manju and Kandarp, welcome to the program.

Manju Boraiah: Thanks for having us, Marilyn.

Kandarp Acharya: Yes, great being here. Thank you, Marilyn.

Marilyn: So to get us started, Kandarp, could you explain what a tax cost is and why it may be the most important cost for a taxable investor?

Kandarp: Sure. Let’s start with the notion of profit. Everyone knows that when you sell something for more than the purchase price, that’s profit. Now costs like commission, bid-ask spread, and even management fees can reduce the take-home profit.

For a taxable investor, however, there is a hidden cost: the tax due on profit, or its more common name, capital gains. We call it the tax cost, and just like the other costs, this also reduces profit. And depending on an investor’s combined marginal tax rate, it could be more than 50%. In other words, the tax cost could reduce the take-home capital gains by more than half. It is perhaps the most impactful of all costs and managing it should be of paramount importance.

Marilyn: Well, given the tax cost and its importance to taxable investors, what’s the relevance, Manju, of tax-aware portfolio transition to investors?

Manju: Sure. Nearly two-thirds of investable assets in the U.S. are held by taxable investors. And we know that investors’ objectives change through time due to various factors. Their overall asset allocation preferences itself could change due to changing market conditions.

As their objectives change, their advisors need the ability to reposition or evolve their portfolios that may have embedded gains or losses. This process can be quite challenging and complex, given the impact of tax cost, as Kandarp pointed to, on the after-tax returns.

So we need a framework that can help advisors reposition their clients’ portfolios to reach their desired objectives but do so in a tax-aware and risk-aware fashion to ultimately improve the after-tax performance of that portfolio.

This process of transitioning an existing portfolio with unrealized gains and/or losses to what’s an active or passive investment strategy by paying close attention to the various risk factors and impact of tax cost is what we generally refer to as the tax-aware portfolio transition process.

In our view, the key advantage of this approach to taxable investors is that it really helps them provide the flexibility to make changes to their existing portfolio with an eye towards maximizing and growing their after-tax returns.

Marilyn: Kandarp, can tax cost become a tax advantage or, in other words, tax alpha? And if the answer is yes, can you explain how that could happen?

Kandarp: Tax cost exists when one has net capital gains. Through careful selection of what to sell in a portfolio, realization of net capital gains can be managed quite effectively. I’ll give you two examples.

One is selecting a specific lot so that the highest cost lots are sold first to minimize gains.

Or a second example is if gain realization in inevitable, meaning all the positions you’ve ever bought are all held at a gain, then we can find other names and other positions that are held at a loss to offset that gain. This is called loss harvesting. Now it doesn’t mean that the portfolio is losing money. Even in an appreciating portfolio, we can typically find individual positions that can be sold to offset the gains. Now the savings in taxes are just as real as profits from selling an appreciated position. We refer to the profits in percent terms as alpha, and in a similar manner, tax savings provide a tax alpha. Depending on the volatility of the asset class and the market moves, the loss harvesting can be managed to more than fully offset the capital gains in a portfolio, allowing the investor to reduce the tax on capital gains or even ordinary income, subject to IRS limits.

Marilyn: Manju, what are some of the other possible benefits of transitioning a portfolio in a tax-aware fashion?

Manju: A tax-aware approach mainly involves a portfolio optimization process, and the key benefit is that it really helps investors and their advisors to evolve and customize their portfolios by balancing multiple objectives.

As Kandarp highlighted earlier, there are multiple ways of achieving tax efficiency in a portfolio, but it has to be done in a way so that you can balance it against managing the exposures to various risk factors in the portfolio and also achieving the financial and value-based objectives of clients.

During the transition process, investors can offset their current-year gains against any losses that were harvested during the process, or they can take advantage of carrying their losses forward to balance against future taxable gains.

Also, after the portfolio has been transitioned to its preferred state, continuing to rebalance the portfolio in a tax-aware fashion can help investors maintain and grow the different gains in the portfolio over the long run.

Marilyn: Okay. So Kandarp, on the other side, what are the potential pitfalls of tax-loss harvesting and how could those risks be managed?

Kandarp: Loss harvesting involves selling positions held at a loss, but doing so indiscriminately can produce an imbalance in a portfolio by introducing significant and, perhaps, unintended, over- or underweights to sectors, industry, or even style factors – all of which are important drivers of pre-tax returns of a portfolio.

Not having an appropriate exposure to these return drivers can expose the portfolio to the risk of performing very differently than expected. This is commonly referred to as the projected tracking error. Larger the tracking error, more erratically the portfolio returns are likely to be.

To manage this risk, any active loss harvesting strategy has to simultaneously manage the tracking error. Now management of tracking error is a topic unto itself, but in a nutshell, we manage it by using a state-of-the-art multi-factor, multi-asset risk model that allows us to quantify the impact of potential changes to the portfolio when we do loss harvesting and helps us make a balanced tradeoff between loss harvesting and tracking error.

Marilyn: Manju, what are some key points to consider when employing tax-aware transition for a client?

Manju: I think there are several factors that need to be considered. From a client’s perspective, a quintessential factor is portfolio customization. So the ability to integrate client preferences, be it value-based or financial, in the transition framework is critical.

Financial goals generally include maximizing yield or income targets, diversifying across credit quality, factor tails, industry and sector preferences, risk targets, and tax objectives.

Value-based goals include considerations such as environmental, social, and corporate governance preferences.

Other customization options include reinvestment of proceeds, loss harvesting targets, systematic withdrawal of cash, among others.

From a risk management perspective, diversification is the key consideration, in our view, to achieve optimal outcomes. So lack of diversification generally increases a portfolio’s uncompensated risks that can lead to suboptimal outcomes for clients.

Finally, a tax-aware transition framework should be structured to balance clients’ objectives in the target portfolio while minimizing the concentration risks through diversification across multiple risk factors.

Marilyn: Kandarp, what asset classes do you view as a better fit for loss harvesting strategies?

Kandarp: Well, any asset class that provides us with more opportunities for loss harvesting, where the price fluctuations are higher. It also helps if the asset does not throw off a lot of income, which would be taxed as ordinary income. Equities, for example, with higher volatility and tax-preferred dividends fit this definition nicely. In fact, most of the growth in tax-managed assets is in equities, outside of, of course, municipal bonds.

Marilyn: So Manju and Kandarp, do you have any closing thoughts for our listeners?

Kandarp: Clearly, we have shown that taxes play a critical role in the investment-planning process for taxable investors.

Manju: Yeah, and as we discussed earlier, a tax-aware transition framework is a key tool for us to help unlock investment opportunities and potentially deliver strong after-tax performance to our clients.

Marilyn: Manju and Kandarp, thanks so much for taking the time to discuss tax-aware investing today.

Manju: Thanks again, Marilyn. It was great being here.

Marilyn: And that wraps up this episode of the On the Trading Desk® podcast. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Stitcher, Overcast, Google Podcasts, or Spotify. Until next time, I’m Marilyn Johnson. Thanks for joining us.

 

Disclosure

All investing involves risk, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Alpha measures the excess return of an investment vehicle, such as a mutual fund, relative to the return of its benchmark, given its level of risk, as measured by beta. Alpha is based on historical performance and does not represent future results. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges, such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy.

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