From the April 2005 issue of Investment Advisor • Subscribe!

April 1, 2005

All Hail the Overlay Manager

UMAs offer advisor many advantages.Tax management is probably the most effective and least understood

Unified Managed Accounts (UMAs) give advisors the flexibility to choose their own asset allocation and preferred products while delivering enhanced levels of customization. But the UMA's least understood and most effective customization benefit is tax management.

In today's most sophisticated UMAs, a single discretionary manager, called the overlay manager, coordinates the trading activity of all underlying products. By doing so, the overlay manager can create a more personalized solution for each client. Overlay management and the single account UMA structure are prerequisites for enabling efficient tax management.

However, the adage, "just because you can doesn't mean you should" is very appropriate when discussing tax management. To understand when tax management is a viable option for a client, an advisor should understand the concept of a product's tax burden.

This concept is not unique to separate accounts and is broadly applicable to any taxable account. Learning its meaning will enable an advisor to make better informed product selection decisions and use techniques that reduce a client's taxes without materially compromising long-term investment returns. It is important to understand that utilizing tax management techniques introduces the potential for performance deviation versus similar products that are not tax managed. However, as long as this deviation is monitored and managed, the client can obtain similar pre-tax returns and improved after-tax returns.

To illustrate the tradeoffs involved in tax management, consider an extreme approach: managing taxes by never recognizing any gains. Say an advisor selects an active manager with 100% annual portfolio turnover. The advisor anticipates the manager will add substantial value via stock selection, but asks the manager to reduce the client's tax burden by never recognizing gains. In a year the client's portfolio will differ substantially from the manager's current stock picks. The basis for selecting the manager--his stock selection ability--contrasts with tax aversion. This contradictory set of decisions is worth considering to better understand the balance between reducing tax burden and avoiding material deviations from the manager's model portfolio.

Understanding "Tax Burden"

Many terms are used interchangeably when referring to tax burden. Most notable is the tax, or alpha, hurdle. However, there is a very distinct difference between "tax cost" and "tax burden." Tax burden is defined as the annualized difference in return over the client's time horizon between a given strategy and a passive strategy, resulting in the identical ending after-tax account value.

Here's a tax burden example: Assume an investor has $100,000 and two investment alternatives. The first is to buy a basket of securities to be held 10 years and then liquidated, recognizing a 10% annualized return. The second is to hire a separate account manager who will manage a portfolio with 100% turnover per year (holding each security for one year so any gains will be taxed as long-term ones), recognizing a 10.52% return after management fees. Since the first portfolio holds all securities, the client won't have a tax bill until liquidating the stocks at the end of the time horizon. In contrast, the second portfolio has an annual tax cost of 15% (the capital gains rate) times the pre-tax return of 10.52%, or 1.578%.

After 10 years, both portfolios' account values will be essentially equal. We've posted a chart illustrating the two strategies here.

In the active strategy, the value drops each year as taxes are paid, while there is no reduction in the passive strategy until the end of the client time horizon. At that point the client with the passive strategy would pay a large tax bill on the entire portfolio gain over the 10-year period. In this scenario, the tax burden is 0.52%. So taxes required the active strategy to generate an additional 0.52% to make it equivalent to the passive strategy at the end of the client's time horizon. Had the active strategy achieved a return in excess of 10.52%, the client would have been better off with the active strategy, and vice versa.

Obviously, one cannot compare the pre- and after-tax returns in a given year to determine which choice added more value. Doing so would ignore the effect of embedded but unrealized portfolio gains. In practice, determining a tax burden involves several considerations:

  • Capital Market Assumptions. This is security appreciation plus dividend yield. Unlike the example above, when dividends are paid, even the passive strategy will have an annual tax cost. As far as the contribution of yield to total return, a 15% to 30% general estimate of total return should be reasonable. Unique dividends, such as Microsoft's, can temporarily shift this upward, so be aware of this when reviewing recent index statistics.
  • Passive Turnover. The example above assumes no turnover in the passive strategy, but index reconstitution, involuntary taxable corporate actions, and securities sales to pay management fees will result in some turnover. Five percent to 8% annually is a reasonable estimate.
  • Active Turnover. Manager trading is the primary source of active turnover. When multiple products are employed, the appropriate metric is the average turnover of the products as well as additional turnover for rebalancing and product changes. Turnover results in short- and long-term gains (the example above, where all gains realized were long-term gains, is unlikely unless explicitly monitored by an overlay manager). As turnover approaches 60% it's likely that a reasonable portion of gains will be short-term.
  • Tax Rates. The client's actual tax rates for long-term gains, short-term gains, and dividend income vary not only by income but by state and municipality, work and residence, and other factors.
  • Time Horizon. This critical factor significantly affects results and planning.

Calculating tax burden involves modeling the investment strategy's cost basis, capital appreciation, dividends, realized gains, and tax costs for each period over the client's time horizon. Only then can the advisor calculate the pre-tax return that makes the after-tax liquidation value equal to the passive strategy. You will also find a table on www.investmentadvisor.com that illustrates the tax burden associated with various inputs based on 5% passive turnover and tax rates of 15% for capital gains and 35% for income. While the concept of tax burden is applicable to all investment vehicles, this table is unique to separate accounts, including UMAs. Other vehicles, such as mutual funds, can have lower or higher tax burden attributed to their product's pooled structure and overall cash flows of a particular fund.

Reducing Tax Burden

Effective tax management involves explicitly controlling tax costs to lower the tax burden while attempting to avoid any material differences in pre-tax returns. For example, assume you have a client with a 20-year time horizon. You are considering a combination of products with 100% gains realization (40% short-term) and you expect a 10% equity return over that time horizon (with 0% yield). These products would have a tax burden of 1.78% and would therefore need an 11.78% return for the client to be better off than a passive strategy. As an alternative, you could choose a similar set of products with 80% gains realization and 0% short-term gains and the burden would drop to 0.63%. As long as this product achieved an annualized return of 10.63% (compared with 11.78%), this product would result in a better long-term after-tax performance for the client than either a passive

strategy or the alternative active strategy. Discretionary judgment balancing these tradeoffs is the role of the overlay manager.

An overlay manager uses two methods to reduce an account's tax burden: Harvesting losses and deferring gains. Harvesting losses involves selling tax lots at a loss to offset other portfolio gains. Securities can be repurchased after 30 days (any sooner would result in a wash sale and the deferral of the loss). Gain deferral avoids realizing gains that would have been realized if it were not for adverse tax consequences. The longer the gain is deferred, the greater the risk the portfolio will have material differences in performance by failing to keep up with the preferred picks of the money manager. In practice, the most important gains to defer are short-term gains when offsetting losses are unavailable, as they result in a substantially larger tax burden. One other type of low-risk gain deferral is to put off realizing long-term gains near the end of a tax year, offering the client an extra year before tax costs burden the account.

Applying the concept of tax burden involves integrating it into product selection decisions, determining if the product's tax burden is too cumbersome and if effective tax management can reduce the burden without compromising performance. Remember to consider if each product's anticipated benefits justify its tax burden, and if the tax burden can be lowered through tax management without compromising the anticipated benefits. With investment products whose average turnover does not substantially exceed 100%, it is reasonable to expect an overlay manager can reduce gains realization and eliminate material levels of short-term gains without compromising performance, thus reducing tax costs and improving after-tax returns.

Ron Pruitt is chief investment officer at Placemark Investments in Dallas. He can be reached at ron.pruitt@placemark.com.

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