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.