A Tax Dilemma – How Capital Gains Can Hold Financial Advisors Hostage

While a series of profitable years is wonderful, we all know the ride comes to an end at some point. When that happens, advisors seeking to manage or reduce clients’ risk level can be held hostage to the gains that have built up in taxable accounts.

As advisors add new clients/accounts and plan for 2022, now is the time to consider approaches that reduce the risk of this scenario.

In addition to specific tax-loss harvesting strategies, the most simplistic approach, of course, is already used by most advisors when they help clients maximize returns by capitalizing on an assortment of accounts meant to defer taxes. However, since most of these tools have limits on how much can be contributed and stiff penalties for distributions per certain age requirements, it is common for clients to also have one or more taxable accounts.

While it may seem easy for an advisor to write off this concern of realizing gains to reduce risk as simply a cost of doing business, clients aren’t always so forgiving.

In an industry where unreasonable expectations are the norm, advisors may find themselves between a rock and a hard place. Lose money past a client’s “uncle!” point in a subsequent bear market and face being fired. Surprise the client (or their CPA) with an unusually large tax bill from capital gains and face the same result. You get the picture.

Unfortunately, once an advisor has already amassed a significant unrealized tax liability, the options are a bit limited. But, there are strategies that can reduce the risk of this scenario for new clients and accounts.

A Strategy With Built-In Tax-Loss Harvesting

The traditional view of tactical asset management is that risk management and tax efficiency do not mix well. The conundrum is that most tactical managers do not place proper emphasis on taxes, and most tax-efficient portfolio strategies do not adequately account for portfolio risk. We should know. When we started as a tactical manager, we failed to properly value the importance of tax alpha. Fortunately, we quickly learned from our oversight and have since made tax management a cornerstone of our risk-managed processes.

Trend following strategies can be inherently tax friendly if the developer incorporates a blend of timeframes in line with U.S. tax law. Inherently, losing positions are sold quickly when prices fall because price is the sole input for trend-following allocation decisions. Gains are held if trends persist, and using longer-term timeframes can create a scenario where a portion of gains are usually harvested after 12 months. This process results in a smoothing out of the tax profile, as well as a less choppy ride for clients.

In an average year, a trend following strategy may realize more gains than a passive portfolio. But, somewhat counterintuitively, this does not necessarily reduce long-term compounding over full market cycles or generate an obstruction threatening an advisor’s ability to make sound portfolio decisions.

This year has been a great example of how this works. Frequent tax-loss harvesting in fixed income positions and certain equity sectors has, in most cases, more than offset realized long-term gains in developed and emerging international markets. Despite all the inflation talk, commodities such as gold have been generally directionless for the year, allowing for additional loss harvesting as highlighted in the chart below.

Applying trend following to iShares Gold Trust

The losses have not been enough to meaningfully drag on the great returns provided by U.S. equities, but have provided value from a tax perspective as they offset current realized gains or are carried forward. The net result is a very strong return with realized net capital LOSSES in most Blueprint portfolios.

Impact of Trend Following on Unrealized Capital Gains

As an example, below are illustrations from a simulation that uses the total return of the S&P 500 (expressed by SPDR S&P 500 ETF Trust) since 2000 to compare a buy-and-hold portfolio to one utilizing two trend-following models.

Buy-and-hold versus trend-following percentage of portfolio with unrealized gains

Since 2000, 78% of the buy-and-hold portfolio is made of up unrealized gains. Therefore, an advisor looking to make any change to the portfolio or strategy is likely to sustain a substantial taxable event. On the contrary, the trend-followed portfolio, which has a process for systematically harvesting losses (and some gains), maintains a more palatable 41% in unrealized gains. All else equal, the flexibility afforded the client and advisor when a strategy shift or liquidity is needed is roughly 2x easier over this timeframe.

Impact of Trend Following on Pre- and After-Tax Returns

Given this result, you might assume the buy-and-hold portfolio would outperform the trend-followed strategy. Not so fast.

The graph below illustrates the pre- and after-tax returns for the buy-and-hold and trend-followed portfolios. It also includes the sub-strategies that make up the trend portion of the actively managed strategy. With conservative assumptions on long-term tax rates, the data illustrates the potential for trend-following strategies to generate tax alpha over longer-term time horizons.

Buy-and-hold versus trend following pre- and post-tax CAGR comparisons
Over this sample, not only did the trend-followed portfolio with 3 timeframes outperform a buy-and-hold approach, but it generated tax alpha with a 6 bps higher after-tax CAGR. Even more interesting is the tax alpha generated by the trend sub-strategies. For example, the long-term trend sub-strategy generated 5 bps in tax alpha. This is due to the mechanics of systematically cutting losses and maintaining longer-term holding periods, thus most gains generated by this sub-strategy came after holding a position for more than 12 months.

Balancing Risk Management & Tax Efficiency

As we conclude, it is important to note that at Blueprint we will never let tax considerations supersede risk management. Our research shows that maximizing compounding by avoiding large, sustained drawdowns is statistically more important to meeting financial goals than avoiding taxes. We would rather pay taxes on gains than avoid taxes and make a zero return, or worse, incur large drawdowns to avoid realized gains. Hopefully every advisor would agree.

That said, maximizing after-tax return not only is fundamental to goal achievement but also psychologically important to clients. In a world where it can be difficult for advisors to stand out, offering a combination of risk management and tax management within portfolios can be a differentiator. Certainly, the emphasis on tax efficiency has become a game changer for our own firm.

We hope that as advisors look ahead to 2022 and evaluate ways to avoid being captive to the markets and taxes, that they will consider approaches with baked-in tax efficiency. To learn more about Blueprint’s approach in this regard, please reach out.

Blueprint Investment Partners is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. For more information please visit adviserinfo.sec.gov and search for our firm name.

Past performance is not indicative of future results. The material above has been provided for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.

Information contained on third party websites that Blueprint may link to are not reviewed in their entirety for accuracy and Blueprint assumes no liability for the information contained on these websites.

Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Blueprint.

Model Disclosures for Hypothetical Back-Tested Performance:

The model used in this blog is not a model that Blueprint uses or has ever used. It is merely a general representation of simple trend following models. There is no guarantee of any minimum level of investment performance or the success of any investment strategy. Past performance does not guarantee future results. There is a potential for loss in any investment, including loss of principal invested. All investments involve risk, and different types of investments involve varying degrees of risk. Investment recommendations will not always be profitable. No representation is being made that any Blueprint client account will or is likely to achieve profit or losses similar to those shown in the trend following model. Hypothetical back-tested performance information shown in text, charts, tables, and graphs is provided for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities.

There are certain limitations inherent in hypothetical model results like those portrayed, particularly that such hypothetical model returns do not reflect trading in actual client accounts and do not reflect the impact that material economic and market factors may have had on the adviser’s decision making had the adviser actually been managing client funds. Unlike an actual performance record, hypothetical back-tested performance results do not represent actual trading. These types of simulated trading programs, in general, benefit compared to actual performance results because such simulated programs are designed with the benefit of hindsight. In addition, simulated trading does not involve or take into account financial risk and does not take into account that material and market factors may have impacted Blueprint’s decision making, all of which can adversely affect actual trading results and performance. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can also adversely affect markets in general or the implementation of any specific trading program. Hypothetical back-tested performance does not represent actual performance, trading costs, or the impact of taxes and should not be interpreted as an indication of such performance.

email signup

New call-to-action

Popular Posts