Let’s imagine an insightful advisor who hires a talented investment manager. The manager identifies a winning stock, sells the name, and locks-in an outstanding pre-tax return. The advisor, however, is not quick to celebrate because the sale of the stock results in the realization of a significant capital gain. In the best of circumstances, the sale is long-term and taxed at long-term capital gain rates. In the worst-case scenario, the gain is short term and subject to ordinary rates. The bigger the triumph for pre-tax returns, the larger the impact on after-tax performance.

The need to keep portfolio risk in check is another aspect where a well-intentioned advisor may feel conflicted. While rebalancing is a common risk-mitigating strategy, it demands that an advisor sell some of what has relatively appreciated in value in order to buy more of what has relatively depreciated. In most circumstances this can be a fairly easy and straight-forward process, except that it is likely to trigger a taxable event. Suddenly the advisor faces another Catch-22. What to do – reign in risk, or forego rebalancing in order to avoid incurring a tax liability? Without the benefit of foresight the choice is exasperatingly murky at best.

A fresh start

We see many advisors still focus on tax management only after the portfolio is designed, and as a result, have few options to soften the inevitable consequences of such a tax-unaware structure. In fact, these taxes can be significantly moderated but it requires thoughtful, up-front portfolio construction. Here are four ways to improve portfolio tax efficiency and simultaneously avoid the predicaments inherent in many traditional (non-tax aware) portfolio structures.

1.    Dedicate a significant portion of the portfolio to a passive, buy and hold, core exposure. By shifting towards a fewer number of low-turnover investments, one can expect less capital gains, and perhaps more opportunities to harvest losses. Rebalancing taxes are also reduced because with a lower number of managers, fewer trades are required to realign the portfolio.

2.    Reduce the number of active managers to just a few high-conviction specialists. With a broadly diversified core, there’s no reason to pay specialist managers for risk control. The advisor’s focus can shift instead to a few number of highly specialized, very concentrated satellite managers.

3.    Consider tax-efficient definitions of thematic bets. It is popular today for advisors to desire to add a “smart-beta” factor (e.g. value, quality, momentum), responsible tilt, or other style to their client’s portfolio. Often such biases can be implemented by simply over- or under-weighting names in a low-turnover fashion, thus avoiding the higher tax implications (not to mention management fees) of active specialists.

4.    Using separate accounts can help to ease the negative tax consequences of traditional fund investments. In a separate account structure, advisors are able to tailor turnover by setting client-specific boundaries around when to rebalance and recognize capital gains. Another key benefit of a separate account is the ability to pass through losses, which can be used to offset gains elsewhere.

While the tension between seeking alpha and avoiding taxes will never be completely eliminated, it can be mitigated by electing a tax-friendly core-satellite approach. By reducing the number of active managers, advisors will find there is less need to agonize over impossible choices such as whether to defer capital gain realization or keep portfolio risk in check. As a result, the advisor can spend more time focused on identifying and hiring the best managers for the job.