The US wealth management sector uses a wide range of techniques to measure after-tax returns on portfolios. At a time when the tax bite on investments has become a more urgent concern, this article takes a look at the issue.
When taxes go up, and whatever approaches wealth managers take, clients will definitely want to know about where they stand once the tax bite hits. What will their portfolio look like after tax, and how can this be measured consistently? Those questions are not as easy to answer as they should be – so the author of the following article argues.
At a time when capital gains tax, income tax, and other federal and state levies appear to be headed up, this article is particularly timely. The author is Christine Madel, of Meradia. The firm, which was founded in 1997, provides strategic advisory and implementation services to the investment management industry.
A simple example might help to illustrate the issue. Every time someone sells a security, investors must pay tax on the difference between the purchase price and the sale price. If the sale price is greater than the purchase price, tax is owed and if the price is lower, this is a loss that can be used to cut capital gains or up to $3,000 of ordinary income. Anything that can’t be used in the current tax year can be carried forward to future years. Some wealth managers have told this news service that tax-loss harvesting - as the technique is used - has mixed results. During the massive stock market fall of March 2020 when the pandemic-related lockdowns took hold in the West, anyone who had used this tactic would have had to scramble back to repurchase assets - losing the tax benefit - when markets subsequently shot back. Creating reliable measures of how effective such techniques are over time is not straightforward.
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(Details on the author below.)
As a wealth manager, you spend a great deal of time servicing clients and perhaps even more time explaining the results in a meaningful way. Clients consistently want to know how their portfolio is doing, how they are meeting their financial goals, but they also need to understand the impact of taxes.
When it comes to demonstrating after-tax performance, the advisor may not have the right information to clearly articulate to the clients how their investments are performing on an after-tax basis. For high net worth and ultra-high net worth clients who have multiple investment portfolios, complex investments and often have low-basis investments, understanding the after-tax performance is especially valuable but also the most difficult to measure.
Calculating the after-tax performance of the client’s total investment portfolio is possible; however, the means of doing so requires a holistic methodology that incorporates inputs from disparate systems and documents, and can account for adjustments as more information becomes available.
After-tax performance reporting today
The methodologies firms use today for after-tax returns are imperfect due to the narrow focus rather than holistic view, the plethora of client information that factors into the calculation and the inability of systems to store that data. In addition, changes to the federal, state and local tax code make it challenging to maintain correct formulas. Even when the advisor has complete transparency into the client information and the tax implications are known, there is still the matter of timing. Only estimates are available during the calendar year with final tax code rules and the client’s marginal tax rates known after the fact.
This has a negative impact on the advisor in several ways. First, they are unable to demonstrate tax-sensitive trade and portfolio construction decisions that incorporate both managed and non-managed investments. When pressed for after-tax information, advisors must rely on manual and error-prone processes that reduce efficiency. Lastly, it requires the client to provide this information, which is often presented in an irregular manner and without a centralized aggregation tool.
Though some may argue after-tax benchmarking is a necessary part
of performance reporting, others argue that it’s more applicable
to investment managers who are strictly providing investment
services for a subset of the client’s portfolio, or for firms
providing algorithms to perform tax-optimized trading decisions.
Those taking this counter-view assert that the wealth manager’s
focus is on meeting their client’s goals and helping them
navigate their unique financial circumstances. This may involve a
single portfolio but, more often, includes qualified plans and
illiquid investments which are not part of the data set used for
a stand-alone analysis.