A year-end look at the impact of taxes on asset allocation

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Maximize after-tax returns

As we enter the end of the year, investors should have the opportunity to rebalance their portfolios to position them to maximize their potential after-tax return. Some investments are naturally more tax-efficient than others, but investors who try to minimize taxes will miss opportunities to maximize after-tax returns. By ignoring the impact of taxes at every stage of portfolio design, investors can end up with lower after-tax returns and less capital on which to accumulate growth.

Different investments come with a different mix of income sources, each of which is affected differently by the tax code. Taxable investors must balance the trade-off between tax burden and investment opportunity from the perspective of their current and expected future situation in order to maximize after-tax returns. When designing an asset allocation, the goal is to maximize the likelihood of achieving your specific goals which, in turn, are highly dependent on maximizing after-tax wealth for a given level of risk. This requires moving from traditional portfolio construction frameworks to one that incorporates the tax treatment of investment returns.

Looking at the data, we also find that certain assets, such as stocks, tend to have higher tax cost ratios than fixed income funds which are more tax efficient. However, when making an investment decision, just because an investment may have a high tax cost ratio does not mean that its after-tax return will be lower than an investment with a lower tax cost — it all depends on the strength of the pre-tax return. When it comes to stocks, historical pre-tax returns have often been so much higher that the tax burden always results in a higher after-tax return than more tax-efficient investments. This is why the objective of an investment should not be simply to minimize taxes, but to maximize after-tax wealth.

The tax impact of your implementation vehicle

From a portfolio construction perspective, investors need to consider the tax impact of their implementation vehicle. For example, investors looking for a passive strategy that simply tracks an index may choose to invest in a mutual fund or an exchange-traded fund (ETF). Between two vehicles, however, exchange-traded funds tend to be more tax-efficient due to their structure.

ETFs have two main advantages when it comes to deferring the realization of capital gains. First, exchange trading provides investors with a way to buy and sell ETF shares without causing transactions in the ETF’s portfolio for other investors.

Second, when ETF shares are redeemed (by an authorized participant, not individual investors), most ETF managers do not need to sell securities within the fund (a taxable event). Instead, the securities are delivered from the fund to the authorized participant to make the redemption. This is an “in-kind” redemption and is not a taxable event for fund shareholders.

Similar to the situation with the tax efficiency of stocks versus bonds, the general trend towards greater tax efficiency of ETFs does not mean that mutual funds should be avoided in a portfolio when positioning to maximize after-tax returns. Through stock selection, risk management, or other active portfolio decisions, actively managed mutual funds may be able to generate higher after-tax returns than their passive ETF counterparts.

Meanwhile, separately managed accounts (SMA) offer several advantages, which lead to more opportunities for tax loss harvesting. They are somewhat similar to mutual funds or ETFs, but they allow an investor to own the individual underlying securities directly and are not grouped with other investors. For example, an SMA that tracks the S&P 500 Index could proportionally own individual stocks for each and all index constituents. By directly owning the underlying individual securities of an SMA, instead of buying a mutual fund or ETF, an investor has greater control and flexibility, which, in turn, can provide more opportunities to improve after-tax returns.

Diversification provides opportunities for net gains versus losses

As investors assess after-tax returns, it is important to recognize that diversification has the benefit of reducing the tax burden on wealth. A well-diversified portfolio will naturally have some assets gaining in value while others fall in value. This allows realized capital gains to be offset against realized capital losses, providing opportunities to produce greater tax efficiency over time.

The tax code tends to favor US municipalities in fixed income and US equities, resulting in a natural preference for US investors. However, while other investments may be less tax-efficient, those that don’t diversify into other regions and sectors are likely reducing their after-tax return potential while taking on more concentrated risk.

Important Note: Tax strategies can be complex. In addition to federal taxes imposed on ordinary income and capital gains, there may be state and local taxes that should be considered before implementing a tax loss harvesting strategy. In addition, transaction costs that may apply to the purchase and sale of securities should be carefully considered. Each investor should consult his own tax advisor regarding the tax consequences of any investment strategy he is developing or considering. UBS does not provide tax advice.

Main contributors: Daniel J. Scansaroli and Jeff LeForge

Read the full report Building and Managing Taxable Portfolios: Insights to Help Maximize After-Tax Wealth.

This content is a product of the Chief Investment Office of UBS.

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