Managing Portfolio Taxes and Tax Risk

Portfolio Tax-Management is Key to Attracting and Keeping High-Net-Worth Investors

With the right tools, the most reliable way to generate portfolio alpha is via tax alpha. One way to look at traditional alpha is as a zero-sum game (after subtracting risk-adjusted market returns). Very smart people with substantial financial backing are searching for tradition alpha every day. The competition for alpha is intense, and tautologically when someone generates positive alpha, elsewhere in the market others are offsetting with negative alpha.

Producing tax alpha, however, can be a viewed as win/win cooperative “game” involving the investment advisor representative (IAR) and client. Among the IAR’s many tasks in creating positive tax alpha is asking for regular (quarterly or twice-per-year) updates on the client’s tax situation and expected tax bracket. The client’s responsibility is to monitor and know their tax situation and to provide timely and accurate updates when their expected tax situation has significant changes.

Net-net worth investors tend to be both more tax savvy and tax aware than other investors. Whereas $5M in liquid assets used to be the threshold where investors expect and demand portfolio tax management, investors at the $2M and even $1M level are increasingly demanding portfolio tax management.

Firms that fail to offer effective portfolio tax management services are at risk of losing their most revenue-producing clients. Conversely, firms that offer and effectively communicate quality investment tax-management services stand to win highly sought-after high-net-worth advisory clients.

Developing a Tax-Aware Portfolio Mindset

Effective investment portfolio tax management begins with awareness of the tax implications of investment actions. As a rule of thumb, the two most tax important considerations are:

  1. Awareness of whether asset sale will: A) Generate a large capital gain or loss. B) Result in a short-term (ST) or long-term (LT) gain or loss.
  2. Awareness of the client’s: A) Tax situation, B) Tax preferences.

After choosing to increase one’s own investment tax proficiency, we advise clients to begin slowly and focus primarily on tax awareness for the first month or two. There are many reasons we favor this approach. First there is a tendency to initially swing to a tax-first mentality. We believe that it is best to maintain an investment-first mentality, with tax-awareness and tax-management playing an important secondary role in most cases. Developing a tax-aware mentality requires much more mental energy, especially in the beginning. Much like an amateur juggler adept at juggling three balls, adding a forth is very difficult at first, and it dropping one (or more) balls is increasingly likely. If overwhelmed it is best to drop the “tax ball” first, and pick it up later when circumstances permit.

Our view is that it takes 2-3 months of effort to reach a point where portfolio tax awareness becomes largely second nature. It is only after tax consciousness becomes second nature that the foundation for investment tax mastery is ready. Up until this point, and advisor can learn and become modestly proficient with a small number of basic tax techniques. The long-term goal of developing portfolio tax mastery is an art that requires attention, knowledge, creativity, and perseverance. The benefits to both the client and the practitioner are well worth the effort.

Portfolio Tax-Management Corporate Training

We at Sigma1 are working diligently to develop a set of portfolio tax-management training modules ranging from basic to advanced. We have begun offering limited free “beta” courses in investment management tax basic and intermediate level techniques to investment professionals in the the Northern Colorado region. All we ask in exchange is for participants to agree to fill out a brief survey on the day of our presentation and a followup survey in 6-8 weeks to see if and how they are using the training in their investment management process. If you or your firm is interested in participating in this free beta training, feel free to contact us.