Beating the market and the tax man

There are a number of different ways to measure the return of an investment, though not all of them are equally useful for investors. The gross rate of return indicates the total rate of return of a portfolio before fees and expenses. It is used to measure the effectiveness of a particular investment strategy. However, investors should care more about the net rate of return, or the rate of return of an investment strategy after fees, commissions, and expenses. This is what an investor actually earns on their portfolio, and it is often significantly lower than the gross rate of return. However, even the net rate of return is missing an important component that impacts the true return of an investor’s portfolio. It is the net rate of return after taxes that should be foremost on the mind of investors, as taxes can take a significant chunk out of any portfolio’s return. This is particularly true of high-earning investors who face the highest income and investment tax brackets.

Many investors are often surprised by the amount of taxable income their portfolios generate on an annual basis. In many cases, these portfolios were created by well-intentioned advisors who either don’t make tax mitigation a priority, or who don’t understand how to create tax-efficient investment portfolios.

We implement what we believe is one of the most effective, tax-efficient investment strategies available to high net worth investors. Our approach improves upon one of the most successful investing methodologies in practice today, indexing or “passive” investing, and adds a tax-minimization strategy that frequently results in our clients paying significantly less in taxes every year.

But before we review this approach, let us consider why indexing has been so successful.

Why indexing has an advantage over active management

Stock indexes are ways to gauge the overall performance of the market (or, a specific subset of the market). The S&P 500, for example, tracks the performance of the 500 largest publicly-traded companies in the United States. Similarly, the Russell 2000 tracks the performance of 2000 of the smallest publicly-traded companies in the United States. Indexes have been used as benchmarks for the performance of the stock market since the 1950s, but as an investment strategy, indexing is a much more recent phenomenon.

Historically, the way most investors accessed the stock market was by hiring an “active” portfolio manager, typically a mutual fund or separate account manager. The goal of the portfolio manager was to beat their index or benchmark, also known as generating alpha. For example, you might invest in a mutual fund run by a portfolio manager who would attempt to beat the S&P 500 by overweighting stocks of companies they believed would do better than the S&P 500, and underweighting stocks of companies they believed would do worse than the S&P 500.

But there are several major problems with this approach:

• Research demonstrates that stock markets are remarkably efficient, meaning that any information that could affect a stock’s price is immediately incorporated into that price. Therefore, it is nearly impossible for an active portfolio manager to have an “edge,” or know something about a stock that the rest of the market doesn’t already know.

• Active managers are expensive. Knowing that the markets are highly efficient, active managers employ armies of highly educated and highly compensated researchers and analysts to search for any edge they can find.  In 2019, the average active mutual fund charged investors .76%.

• As these managers trade in and out of stocks in an effort to position the portfolio in a way they hope will lead to outperformance of their benchmark, they incur trading costs and taxes that are passed on to the underlying investors in the mutual fund. These expenses can significantly diminish an investor’s return. In fact, academic research points to active management incurring additional tax costs of 1% – 2% annually.

The result is that in order for an active manager to truly outperform, not only must they beat the performance of the benchmark, they must do so to such an extent that makes up for the fees and taxes they incurred along the way. Studies have proven this is nearly impossible to do over any meaningful period of time. Over a 20 year period, anywhere from 75% to 85% of active managers underperform their benchmark, before accounting for taxes.[1] When judged appropriately, most active managers end up generating significant negative alpha – put differently, they are remarkably adept at underperforming their benchmark, year after year.

If you can’t beat them, join them

Indexing was a major leap in the right direction. Recognizing that it is almost impossible to beat the market over time, index funds try only to match the benchmark’s performance. There are a number of reasons why this strategy has been so successful:

• Because they are not trying to gain any edge over the rest of the market. All they need to do is invest in the stocks that make up the index. For example, an S&P 500 index manager owns the 500 stocks in the S&P 500, at precisely the same weights as the index. This is an incredibly simple strategy to implement.

• Because index funds are not trying to gain an edge over other market participants, they do not need armies of portfolio managers, researchers, or analysts. This leads to a dramatic decrease in costs which makes index funds very inexpensive. On average, index funds cost a fraction of their actively managed counterparts.^[2]

• Because the stocks that constitute the index change infrequently, index fund managers generate far less taxable gains that have to be passed on to the underlying investors of the fund.

All of these benefits have led to investors voting with their feet (and money). Index funds took in over $461,000,000,000, while active funds lost $337,000,000,000 in 2019 alone.^[3]  Indexing has constituted a major improvement in the way most people invest. Investors have saved billions of dollars in fees that would otherwise be in the pockets of overpriced fund managers.

But indexing still isn’t perfect

For all the good that indexing has done, there is still room for improvement.

Consider for a moment what an investor is buying when she buys a share of an index fund. We will use the S&P 500 index as an example. The S&P 500 index fund manager has used the pooled resources of the underlying investors to buy the 500 stocks in the S&P 500. These stocks are then bundled and wrapped into shares of the fund. Each fund share is then sold to an investor, who rather than owning the underlying stocks, owns a share of the pooled fund.

This is all well and good, but there is a structural limitation to pooled investment vehicles; namely, that losses accrued by the fund cannot be passed on to underlying owners of the fund. To illustrate this phenomenon, let us again review the S&P 500.

Over the course of an average year, a majority of the stocks that comprise the S&P 500 will increase in value, but a significant minority will decrease in value. The chart^[4] above demonstrates that, even in years where the index is up, a significant number of stocks within the index will decrease in value. In a perfect world, the fund manager would sell the stocks that have decreased in value. These capital losses could be passed on to the underlying investors, who could in turn use these losses to offset capital gains, or if losses were in excess of gains, could be used to offset the investor’s total income.^[5] This could result in a substantially lower tax liability for the underlying investor. However, because the index fund is structurally unable to pass losses to the underlying investors in the fund, these valuable losses are wasted.

How Wedmont’s clients could outperform the index on an after-tax basis

Wedmont’s clients are those who could benefit the most from this capital loss harvesting strategy – earners in the highest tax brackets who are particularly sensitive to taxes. Because of this, we employ an approach that combines the benefits of passive investing with tax-loss harvesting – direct indexing. And because of our unique fee structure, we offer this capability to our clients at no incremental cost. No AUM fees. No commissions. No performance fees.

When we direct index your portfolio, we purchase the index’s underlying stocks, and regularly harvest losses in your portfolio. We are performing a similar function to the index fund manager, but because our clients own the underlying securities directly, we can take advantage of the normal fluctuations in the stock market to generate significant tax savings for our clients. In fact, under most market conditions our portfolios should outperform the benchmark on an after-tax basis. While these portfolios will generally have more tracking error than an index fund, we also expect the long-term gross returns to closely resemble the returns of the index, particularly if you make frequent cash contributions to your portfolio. Below is an example of how direct indexed portfolios could provide superior results over other investment strategies.

The Wedmont difference: Potential benefit for $3,000,000 portfolio*

*Important notes and sources to the above graphic:

1.  S&P 500 average annual return over 30 years as of 12/27/19, per Standard & Poor’s
2.  Investment Company Institute, see: https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf
3.  Multiple academic studies have shown tax drag of actively managed funds to be between 1% and 2%
4.  Average AUM advisor fee of a $3M portfolio, see: https://www.advisoryhq.com/articles/financial-advisor-fees-wealth-managers-planners-and-fee-only-advisors/#Percentage-AUM
5.  Other direct indexing providers have shown average “Tax Alpha” of .97% over extended time periods, see: “AIA Quantifying the Value of a Tax Overlay”
6.  Benefit from tax-loss harvesting is only realized when there are other gains to offset or to offset up to $3,000 in income, if no gains are available losses may be carried forward for up to seven years

Direct indexing has wide applicability

Direct indexing is appropriate for a number of investor situations, including:

• Implementing equity allocations from cash positions
• Transitioning an existing portfolio of individual securities, Separately Managed Accounts (SMAs), or actively managed equity funds
• Unwinding concentrated positions of company stock

While not appropriate for all situations, direct indexing is an underutilized approach that could result in significant investment and tax benefits for many wealthy investors.

[1] Source: Dimensional Fund Advisors 2019 Mutual Fund Landscape

^[2] Per the Investment Company Institute, passive equity funds cost 0.08% on average, as opposed to their actively managed counterparts at 0.76% https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf

^[3] Morningstar Direct Asset Flows

^[4] Source: Standard and Poor’s

^[5] Up to $3,000

Important Disclaimers:

Wedmont Private Capital (WPC) does not represent in any manner that the tax consequences described as part of its tax-loss harvesting service will be achieved or that WPC’s tax-loss harvesting service, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting service and other strategies that WPC may pursue are complex and uncertain and may be challenged by the IRS. The information with regard to this service was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.

Clients should confer with their personal tax advisors regarding the tax consequences of investing with WPC and engaging in the direct indexing service, based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the Client’s personal tax returns. WPC assumes no responsibility for the tax consequences to any Client of any transaction.

The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes. These performance discrepancies create tracking error between Client performance and performance of the target benchmark. Clients should expect the performance of their account to differ from the performance of the target benchmark, regardless of whether WPC has engaged in tax loss harvesting in the account.

The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any, for a period of seven years. WPC only monitors for tax-loss harvesting for accounts within WPC. The client is responsible for monitoring their and their spouse’s accounts outside of WPC to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time. WPC may lack visibility to certain wash sales, should they occur as a result of external or unlinked accounts, and therefore WPC may not be able to provide notice of such wash sale in advance of the Client’s receipt of the IRS Form 1099. The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the Client will depend on the Client’s entire tax and investment profile, including purchases and dispositions in a Client’s (or Client’s spouse’s) accounts outside of WPC and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). WPC will monitor only a Client’s (or Client’s spouse’s) accounts at WPC to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of such accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the Client in the most efficient manner.

This document may contain references to copyrights, indexes, and trademarks that may not be registered in all jurisdictions. Third party registrations are the property of their respective owners and are not affiliated with WPC. Such third party owners do not sponsor, endorse, or participate in the provision of any WPC services.