Tax management and tracking error


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Two words can set off more alarm bells with investors than any other: taxes and tracking error. Investors in Separately Managed Accounts (SMA) regularly find themselves hearing these burning words from their advisers. That’s why it’s essential to help clients manage their taxes while understanding the role that tracking error plays in potentially reducing their tax burden. Once investors understand how tax management and tracking error work hand in hand, the alarm bells are over.

The importance of tax management
Taxes can have a major impact on the long-term growth of a portfolio. For many high net worth investors, taxes can be a bigger drag on returns than fees or transaction costs. The timing of cash flows and the gains or losses incorporated into the portfolio can also affect the long-term growth of a portfolio.

While many managers ignore taxes on investments and instead focus on pre-tax returns, it’s the after-tax returns that really matter to taxable investors. Any opportunity to moderate taxes is welcome, and this is what tends to attract investors to tax-managed ADMs.

SMAs allow taxable investors to focus on managing their after-tax returns by using losses realized on sales of individual securities to offset gains in their overall investment portfolio. Investors can also use SMAs to pursue additional tax management strategies, such as matching gains and losses, accelerating the realization of gains, transitioning assets, or donating specific tax prizes to works. charities. Because ADMs allow investors to select the type of tax management that meets their needs, they have become a popular tool for taxable investors.

The role of tracking error in tax management

But by choosing to use a tax-managed SMA, investors will inevitably suffer a tracking error. This can be an uncomfortable concept for investors who don’t want a Fault appearing in their portfolio. But the tracking error is not really an error, and it is not necessarily good or bad. It simply measures how well a portfolio tracks its benchmark.

Tracking error is formally defined as the standard deviation of the difference between the returns of the portfolio and the returns of the benchmark index, or the dispersion of excess returns of the portfolio relative to its benchmark index. It is generally expressed both as an annualized number and as a percentage. For example, a portfolio may have a tracking error against its benchmark of 1% per year. For a portfolio with a normal distribution of excess returns and an annualized tracking error of 1%, we can expect its return to be less than 1% of its benchmark return for about two out of three years.

Managed portfolios, like SMAs, behave slightly differently from their benchmarks on a daily, monthly and yearly basis. By managing a portfolio to reap losses, transfer assets, tax effectively or realize gains, an SMA inevitably deviates from its stated benchmark, resulting in a tracking error.

How the tracking error occurs in tax-managed ADMs

Let’s take a look at how a tracking error can occur in a tax-managed SMA that is compared to the S&P 500® Index and designed to search for opportunities to harvest tax losses. The portfolio is initially invested in around 250 to 400 stocks selected to mimic the benchmark in terms of sector and industry weightings. The portfolio is designed to have low tracking error and it resembles the benchmark in terms of risk factors such as yield, beta and market capitalization. Once the initial portfolio is invested, it is watched for opportunities to harvest risk and tax losses.

Opportunities to harvest tax losses arise over time when the market value of various securities falls below its cost base. When this happens, tax lots with material losses are sold and replaced with newly purchased securities. The SMA works as expected: it closely tracks the benchmark on a pre-tax basis while producing excess realized losses.

But by implementing a tax loss harvesting strategy and selling securities, the portfolio naturally underweight those particular securities relative to the benchmark. There is also a natural deviation from the benchmark in the opposite case, if an investor decides to hold a valued security to defer the realization of a gain. In this case, the portfolio may hold these overweighted securities relative to the benchmark index.

How to handle the tracking error in a tax-managed ADM

While tracking error can be inevitable, it can also be managed to match an investor’s risk tolerance. Investors can work with an advisor to balance tax management techniques with a resulting tracking error that suits their risk tolerance and long-term financial goals. For example, investors who want to balance their risk tolerance with their tax management efforts may aim for a fairly standard tracking error of 1%. Those who are more aggressive may allow their tracking error to drift higher, closer to 2%, allowing for a larger harvest of potential losses and carryover of gains.

While tax management introduces a tracking error into an SMA, the goal is for the portfolio to provide similar returns to the benchmark while helping investors pay less tax. The cumulative effect of this tax deferral can be quite powerful over time, even with the existence of a tracking error.

The bottom line

The personalization of a portfolio through tax management inevitably leads to a tracking error. But advisors can work with clients to find a comfortable balance between tax management techniques for a portfolio and its deviation from the benchmark. Ultimately, while tax-managed portfolios can lead to tracking error, they also allow investors to keep more of their invested money while maximizing their after-tax return.

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