By David M. Stein, PhD, Managing Director, Chief Investment Officer, Parametric Portfolio Associates LLC

Large cap. Mid cap. Small cap. Growth. Value. Momentum. Sectors. Active. Passive. Tactical timing. These style buckets, and others, help professional advisors select portfolio specialists with beat-their-benchmark track records. Risk is minimized. What's wrong with that?

What's wrong is that a complex portfolio structure hurts investors like you by generating excessive capital gains taxes. While this model may work for tax exempt organizations, it may not be optimal for you.

The alarm is rarely sounded because few advisors take the time to review performance statistics on an after tax basis. If they did, they'd discover that some of the strategies that they thought were doing so well were not.

Equity Portfolio Structure

Standard approaches to equity portfolio structure that are accepted by much of the investment advisory and consultative world have typically evolved for tax-exempt institutions.

Figure 1 shows the spirit in which many equity portfolios are partitioned. In partitioning a portfolio into Large Growth, Large Value and Small-Cap segments, the advisor expresses a number of implicit ideas.

First, he believes that style and size are major dimensions of risk. Second, he believes that investment management skill requires specialization or that specialist managers have the ability to outperform generalists. Third, he believes he is able to control the risks cleanly by selecting managers who remain true to their style and by evaluating their performance and rebalancing them regularly.

If the portfolio is passive in some sectors and active in others, he expresses a belief that some sectors of the market are more efficient than others, and/or that he has more skill in selecting managers in these sectors.

This approach has been found to be very useful for tax-exempt institutions, and the beliefs seem often to be true in practice. Advisors will classify managers, for example, by their investment philosophy (active or passive), discipline (quantitative or fundamental), specialization (style or size), skill (stock selection, sector rotation, hedging, technical analysis, or trading), risk control (diversified or concentrated), sensitivity to taxes, or other attributes.

Advisors Select Managers and Monitor Them

Typically, advisors will then select a set of managers and monitor their performance, replacing them as necessary, rebalancing the assets of each, and ensuring that the aggregated risks are aligned to their requirements. They may then observe that some sector of the market is lacking (many managers underweight utilities, for example) and install a completion portfolio, or they may note that the structure inhibits a manager from rotating between Growth and Value, and compensate with a tactical style rotator.

While a complex equity structure has its benefits, the intricacy can lead to difficulties. For example, complexity can drive high implementation, advisory and rebalancing costs. And, it can lead to a focus on the wrong issues: for example, issues of pre-tax performance evaluation, issues surrounding a search for a better manager (rather than a better structure), and overpriced entertainment.

All said, the investor pays high fees for active investing but often gets mediocre performance before taxes and inferior performance after taxes.

Make Sure Your Advisor Recognizes Equity Portfolio Tax Traps

There are differences between institutional tax-exempt investing and private investing: as a private investor, you have a more limited lifespan, have higher borrowing costs, and need to pay advisory costs that are a greater proportion of your assets. In addition, you pay taxes, and this factor changes the investment management landscape.

The advisor who practices tax-efficient portfolio management will think in terms of a buy-and-hold portfolio which delays the realization of capital gains, will comprehend the value of active tax management, and will choose the right investment vehicle. However, even this is not enough. The tax-efficient advisor also must understand the hidden taxes that equity structure exacts.

The following can cause you the pain of capital gain taxation:

1. The portfolio manager's alpha tax. In his search for alpha, or added value, the portfolio manager sells appreciated stocks and incurs, for the investor, capital gains taxes. But new securities rarely appreciate enough to compensate for the taxes generated by the sale of the old ones. Indeed, the active manager typically needs the replacements to outperform the original by 2-4 percent per year, before taxes, to justify his realization of capital gains.

   
   
   

2. The re-balancing tax. Over time, style buckets lose alignment. When Growth increases more than Value, for example, it requires the sale and purchase of securities to restore proper weight to each style bucket. If the advisor is trying to tactically time between the styles, the rebalancing cost can be high. This balancing act generates more sales and, alas, more tax pain for the investor.

   
   
   

3. Manager selection tax. Just as the active manager continually seeks more attractive securities, so the advisor seeks more attractive managers. When the advisor hires a new manager, that manager will reconfigure his sub-portfolio to suit his own trading philosophy and preferences. Again, capital gains are taxed.

Even more pain is inflicted here by the multi-manager tax. This tax occurs every time a manager is hired or fired, when a manager buys a security that another manager is selling, or when a manager sells a security the investor also holds at a higher basis. The need to improve after-tax performance has prompted some to employ a tax-quarterback who is aware of what the managers are doing, identifies the best tax lots, and prevents wash sales.

4. Benchmark reconstitution tax. When the specialist benchmarks are re-defined, some securities switch buckets. For example, Value stocks migrate to Growth, or Small cap securities grow to Large. Managers reconstitute their portfolios when this happens so as to be aligned to their benchmarks and, voila, more taxes. This tax is typically in the range of 80 and 100 basis points a year.

In thinking about tax costs in these ways, the investor does not typically pay all of the four taxes independently. In the extreme case -- with active, high-turnover managers -- all appreciation is taxed at the short-term rate each year. The advisor can dodge the alpha tax by selecting tax-sensitive managers, but unless the advisor focuses on the structural taxes, the investor will be assessed the other forms of taxation. Investors in certain mutual funds, who change their minds or rebalance frequently, pay dearly.