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

It is easy to be tax inefficient; to be tax-efficient requires a focus on the issues at all times. You might have your advisor abandon the complex portfolio with lots of turnover that generates tax. So, what should your advisor suggest? Here are some recommendations:

1. Simplify portfolio structure by seeking a centralized broad core exposure.
   Instead of the standard partitioned equity structure, the advisor should simplify portfolio structure with a buy-and-hold core, a broad cap-weighted universe of stocks index, such as Russell 3000 or Wilshire 5000, as illustrated in Figure 1. The management should be centralized in a single portfolio. This structure eliminates the benchmark reconstitution tax and the rebalancing tax.

   

   Also, focus on tax management by implementing a passive, tax-managed core. A passively managed core, with a single core manager, provides inexpensive diversification and avoids the alpha tax. It requires very low realization of capital gains. If actively tax-managed, it provides additional after-tax benefits through loss management and careful cash flow transitions. The passive core avoids costs associated with manager selection and de-selection and the multi-manager tax.

2. Choose a small number of satellite active and focused managers.
   Paying active fees for risk control is expensive and unnecessary if the core portfolio provides suitable diversification. If the advisor wishes to make active bets, he can employ satellite managers around the central core.

   Active approaches that are diversified, that make numerous small bets with small expectation of alpha, are more suited to tax-exempt portfolios. However, if the taxable investor desires pizzazz and entertainment, high-risk active managers can provide this. With concentrated high-risk managers, the advisor can manage risks by limiting the size of these portfolios.

   With the central core controlling risks and taxes, the advisor's satellite managers can concentrate on what they do best. The advisor should set the managers' mandates broadly-- skill requires scope – and let them take aggressive bets. Hedged or market-neutral, long-short approaches are suitable; long-short portfolios can enhance the manager's alpha by allowing him to underweight smaller stocks he dislikes. These approaches are also likely to realize capital gains, which should be offset by loss-management in the core portfolio.

   Measure Manager Performance on After-Tax Basis

   Nevertheless, the advisor needs to measure manager performance on an after-tax basis so that the advisor, and the managers, and you know what they are actually achieving. Specifically, all should be very sensitive to the problem of realizing short-term gains. If the investor has both a taxable and a tax-deferred investment account, the tax-deferred account is the ideal place for satellite active managers.

   How many active managers does the advisor need? How aggressive should they be? How large should their portfolios be? The answers will depend on the advisor's confidence in their skills. With greater confidence in them, the advisor will increase the size of their portfolios and allow them to take larger bets. Remember, though, that too many managers make it more difficult to oversee the total enterprise, inviting the possibility of over-diversification.

3. If you want a style or size tilt, do it with a tax-efficient definition of the sector.
   Note that by passive in Figure 1 we mean buy-and-hold. Passive is not necessarily indexed. Many investors prefer a long-term sector or theme tilt to their portfolio. Many times sectors or themes can be over- or under-weighted in a low-turnover, passive fashion that does not depend on short-term signals or price movements.

4. Keep the portfolio in place over the long haul.
   Each time the advisor changes his mind, the portfolio is exposed to taxation. Broad diversification is suitable for an extended horizon, and the core will still be diversified in a generation's time. A good tax-efficient core manager will maintain this diversification and will buy into evolving technology companies, for example, at lowest tax cost.

Conclusions

For efficient tax management, the advisor needs to focus on more than the selection of a tax-efficient manager, he must design the equity structure well. This requires forethought and attention to detail. A poor design requires expensive maintenance and undermines other attempts at tax-efficiency.

There are four types of capital gain taxation lurking to trap the unwary: the portfolio manager's alpha tax; the rebalancing tax; the manager selection tax, and the benchmark reconstitution tax.

To avoid these taxes, we need to reject the conventional wisdom and embrace a new portfolio structure model. This model features a broad core equity investment that is passive and tax managed, and allows for concentrated active managers with relatively small portfolios who are unconstrained with respect to risk and taxes.

This simpler approach makes regular review, decision-making and rebalancing much easier. By keeping this structure in place for a generation or longer, the taxable investor can achieve returns superior to that of the traditionally partitioned portfolio structure.