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7/30/2019 Parametric U.S. Tax Primer 2013.Web .CA
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TAX-EFFICIENT
EQUITY INVESTINGA Primer from Parametric
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The scal cli negotiations o late 2012 culminated in the biggest tax increase in
more than 20 years. As a result, building wealthreal wealth ater taxes and costsis
even harder. Taxpayers can take modest solace in the act that the increases might
have been greater. However, we suspect that this process is not complete. We oresee
that the scal challenges acing the U.S. could translate into urther tax hikes down
the road.
For investors and their advisors, there is meaningul work to be done. Investment taxes
can be managed, and a ocus on ater-tax returns can be central to a successul
client-advisor relationship. There are numerous strategies or improving ater-tax
investment perormancetime-tested strategies that are even more valuable today.
Not surprisingly, there is spin and misconception around the 2013 tax changes. One
common myth is that only the highest-income Americans will eel the pain. The reality
is that the tax increases have a much broader eect. And while the increase in capital
gains tax rateswhich is substantialis central to the story, other major tax increases
have garnered less attention.
In the ollowing guide, we shed some light on these issues and provide strategies or
survivingand ideally thrivingin the new world o higher taxes. More specically, we
address these questions:
> What is the current tax environment or U.S. investors?
> What does this mean or the active versus passive equity decision?
> What is active tax management and why is it important?
> How does tax management t into an overall equity portolio?
> What strategies can Parametric oer investment advisors and
their taxable clients?
FOR PROFESSIONAL USE AND ONE-ON-ONE PRESENTATIONS ONLY
A LETTER FROMPARAMETRIC
Dd S, P.D.
Chie Investment Ofcer
Parametric
Parametric & tax-eicient inveSting
Parametric invested its rst tax-ecient separate account in 1992. Since then, we
have remained ocused on improving tax eciency, and have built a reputation
or excellence in the eld. We currently manage more than $20 billion in explicitly
tax-managed strategies.
Parametric is a global asset management rm oering a broad range o strategies,
each engineered to achieve the right blend o risk, cost and return. Our capabilities
span U.S. and non-U.S. markets, as well as traditional and specialty asset classes.
Parametric is a subsidiary o Eaton Vance Corporation, one o the worlds most dynamic
global asset management companies.
www.parametricportolio.com
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TABLE OFCONTENTS
01/ The Current Tax Environment or Investors . . . . . . . . . . . . . . . . . . . . . . . .5
02/ Is Your Alpha Big Enough to Cover Its Taxes? . . . . . . . . . . . . . . . . . . .11
03/ The Theory o Active Tax Management . . . . . . . . . . . . . . . . . . . . . . . . . . 17
04/ The Practice o Active Tax Management at Parametric . . . . . . . . . . .27
05/ Why Parametric Tax-Managed Core?. . . . . . . . . . . . . . . . . . . . . . . . . . . 35
We hope the guide deepens your understanding o tax-ecient investing. Our ocus
here is primarily on equities, since equities are the largest allocation in most portolios
and our research and experience are centered there.
Parametric has been a leader in tax-ecient investing or more than 20 years. To us,
the trend is clear: Rates are going up or U.S. taxpayers and will likely continue to rise
in the uture. As a result, i t is imperative that investors and their advisors ocus on
ater-tax returns.
Sincerely,
David Stein, Ph.D.
Chie Investment Ocer
Parametric
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01/
THECURRENTTAX
ENVIRONMENTFORINVESTORS
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Key taKeawayS
> The combined eect o several tax increases (capital gains + health care + reinstated
limitations) will increase the tax burden on investors by as much as 60%.
> Most long-term investors will experience taxes as their largest cost. Techniques that
can mitigate the drag o taxes on investment returns are extremely valuable.
On January 1, 2013in rather dramatic ashionCongress passed the American
Taxpayer Relie Act (ATRA), which President Obama signed into law on January 2.
This legislation makes permanent the Bush-era tax rates or most Americans and
allows the top t ax rates to ri se or high-income earners. For example, or individuals
making at least $400,000 ($450,000 or couples):
Ttpmnltxtnncmncssfm35%t39.6%.
Ttxtndvdndsndln-tmcptl nsncssfm
15%t20%.
Even though the law narrowly avoided the scal cli chaos that would have been
caused by a tax-rate increase or all taxpayers, many investors will still eel the sting o
higher tax rates.
the health care Su rtax
New health care taxes also come into play in 2013. The Patient Protection and Aord-
able Care Act o 2010 created the Unearned Income Medicare Contribution (UIMC)
tax. Under UIMC, individuals earning more than $200,000 ($250,000 or couples)
must pay a 3.8% tax on net investment income. Figure 1 shows the highest marginal
tax rates and how they dier rom previous rates.
01/
THE CURRENTTAX ENVIRONMENTFOR INVESTORS
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reinStateD limitationS
The recent tax law changes also include a stealth tax increase in the orm o limi-
tations on exemptions and itemized deductions. These provisions do not increase
the nominal tax rate, but they do increase the eective marginal rate and the overall
amount o taxes paid. The limitations are:
Thereinstatedphase-outofpersonalexemptionsforindividualtaxpayerswith
adjusted gross incomes o $250,000 to $375,000 ($300,000 to $425,000 or
couples). The phase-out increases marginal tax rates on income in the aected
range by approximately 1% or each personal exemption taken. Marginal tax rates
on income above the aected range do not change.
Thereinstatedlimitationonitemizeddeductionsfortaxpayerswithadjustedgross
incomes above $250,000 ($300,000 or couples). This increases marginal tax
rates on income above the baseline levels by 3% o the relevant tax rate. Forexample, the increase on a 33% marginal tax rate would be 1% and the increase
on a 39.6% marginal tax rate would be 1.2%.1
the imPortance o active tax management
For many investors, the biggest issue in the new tax legislation is the dramatic in-
crease in the taxation o long-term capital gains. The spike in rates rom 15% to
23.8% means that many investors will pay almost 60% more o this tax relative to
2012 rates and rules. This can have a major impact on the long-term growth o an
investment portolio.
Consider the ollowing strategies or a $100,000 portolio earning a 6% annual return.
The strategy that ignores taxes results in a substantially worse outcome than the one
that is perectly tax-ecient, as shown in Figure 2.
Fig 2:
THE BENEFIT OF ACTIVE TAX MANAgEMENT
STRATEgIES
CAPITAL
gAINS
TREATMENT
AFTER-
TAX
RETURN
PORTFOLIO
VALUE IN 20
YEARS
Tax oblivious:no considerationgiven to taxes
100% o the returns are sub-ject to the short-term tax rateo 43.4%
3.40% $200,000
Tax-awaremanagement
100% o the returns aresubject to the long-term rateo 23.8%
4.57% $240,000
Perectly tax-efcientmanagement
All net gains are deerred oroset by realized losses(and there are no dividends)
6.00% $320,000
1 3% x 33% = 1.0%; 3% x 39.6% = 1.2%
The health care tax has an additional wrinkle. The tax rate applies to the lesser o:
Ntnvstmntncm,
Mdddjustdssncmnxcssfttsld
($200,000fndvduls;$250,000fcupls).
Consequently, in some situations, the 3.8% tax rate might not apply to the total
investment amount. The interactions between the ATRA law and the UIMC law are
conusing, to say the least. While we might hope or a cleaner tax code, any unda-
mental tax reorm that occurs in the uture is likely to result in urther tax increases
due to the magnitude o our nations budget decit and debt burden.
Fig 1:
HIgHEST MARgINAL TAX RATES
2012
TAX RATE
2013
TAX RATE
2013
HEALTH
CARE TAX
2013
TOTAL
%INCREASE
Tax-exempt interest 0% 0% 0% 0% 0%
Qualifed dividends 15% 20% 3.8% 23.8% 59%
Long-term gains 15% 20% 3.8% 23.8% 59%
Non-qualifed dividends 35% 39.6% 3.8% 43.4% 24%
Short-term gains 35% 39.6% 3.8% 43.4% 24%
Taxable interest 35% 39.6% 3.8% 43.4% 24%
Source: Parametric
The recent tax law changesalso include a stealth taxincrease in the orm olimitations on exemptionsand itemized deductions.
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The results o these scenarios are shown graphically in Figure 3. While this is admittedly
a simplistic analysis, it demonstrates that taxes are important and worthy o careul
consideration by investors and their advisors.
A Note on Pre-Liquidation vs. Post-Liquidation Values
Figures 2 and 3, as well as tables and commentary elsewhere in this primer, track the
growth o an investment prior to liquidation. At the end o the period, all three scenario
portolios have unrealized capital gain positions. Fully liquidating the portolio would result
in paying capital gain taxes and would reduce, but not eliminate, the relative advantage
o the Tax-Efcient and Tax-Aware portolios. Many U.S. investors avoid ull liquidation o
portolios due to cost basis step-up provisions at death and the giving o appreciated
securities to tax-exempt charities. Parametric has explored the tax-impact o ull or partial
liquidation on terminal portolio value and ater-tax perormance in several research pieces
originally by CIO David Stein in Measuring and Evaluating Portolio Perormance Ater
Taxes,The Journal o Portolio Management, Winter 1998, Vol. 24 No. 2.
Resources and Additional Reading
State and Federal Individual Capital Gains Tax Rates: How High Could They Go?
ACCF Center or Policy Research. March 2012.
Swerving rom the cli: tax provisions in the American Taxpayer Relie Act o 2012.
Tax Policy Group o Deloitte Tax LLP. January 2, 2013.
Fig 3:
AFTER-TAX gROWTH IN PORTFOLIO VALUE
$350,000
$250,000
$150,000
$50,000
Years
0 5 10 15 20
Tax Ecient: $320,000
Tax Aware: $240,000
Tax Oblivious: $200,000
Source: Parametric
02/
IS YOURALPHABIg ENOUgH
TO COVERITS TAXES?
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Key taKeawayS
> Many investment managers overlook taxes in their pursuit o pre-tax excess returns.
As a result, negative tax consequences requently obliterate the alpha generatedrom a managers skill.
> Given the dramatic increase in capital gains tax rates, taxable investors should
demand active tax management in their portolios.
In the 1993 article, Is Your Alpha Big Enough to Cover Its Taxes? Jerey and Arnott
observed that most o the energy devoted to improving portolio eciency was being
directed at tax-exempt investors. The emphasis was squarely on pensions, oundations
and endowments, even though most o the managed assets in the United States are
taxable. This ocus typically triggers avoidable taxesa negative tax alphain the
quest or oten illusory gainsthe pre-tax alpha.
Twenty years later, despite signicant advancements in both the theory and practice o
tax management, little has changed. Most investment managers run their businesses
ocused exclusively on their pre-tax perormance relative to a benchmark and remain
reluctant to report ater-tax perormance.
It is ironic that portolio turnoverthe very activity designed to enhance returnsis the
primary cause o tax drag. The portolio manager sells one asset, potentially incurring
a tax obligation, and buys another asset based on the belie that the trade will benet
the investor. In many cases, however, the resulting tax turns out to be larger than the
unknowable return potential o the trade.
When evaluating managers, it would be absurd to consider a pre-cost perormance
record without accounting or the transaction costs and ees required to achieve it.
But this happens all too requently with regard to the eect o taxesmaybe because
the investors tax liability is calculated independently rom the manager and likely paid
later rom another account.
02/
IS YOUR ALPHABIg ENOUgH TOCOVER ITS TAXES?
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Given the large alpha hurdles or taxable investors, and the considerable erosion o
wealth i that alpha doesnt materialize, a low-turnover strategy starts to look quite
attractive relative to the uncertain perormance oered by strategies with substantial
turnover.
Several academic studies ound that taxes have a signicant negative impact on
returns averaging 1% to 3% per year or the typical active manager.2 With the recent
tax increases, we estimate that an active manager would have to generate approxi-
mately 2% to 4% additional return per year to compensate or the drag rom taxes.
The tax costs are mainly due to requent trading and the resulting short-term capital
gains taxes. All too oten, the negative tax impact exceeds the value added by the
managers skill. Most managers alpha simply does not cover their clients tax bills, which
likely explains the industrys overall reluctance to draw attention to ater-tax returns.
the time iS now
The investment management industry is ar too willing to incur a large negative tax
alpha or their taxable clients while pursuing pre-tax alpha. The result is that mostinvestment products oer a combined alpha that is negative: pre-tax alpha, whether
good or bad, less a relentlessly negative tax alpha.
The good news is that the problem is xablemanagers need only pay adequate
attention to the tax consequences o their actions. Done correctly, a manager can
capture the alpha o a sound investment process with a minimum o tax conse-
quences. Its a lot o mechanistic and tedious work or the manager, but the rewards
or the taxable client are well worth the eort.
2 See Arnott, Berkin and Ye (2000); Longmeier and Wotherspoon (2006); and Arnott, Berkin and
Bouchey (2011).
Fig 5:
ADDITIONAL ANNUAL PRE-TAX gROWTH REqUIRED TO OFFSET TAXES
MarkeTgrowTh% 4 6 8 10 12
Turnover 5% 0.65 0.89 1.09 1.26 1.40
10% 1.16 1.60 1.97 2.29 2.58
25% 2.05 2.91 3.69 4.40 5.04
50% 2.65 3.88 5.05 6.17 7.25
75% 2.92 4.34 5.73 7.09 8.45
100% 3.07 4.60 6.14 7.67 9.20
Source: Parametric, based on the model proposed i n Jerey and Arnott (1993).
a high hurDle
In light o the recent tax increases, it makes sense to revisit the question o whether
the typical active managers alpha is large enough to cover its taxes. We ignore divi-
dends in our analysis or simplicity.
Assuming that the price-only return o a portolio grows at 6% per year, then $100,000
will compound to approximately $320,000 ater 20 years. However, as shown in
Figure 4, i we assume there is 25% turnover within the portolio, taxed at a 43.4%
rate, the portolio will grow to just over $217,000. This example eectively demon-
strates the relationship between turnover, taxes and compounded growth.
Figure 5 shows the alpha required to break even, ater tax, using dierent assumptions
or turnover and market growth. For example, holding turnover constant at 25%, thepre-tax growth o the portolio must increase rom 6% to 8.91% to generate ater-tax
ending wealth o $320,000. In other words, an annual alpha o 2.91% (in bold in the
table) is required to cover the tax bill.
Fig 4:
EXAMPLE CALCULATION OF AFTE R-TAX gROWTH* in thousands o dollars
YEAR 1ST 2ND ... 20TH
Beginning market value 100.00 105.35 209.86
Ending market value pretax 106.00 111.67 222.46
Beginning cost basis 100.00 100.85 177.00
Realized gain 1.50 2.71 11.36
Capital gain tax 0.65 1.17 4.93
Ater-tax proceeds reinvested 0.85 1.53 6.43
Ending cost basis 100.85 102.38 183.43
ed k 105.35 110.50 217.52
*Assumes 6% growth o principal per year, 43.4% capital gains tax and 25% turnover.
Source: Parametric, based on the model proposed in Jerey and Arnott (1993).
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Resources and Additional Reading
Arnott, Robert, Andrew Berkin and Paul Bouchey. Is Your Alpha Big Enough to Cover
Its Taxes? Revisited. Investments and Wealth MonitorJanuary/February (2011): 6-10.
Arnott, Robert D., Andrew Berkin and Jia Ye. How Well Have Taxable Investors Been
Served in the 1980s and 1990s? The Journal o Portolio Management26, no. 4
(2000): 8493.
Jerey, Robert H., and Robert Arnott. Is Your Alpha Big Enough to Cover Its Taxes?
The Journal o Portolio Management19, no. 3. (1993): 1525.
Longmeier, Geo, and Gordon Wotherspoon. The Value o Tax Ecient Investments:
An Analysis o Ater-Tax Mutual Fund and Index Returns. The Journal o Wealth
Management9, no. 2. (2006): 4653.
03/
THE THEORYOFACTIVE
TAXMANAgEMENT
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Key taKeawayS
> There are six basic techniques or increasing a portolios tax eciency, including
deerring gains and realizing losses.
> A separate account oers the most options or implementing tax-ecient
investment strategies because o the fexibility it oers.
> Based on theoretical results rom academic research, thoughtul tax management
can boost ater-tax returns by 1% to 3%results borne out by actual client
experience. This positive tax alpha is likely to increase in the uture given the new,
higher tax rates.
Active tax management involves more than just letting gains run and cutting losses. It
requires paying close attention to the trade-o among risk, return and taxes whenever
an investment decision is made and whenever assets go through a transition. Decisions
that have a taxable component include selling an investment, changing benchmarks,
changing managers, making contributions and withdrawals, giving to charity and rebal-
ancing the asset allocation.
03/
THE THEORYOF ACTIVETAX MANAgEMENT
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inveStment vehicleS
Tax-management techniques must be applied in context. The vehicle used to
implement an investment strategy has important consequences or a taxable investor.
Below are some common ways investors access the market:
MutulFunds. Interest, dividends and realized capital gains o a portolio are
distributed pro-rata to mutual und holders each year via the IRS 1099 orm. Mutual
und managers can actively harvest losses, but those losses may only be used or
carried orward within the undthey may not be distributed to individual mutual
und holders. Some mutual unds are explicitly tax managed. However, or the
majority o unds, tax management is a secondary consideration at best.
excn-TddFunds. ETFs are distinct rom traditional mutual unds primarily
due to the act that they trade intra-day on an exchange. ETF managers can also
employ tax-management techniques to avoid capital gains rom being distributed toinvestors. ETFs are open unds that allow new investment dollars to fow into the
und or be redeemed rom the und. The und manager may identiy specic tax lots
to be used in the redemption process. By choosing to deliver low-basis tax lots or
delivery, the manager can improve tax eciency.
hdFunds.Hedge unds typically use a partnership structure, in which the
investment manager is the general partner and the investors are limited partners.
Gains and losses incurred within the portolio fow through to the limited partners
via the IRS Schedule K-1. Typically, hedge unds are tax-inecient due to high
levels o bad turnover (dened below). Investors who evaluate hedge unds tend to
be more ocused on pure perormance and less ocused on the rictions caused by
high ees and high taxes.
Sptaccunts. The key advantage o a separate account owned by a single
taxpayer is that it oers the most fexibility. Realized losses can be used to oset
other gains (or rom the sale o property, etc.). I the taxpayer has other goals or
prioritiessuch as the desire to match gains and losses, to accelerate the realization
o gains, to transition assets to another strategy or to give specic tax lots to
charityhe or she has the fexibility to do that. In this way, the separate account is
the most potentially tax-ecient investment vehicle.
toolS o the traDe
Investment managers have six basic techniques they can use to build a comprehensive
tax-management strategy and increase the tax eciency o a portolio:
Dftrlztnfgns. A manager has to sell an asset to i ncur a capital
gain tax obligation. I the asset is held, the tax liability is deerred, which is math-
ematically identical to receiving a zero-interest loan o that amount rom the
government. An increase in the value o the investment increases the uture tax
liability, but the payment o that liability can, in some instances, be deerred
indenitely, allowing that money to compound over time. For some investors, the
cost basis o assets in an estate is reset at the taxpayers death. As such, the
loan never needs to be repaid. This is the bread and butter o tax management.
MnthldnPd.Capital gains rom the sale o a security are taxed as
ordinary income, unless the investment is held or longer than 12 months, in whichcase, it qualies or a lower tax rate.
hvstLsss. Selling a security whose price has allen below its purchase price
(the market value is below the cost basis) results in a realized capital loss. These
losses may be used to oset realized capital gains. This oset can be used in the
current year or can be carried orward into uture years. While many investors only
harvest losses in December, this activity is ar more valuable i it is done throughout
the year within an overall portolio management process.
CnsdtYld.Dividends are also taxed as ordinary income, but most can
qualiy or a lower tax rate i the security is held or longer than 61 days. Tilting
away rom dividend-paying stocks toward capital appreciation can also increase tax
deerral and reduce the tax bill. But be wary o the allure o low yields: l ow payout
ratios are no assurance o aster earnings growth.
PyattntntTxLts.Managers who pay attention to taxes will generally use
highest in, rst out (HIFO) tax-lot accounting whenever a security is sold to reduce
the tax impact o the sale and improve ater-tax returns. In some cases, however,
HIFO may not be the desired method. For example, an investor with a tax-loss carry
orward may nd it benecial to accelerate gains. Investors who need to generatecash fow rom their investments or have charitable giving plans will benet rom a
manager who pays attention to identiying the best tax lots or each event.
avdwsSls. When a security is repurchased within 30 days o it s sale, any
loss realized cannot be used to shelter gains. Tracking wash sales is particularly
challenging when an investor uses multiple managers. For example, the tax loss
generated by manager A will be voided i manager B buys the same security
within 30 days.
All managers who invest on behal o taxable investors should employ the basics o
tax management. However, these techniques are oten ignored or implemented only
as an aterthought.
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a ocuS on Strategy, not tacticS
For taxable investors, tactical shits in the portolio come at a high cost. There is no
question that dramatic market movements create a strong temptation to react. How-
ever, a portolio should be designed to withstand the inevitable tempests that come
whenever emotions or the need or liquidity are at their height.
It is important to remember that the investment industry and some o its constituents
were built on active portolio trading. Brokers generally have little incentive to recom-
mend that an investor sit back and do nothing. In addition, some o the media has
turned investing into a sport, urging action and reaction at every turn. Unortunately,
tradingi done without regard or t ax consequencescan create signicant tax
liabilities. Thereore, a ocus on the strategic, not tactical, structure o the portolio
should be the primary consideration or t he taxable investor.
evolution o tax-eicient Portolio Structure
The optimal strategic structure or tax-ecient portolios has evolved over time, as
shown in Figure 6. The rst phase was moving rom a style box to a passive core-and-
satellite approach. Style box investing was created or institutional investors to ensure
they remained ully allocated. However, it turned out to be a very poor strategy or tax-
able investors given the tax consequences o transitioning assets between style boxes.
Taxable investors embraced the core-and-satellite ramework or its tax eciency, as
well as the added benets o better risk control and a lower portolio cost structure.
The next phase in the evolutionTax-Managed Coreis to manage the core portolio in
a separate account so that gains realized by satellites can be oset by losses realized
rom the core. Our research shows that most or all o the perormance drag rom taxes
can be mitigated by allocating 60% to 80% o an investors portolio to a passive,
Tax-Managed Core separate account.
A ocus on the strategic,not tactical, structure othe portolio should bethe primary considerationor the investor.
meaSuring tax eiciency
The terms tax ecient, tax managed and tax aware can mean dierent things
depending on the context. Sometimes a strategy with low-to-moderate turnover is
called tax aware even though there are no specic tax-management techniques used
by the manager other than a tendency to hold stocks or a long time. The ability to
measure the impact o taxes objectively is the rst step in creating a more tax-ecient
investment strategy. Some requently used measures o tax eciency are:
Tunv. Many advisors use turnover as a proxy or tax eciency, believing that
the higher the turnover, the less tax-ecient the portolio. This view ignores the
act that there i s bad turnover and good turnover. From a tax perspective, bad
turnover includes selling positions that trigger capital gains tax, especially at the
higher short-term rate. Good turnover pays attention to the holding period (such
as deerring gains to the longer-term rate) and includes realizing capital losses.
UnlzdCptlgns/LssCyFds. Funds and other pooled
investment vehicles disclose the amount o unrealized capital gains that are embed-
ded in the current portolio, as well as the amount o realized losses that are
available to be carried orward. These measures can give an incoming investor an
idea o the potential uture tax liabilities. A large unrealized gain means lower
ater-tax returns in the uture, while a large loss carry orward implies that ew
gains will be distributed in the coming years.
aft-Txrtun(P-Lqudtn). In 2002, the SEC adopted a rule that requires
mutual unds to report both beore- and ater-tax returns. As part o the rule, the
SEC dened two dierent measures o ater-tax return: pre-liquidation and post-
liquidation. The post-liquidation return is what an investor would earn i he or she
were to liquidate the portolio and realize all o the tax liabilities. The pre-liquidation
return only refects the tax eects o und distributions, such as dividends and
capital gains. It is thus a better measure o tax-eciency or long-term investors.
Tx-efcncyrt. The tax-eciency ratio, employed by Morningstar and others,
shows how much investment return the investor can keep ater paying taxes. The
ratio is simply ater-tax return divided by pretax return. For example, an investor who
buys a und with a tax-eciency ratio o .80 keeps 80% o the annual return and
gives up 20% to taxes.
Txalp.Attributing ater-tax perormance to the tax-management skill o a
manager requires an ater-tax benchmark. However, ew managers report their re-
turns relative to an ater-tax benchmark. The metric tax alpha introduced in 1998
by David Stein, Parametrics Chie Investment Ocer, uses pre-liquidation returns
to isolate the value added rom tax management. Tax alpha is dened as:
Tax Alpha = Ater-Tax Excess Return Pretax Excess Return
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This simulation assumes that losses realized in the core portolio can be ully utilized
by the taxpayer in the same year the loss was realized. (Fortunately, unused losses can
be carried orward to uture years.) Some investors will eventually liquidate and pay the
taxes, thus reducing their tax alpha. Others will either give low-basis securities to char-
ity or get a step up in basis at their death, never having the appreciation taxed.
The most important variable in managing a tax-ecient core portolio is the level o
benchmark-relative risk that a manager must create when harvesting losses, deer-
ring gains, or other tax-related activities. Most taxable investors are willing to accept
some variability o returns relative to the benchmark to capture the tax benet. Tax
alpha increases in lower-return markets, higher-volatility markets and higher-tax-rate
environments.
Centralized portolio management (CPM) is the nal phase. This strategy brings the
active managers into the tax-management old and can be applied to a style box
structure or include a passive core. Typically, the CPM also manages the
passive core portolio.
Beyond the six tax-management techniques described earlier, a centralized portolio
manager can also coordinate buys and sells across multiple active managers, implement
manager and asset allocation changes and apply rebalancing policies to the overall
portolioall in a tax-ecient manner.
the value o active tax management
A number o academic studies examine the benets o actively harvesting losses
in a portolio and show that the cumulative tax benet continues to rise over time.3
While the amount harvested is largest in the early years, when market values are
close to cost basis, the benets continue to accrue due to compound growth o the
tax savings. As discussed above, loss harvesting is only one aspect o active tax
management. However, it is the aspect that is the easiest to quantiy, and has received
most o the attention rom the academic community.
Figure 7 shows the theoretical tax alpha generated rom loss harvesting over a
10-year horizon, assuming a 6% annual market return, 15% market volatility, 35%
stock volatility and the current highest marginal tax rates o 43.4% and 23.8%.
3 See Stein and Narasimhan (1999); Arnott, Berkin and Ye (2001); Berkin and Ye (2003);
Horvitz and Wilcox (2003); Rogers (2006); and Stein, Vadlamudi, and Bouchey (2008).
Fig 6:
THE EVOLUTION OF EqUITY PORTFOLIO STRUCTURES
FOR TAXABLE INVESTORS
Style Box CoreSatellite
Tax-ManagedCore
CPM CPM withCore
Source: Parametric
Fig 7:
TAX ALPHA SIMULATION* gross o ees
18
12
6
0
Ys
Txalph%
2 4 6 8 10
Average = 1.7%
Cumulative Tax Savings = 16.7%
*Using the methodology developed in Stein, Bouchey and Vadlamudi (2008).
Source: Parametric
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real imProvement
Our simulation and the theoretical results rom the academic literature tell us that
careul tax management can improve ater-tax returns by 1% to 3%, on average, with
much o the benet coming in early years. In practice, Parametric has ound these
estimates to be close to our own experience across many individual client accounts.
The average tax alpha across our Tax-Managed Core accounts has been approximately
1.7% per year over the last 13 years. For CPM accounts, Stein and McIntire (2003)
predicted 0.6% per year o tax alpha. In practice, Parametric has garnered 1.1% per
year over the last ten years across hundreds o accounts in our CPM composite.
All else being equal, with higher tax rates going orward, we expect the ater-tax return
experience to be higher than it has been in the past.
Resources and Additional Reading
Arnott, Robert D., Andrew Berkin and Jia Ye. The Management and Mismanagement
o Taxable Assets. The Journal o Investing10, no. 1 (2001): 1521.
Berkin, Andrew, and Jia Ye. Tax Management, Loss Harvesting, and HIFO
Accounting. Financial Analysts Journal59, no. 4 (2003): 91102.
Horvitz, Jerey, and Jarrod Wilcox. Know When to Hold Em and When to Fold Em.
The Journal o Wealth Management6, no. 2 (2003): 3559.
Rogers, Douglas. Tax Aware Investment Management: The Essential Guide. New York:
Bloomberg Press (2006).
Stein, David. Measuring and Evaluating Portolio Perormance Ater Taxes.
The Journal o Portolio Management24, no. 2 (1998): 117124.
Stein, David, Hemambara Vadlamudi and Paul Bouchey. Enhancing Active Tax
Management through the Realization o Capital Gains. The Journal o Wealth
Management10, no. 4 (2008): 916.
Stein, David M. and Premkumar Narasimhan. O Passive and Active Equity Portolios
in the Presence o Taxes. The Journal o Wealth Management2, no. 2 (1999): 55-63.
04/
THE PRACTICEOF ACTIVETAX MANAgEMENT
AT PARAMETRIC
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Key taKeawayS
> Because o the complexities o implementing tax-management techniques, a
mathematical algorithm is used to identiy the optimal portolio trades.
> Parametrics composite o tax-managed accounts benchmarked to the S&P 500
Index delivered an average tax alpha o approximately 1.7% rom 2000 through 2012.
> Tax alpha tends to be greater in bear markets, in markets with positive momentum
and when cross-sectional volatility is high.
> Active tax management can mitigate the potentially negative consequences o
special situations, such as transitioning a portolio rom one manager to another.
Managing a taxable portolio is a complex process that involves paying attention to
taxes at the asset class, portolio and security levels. In this section, we discuss the
security-level process or a passive core portolio. The theory is actually quite straight-
orward: avoid selling stocks at a gain and sell stocks that are at a loss. In practice,
however, there are a number o complications.
The primary complication is the wash-sale rule, which negates the tax value o a
realized loss i the stock is purchased within 31 days beore or ater the sale. Thereare several strategies that allow a portolio to be managed tax eciently, while still
complying with the wash-sale rule. The simplest is to just hold cash or 31 days and
then buy back the same security. Many investors engage in this type o transaction
each December, which some have theorized is the cause o the turn-o-the-year return
anomaly observed in the markets. The problem with this approach is that it leads to
large perormance dierences between the portolio and the benchmark index.
Instead o holding cash, replacement stocks can be used. Sell Coke to harvest a loss
and buy Pepsi to maintain a similar exposure in the portolio. It is dicult to nd pairs
or all stocks, but i we use a risk model as a ramework or classiying stocks and
estimating their return behavior, the problem becomes tractable. For example, Microsot
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THE PRACTICE OFACTIVE TAX MANAgEMENTAT PARAMETRIC
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an examPle
Consider a trade executed in a two million dollar, tax-ecient, core equity separate
account. Eighty tax lots were sold to harvest losses, and 60 securities were bought to
control risk, resulting in a one-way turnover o 10%. Figure 9 shows the tax and risk
results rom the trade, which were generated by portolio managers using the decision
model, or solver.
In addition to the tax benet o $17,514, the trade also produced the ollowing
risk benets:
Cashwasreducedfrom1.5%to0.8%
Predictedtrackingerrorwasreducedfrom1.2%to0.98%
Financialsunderweightwasreducedfrom0.4%to0.2%
Valuefactoroverweightwasreducedfrom3.1%to2.0%
Allotherindustry,sector,country,currency,fundamentalfactorconstraintsandclient
restrictions were satised
At the end o the year, the investor will be able to oset $39,000 in gains realized
elsewhere with the losses realized by this trade in the core portolio. This is equivalent
to capturing 0.88% o tax alpha while, at the same time, tightening up benchmark-rel-
ative risk. This particular trade was quite valuable. However, over a long horizon, what
value has been generated through these techniques? To get the ull benet implied by
the simulation, loss harvesting needs to be a practice throughout the year, not just as
housekeeping in December.
Fig 9:
EXAMPLE OF A LOSS-HARVESTINg TRADE
INITIAL
UNREALIzED**
FINAL
UNREALIzED ** REALIzED
Short Gains $120,000 $120,000 $0
Long Gains $245,000 $242,000 $3,000
Short Losses ($48,000) ($6,000) ($42,000)
Long Losses $0 $0 $0
Net Gain (Loss) ($39,000)
t Bf* $17,514
*Assumes highest ederal marginal tax rates o 43.4% and 23.8%.
**Initial Unrealized reers to the gains and losses embedded in the portolio beore the tradewas made. Final Unrealized reers to the embedded gains and losses ollowing the trade.The dierence represents the tax consequences o the trade.
Source: Parametric
may not have an exact analogy the way Coke does. However, we can use a risk model
to identiy other large cap U.S. sotware companies with similar valuation, momentum
and volatility characteristics.
the DeciSion moDel
A typical risk model will have more than 50 variables to consider. So nding the correct
trades that will balance the portolio versus the index and harvest losses requires a
mathematical algorithm. This algorithm takes both the market environment and the
investors individual situation into account.
asnxmpl,tltmmtbstuctudtndptmltdstt:
Maximizerealizedlosses
Minimizerealizedgains
Minimizetrackingerrorrisk(estimatedusingariskmodel)
Minimizetradingcosts
Satisfyallconstraints,suchas:
> Bounds on industry, sector, > Corporate action restrictions
country weights > Wash-sale restrictions
> Bounds on stock weights > Turnover limits
> Client restrictions > Cash limits
Portolio managers run the algorithm, adjust parameters to test variations and nalize
the trades. The conceptual ramework is shown in Figure 8.
Fig 8:
CONCEPTUAL FRAMEWORK FOR TRADE IDENTIFICATION
Market Environment
Investor Situation
Market and
Index Data
Tax Lots andTax Rates
Constraints
Risk Model
Tax-EcientTrades
Ptflrblncn
altm
Source: Parametric
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AIG, Citigroup, Bank o America and Wells Fargo. These were prime candidates or
loss harvesting and tended to be sold out o the portolio or held at a below-benchmark
weight. While the overall weight o nancials and banking stocks was controlled,
individual stocks like these were underweight. These stocks did even worse in the last
hal o 2008, and their relative underweight in the portolio generated as much as 1%
in excess return, on average, across the composite. In momentum markets, when winners
keep winning or losers keep losing, a tax-managed portolio will tend to outperorm.
In rapid reversal markets, like in 2001 and 2003, where stocks that were loss har-
vested bounce back suddenly, the strategy lags. Over the course o a ull market cycle,
this eect tends to cancel out.
We also observe that the tax alpha was strong in the early years, then declined in
2004. This is predicted by our theoretical simulation o tax alpha over time. In the
simulation, we assume a steady growing market environment and volatile underly-
ing stock returns. However, the 2008 market crash showed that tax alpha does not
always decrease over time.
SPecial SituationS
There are several practical issues that arise or investment managers once they start
paying attention to the impact o taxes. They include portolio transitions, gits o low-
basis securities to charity, and concentrated, low-basis positions.
Portolio Transitions
Any time assets are moved between asset classes, managers or accounts, there is the
potential or the realization o gains. Typically, switching between investment strategies
involves liquidating securities and sending cash to the new manager. Parametric takes
a dierent tact by ollowing this procedure:
1. The advisor reports the tax lots o the current holdings to Parametric.
2. Parametric analyzes which securities should be sold and which should be retained.
3. The advisor and client work together to choose an appropriate level o tax cost andbenchmark-relative risk.
4. The retained securities are transerred in kind to the new account.
5. Parametric optimizes the portolio to minimize tax cost and tracking error.
Take an account that was unded with a portolio o 58 stocks that transerred into
the account in kind. This portolio had an estimated tracking error o 3% versus the
S&P 500 Index. Liquidating all o the holdings would have resulted in realized gains
equal to about a third o the portolio and a tax liability equal to 7.4% o the portolio.
However, careul transitioning to a portolio with close tracking to the index (less than
1%) incurred a tax liability o only about 2.7% o the portolio. Figure 11 illustrates the
relationship between tracking error and tax cost or this transition.
long-term reSultS
Figure 10 shows the tax alpha and pre-tax excess returns or Parametrics composite
o Tax-Managed Core equity accounts benchmarked to the S&P 500 Index. The com-
posite includes all accounts that were unded in cash in 1999 and had no investment
restrictions. We call this a vintage composite because it tracks a group o portolios
with substantially similar start dates and liecycles. This methodology avoids a problem
inherent in traditional ater-tax compositesnamely that they tend to overstate the
benets o tax management because the cost basis is continually rereshed rom the
addition o new portolios. In our vintage composite, the portolios tracked the Index
closely, with an average excess return o 0.2% per year. The average tax alpha over
this 13-year period was 1.7% per year.
Bear markets clearly enhance tax alpha: 2000 to 2002 and 2008 to 2009 wereperiods o negative market returns or the S&P 500 Index and large tax alphas.
Cross-sectional volatility is another actor that drives tax alpha. The middle part o
the chart, 2004 to 2006, was a period o positive returns and distinctly low volatility
with less opportunity or realizing losses.
It is also interesting to l ook at the pattern o pre-tax excess returns. To realize the tax
benet mentioned in the above loss-harvesting example, the portolio manager must
step away rom the index by selling stocks that have gone down and holding onto
stocks that have gone up. This can create a momentum bias in the portolio that must
be careully controlled.
For example, in the rst part o 2008, many nancial stocks were at a loss, including
Fig 10:
PARAMETRIC TAX-MANAgED CORE U.S. LARgE CAP COMPOSITE
ForaCCoUNTSiNCePTeDiN1999 gross o ees
6%
4%
2%
0
2%2000 2002 2004 2006 200 8 2010 2012
Excess Return
Tax Alpha
Average
Source: Parametric
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I the client had been willing to accept a higher tracking error o 2%, then tax cost
would have only been 0.3% o the portolio. In this case, we would have managed the
portolio with the objective o matching gains and losses until tracking error ell to
1%. Once the portolio reached this level o risk, we would then switch the objective to
generate the maximum net losses.
Gits o Low-Basis Securities to Charity
In typical markets, an equity portolio appreciates signicantly over time. At some point,
the investor will sell the shares and realize the capital gain, give the shares to charity or
potentially be eligible or a step up in cost basis at the time o death. Oten in the course
o managing a tax-ecient core portolio, we are asked to identiy tax lots or the client
in order to satisy a charitable donation. Transitioning the shares directly to the charity
and allowing the charity to sell the position avoids the realization o capital gains tax.
As with loss harvesting, it is important to ensure that the benchmark-relative risk
o the portolio does not become too high, and that a balance between risk and tax
management is maintained when addressing this need.
Concentrated, Low-Basis Positions
Another special case in portolio construction is when an investor has a signicant
portion o his or her portolio concentrated in a single security, oten at a very low cost
basis. I signicant wealth has been created by a concentrated position, the stock
price has likely appreciated exponentially. How long can the trend continue, and how
much downside risk is embedded in the current price?
The simplest approach to dealing with concentration risk is to sell the stock, pay the
taxes and invest in a broadly diversied portolio o stocks, bonds and other assets.
A more nuanced approach is to stage the diversication over several tax years, add
the proceeds to a tax-ecient core to help realize losses and thus mitigate some o
the tax pain o the transition. Covered call writing and other strategies can also be
employed to manage a concentrated position.
Fig 11:
TAX VERSUS RISK FRONTIER
8
6
4
2
0
TaXCoST%
Tcne%
0 0.5 1.0 1.5 2.0 2.5 3.0
Source: Parametric
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WHYPARAMETRICTAX-MANAgED
CORE?
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Key taKeawayS
> Tax-Managed Core is a proven strategy ocused on delivering compelling
ater-tax perormance.
> TMC capitalizes on Parametrics experience having managed tax-ecient
portolios since 1992.
> A high level o customization denes our approach. Each TMC portolio is
tailored to the individual circumstances and goals o the client.
Parametrics Tax-Managed Core (TMC) solution strives to provide better beta
regardless o whether the investor is using a passive capitalization-weighted index, an
alternative equity index or an actively-managed portolio. Better beta or a tax-paying
investor means delivering predictable pre-tax returns, superior ater-tax returns and
customization benets o many types. The combination o active tax management and
fexible per-client customization is, or many afuent investors, an extremely compel-
ling alternative to mutual unds or ETFs.
Working with our clients to create a customized solution is oten the genesis o a new
type o product oering. This was the case with our rst TMC portolio in 1992, whena amily oce inquired about actively managing the taxes incurred by custom growth
and value index portolios.
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WHY PARAMETRICTAX-MANAgED CORE?
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Custom Fundamental Exposures
Sometimes advisors have strategic views they would like incorporated in clients core
portoliostilts to value, growth, large cap, small cap and low volatility, among other
actors. In the current low interest rate environment, increasing portolio yield is a
requent Parametric project.
Custom Target Benchmarks
Sometimes there isnt a publicly available index target with the desired characteristics.
In these instances, Parametric oers a variety o custom benchmarks:
CustmCmbntnBncms.Our proprietary portolio management
systems allow us to combine dierent indexes to create unique combinations. This
oten means blending U.S. and non-U.S. target indexes to create desired global
beta exposure or blending style target indexes to emphasize growth, value or a
capitalization segment.
CustmexclusnyBncms.Parametric requently responds to requests
to exclude securities or industries rom a target index. In many cases, the goal is to
increase diversication relative to other holdings or express a perormance or valu-
ation view. When exclusions are a large portion o the target index, Parametric can
provide inormation on the diversication and tracking error trade-os. Perormance
measurement can also be customized to measure target perormance with and
without exclusions.
CustmCnstuctdindxs.The advisors we work with are among the sharp-
est and most creative in the industry. It is exciting or us to be involved in building
portolios aimed in new directions. Recently, this meant developing a Master Limited
Partnership (MLP) target index and a portolio with limited Schedule K-1 issuance.
cuStomizing or outSiDe conStraintS
Estate Planning Vehicles and Alternative Minimum Tax (AMT)
When clients tax situations change, we work with advisors and adapt accordingly.
Estate planning vehicles have unique tax treatments rom one year to the next, andclients sometimes move in and out o AMT status. Wherever practical, we coordinate
with advisors to i ntegrate new or anticipated rates and any unique, trust-related,
taxable items.
Option Writing
Through our aliate, Parametric Risk Advisors, we can alter, and potentially enhance,
risk control and return patterns through option writing strategies. Our Index DeltaShit
covered call or buy-write strategy can be managed in conjunction with a Tax-Managed
Core portolio to help to increase current cash fow and oer downside protection.
cuStomizing tax management
Transition Tax Management Custom Analysis
Building an index-based separate account rom cash is a straightorward task.
However, or investors unding the portolio with existing securities, it is essential to
understand current gain or loss status and short-term versus long-term holding
periods or each security. Unlike mutual unds or ETFs, which orce investors to raise
cash to invest, a TMC portolio can selectively use existing securities and raise cash
tax-eciently to reduce the impact o taxes at portolio inception. A Parametric
custom transition analysis can illustrate potential savings and trade-os.
Transition Tax Management Gain Budgeting and Staged Diversifcation
TMC investors sometimes respond to a transition analysis with a desire to limit the
initial tax bill. In these cases, we can establish a gain budget (maximum gain realized
per period), set up a multi-year plan or diversication, or both. A multi-year approach
has the potential benet o allowing loss harvesting to occur to oset some or all o
subsequent gain realization. We have many clients who have ully transitioned airly
concentrated, low-basis portolios with this type o approach. Transition analyses can
be perormed and evaluated by advisors beore any contract i s signed, relationship is
ormed or ees are i ncurred.
Ongoing Tax Management Strategic Gain Realization
Given the U.S. governments debt problems, we see the potential or urther tax in-
creases. When rising tax rates are on the horizon, it may make sense to accelerate the
realization o select long-term gains to take advantage o current tax rates, reset the
basis and holding period o a portolio, and create greater potential or uture short-
term losses. Parametric can help describe and analyze the key variables, which include
uture tax rates, short-term versus long-term rate dierences, time horizon and gain or
loss realization outside the portolio.
cuStomizing the inveStment target
Socially Responsible Investing (SRI) /
Environmental, Social and Corporate Governance (ESG)
Incorporating client values and related preerences has been part o the TMC process
since we started managing our rst TMC portolio. Parametric oers a number o
ways to achieve this goal beyond the basic case o targeting an SRI or ESG index. We
requently work with clients and their advisors to apply custom social screens or ocus
on best-in-class companies.
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David Stein, Ph.D., Chie Investment Ofcer
Mr. Stein leads Parametrics Investment, Research and Technology activities. Davids
experience in the investment industry dates back to 1987. Prior to joining Parametric
in 1996, he held senior research, development and portolio management positions at
GTE Investment Management Corp., The Vanguard Group and IB M Retirement Funds.
He has additional experience as a Research Scientist with IBM Research Laboratories
where he designed computer hardware and sotware systems. He has served on the
Ater-Tax Subcommittee o the AI MR-PPS standards committee and on the advisory
board o The Journal o Wealth Management. David holds a number o patents
and is published in multiple academic journals, including Mathematics o Operations
Research, The Journal o Wealth Managementand The Journal o Portolio
Management. He earned B.S. and M.S. degrees rom the University o Witwatersrand,
South Arica. He earned a Ph.D. in Applied Mathematics rom Harvard University.
PulBucy,CFa,Managing Director Research
Mr. Bouchey leads the Research team at Parametric. He is responsible or setting the
overall research agenda and new product development. Prior to joining Parametric
in 2006, Paul was a quantitative analyst at Russell Investment Group, where he
ocused on simulation, optimization and quantitative decision models or institutional
and private clients. He holds a patent on cross-sectional volatility indexing and has
authored more than 10 academic and practitioner articles in journals such as The
Journal o Wealth Management, Investments and Wealth Monitorand The Journal o
Index Investing. Paul graduated with a B.A. in Mathematics and Physics rom Whitman
College and earned an M.S. in Computational Finance and Risk Management rom
the University o Washington.
CONTRIBUTINgAUTHORS
PARAMETRICMEANSCUSTOMIzATION
In one orm or another, Parametric customizes every Tax-Managed Core
portolio we manage. Since investors can create standard equity index
exposure inexpensively and conveniently via mutual unds and ETFs,
our value proposition is centered on customization. In the base case, we
build a portolio rom cash, target a standard benchmark and customize
the construction as well as gain/loss recognition or each client.
However, or the majority o our TMC clients, we extend our activities
to one or more custom analyses or implementations.
Parametrics credentials in the eld o tax-ecient investing are
unsurpassed. In terms o seminal research, years o practical experience,
numbers o portolios and breadth o custom implementations,
Parametric is the market leader, advancing the art more than any
other provider. We welcome an opportunity to discuss how our
solutions may be a t or your clients or your portolio.
Our value propositionis centered
on customization.
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hmmbVdlmud,CFa,Director o Research Algorithm Development
Mr. Vadlamudi is responsible or implementing and supporting Parametrics optimiza-
tion and simulation systems. He i s also responsible or creating prototypes or
various research ideas. Prior to joining Parametric in 2005, Hemambara worked as
a Senior Sotware Engineer in the Ultrasound division at Philips Medical Systems.
He received an M.B.A. rom the University o Washington and a B.S. in Electronics
and Telecommunications Engineering rom National Institute o Technology, India.
VsslNmtcnv,P.D.,Director o Research Equity Strategies
Mr. Nemtchinovs primary responsibilities are the management and implementation o
Parametrics product development research. Within his broader responsibilities, Vassilii
maintains particular ocus on Parametrics proprietary portolio optimization technolo-gies and advanced quantitative portolio management. Prior to joining Parametric
in 2003, he worked in both industry and academia. Vassilii holds a Ph.D. rom State
University o New York.
rySntdmn,CFa,Director o Research Tax Managed Strategies
Mr. Santodomingo is a member o the Research and Product Development team. Prior
to joining Parametric in 2008, Rey was a Vice President in Product Management at
MSCI Barra where he developed risk and portolio management solutions or asset
managers and institutional investors. He holds an M.S. degree in Financial Engineering
rom the University o Caliornia, Berkeley and a B.S. in Chemical Engineering rom the
University o Caliornia, Santa Barbara. He is a Board Member o the CFA Society
o Seattle and an adjunct instructor at Seattle Universitys Albers School o Business
and Economics.
S&P 500 is a registered trademarks o the McGraw-Hill Companies, Inc. Parametrics strategies
are not sponsored, endorsed or promoted by the frms mentioned herein. Standard & Poors makes no
representation regarding the advisability o investing in the strategy.
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1918 8th Ave., Suite 3100Seattle, WA 98101t 206 694 5575.pmtcptfl.cm
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