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A Global Approach to Managing Taxable Equity

Portfolios

Sandy Warrick, CFAWarrick Family Office

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Disclaimers• This presentation describes the approach used to invest

the Warrick family’s equity allocation.• All assertions represent the opinions of the author and

are not to be considered endorsements of any product or service mentioned.

• Nothing in this presentation should be construed as specific investment advice or a recommendation to buy or sell securities.

• Any investment advice given here is general in nature and offered without expectation of compensation.

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Why Global Portfolios?• They more closely approximate the theoretical

“market-portfolio” that represents the risky asset in the Capital Asset Pricing Model.

• Because global portfolios invest in a wider variety of stocks, the portfolio:– Is more diversified than a domestic only portfolio. This can lower

absolute risk and reduces need for external or ETF management of non-US allocation.

– Has more opportunities for loss harvesting to help reduce the risk of concentrated low cost basis stocks.

– Has more opportunities for generating alpha across asset classes without moving assets from one fund or manager to another.

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Why Does Tax Efficiency Matter?• Deferring the sale of a stock with an unrealized

capital gain defers payment of taxes.• The time value of deferred taxation is an option

that need not be exercised if other sources of income can meet consumption expenses at lower tax costs.

• It is likely that an investor only needs to liquidate a portfolio for consumption when income (tax rate) is lower.

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Why Does Tax Efficiency Matter?• American shareholders escape capital gains

taxes entirely when the shareholder dies, since the cost basis steps up to its level at death.– Note: This may or may not be true in the tax year 2010!

• Gifting to future generation: no tax on capital gain until sold.

• From husband + wife to 3 children + 3 spouses + 6 grandchildren = 156,000 per year!

• Donating low cost basis stock to qualified charities is a very effective way of reducing future estate tax liabilities.

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Why Hasn’t Everyone Done This?

• Successful separate account management requires the ability to manage separate accounts separately

• Most HNW clients use a specialist approach, represent each asset class (size, style, location) by selecting one or more managers or ETFs.

• Some managers are reluctant to use quantitative methods or optimization because they are afraid of estimation error (“garbage-in, garbage-out”)

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Why Hasn’t Everyone Done This? (Continued)

• Taxable Accounts are labor intensive– Each account is different– Accounts start with very different positions,

often with concentrated portfolios with both high active risk and low cost basis.

– Even identical accounts started on different dates will have different cost basis and tax consequences

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What Do We Do About Taxes?• Northfield has been working on tax-aware

optimization for more than 15 years.– Taxes are directly modeled as a transaction cost for

each share lot that has its own purchase date and price.

– SoftPak has teamed with Northfield to develop the Multiple Account Rebalancing System (MARS) which can manage several accounts in an automated

• The model portfolio can be simulated ignoring taxes.– Tax efficiency is implemented by an overlay.– Placemark offers this service to managers through a

Unified Managed Account (UMA).

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What Do We Do About Taxes?• The most crucial goal is to avoid realizing net short term

capital gains during any tax year.– Short term capital gains need to be offset by a combination of

short term capital losses or excess long term capital losses.– Excess long term capital losses are those that exceed realized

long term capital gains.• Short term capital gains are netted to short term capital

losses.• Long term capital gains are netted to long term capital

losses. – If this is positive, this is the long term capital gain.– If this is negative, this can be used to reduce short term capital

gain.– Any unused capital loss can be used in the future against future

gains or can reduce ordinary income by a very small amount.

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What is the Benchmark?• We use the same constituents as the market

portfolio used by the Northfield Fundamental Risk Model.

• The companies all have a market cap that exceeds $250 million regardless of time period.

• Market capitalization weighting:– Assumes that markets are close to efficient.– Reduces turnover.

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What is the Benchmark? (Continued)

• The benchmark contains several stocks that are not in the S&P 1500 or Russell 3K indices:– Several Canadian stocks that are sold outside the

Toronto Stock Exchange such as:• Toronto Dominion (TD)• Royal Bank of Canada (RY)• Research in Motion (RIMM)

– American Depository Receipts• Developed Markets• Emerging Markets

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What is the Benchmark? (Continued)

Developed Markets ADR:• Royal Dutch Shell (RDS.A & RDS.B)• HSBC HLDGS PLC ADS (HBC)• BP PLC (BP)• TOTAL S.A. (TOT)• BANCO SANTANDER ADR (STD)• NOVARTIS AG ADS (NVS)• TOYOTA MTR CP ADS (TM)• Vodafone Group Plc (VOD)• TELEFONICA SA (TEF)• BHP BILLITON LIMITED (BHP)• GLAXOSMITHKLINE PLC (GSK)

Emerging Markets ADR:• AMERICA MOVIL, S.A.B (AMX)• CHINA LIFE INS CO (LFC)• CHINA MOBILE LIMITED (CHL)• ITAU UNIBANCO ADS (ITUB)• PETROLEO BRASILEIRO (PBR)• TAIWAN SEMICOND ADS (TSM)• Teva Pharmaceutical Industries (TEVA)• VALE S.A. ADS (VALE)

And Many Others…

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The First Tradeoff: Taxes vs. Tracking Error

• Tracking error is the 1 standard deviation confidence of the difference between portfolio and benchmark value for a given time period, usually one year.

• If you believe that markets are efficient, then you would want the tracking error to be very low.

• Many taxable portfolios have low cost basis, concentrated positions:– Requires realizing high capital gains for acceptable

tracking error.

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The First Optimizer Task: Reduce Tracking Error with Minimal Trades

• The optimizer has a feature that allows you to create a composite asset that consists of other assets with specified weighting.

• In order to minimize trading, you can restrict the “buy-list” to ETF’s that represent capitalization, style, sector and geographic “slices” of the benchmark:– iShare large, mid and small cap Russell Indices– iShare all-cap sector indices– SPDR large cap style and sector indices– BLDRS Developed and Emerging ADR indices– iShare Canadian index

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The First Tradeoff: Taxes vs. Tracking Error (Continued)• By varying optimization settings, you can

create a curve that trades taxes for tracking error.

• This will help you determine:– What tracking error (or tax bill) do you feel

comfortable with?– Whether you want to look into other ways to

reduce the risk of concentrated positions.

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Taxes vs. Tracking Error

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The First Tradeoff: Taxes vs. Tracking Error (Continued)Tom Boczar’s rule of thumb:• Sell 1/3rd and use proceeds to create a complementary

positions that balances taxes and tracking error.• Put 1/3rd in an exchange fund. The equity holdings of

this fund can be represented with a composite asset.• Hedge 1/3rd to limit downside. If you use a collar with a

delta of -1/2, then the composite asset is:– 150% Cash– -50% Stock

2009 CFA Institute Concentrated Stock Workshop

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The Second Tradeoff: Tracking Error vs. Alpha

• Do you believe that active management is worth pursuing?

• Once you have selected a tracking error and perform initial trades, you can then add in alphas.

• We start this process by creating fundamental factor alphas.

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Factor Alphas: Ceteris Paribus• Imagine two companies in the same industry whose

price, beta and fundamentals was essentially identical except with respect to one factor.

• We might believe that these two stocks are relatively mispriced since:

– If the factor was earnings, we would prefer the higher earning stock because we could buy more assets for the same price.

– If the factor was book value, we would prefer the higher book value stock because we could buy more assets for the same price.

– If the factor was sales, we would prefer the higher revenue stock because we might believe that margins should converge.

– If the factor was dividends, we would prefer the higher yield stock because we could buy yield for the same price.

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Factor Alphas: Ceteris Paribus (Continued)

• We might believe that these two stocks are relatively mispriced since:– If the factor was relative strength, we would prefer the higher

momentum stock if we believe that momentum predicts future stock returns.

– If the factor was market cap, we would prefer the smaller company because it would have more opportunity to grow.

– If the factor was earnings variability, we would prefer the company with smoother earnings.

– If the factor was EPS growth, we would prefer the higher growth stock because we could buy more growth for the same price.

– If the factor was debt, we would prefer the lower debt stock because it is safer.

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Northfield Fundamental Factors AlphasFactor Type WeightEarnings / Price Value 0.60

Book / Price Value 0.20

Revenue / Price Value 0.25

Dividend Yield Value 0.35

Relative Strength Growth 0.25

Log of Market Cap Growth -0.20

Earnings Variability Safety -0.45

EPS Growth Rate Growth 0.25

Price Volatility Safety 0.20

Debt / Equity Safety -0.25

The factor alphas are optimized usingNorthfield’s asset allocation programand the fundamentalfactor returns from 1989-2009

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Time History of Excess Factor ReturnsPerfomance Comparison Graph

Monthly Rebalancing

Date2008/122007/122006/122005/122004/122003/122002/122001/122000/121999/121998/121997/121996/121995/121994/121993/121992/121991/121990/121989/121988/12

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Factor Alphas: Portfolio Construction

• Although we probably can’t find any examples of such mythical stocks, we can easily construct portfolios that are identical to their benchmark except for one factor.

• If these portfolios provide the expected excess return in the past, we might have an expectation they will outperform in the future.– This is the basis of ALL active management

• Except for TRUE contrarians who believe that strategies that underperform in backtest will perform well in the future.

• I have never met such a contrarian.• We can combine these factor portfolios into optimal

portfolios and then modify risk model factor files by introducing factor alpha.

– Please do not do this to the file distributed by Northfield. Make a copy and give in another name!

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Backtesting the Predictions

• We optimize and split adjust the portfolio every month.

• We save each month’s optimization reports and portfolio files

• We repeat this for every month of the study period. We use 12 to include two bull and two bear markets.

• We use each month’s optimum portfolio as input to Northfield’s Performance Attribution Software.

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Backtesting the Predictions (Continued)

Stock Specific returns are negative, reducing active returns. Is this an example of estimation error?

Factor Portfolio Benchmark ActiveAnnualized Return 7.92% 2.91% 4.88%Annualized Risk 17.94% 17.29% 4.78%

Return Model

SD TstatStock Specific -0.21% 0.84% -2.89%Factor Model Specific 0.62% 1.23% 5.76%

Performance attribution compares the portfolio and benchmark’s returns and risk.

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Backtesting the Predictions (Continued)

We use performance attribution to compare the portfolio and benchmark’s fundamental averages.

Factor Portfolio Benchmark Z-scorePrice / Earnings 11.08 21.65 -1.08Price / Book Value 1.85 2.66 -0.45Dividend Yield 2.71 1.87 0.34Trading Activity 0.13 0.11 0.12Relative Strength 1.15 1.13 0.04Market Capitalization $50,068 $71,421 -0.82Earnings Variability 0.25 0.42 -0.18EPS Growth Rate 22.65 14.14 0.57Price / Revenue 0.88 1.32 -0.27Debt / Equity 0.37 0.69 -0.37Price Volatility 0.27 0.24 0.15

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Backtesting the Predictions (Continued)

We use performance attribution to compare the portfolio and benchmark’s average sector weight.

Factor Portfolio Weight

BenchmarkWeight

Active Weight

Material 6.5 5.0 1.5Industrial 9.7 7.8 1.9Telecommunication 7.8 9.4 -1.6Consumer Discretionary 9.3 12.1 -2.9Consumer Staples 5.5 6.5 -1.1Energy 9.6 9.1 0.5Financials 25.4 19.7 5.8Health Care 7.1 11.0 -3.8Information Technology 15.6 15.6 0.1Utilities 3.5 3.9 -0.4

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Backtesting: Style AnalysisFund Name

Benchmark Style Wt.%

Std. Error

Portfolio Style Wt.%

Std. Error

Russell Top 200 Growth 25.99 1.15 4.46 7.65Russell Top 200 Value 15.47 1.15 20.80 7.65Russell Midcap Growth 9.91 1.64 13.98 10.92Russell Midcap Value 3.49 1.84 0.00 12.25Russell 2000 Growth 0.00 1.28 0.00 8.47Russell 2000 Value 7.60 1.19 24.37 7.87S&P Toronto Stock Exchange 60 4.80 0.61 9.03 4.05BLDRS Developed Markets 100 ADR 25.93 2.28 0.00 15.11BLDRS Emerging Markets 50 ADR 6.16 0.62 13.26 4.10S&P Asia Pacific Large & Mid Growth 0.00 1.69 0.00 11.24S&P Asia Pacific Large & Mid Value 0.00 1.39 1.91 9.23S&P Europe Large & Mid Growth 0.04 1.65 12.20 10.94S&P Europe Large & Mid Value 0.61 1.42 0.00 9.44

Alpha 0.00   1.97  Tracking Error 0.53   3.56  

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Can We do Any Better?

• We might be able to reduce the drag of negative stock specific return by adding in effective stock specific alphas.

• Such candidates might be:– Estimate revision (Starmine, for example)– Corporate governance ratings– Sell side ratings– Your own predictions

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Add in Tax Efficiency• To simulate a typical concentrated, low

cost-basis portfolio, minimize the tracking error to the benchmark in January 1999 using 30 stocks.

• Split adjust and bring to a starting point of January 1998.

• Cut the cost bases to zero and double the weight in half for the two largest holdings to make it even more challenging to maintain tax efficiency.

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Combine Tax Efficiency & Active Management

• Tax efficiency may reduce trading in pursuit of alpha:– Stocks with low alpha will not be sold if the tax

consequences are too high.– Stocks with high alpha might be sold if they can

be loss harvested.• Usually the tradeoff is between tracking error

and alpha, with transaction costs a lower consideration. – Tax consequences can dwarf TE and Alpha.

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A Few Subtleties• It’s a multi-period problem

– Returns accrue wealth over time– Portfolio volatility risk is experienced over time– Taxes and trade costs occur at moments in time– Incremental taxes for short-time gains as compared to long

term gains– My market outlook may change tax preferences– Gain harvesting early in year offset by loss harvesting later

in the year.• Wash sales

– Potential loss of previously realized tax losses – Wash sale opportunity costs

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Solution to the Timing Issues• Amortize all costs over expected average

holding period.• If average holding period is five years, then

one-way turnover is 20%.• Amortize long term capital gains taxes over

expected time horizon (average holding period)– Amortize incremental taxes on short term gains over

time before getting long term status on the position– If explicit returns forecasts are available, consider the

opportunity cost of not owning a high-return stock in order to harvest a tax loss.

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Adjusting Amortization Rates• Investors may wish to adjust amortization rates

to reflect various circumstances– Possibility of escaping capital gains taxes through

bequest– Deferral of tax payments is worth more when

interest rates are high– Investors learn whether the market is up or down for

the year. • They can adjust tax preferences to reflect having

net gains or losses as the year progresses– Market expectations matter. Investors’ preferences for

taxes may change if they have a bullish or bearish view of the market

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Run Tax Efficient Optimization• Combining alphas, tax costs and other

considerations, run a simulation from 1999-2009.

• Keep track of tracking error, total returns, active returns, tax costs, and transaction costs.

• Revise until satisfied that this process can add value.

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Summary• The benchmark should be global• The benchmark should be multi-cap• The most important tradeoff is between tracking

error and capital gain taxes.– The main goal is to avoid net short term capital gains.– The secondary goal is to minimize net long term

capital gain.• If you believe that active management can be

effective, you can add in factor or stock alphas.• Backtesting can help you decide what

optimization settings are likely to work in the future.