Parametric U.S. Tax Primer 2013.Web .CA

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

2 / Parametric Tax-Ecient Equity InvestingA Primer /3


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01/

THECURRENTTAX

ENVIRONMENTFORINVESTORS

Tax-Ecient Equity InvestingA Primer /54 / Parametric


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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

Tax-Ecient Equity InvestingA Primer / 76 / Parametric


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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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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.


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



16/24

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

04/

THE PRACTICE OFACTIVE TAX MANAgEMENTAT PARAMETRIC



17/24

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



19/24

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

05/

WHYPARAMETRICTAX-MANAgED

CORE?



20/24

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.

05/

WHY PARAMETRICTAX-MANAgED CORE?



21/24

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.



22/24

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.



23/24

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.

42 / Parametric


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Documents

Parametric U.S. Tax Primer 2013.Web .CA