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Acknowledgments................................................................ vii

Introduction........................................................................ ix

P A R T O N E | EVOLUTIONOFKNOWLEDGEPERTAININGTOTAX-AWAREINVESTMENTMANAGEMENT 1

1 TheEvolutionofTax-AwareInvestmentManagement.. .. .. . 3

2 TheSourcesandImpactofTaxeson

InvestmentReturns........... .......... ........... .......... .......... ....... 11

3 SeminalResearch.............................................................. 21

4 TheTax-AwarePractitioner.......... .......... ........... .......... ..... 33

5 CreatingtheTriumvirateofQualified

Professionals..................................................................... 45

P A R T T W O | AFTER-TAXREPORTINGANDMEASURESOFTAXEFFICIENCY 55

6 MutualFundAfter-TaxReporting.......... ........... .......... ..... 57

7 SeparateAccountAfter-TaxReporting............................. 77

8 MeasuresofTaxEfficiency.......... ........... .......... ........... ...... 95

P A R T T H R E E | TAX-AWAREPORTFOLIOMANAGEMENT 101

9 OutperformingtheIndexFund...................................... 103

10 QuantitativeTax-AwarePortfolioManagement

andConcentratedStock........... .......... ........... .......... ........ 117

C O N T E N T S


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11 PracticesofEliteTax-AwareEquityActiveManagers..... 133

12 PracticesofEliteTax-AwareFixedIncome

ActiveManagers.............................................................. 149

13 TheHedgeFundDilemma............................................. 167

14 AmendingtheSearchProcessforTax-Aware

ManagerSelection.......... .......... .......... ........... .......... ........ 175

P A R T F O U R | CHALLENGINGTRADITIONALASSETALLOCATIONMETHODS 189

15 ChallengesWithTraditionalInvestment

PolicyDevelopment........................................................ 191

16 DevelopingAfter-TaxAssetClassAssumptions.......... .... 209

17WhytheStyleBoxHurtsTaxableInvestors.... .... .... .... .... 225

18 PositioningAssetsbytheTaxCharacteristics

oftheEntity.................................................................... 243

19 TheRoleofSystemsSolutionsin

Tax-AwareInvesting.......... ........... .......... .......... ........... .... 271

Summary. . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . 281

Appendix.......... .......... ........... .......... ........... .......... .......... ........ 283

ContinuingEducationExam.......... ........... .......... ........... .. 287

Index. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . 294


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Tax-AwareInvestmentManagement:TheEssentialGuideembodiesthecol-lectivewisdomofmanypeoplewithwhomIhavebeenfortunateenoughtointeractduringmyinvestmentcareer.Iwanttoacknowledgethosewhohavesupportedmyeffortsandprovidedmemanyoftheinsightsneces-

sarytocompletethiswork.IapologizetoanyoneImayhaveinadvertentlymissedinmyattempttogivecreditwhereitisdue.

IextendmygratitudetoRalphRittenourJr.,toJeffreyGrubb,andtomyotherassociatesatCTCConsultingfortheirbackingofthisproject.IamespeciallymindfulofthesupportofDonLindowandChrisArvaniwhorecognizedearlyoninmycareermydesiretotakeonnewandex-citingresearchpertainingtothenucleardecommissioningtrust(NDT)industry.MyparticipationatNDTconferencesandmyinteractionwith

ArlandBrusven,DavidKrause,JamesMeehan,JoanneHoward,MaryJoDempsey,ThomasTuschen,Eric Knause,Mary Miller,andothersonlyheightenedmyenthusiasm.MichaelBrilleyandGeneSitencouragedmetosubmitmyfirstarticleforpublicationontax-awareinvestmentmanage-ment,whichsetthestageforotherprojectstofollow.SimilarappreciationisextendedtoLouiseWasso-JonikasandMichaelRadfordforencouragingmyinvolvementinCFAInstitute(formerlyAIMR)activitiesandpublicspeaking.

LeePricehasalwaysbeenarespectedmentor,andtoservewithhimonbothAIMRSubcommitteesonAfter-TaxReportinghasbeenanhonorandprivilege.IwillalwaysbeindebtedtothemembersoftheSubcommittee.TheirresponsetotheSECproposalforafter-taxreturnsonmutualfundsandrecommendedrevisionstotheexistingstandardswouldnothavebeenpossiblewithouttheassistanceofPaulinePilateandAleciaLicata.StanleyLeeandLizMilleroftheNewYorkSocietyofSecurityAnalystshavebeenconsistentsupportersofthistopicandrelatedissues.

IamtrulythankfulforthewillingnessofTadJeffrey,JamesGarland,

RobertArnott,JoelDickson,JackBogle,PeterBernstein,MarcMoulton,BrianLangstraat,DavidStein,andBobBreshocktosharetheirexpe-rienceson critical researchand productdevelopment.JayWhipple III,Ron Surz, James Hollis,and Matt Schott have played critical roles infurtheringmyunderstandingofsystemstechnology.RobertGordonand

A C K N O W L E D G M E N T S

vii


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ThomasBoczarplayedasimilarrolewithtaxissuesastheyrelatetohedgefundinvesting.LeslieGiardaniandherresearchofferedvaluableinsightintothefuturedirectionoftheinsuranceindustry.TonyRochteandhis

associatesatBarclayssharedtheirknowledgeofexchange-tradedfunds,asdidGaryGastineau.WilliamReichenstein,WilliamJennings,andJamesPoterbawerethoughtfulenoughtointroducemetotheleadingcontribu-torsfromacademia.DonPhillipswasgraciousenoughtoallowtheuseofafter-taxreturndatafromMorningstarPrincipia.Whilestockpickersalwaysseemtotakecenterstageoverthosewhosespecialexpertiseisinfixedincome,ithasbeenajoytoshareideaswithpassionatebondportfo-liomanagerslikeGuyDavidson,ChristineTodd,andPaulJungquist.

HaroldEvenskywasinstrumentalinintroducingmetoJaredKieling,

whohassupportedtheprojectwithsageeditorialadvice.JefferyYablonwaskindenoughtosharehisquotesfrom TaxNotesthatappearasepi-graphs throughout the book.1 Encouragement fromNancy Jacob, JeanBrunel,andDaveSpauldingtocontinuetopublishhasbeenadrivingforcethathasculminatedinthiseffort.

Thisbookcouldnothavecompletedwithoutthecontinuedencour-agementofclosefriendsandrelatives.Last,andmostimportant,Ithankmychildrenandmywife,SoonHee,fortheirunwaveringsupportand

sacrificesmadeduringthemanyeveningsandweekendsthatwereneededtocompletethistext.

ChapterNotes

1. The tax-relatedquotations that open each part and chapter werecompiledandarrangedbyJefferyL.Yablon,AsCertainasDeath:QuotationsAboutTaxes(2004Edition),TaxNotesvol.102,no.1(January5,2004):99-116.

viii Acknowledgments


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TheImportanceofTax-AwareInvestmentManagement

Our Constitution is in actual operation; everything appears topromisethatitwilllast;butnothinginthisworldiscertainbutdeathandtaxes.

BenjaminFranklinFoundingfather

Taxeshavebeenapermanentpartofthesocial-politicallandscapeintheUnited States sincethe Sixteenth Amendment tothe Constitution was

ratifiedin1913.Soonthereafter,PresidentWoodrowWilsonapprovedtheformoffederalincometaxationthatweknowtoday.Initiallyaffect-ingonlythewealthy,itwasnotuntilafterWorldWarIIthatthefederalincometaxbegantohaveasignificantimpactontheeconomicwell-beingoftheaveragecitizen.1

Althoughnooneenjoyspayingthem,taxesserveanimportantpur-pose.Taxesarethesourceofrevenuethatenablesthegovernmenttobuildtheinfrastructurenecessarytomaintainandenhanceourqualityoflifeandtoprovideforthecommondefense.Andlikethepricesofsecurities,taxeswillchange!Thepricesofsecuritiesfluctuatedailyasmarketpartici-pantsassesstheimportanceofthevariousforcesaffectingtheeconomy,whereastaxrateschangemoreslowly,reflectinggovernmentpoliciesandspending.Sincetheadoptionofthefederalincometax,taxpolicyhasbecomeanincreasinglyimportantstimulustoolwitheachsuccessivead-ministration.Therefore,majorchangeinthetaxcodeisexpectedtobethenormratherthantheexception.Forthisreason,tax-awareinvestmentpracticesareessentialtomaximizingwealth.

Tax-awareinvestmentmanagementreferstotheapplicationofsoundjudgmentthatresultsinoptimalresultsafteralltaxesandfeeshavebeenpaid.Itisnotaboutavoidingthepaymentoftaxesthroughquestionableaccountingorestateplanningorsimplyattemptingtopaynotax.Rather,

I N T R O D U C T I O N

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Introduction xiii

ChapterNotes

1. TouisAllenTalley, CRSReport on History of FederalTaxes,CRSReportforCongress,January19,2001,18,http://www.taxhistory.org/thp/readings.nsf

(accessedJuly7,2004).

2. UnderSection4940oftheInternalRevenueCode,charitableorganizationsmaybesubjecttoataxof2percentonnetinvestmentincome.

3. Throughoutthisbookthetermseparateaccountisusedinitstraditionalmean-ing,i.e.,anestablishedaccountwithamoneymanager,ratherthantheretail-orientedwrapaccount industrywhere abundle ofinvestmentsand services isprovidedforasinglefee.


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4 EvolutionofKnowledgePertainingtoTax-AwareInvestmentManagement

DecommissioningNuclearPowerPlantsTheinitialcalltoactionfortheinvestmentmanagementindustrycame,

oddlyenough,fromamarketnichethatmostpeopleareunawareof.In1984,Title26,Section468AoftheInternalRevenueCodewasamendedtoallowelectricutilitiestoclaimadeductionforcostsrelatedtodecom-missioning the nations 103 nuclear-powered generating plants.2 Withtheaverageestimatedcostofdecommissioningexceeding$200million,asmallgroupofinvestmentmanagerssawamajormarketopportunity.Theybegantoanalyzetheimpactoftaxesandtomodifytheirportfoliostrategiestodistinguishthemselvesfromthecompetition.Electricutili-tiesfirstturnedtotheirpensionmanagersforadvice,buttheyknewthat

morehadtobedone.TheUtilityPensionFundStudyGroup,foundedin1969,beganaseriesofannualconferencestodiscusstopicsrelatedtotheefficientmanagementofretirementassets.3

In1989,ArlandD.Brusven,treasurerofNorthernStatesPowerCom-pany,addedahalf-daytotheagendainordertoincludeissuespertainingtonucleardecommissioningtrusts.4Theresponsewasoverwhelming.Moreattendeessatthroughthesessionsonnucleardecommissioningthaninthesessionsdevotedtopensionmanagement.5ThefirstNuclearDecom-

missioningTrusts(NDT)FundStudyGroupConferencetoaddresstheinterestsofelectricutilitiesandmoneymanagerswasheldinWrightsvilleBeach,NorthCarolina,in1990.Inrecentyears,theeventhasattractedmorethan150attendees,andatleastthatmanyareexpectedin2006.

Thepresentationsbyinvestmentmanagers initiallyanalyzedtheim-pactoftaxesontheNDTfundingprocessandmightbeconsideredprimi-tivebytodaysstandards,buttheywereastepintherightdirection.Afteronlyafewyears,thelevelofsophisticationofthepresentationsimproveddramatically.Perhapsthemostimportantresultofthenucleardecommis-sioningexperienceisthattheinvestmentmanagementindustrycouldnolongeroperateinavacuumandcontinuetodisregardtheimpactoftaxesoninvestmentreturns.Furthermore,themanagerswhoachievedmean-ingfulmarket share inthisnichewere thosewho effectivelycommuni-catedallrelevantfactorsthataffecttheday-to-dayportfolioconstructionandmanagementprocesstothepartiesinvolved.

FortheNDTindustry,thebasicrelevantfactorsincludecostesti-mates;theestimatedremaininglifeofthereactor;anunderstandingof

theapplicablefederal,state,andlocaltaxcodes;allocationofassetsamongtrustssubjecttodifferenttaxrates;andtheevolutionofregulatorymat-ters.Unliketaxablecorporateassets,nuclearreactorshaveanestimatedlifeofapproximatelyfortyyears.Thefutureliabilityordecommissioningisfundedthroughtwotrusts.Theelectricutilitiesfirstfundedaqualified


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plan,401(k)plan,ortrust,aspreadsheetsolutionwassatisfactory.Butwhenmultiplevehiclesorentitiesenteredthepicture,thesolutionwasoftenlessthandesirableinatleastoneaspect.WithfundingfromCTC,

JacobteamedwithMarcMoultontodevelopthefirstcommerciallyavail-able software program that truly accounted for the impact of taxesPORTAX.Otherconsultingfirms,investmentmanagementfirms,andbanksweredevelopingsimilarproductsforusewiththeirinternalclients,butnoneofthesecouldbepurchasedforindependentuse.

Although it is a complex tool to learn and master, the beauty ofPORTAXisthatitenablestheinvestortoincorporatetheimpactofthetaximplicationsofvariousentities,cashflows,andtimeintheoptimiza-tionprocess.Italsoallowstheusertoquantifytheimpactoftax-efficient

assetlocation,atopicthatJacob,JeanL.P.BrunelofBrunelAssociates,andGregoryFriedmanofGreycourt&Co.hadaddressedinpreviouscollaborationsforarticlesandpublicpresentations.PORTAX,availablefromWindermereInvestmentAssociates,isstillconsideredtobethesys-temofchoicebymanagersworkingwithsophisticatedclientsandcom-plextaxablesituations.

PublicizingtheNeedThe adage aboutthe squeakywheelgetting the grease certainly appliestotheinvestmentcommunitysreactiontothearticleIsYourAlphaBigEnoughtoCoverItsTaxes?byR.H.(Tad)JeffreyandRobertArnott,whichappearedintheJournalofPortfolioManagement inthespringof1993.6Thearticlehighlightshowlessthan20percentofthemutualfundstheauthorsanalyzedoutperformedtheVanguard500IndexFundonanafter-taxbasis.AtthesametimethatJeffreyandArnottwereworkingontheirarticle,StanfordprofessorJohnB.ShovenandgraduatestudentJoelM.DicksoninitiatedaworkingpapertitledRankingMutualFundsonanAfter-TaxBasis.Althoughtherehadbeennocollaborationbetweenthetwoparties,bothstudiespointedtothefactthatmanagerswereig-noringtheimpactoftaxes.Theresultsofthestudies,coveredingreaterdetailinchapter3,providedtheevidencethatwasneededtoshockfundmanagersintopayingattentiontotaxissues.Managerswereonnoticethattheirfailuretoaddresstaxesintheportfoliomanagementprocesswasap-parentandthattheinvestingpublicwouldbegintoholdthemtoahigher

standardofaccountability.JeffreyandArnott,alongwithShovenandDickson,broughtthene-

glectofmanagerstocenterstage,butastandardmethodofmeasuringresults onan after-tax basis was needed.In response torequests fromclients, Lee N. Price, of Rosenberg Capital Management, approached


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TheEvolutionofTax-AwareInvestmentManagement 7

theAssociationforInvestmentManagementandResearch(AIMR)withtheideaofdevelopingstandardsforreportingafter-taxreturns,similartowhatwasinplaceforbefore-taxreturns. 7Atthe1993NDTFund

Conference,PriceannouncedhisvisionandtheAIMRSubcommitteeforAfter-TaxReportingwasformed.TheSubcommittee,co-chairedbyPriceandRobertE.Pruyne,consistedofworkingprofessionalswhohadextensiveexperiencewithtaxableaccounts.Thestandardswereadoptedby AIMRin1994,butonlyafew firms,primarilythose withnucleardecommissioningaccounts,implementedthem.

SECIssuesaProposalThe importance of this initial work, spearheaded by Price, cannot beunderestimatedsinceitaddressedmanyofthekeyconceptsandlaidthefoundationforfutureinitiatives.Onceagain,however,amajorcatalystwas needed to achieve a lasting result, and that catalyst proved to bethe escalation of private wealth in the late 1990s. With the favorablereturnsoftheequitymarketsduringthisperiod,anincreasingnumberofinvestorswerebecomingconcerned,ifnotdownrightupset,aboutthecapitalgainsdistributionsfromtheirmutualfunds.TheSecuritiesand

ExchangeCommission(SEC)begantoresearchafter-taxreportingandissuedaproposalforpubliccommentinMarchof2000.TheU.S.HouseofRepresentativesunderscoredtheimportanceofthesubjectbypassingtheMutual FundTax Awareness Act of 2000 in April, introduced byCongressmanPaulGilmourandadoptedbyavoteof3852. 8TheAIMRsubcommittee was reconstituted, with the author, Douglas S. Rogers,aschairman.AdozenuniquelyqualifiedanddedicatedSubcommitteemembersworkedselflesslyoverathree-yearperiodfirsttorespondtotheSECsinitiativeandlatertomakerecommendationstotheAIMRboardandtheInvestmentPerformanceCouncil(IPC).Mostmutualfundsarenowrequiredtoprovideafter-taxreturnsintheprospectus.RevisionstotheseparateaccountstandardsforthosefirmswiththedesiretoadoptthemwentintoeffectinJanuary2005.

ConferencestoShareInformationAnotherkeydevelopmentintheevolutionoftax-awareinvestmentman-

agementhasbeenineducation,orthedisseminationofinformation.Ini-tiativesbytheFamilyOfficeExchange(FOX)andtheInstituteforPrivateInvestors(IPI),underfoundersSaraHamiltonandCharlotteB.Beyer,respectively,addressedtheneedsoftheinfluentialbuyerinthemarket-placethehigh-net-worthfamily.BothFOXandIPImanagedtobring


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togetherbuyersandprovidersinamannerthatfacilitatedanopenex-changeofinformation,forcingallpartiestoseekahigherlevelofknowl-edgeandsophistication.Theeffortreinforcedthelessonslearnedthrough

thenucleardecommissioningexperience.Sincehigh-profilefamiliesandindividualinvestorsareeasiertoidentifywiththannuclearreactorsandhaveinfluencewithotherbuyersinthemarketplace,theseandsimilareducationeffortsbyotherorganizationsanduniversitiesarewhatfinallybroughthometotheprofessiontheimportanceoftax-awareinvesting.

Perhapsthemostimportantconferencesonthetopicoftax-awareinvestinghavebeenthoseheldbyAIMR.TheInvestmentCounselingforTaxableInvestorsConferenceheldinNovember1998wasthefirstoftheseannualeventsthatattractedspeakerswithexpertiseinvarious

taxable-account-relatedfields.9Thesemeetingscapturedanenormousamountofintellectualthoughtoftheday,andthepublishedAIMRConferenceProceedingscanbeorderedfromtheorganization.Forany-oneservinghigh-net-worthindividualsandfamilies,thesepublicationsareconsideredanessentialelementofthemanagersprofessionallibrary.Althoughsomeofthearticlesfocusontheneedsoftheultra-affluent,theconceptspresentedcanbeappliedtoalmostalltaxable-accountopportunities.

BabyBoomersCauseaShiftWithmorethanfifteenyearsofprogressinthetheoreticalapproachtotax-awareinvestmentmanagement,andwithafter-taxreportingstandardsnowinplace,theemphasisisshiftingtowardimplementingstrategiesthroughscalablesoftwaresolutionsthattakeintoaccounttheuniquecharacteris-ticsofeachclientrelationship.Surprisingtomanyisthecurrentemphasisonallocatingresearch-and-developmentdollarstodevelopingsystemsforsmalleraccountsandtheretailsegmentoftheinvestmentbusiness.Thus,ratherthansoftwaredevelopmenttricklingdownfromthemoresophisti-catedportionofthemarket,itisnowbuildingmomentumfromdemandthatwascreatedfollowingtheSECsmandatethatmutualfundsprovideafter-taxreturninformation.Manybelievethisisoccurringbecauseasthewealthofthebabyboomersincreases,theseinvestorsareshiftingtheiras-setsfrommutualfundstowrapaccounts.Theynaturallyaskthequestion,Ifyourfirmcanprovideafter-taxreturnsonyourmutualfunds,whycant

youdoitherewhenthefeesarehigher?Whichportionofthemarketgetstherefirstisreallynotimportant.Whatissignificantisthatthestateoftax-awareinvestmentmanagementhasneverbeenbetter:progressisbeingmadeandthefutureispromising.


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TheEvolutionofTax-AwareInvestmentManagement 9

ChapterNotes

1. U.S. Department of Labor, Employee Benefits Security Administration,http://www.dol.gov(accessedJuly27,2004).

2. Title 26 of the Internal Revenue Code, http://frwebgate.access.gpo.gov(accessedJuly27,2004).

3. UtilityPensionFundStudyGroup,http://www.upfsg.com,(accessedJuly27,2004).

4. NuclearDecommissioningTrustFundConference,http://www.ndtconference.com(accessedJuly27,2004).

5. ArlandBrusven,indiscussionwiththeauthor,July17,2004.

6. RobertH.JeffreyandRobertD.Arnott,IsYourAlphaBigEnoughtoCoverItsTaxes?TheActiveManagementDichotomy,JournalofPortfolioManagement(Spring1993):1525.

7. TheAssociationforInvestmentManagementandResearchchangeditsnametotheCharteredFinancialAnalystsInstitute(CFAI)in2004.

8. SecuritiesandExchangeCommission,SECRequiresDisclosureofMutualFundAfter-TaxReturns,newsrelease,January22,2001.

9. Association for Investment Management and Research,AIMR ConferenceProceedings:InvestmentCounselingforPrivateClientsno.2(1999).


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IncomeComponentofInvestmentReturnInvestment returns consist of three components: income, appreciation,

andthereinvestmentofincome.Thethirdcomponentreinvestmentofincomeisnotasignificantfactorforshortperiodsofanalysisbuthasameaningfulimpactforlongerperiods.Notallincomeistreatedequally.Forexample,theUnitedStatesandItalyaretheonlytwocountriesintheworldtooffertax-exemptbonds.Tociteanotherexample,asignificantprovisionoftheJobsandGrowthTaxReliefReconciliationActof2003istheloweringofthetaxrateonqualifieddividendsfromtheordinaryincomeratetothemorefavorablerateforlong-termcapitalgains.Yetal-thoughmostdividendsqualifyforthelowerrate,taxedatamaximumrate

of15percent,themajorityofincomedistributedfromrealestateinvest-menttrusts(REITs)doesnot.AsofDecember31,2004,commonstocksintheUnitedStatesprovidedadividendyieldof1.6percent,whereasREITswereofferingayieldofapproximately4.6percent.Letsassumeaninvestoranticipatesa10percenttotalreturnonstocksandREITsoverthenextyear,andthathecangointothemarketandpurchaseaunitofeachfor $100. Iftheinvestordoesnotholdthe units inatax-deferredaccountandissubjecttothehighestfederaltaxrate,thenthecommon

stockinvestmentwillgenerate$1.60individends,causingataxof$0.24($1.60 dividendtaxedat15percent).The REIT investment,however,willgenerate$4.60innonqualifyingdividendstaxedatthemaximumrateonordinaryincome,resultinginataxof$1.61($4.60dividendtaxedat35percent).Severalsourcesreportthatupto25percentofREITsgeneratequalifieddividends,butthegeneralconsensusofportfoliomanagersserv-ingthisnichesuggeststhatqualifieddividendsfromREITsarequiterare.

Thekeycommontotheseexamplesisthatthenatureoftheincomematters.Ifyouhavetheopportunity,placeinvestmentsthatgenerateahighleveloftaxableincomeintheprecedingexample,REITsintax-deferredaccounts!

Pre-LiquidationandPost-LiquidationReturnPriorto2003,stockdividendsintheUnitedStatesweretaxedattheordi-naryincomerate.Thiscreatedadisparityinthepotentialafter-taxreturnsbetweentwostocksofferingsimilaroverallresultswhentherewasamean-

ingfuldifferenceintheirdividendyields.Inthelasttwenty-fiveyearsorso,themaximumrateonordinaryincomehasfallenfrom50percentto35percent,andtherateonlong-termcapitalgainsfrom39.9percentto15percent.Inaddition,commonstockdividendyieldshavefallenfrom5percenttoapproximately1.6percent.Afewselectyearswereanalyzed


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TheSources andImpact ofTaxes on InvestmentReturns 19

tax-awaremanagerorinvestormustaskiswhetherthefeesarereasonableforthevaluethataparticularproductorservicecontributestowealthcreation.Thesadfactisthatinmanycasestheanswerisno,andweowe

ittoourselvesandtoclientstodeterminewhatmakesthemosteconomicsense.Withtheaveragefeesforcommonstockmutualfundsat1.5per-centperyearandindexfundsatorbelow0.2percent,FIGURE2.5suggeststhatfeesareaformoftaxationandthattheyreallydomatter.

Thefirstrowofinformationinthefiguresuggestsa0percentfeescenario,andyoumightthinkthemanagerisworkingforfree.Thefactisthatlargeindexportfoliosoftenputtheirsecuritiesoutforlendingtobroker-dealers,whichmaygeneratesufficientrevenuetocreate,ines-sence, close to a free orzero-cost proposition.Fees make it extremelydifficultfortheproduct-basedadviserdealingwithalimitednumberofofferingstocompeteinthetax-awarearenatoday.WhenyoulookatthelastrowinFigure2.5,itbecomesclearthatevenwithamildfront-endload,ittakesmanyyearsbeforethistypeofproductcancatchupwithitsno-loadcounterparts,unlessthefundisgeneratingextremelystrongpositiveresultsthroughsuperiorsecurityselectionthatislikelytogener-ateahighlevelofcapitalgains.Thisisespeciallytrueformilitaryperson-nel,whoareoftenapproachedbyadvisersextollingthemeritsofusing

front-end-loadedfundsanddollar-costaveragingintothemarketoveranextendedperiodoftime.Theunderlyinglogicofthesesystematicsav-ingsplansissound,sinceoverseasdeploymentsmakeitparticularlychal-lengingformilitarypersonneltomanagetheirfinancialaffairs.However,whentheproductisnottax-efficient,themilitaryinvestorwithlimited

Source:DouglasS

.Rogers

FIGURE2.5 TheImpactofFeesonAfter-TaxReturns

FRONT FEE ONEYEAR TWENTYYEARSLOAD RATE PRE-LIQ. POST-LIQ. PRE-LIQ. POST-LIQ.

None 0.0% 9.47% 6.82% 9.04% 8.63%

None 0.2% 9.26% 6.61% 8.82% 8.41%

None 0.5% 8.94% 6.30% 8.50% 8.09%

None 1.0% 8.42% 5.77% 7.97% 7.54%

None 1.5% 7.89% 5.25% 7.43% 7.00%4.5% 1.0% 3.54% 1.01% 7.72% 7.30%


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Readers,especiallythoseintheinvestmentmanagementcommunity,wereshockedtodiscovernotthatonly21percent(15outof71)fundsbeattheVanguard500IndexFundonapretaxbasisbutthatonly13percent

(9outof71)outperformedonanafter-taxbasis,oncetaxesoncapitalgainsanddividenddistributionswereaccountedfor.Thismethodofcal-culationisnowknownasthepre-liquidationmethodology,asthetaxontheunrealizedcapitalgainorlosspositionisnottakenintoaccount.Sincelarge-capitalizationstockindexfundshaveverylittleturnoverintheirhold-ings, capital gainsdistributions are primarilyattributable toshareholderactivityormergersandacquisitionsthatareconsummatedasataxablecashtransactionratherthanasatax-freeexchangeofshares.Therefore,allelsebeingequal,indexfundsarelikelytohavegreaterembeddedunrealized

capital gainspositionsthanactivelymanagedfundsthatareconsistentlygeneratingcapitalgainsthroughthesaleandpurchaseofindividualsecu-rities. Evenwith the mostconservativepost-liquidationcalculationonly17percent(13out71)ofthefundsoutperformedtheVanguard500IndexFundonanafter-taxbasis.

OfthethirteenmutualfundsthatoutperformedtheVanguard500IndexFundonanafter-taxbasis,onlytwodidsobyameaningfulmargin(see FIGURE3.2).TheseweretheCGMCapitalandFidelityMagellan

fundsmanaged bylegendarymanagersKenHeebnerand PeterLynch,respectively.ThehelmofFidelityMagellanhaschangedhandsseveraltimessincePeterLynchmanagedthefund,butneitherfundhasrepeated

FIGURE3.2 Ten-YearPretaxandAfter-TaxGrowthofDollarsInvestedinVariousMutualFunds(19821991)

CGMCapital

Magellan

Closed-EndIndex500

Vanguard500Index

10

9

Dollars

8

7

6

5

4

3

2

1

Pretax

Aftercapitalgainstax

Aftercapitalgainsanddividendtax

Afterdefferredcapitalgainstax

Windsor

Source:RobertH.

JeffreyandRobertD.

Arnott,

IsYourAlphaBi

gEnough

toCoverItsTaxes?JournalofPortfolioManagement(Spring19

93)


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Reviewofthekeyarticlesontax-awareinvestinghighlightsfourimpor-tantfactors.First,changeinthefinancialmanagementindustryrequiresavision.BothTadJeffreyandCharlesSchwabaddressedanissuethatothers

ignored.Throughtwodecadesofpersistenceandinteractionwithcount-lessprofessionalsJeffreyshouldbedesignatedasthefatheroftax-awareinvesting,and due tohis financialsupportCharlesSchwab beknownas the godfather of tax-aware investing.The second point is it oftentakesgiftedindividualstocommunicatethedreamsofothers.Therefore,weneedtobethankfulthatRobArnott,JohnShoven,andJoelDicksonrecognizedtheissueandwereabletocommunicatetheirconclusionsinamannerthatallowedpractitionersandinvestorstotakeaction.Third,thecontentofmaterialsavailabletotheinvestorwillcontinuetoimproveas

needsareaddressedbyserviceprovidersandregulators.Todemonstratehowtheindustryhasprogressed,refinementsintheMorningstarPrincipiadatabasenow allow individual investors toconduct theirown after-taxmutualfundanalysiswhichwouldrivalthepioneeringworkdonebyresearcherswithadvanceddegreesonlyadecadeagoonalmostanyas-setclassinamatterofminutes!Fourthandlastly,whilemoststockfundshaveunderperformedtheVanguard500IndexFundonanafter-taxbasis,itdoesnotmeanallfundsshouldorwillunderperforminthefuture.

Sincewenowunderstandwhatcauseslacklusterafter-taxperformance,enlightenedpractitionersarenowofferingandcreatingdistinctiveservicesandproducts.However,compellingresultscannotbeachievedunlessin-vestorsortheirtrustedadvisersareabletoidentifythegrowingnumberofuniquelyqualifiedtax-awareprofessionalsinthemarketplacetoday.

ChapterNotes

1. GeorgeM.Constantinides and Myron S.Scholes, OptimalLiquidationofAssetsinthePresenceofPersonalTax,JournalofFinancevol.35,no.2(1980):439449;GeorgeM.Constantinides,CapitalMarketEquilibriumWithPersonalTax,Econometrica51(1983):611636;GeorgeM.Constantinides,OptimalStockTrading With PersonalTaxes: Implications for Prices and the AbnormalJanuaryReturns,JournalofFinancialEconomics,13(1984):6589;GeorgeM.Constantinides,OptimalBondTradingWithPersonalTaxes,JournalofFinan-cialEconomics,13(1984):299335.

2. InvestmentCompanyInstitute,MutualFundFactBook2004(Washington,

D.C.:InvestmentCompanyInstitute,2004),105.

3. RobertH.JeffreyandRobertD.Arnott,IsYourAlphaBigEnoughToCoverItsTaxes?TheActiveManagementDichotomy,JournalofPortfolioManagement(Spring1993):1525.


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SeminalResearch 31

4. RobertD.Arnott,PeterL.Bernstein,JohnC.Bogle,andJamesP.GarlandandRobertH.Jeffrey,indiscussionwiththeauthor,August30,September1,September2,andAugust4,2004,respectively.

5. RobertH.JeffreytoPeterO.Dietz,April26,1983.6. RobertH.JeffreytoJohnC.Bogle,May29,1985.

7. JohnC.Bogle,indiscussionwiththeauthor,September2,2004.

8. MorningstarPrincipia,June30,2004.

9. JoelM.Dickson,indiscussionwiththeauthor,September21,2004.

10. JoelM.DicksonandJohnB.Shoven,RankingMutualFundsonanAfter-TaxBasis,NBERWorkingPaperno.4393,NationalBureauofEconomicResearch,

July1993.

11. JoelM.DicksonandJohnB.Shoven,AStockIndexMutualFundWithoutNetCapitalGainsRealizations,NBERWorkingPaperno.4717,NationalBu-reauofEconomicResearch,April1994.

12. RobertD.Arnott,AndrewL.Berkin,andJiaYe,HowWellHaveTaxableInvestorsBeenServedinthe1980sand1990s?JournalofPortfolioManagementvol.26,no.4(Summer2000):8494.

13. DanielBergstresserandJamesPoterba,DoAfter-TaxReturnsAffectMutualFundInflows?JournalofEconomicsvol.63,no.3(2002):381414.


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experience, and providing professional references. Some of the profes-sional-designationcertificationprogramsalsohaveacontinuing-educationrequirement.Unfortunately,noneofthemadequatelytrainthebeginning

professionalintheareaoftax-awareofinvesting,butweaknessesincurricu-lumarebeingaddressed.Severalsupplementaleducationinitiativesareun-derwaytoimprovethecurriculumandtestingtoenhancethecapabilitiesofthetaxable-accountpractitioner.OneinitiativetheMay2004launchingoftheInvestorEducationCollaborativebyCharlotteB.BeyerandSusanRemmerRyzewicisextremelypromising,astheprincipalsinvolvedhaveextensivehands-onexperienceineducationfortheultra-affluent.8Inthemeantime,thesefiveprogramsservetheneedsofpractitionerswhofocusonthehigh-net-worthfamilyorindividualmarket:

AmericanBankersAssociation(ABA)PrivateWealthManagementSchoolThe school introduces seasoned relationship managers touniqueconsultativesalesapproachesfordeliveringfinancialservicestowealthyclients.Duringasix-dayresidentsession,studentsreceivein-termediate-levelinstructiononbuildingtheskillsnecessarytobecomeamorecompetentandproactiveadviser.Recognizedpractitionersandindustry experts assemble at the Duke University Fuqua School ofBusinesstoserveasfacultyandcounseltostudents.Twomodulesare

offeredoverconsecutiveyears.9

InstituteforPrivateInvestors(IPI)/WhartonSchoolPrivateWealthManagementProgramThroughclasslecturesandinteractivecase-work,participantscanincreasetheirdepthofknowledgeinkeyareasofwealthmanagement.Aspartofthecorecurriculum,theprogramplacesparticipantswithinafictitiousfamilywithworldwidebusinessesandinvestments.Duringasix-dayresidentsession,theymakedeci-sionsthatwillaffectthefamilyswealthforfuturegenerations. 10

InvestmentManagementConsultantsAssociation(IMCA)WealthManagement Certificate ProgramThis program teaches the toolsandtechniquesforcreatingandimplementingstrategicsolutionstothecomplexchallengesassociatedwithwealthyclients.Thecurriculumisdividedintothreephasesreflectingthenaturallifecycleofwealth.Studentsstudyassignedmaterials,completeonlinequizzes,andthenattendafulldayseminar.Itculminateswithatwo-daysymposium.11

New York University Certificate in Wealth ManagementThiscourseisdesignedtoenhancetherelationshipbetweenadvisersand

high-net-worth clients toachieve desired goals. The curriculum in-cludescorecoursespluselectivesthataddressinvestmentmanagement,alternativeinvestments,andwealthtransitionandtransfer.12 AmericanAcademyofFinancialManagementCharteredWealthManagerThe five-day program offers a core group of courses


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TheTax-AwarePractitioner 37

focusedonskillsforhigh-net-worthconsulting.Prerequisitesincludearecognizeddegree,aprofessionalcertification,andfiveyearsofre-latedindustryexperience.13

Schooling, certification, and supplemental education provide thefoundationofknowledge,buttax-awareinvestingasanartformisstillrelativelynew.Moreover,aswillbecomeobviousinthefollowingchap-ters,thecurriculumoftheprogramsnotedaboveusuallydonotcovertheapplicationoftax-awareprinciplestosecurityselection,portfolioman-agement,assetallocation,andlocation,astheysimplylackfacultywhoarequalifiedtoteachit.Additionally,onemustbecarefulaboutusingthetermswealthmanagement and high-net-worthclient.These terms

were previously reserved for clients with liquid financial assets above$100million.Withtheretailizationoftheinvestmentmanagementin-dustry,thesetermsareoftenusedbyoverzealousmarketersandfinancialplannersthatreflectanyopportunitywherethereareinvestableassets,nomatterwhatthemagnitude.Therefore,thetax-awarepractitionershouldseekeveryopportunityforself-improvementthroughavenuesthatwillallowforcontinualimprovementofthepractitionersskill.

InquisitivenessThetax-awarepractitionerknowsthatmanymarketsandindividualsecuri-tiesareinefficientlypricedwhentaxesareconsidered.Agreatdealoftrulyoutstandingworkhasbeendoneinthemoderneraofinvestingtodevelopwell-knowntheories,suchastheefficientmarkethypothesisandcapitalassetpricingequation,butinmostcasestheimpactoftaxeswasnotpartoftheprocess.Therefore,arbitrageopportunitiesareoftenavailableforthetax-awarepractitionerwho iswilling toquestionthe traditionalwisdomthatwasdevelopedfortax-exemptaccounts.Moreover,manyofthesecon-ceptsaresimpleandrequirenomorethanabackoftheenvelopeexpla-nation.Forexample,before2003,thetaxrateondividendsintheUnitedStateswasalmosttwicetherateforsecuritiessoldwithgainsheldtwelvemonthsormore.Letscreateascenariooftwocommonstocksthathavethelong-termpotentialtoproduceatotalrateofreturn,dividendsplusappre-ciation,of10percentperyear.AsFIGURE4.1shows,theresultsaresimilarforthestocksofthetwocompanies(AandB),withtheexceptionofhowmuchoftheirearningstheypaytoshareholdersindividends.

Investorswhoareconsideringthetwosecuritiesforatax-exemptac-countshouldbeindifferenttowhethertoholdstockAorB,astheyendupwiththesameamountofdollarsattheendofeachyear.However,letsseewhathappensifwestartwitha$100purchaseofbothstocksandsellthemafterone-,five-,andten-yearperiodswithdividendssubjecttoatax


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of39.6percentandlong-termcapitalstaxedat20percent,whichwasthecasenottoomanyyearsago(seeFIGURE4.2).

Again, we started with $100 invested in each stock. Dividends aretaxedeachyearat39.6percentandthedollaramountofthetaxhaircut

isdeducted.Fortheone-yearscenario,weassumetheholdingperiodisjustlessthantheamountoftimerequiredtoqualifyforthemorefavorabletaxrateonlong-termcapitalgains.Therefore,bothdividendsandappre-ciationfortheone-yearscenarioaresubjecttoataxrateof39.6percent.Inthiscase,regardlessofwhetherinvestorsholdstockAorstockBinatax-ableaccount,theyendupwith$106.04afterpayingfederaltaxes.Astimeincreases,weuncoverthepotentialofanarbitrageopportunitycreatedbyjusthavingarudimentaryunderstandingofthetaxcodeforindividuals.StockAhas3percent(4percentdividendyieldofstockAversus1percent

FIGURE4.2 TerminalDollarValueofTwoStocksWithDifferentDividendYields

(39.6%TaxonOrdinaryIncomeand20.0%TaxonLong-TermCapitalGains)

YEARS STOCKA STOCKB

1 $106.04 $106.04

5 $142.69 $147.27

10 $206.62 $222.04

FIGURE4.1 StocksofSimilarCompaniesWithDifferent

DividendYields

Appreciation

6%

Appreciation

9%

StockA StockB

Income4%

Income1%

Source:DouglasS.

Rogers

Source:DouglasS.

Rogers


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NewYorkUniversityInstituteonFamilyWealthManagement NMSManagement NuclearDecommissioningTrust(NDT)

RegionalandlocalprogramsarealsoarealsoofferedbytheCFA,FPA,andNAPFAorganizationsandtheirlocalchapters.TheNewYorkSocietyofSecurityAnalysts(NYSSA),alocalchapteroftheCFAInstitute,hasaccesstosomuchtalentitconsistentlyproduceshigh-caliberprogramsonaparwiththefinestnationalorganizations.Additionally,FinancialPlan-ningpublishesannuallyanextensivelistofbroker-dealerprogramsthatmaybeofinterest.Thekeyhereistobuildanassociationwithorganiza-tionsandindividualsthatbestsuittheneedsoftheclientsyouserveand

tostayintunewithinnovativedevelopments.

Patience

Toaccomplishsuperiorresultswithtaxableaccountstakestimeandpatience!Someonewhohasadaytradersmentalityandwantstobeasuccessfultax-awarepractitionerwillhavetoattaintheself-disciplinenecessary.Therearenoshortcutshere,andthatiswhyitissodifficulttoeducateindividualsonthebenefitsoftax-awareinvestmentmanagementwhenforyearstheymay

havebeensubjecttoatransaction-orientedarrangement.A1to2percentenhancementinperformanceisnotoutofthequestionwhenapplyingtax-awareprinciplesandconcepts.14Thisincrementmayinitiallyseeminsignifi-canttosomeindividuals,butthelong-termbenefitoftax-awareinvestmentmanagementismeaningful,ashighlightedinFIGURE4.3.

Wewillstartwithaportfolioof$10,000.Obviously,mostclienttax-ableportfoliosaremuchlarger,but thisamount isused for thesakeofsimplicity. For an initial $10,000 investment, the benefit of tax-awaremanagementinthefirstyearis$100to$200andmayatfirstappeartobehardlyworththeeffort.However,astheinvestmenthorizonincreasesandthebenefitcompounds,thetotaldollarbenefitbecomesmoremeaningful.Notethatwitha2percentannualbenefit,assetsdoubleinvalueinslightlymorethanthirty-fiveyears.Thatmayseemlikealongtime,butitiscer-tainlynotanunreasonableoneforyoungprofessionalsjustoutofcollegeenteringthe workforce who areestablishing asavingsplanorfor long-termtrusts.Moreover,thisisnotjustanexerciseforthewealthy.Failingtoachieveoptimalresultsmostlikelywillnotdisruptthelifestyleofwealthy

people,butitcouldmeanthedifferencebetweenenjoyingretirementandhavingtoworkforafewadditionalyearsforaverageindividualinvestors.Toanalyzeaspecificsituation,simplydividethesizeoftheclientportfolioby$10,000andmultiplytheresultbythelevelofbenefitfromthetable.Forexample,ifyouhavea$1millionportfolio,andthelevelofbenefit


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TheTax-AwarePractitioner 41

youestimateis2percentoverfortyyears,multiply100($1,000,000/$10,000)by$12,080toarriveatanestimatedbenefitof$1,208,000.Re-member,fortaxableaccounts,compoundingtax-freeisabeautifulthing.Some professionals even consideritthe equivalent ofgetting a tax-freeloanfromthegovernment!

Passion

Tax-aware practitioners are passionate about their craft. This passionbuildsovertime,becausetheyrealizetheyaredoingtherightthing.Manywilltakethetimetosharetheirwisdomandknowledgetofurtherthebodyofknowledge.Ariskinherentwithwritinganytextrelatingtotaxesisthataftersomeonehaslaboredforhourstocompleteit,amajorchangeinthetaxcodecanrenderitobsolete.Therefore,itisimportanttoidentifysourcesofinformationthatexplainconceptsandmethodsinad-ditiontothosethatsuggestaparticularstrategythatmaycomeaboutorchangewiththedynamicsofthetaxcode.Anotherchallengeforresearchontax-awareinvestingisthatinformationonpretaxreturnsforsecurities

andassetclassesisfarmorereadilyavailablethaninformationonafter-taxreturns.Perhapsthegreatestchallengeforeducationrelatingtotaxableaccountsingeneralistryingtoobtainfunding,becausethegroupthatbenefitsthemostfromtheprocessistypicallywealthyindividuals.Asonewell-knownpractitionerintheindustryputit,Ifyouaskawealthy

FIGURE4.3 DollarBenefitofTax-AwareInvestmentManagement

(BeginningWith$10,000) LEVELOFBENEFIT

YEARS 1% 2%

1 $100 $200

10 $1,046 $2,190

20 $2,202 $4,859

30 $3,478 $8,114

40 $4,889 $12,080

50 $6,446 $16,916

Note:At2%growth,theprincipalamountdoublesinslightlymorethan35

years.

Source:DouglasS.

Rogers


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individualorcharitableorganizationtofundacharitablecausefortheless-privilegedinadistantlandtheycanrelatetotheneed,butaskingthemtofundanefforttoteachthosewhoarealreadyconsideredtobe

privilegedsimplydoesnotresonatewiththem.Thepointhereisthatthoseofusintheindustryandourclientsarealreadydoingwell,solim-itedresourcesshouldbesharedwiththosethathavethegreatestneed.Manyjournalsaresupportedbythecertificationprogramsmentionedearlier.Whatfollowsisalistofthebest-knownjournalsandperiodicals.

Advisor AmericanBankersAssociationTrustsandInvestments WealthManager FinancialAnalystsJournal FinancialPlanning FinancialServicesReview InvestmentAdvisor JournalofAccountancy JournalofFinancialPlanning JournalofInvesting JournalofInvestmentConsulting JournalofPortfolioManagement

JournalofWealthManagement Monitor PrivateAssetManagement Trusts&Estates

ThemostprestigiousjournalwithinacademiccirclesisFinancialSer-vicesReview,editedbyConradS.CiccotelloofGeorgiaStateUniversity.Theonemostfocusedontax-awareinvestmentmanagementissuescur-rentlyisJournalofWealthManagement.Itseditor,JeanC.Brunel,anin-fluentialauthorandspeakerintheultra-affluentmarket,hasbeenabletoattractnoteworthysubmissionsfrommanyof thewell-knownpractitio-nersyouwilllikelyencounteratnationalandregionalconferences.

Thefollowingthreebooksshouldbeinthelibraryofanyoneattempt-ingtounderstandtaxable-accountinvestingandarerecommendedfortheprofessionalabilityoftheirauthors.

IntegratedWealthManagement,byJeanL.P.Brunel(InstitutionalInvestorBooks)Presentsthenewparadigmofwealthmanagement

forultra-affluentclients. WallStreetSecretsforTax-EfficientInvesting, byRobertN.GordonwithJanM.Rosen(BloombergPress)Offersaworkingknowledgeoflittle-knownacceptedmethodstoefficientlyconducttaxabletrans-actions.


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CreatingtheTriumvirateofQualifiedProfessionals 49

ationand personalchemistrybetweenthe client and each professional.Whileallpartiesmaynaivelybelievetheyserveasthetrustedadviser,thetruedesignationisultimatelyawardedtotheprofessionalthatearnsthe

clientstrustwiththemostsensitivematters.Unfortunately,thetermtrustedadvisermaybeusedasamarketinggimmickwithoutunderstandingthetruemeaningandsignificanceofthedesignation.DavidH.Maisteroutlinesinhisbook, TheTrustedAdvisor,thehierarchyofclient/providerrelationships,shownin FIGURE5.2.1Hethenliststhevariouscharacteristicsoftherelationshiplevelsinatable(seeFIGURE5.3).

AsFigure5.2suggests,establishingtruststandsatthepinnacle,aboveprovidingeducation,solvingproblems,andgeneratingideas.Trustisnot

somethingthat is immediately achieved; it grows over time. Moreover,itcannotbeachievedsolelywithinthephysicalconfinesoftheserviceorganization,asinteractionwiththeclientismandatory.Itmayalsocrossthe fine line fromdevelopinga professional relationship toa long-last-ingfriendship.Fromanethicalstandpoint,developingtrustcanbestbeachievedbydoingwhatisrightfortheclient,whichmayinvolveoffer-ingsolutionsthatforgoimmediateprofitsinordertodevelopamutuallyrewarding,long-termrelationship.

Whyistheconceptofthetrustedadvisersoimportanttotax-awareinvestmentmanagement?Forthesimplereasonthatiftheadviserdoes

FIGURE5.3 CharacteristicsofRelationshipLevels

ENERGY CLIENT INDICATIONS FOCUSON SPENTON RECEIVES OFSUCCESS

Service- Answer, Explaining Information Timely,Based expertise, high-quality

input responses

Needs-Based Business Problem Solutions Problems

problem solving resolved

Relationship- Client Providing Ideas Repeat

Based organization insights business

Trust-Based Client Understanding Safehaven Varied individual theclient forhard e.g.,creative

issues pricing

Source:DavidH.

Maister,TheTrustedAdvisor(NewYork:Touch

stone,

2001),910


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CreatingtheTriumvirateofQualifiedProfessionals 51

usinginternalproducts,suchastradingthroughthefirmsbroker-dealer,whichmaycreatepotentiallayersofhiddencosts.

Likemarriages,relationshipsbetweenclientsandtheirprovidersdo

not always last until death. When clients have security positions withsubstantialunrealizedgains,thedecisiontoendtherelationshipcanbecostly.Therefore,itisimportantfortheinvestorseekingtaxable-accountservicestoconsidernotonlytheinconveniencebutespeciallythefinan-cialconsequences ifitbecomesnecessary for any reasontoterminate arelationship.Withanondiscretionaryplatform,theadvisory,custodial,andmanager/fundservicesareusuallymodularandcanbereplacedsepa-rately.Replacingaparticularelementmayrequiretimetoselectanotherproviderandattentiontodetailtotransfertheresponsibility,butifthe

transition is conducted with new providers that appreciate and under-standtax-awareinvestmentmanagement,thetimeanddisruptioncanbeminimal.Atransferofassetsinkindofexistingsecuritypositionstonewmanagerswithoutsellingwillallowthenewteamtodowhatisbestfortheclient.Ifdoneproperly,itmaytaketax-awareportfoliomanagersayearormoretomakethetransitiontotheirmodelportfolio.However,withthediscretionaryplatform,especiallywhenproprietyproductsare involved,clientswillbeforcedtoliquidatealltheholdingsandbeginanewifthere-

lationshipisterminated.Nondiscretionaryplatformscanbeagoodfitforcertainclientprofiles.However,investorsthatchoosethemneedtohaveamuchhigherdegreeofconfidenceinthesoundnessoftheirdecisionmak-ingthaninvestorsselectingdiscretionaryplatforms.

With the proliferation of high-net-worth individuals, as a result ofwealthcreatedduringthelatterhalfofthe1990s,thenumberoffirmsem-ployingnondiscretionaryserviceplatformsalsoproliferated.Theprimaryreasonisthatittakesanextremelyexperiencedinvestmentprofessionaltocarrythesophisticatedrelationshiprequiredforadiscretionaryplatform,andthesupplyislimited.Thissituationgetsevenmorechallengingwhenthe client desires exposure to alternative investments. Therefore, manyfirmshavenochoiceinwhatplatformtheyoffer.Asaresult,individualsseekinganindependentdiscretionaryplatformwilllikelydiscovertheirnicheisservedbyonlyasmallnumberoffirms.

Thepotentialofaparticularplatformtoachieveatax-awaresolutiondependsonthe abilitytosatisfythe fourcriticalelementsoftax-awareinvesting:

1 Utilizingafter-taxassumptionsintheassetallocationprocess2 Allocatingassetclassesandmanagers/fundsaccordingtothechar-

acteristicsofeachinvestmententity3 Positioningtax-awareequitymanagers4 Identifyingtax-awaremanagers/funds


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P A R T T W O

55

Alltaxesareadragoneconomicgrowth.Itsonlyaquestionofdegree.

AlanGreenspan

After-TaxReportingandMeasuresof

TaxEfficiency


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58 After-TaxReportingandMeasuresofTaxEfficiency

berofcommentscamefromvisitorstotheMotleyFoolwebsite.Theweb-siteseducationinitiativewascertainlynotfoolishwithregardtotax-awareinvestmentmanagement,andvisitorswereencouragedtorespondtotheSECinsupportof theproposal.However,severalprofessionalorganiza-tionslobbiedtooverturnthestandardsevenaftertheyweresignedintolawbyPresidentClinton.Inspiteofthesechallenges,U.S.SecuritiesandExchangeCommission,FinalRule:DisclosureofMutualFundAfter-TaxReturns,SectionII.D,cameaboutonApril16,2001.Readerscanobtainacopyofthemutualfundafter-taxstandardsbyvisitingtheSECswebsite(www.sec.gov). This document should certainly be part of the libraryofanyprofessionalwhointeractswithtaxableinvestorsholdingmutualfunds.

AperformancedisplayfromanactualfundreportfortheVanguard

Tax-Managed Growth and Income Fund for periods ending June 30,2004,willhighlightseveralkeypointsaboutthestandards(see FIGURE6.2).Ithasanenviablerecordofnothavingmadeanycapitalgainsdistri-butionssinceitsinceptionin1994. 3Thisfundwasselectedforillustrativepurposes,notasanendorsementoftheproduct.

Source:InvestmentCompanyInstitute,

2004MutualFundFactBook(www.ici.org).Reprinted

withpermission.

FIGURE6.1 CapitalGainDistributionsPaidbyMutualFunds,

19962003(billionsofdollars)

100

1996

53

30

17

183

1997

97

60

26

238

1999

143

68

27

326

2000

194

95

37

165

1998

97

49

18

Tax-DeferredHouseholdAccounts*

TaxableHouseholdAccounts*

Non-HouseholdAccounts

16

2002

952

69

2001

49

14 6

14

2003

753

*Householdsaredefinedtoexcludemutualfundassetsattributedtobusinesscorporations,financial

institutions,nonprofitorganizations,fiduciaries,andotherinstitutionalinvestors.

Note:

Componentsmaynotaddtothetotalbecauseofrounding.


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MutualFundAfter-TaxReporting 59

ThefigureshowsthetwodifferentmethodsrequiredbytheSECforpresentingafter-taxreturnsinalogicalprogressionthatbuildsonthebe-fore-taxreturns.Thefirstrow,ReturnBeforeTaxes,isthesameinfor-mationrequiredfordisplayingpretaxreturnsandincludestheimpactoffees.Thesecondrow,ReturnAfterTaxesonDistributions,takesintoaccountonlythetaxesonincomeandcapitalgainsdistributions.Asmen-tionedinchapter3,thisisknownasthepre-liquidationmethodologyforcalculatingafter-taxreturns.Thethirdrow,ReturnAfterTaxesonDistributionsandSalesofFundShares,isknownasthepost-liquidationcalculationmethodology.

Bothcalculationmethodologiesprovideusefulinformation.Togethertheyallowthetaxablemutualfundinvestortomakebetter-informedin-vestmentdecisions.Therearecaseswhereonecalculationmethodology

or type of after-tax return is more appropriate than the other. Forex-ample,thepre-liquidationafter-taxreturninformationisappropriateforindividualswhowilltakeadvantageofthestep-upinbasisatdeath.Forsomeonewhoisrebalancingaclientsassetallocation,thepost-liquidationmethodologyismoreappropriate,becauseittakesintoaccounttheimpact

FIGURE6.2 SampleDisplayofMutualFundAfter-TaxReturn

Reporting

VanguardTax-ManagedGrowthandIncomeFund

AverageAnnualTotalReturns*

PERIODSENDEDJUNE30,2004

SINCE

ONEYEAR FIVEYEARS INCEPTION**

ReturnBeforeTaxes 17.86% 2.16% 11.06%

ReturnAfterTaxeson

Distributions 17.58 2.56 10.76

ReturnAfterTaxeson

DistributionsandSalesof

FundShares 11.95 2.04 9.77

*Allfundreturnsareadjustedtoreflectfees.EachoftheVanguardTax-ManagedFundsassessesa2

percentfeeonredemptionofsharesheldinthefundforlessthanoneyearanda1percentfeeonre-

demptionsofsharesheldinthefundforatleastoneyearbutlessthanfiveyears.

**InceptiondateisSeptember6,1994.

Source:Va

nguardGroup,

VanguardTax-ManagedFundsSemiannualReport,

June30,

2004,

19.


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itwasanAIMRSubcommitteerecommendation,theSECultimatelyde-cidednottorequirethepercentageofunrealizedgainsorlossesintheperformance display.4 With taxable accountsin contrast to the tax-

exemptaccountarenawhatthefundhasdoneinthepastinfactcananddoeshaveasignificantimpactonfutureafter-taxreturns.Tohigh-lightthispoint,recallthatinvestorsinthelatter1990swereconcernedabouthowtoavoidequityfundswithsubstantialunrealizedcapitalgainspositions, which reached 50 percent of total assets or more for large-capitalization,growth-orientedstylefunds.Forexample,theStagecoachEquityFundIndexAFundhadanunrealizedgainpositionof70per-cent!5Somepractitionerseventhoughtfundswithlargeunrealizedcapi-talgainspositionsshouldhaveincludeda warninglabel,similartothe

oneonapackofcigarettes,statingthatinvestinginthemcouldresultindetrimental taxconsequences.Thesituationbecamesuch aconcernin1999that somefund groupscontemplatedopeningvintageyearindexfundsfortheirtaxableinvestors.Bythespringof2003thependulumhadswungtotheoppositedirection,andafterthreeyearsoflossestherewasanopportunitytopurchasefundswithsubstantialembeddedunreal-izedlosses.Whilethepercentageofunrealizedcapitalgainsembeddedinafundislimitedto100percentofassets,thepercentageoflossescanbe

greaterthan100percent.Thisoccurswhenfundmanagerssellsharesandlossescannotbepassedthroughtoshareholders,becauseoftheaccount-ingconventionthatfundsmustapply.Iftheredemptionsaresignificantandthemanagermustsellsharesbelowcost,theamountoflossesindollarscanexceedtheremainingassetsinthefund.AsofJune30,2004,therewereapproximately5,900mutualfundsonMorningstarPrincipiathatshowedanegativepercentageofunrealizedcapitalgainswithafewcloseto1,000percent!6Adviserscanaddmeaningfulvaluefortheircli-entsbyconsideringthepercentageofunrealizedcapitalgainsofpossiblefundalternativeswhentheymakepurchaserecommendationsforthetax-ableportionofassets.Giventwofundsthatareequalineverydimensionexcepttheunrealizedcapitalgainsposition, the tax-awareinvestorwillalwayschoosetheonewiththeleastamountofunrealizedgainsorgreat-estamountofunrealizedlosses.Aswewillseelaterinthischapter,theaccounting convention lends itself to arbitrage opportunities, or whatsomemayconsiderafreelunch.

Fortunately for the taxable investor, information pertaining to the

percentageofunrealizedcapitalgainsorlossescanbeobtainedfromaMorningstarInvestmentDetailReport(againusingtheVanguardTax-Managed Growth and Income Fund as an example).7As FIGURE 6.3shows,thisparticularfundhadaninternal+6percentunrealizedcapitalgainsposition.Thispercentagechangeswiththemarketvalueofsecuri-


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each individualan annualdeductionfromcapitalgainsdistributions.11Also, Congressman Paul Ryan has introduced legislation (H.R. 1989)thatwouldrequireindividualstopaytaxesoncapitalgainsonlywhen

theysellfundshares.12

Bothproposalsareintendedtomakethingseasierformutualfundinvestors.However,whatisoftenignoredisthatthesebillswouldonlyexacerbatetheproblemofportfoliomanagersignoringtheimpactoftaxes.Moreover,aswewilldiscoverinchapter9,therearealreadyfreemarketsolutionsthathavesolvedthisissue.Unfortunately,tax-awaresolutionsdonotvoteandtheshareholderswhousethemstillrepresentasmallportionofthemarket.IfCongressreallywantstopro-videinvestorswithameaningfulchange,itshouldchangetheaccountingconventionformutualfundstoallowlossestoflowthroughtoinvestors.

Itmaytakeseveralyears,ifever,forafundmanagertotakeadvantageofthelossposition,whereasindividualinvestorsmaybeabletoapplythemimmediatelysincetheytypicallyholdmultiplefundsandportfolioswheregainscanbetaken.

Theactualafter-taxreturnsforindividualswhoinvestindollar-costaveragingprogramsorreinvestfunddistributionscanbequitedifferent,dependingonwhataccountingconventiontheypersonallyapply.Therearethreeprimaryaccountingconventionsthatinvestorsandtheiradvisers

shouldbeconcernedwith: Firstin,firstout Specificlotidentification Averagecost

TheIRSallowsinvestorslatitudeinchoosingtheirpreferredmethod.Theaveragecostmethodistypicallythedefaultmethodusedbycustodi-ans.Therefore,ifyoudesiretoapplyoneofthefirsttwoconventions,youneedtomakeanelectionbeforetransactionsareaccountedforbytheaver-agecostmethod.Theparticularaccountingconventionappliedcanhaveasignificantimpactontheamountoftaxesthatwillbepaidinanyyear.Itwillnotchangethedollaramountofcapitalgains,butitcanchangeorshiftthetaxliabilityconsiderably.Thiscanbeseeninthefollowingexam-ple,usingmonthlypricesfromtheVanguard500IndexFundin2003.13TheinvestorstartswithaninitialpurchaseinJanuaryof$3,000tosatisfytheaccountminimumandmakesadditionalpurchasesineachofthenextsevenmonthsforatotalinvestmentof$10,000(seeFIGURE6.8).

Duringthistimeframe,themarketbottomedinthespringandralliedstronglyfortheremainderoftheyear.Eventhoughtheinvestorintendedtohavealong-terminvestmenthorizon,inDecemberheranintoasitua-tionthatforcedhimtosellthirtysharesatthepriceof$102.67.Hewillbe


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requiredto paytaxeson thetransactionatthefederalshort-termcapitalgainsrateof35percent.AsFIGURE6.9shows,thethreedifferentaccountingconventionsresultintaxobligationsrangingfrom$326.93to$709.85.

Firstin,firstout(FIFO)accountingismechanicalinnatureandprob-ablysatisfactoryforfixedincomefundswhereappreciationisusuallynotasignificantpartofthe totalreturn.AsFigure 6.9 shows, thirty shareswereusedtoestablishthecostbasisfromthefirstpurchase.Ifmorethan37.97sharesthenumberofsharesacquiredintheinitialpurchase,ortax lotweresold,itwouldbenecessary toexaminethe second-oldestpurchaseandcontinuetheprocessuntilsharesequalingtheamountofthesaletransactionwereaccountedfor.

Specificlotidentificationrequiresabitofextrawork,butthebenefitcanbewellworththeeffort.AsFigure6.9shows, thefirstlotchosenwastheonewiththehighestcostbasis,followedbythelotwiththenext-highestcostbasis,andsoonuntilatotalof30sharesisreached.Therefore, only 8.37 of the total 11.11 shares in tax lot 6 are used.

Theremaining2.74shareswillbeaccountedforduringafuturesaleofshares.Thismethodrequiresaccurateaccountingrecords.Theexampleaboveisquitesimpleanddidnotincludeanyreinvestmentofdistribu-tions.Toensurethattheyarekeepingadequaterecordsandadheringtoproperprocedures,taxableinvestorsandtheiradvisersshouldadoptthe

Source:DouglasS.

Rogers

FIGURE6.8 MutualFundAccountingConventionExample

DOLLAR PURCHASE ENDING PROFIT/ MONTH PURCHASE INVESTMENT PRICE SHARES VALUE LOSS

January 1 $3,000.00 $79.02 37.97 $3,897.87 $897.87

February 2 $1,000.00 $77.82 12.85 $1,319.33 $319.33

March 3 $1,000.00 $78.27 12.78 $1,311.74 $311.74

April 4 $1,000.00 $84.73 11.80 $1,211.73 $211.73

May 5 $1,000.00 $89.19 11.21 $1,151.14 $151.14June 6 $1,000.00 $90.02 11.11 $1,140.52 $140.52

July 7 $1,000.00 $91.59 10.92 $1,120.97 $120.97

August 8 $1,000.00 $93.36 10.71 $1,099.72 $99.72

December 10 $10,000.00 102.67 119.34 $12,253.03$2,253.03


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long-term capital gains.The FIFOmethod will most likely proveevenmorecostly,as itwould haveexpendedmostof the oldest lot withthegreatestamountofappreciationpersharetobetaxedat35percentandasmalleramountofcapitalgainsnowremainsintheportfolio.Thisex-ampledemonstratesthatitmaybeworththeadditionaltimeandexpensetouseanaccountingconventionotherthanaveragecostfortheparticulartypeoffundandthesizeoftheinvestment.

Thetaxactof2003maygodowninhistoryasthetaxbreaktheaverageindividualneverreceived! 15Mutualfundscansaveshareholderstaxesbyapplyingtheincometheyreceivefromdividendstooffsetfundexpenses. Prior to 2003, this worked to the advantage of the averageshareholder,asitdoesntmakesensetodistributeadividendandpaya38.6percent(themaximumfederalrateatthetime)taxonitwhenitcan

beavoided.However,whenthetaxonqualifieddividendswasreducedto15percent,manyholdersofactivelymanagedequitymutualfundsreceivedalmostnoneofthetaxbreak.Forexample,thefeeontheaverageactivelymanageddomesticstockiscurrently1.5percentandtheaveragedividendyieldisonly1.6percent.Sinceonly0.1percentoftaxabledivi-

FIGURE6.10 SampleMutualFundAccountingFormat

ACQUIRED1

SOLDOR REDEEMED

NUMBER COST ADJUSTMENTTO ADJUSTED2 NUMBER

MUTUAL DATE OF PER BASISPER BASISPER OF

FUND SHARES SHARE SHARE SHARE DATE SHARES

1Includesharereceivedfromreinvestmentofdistributions.2Costplusorminusadjustments

Source:InternalRevenueServicePublication564


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Alltoooften,theinvestorpaystaxesonthedistributionwhenreportedonForm1099-DIVandthenagainwhensharesaresold.Thus,thein-vestormayinadvertentlypaytaxesonthesameamountofcapitalgainstwice!This happens more frequentlythan most people realize, becausemanyfundshareholdersdonotunderstandtheaccountinginvolvedandfailtokeepgoodrecords.Thisbringsustothefollowingrulesofthumbformutualfundinvestors:

Besuretocheckwhenthefundsfiscalyearendsandtheamountofincomeandcapitalgainsdistributionsanticipatedbeforemakinganinvestment,soyouwillnotenduppayingtaxesonasignificantamountofcapitalgainsyoudidnotearn. Keepinmindthatwhennewinvestorsmakecontributionstoafundinarisingmarket,taxablegainsarelikelytobedistributedtoagreaternumberofshareholders,whichcanenhanceafter-taxreturns.Ontheotherhand,wheninvestorssellsharesinadecliningmarket,theportfoliomanagermaybeforcedtotakegains,tothedetriment

ofthedwindlingnumberofremainingshareholders. ConsiderwhetherspecificlotidentificationorFIFOisworththetimeandefforttoachieveapotentiallymoredesirableresultthantheaveragecostconventionofaccountingforgainsandlosses. Keepgoodrecordsofmutualfundpurchases,reinvestmentofdis-

Source:InternalRevenueService

FIGURE6.11 SampleIRSForm1099-DIV


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constitutedinthespringof2000,firsttorespondtotheSECproposalandthentoreviewtheexistingafter-taxstandardsforseparateaccounts.Ablue-ribbonpanelofexpertsinvariousrelatedfieldsvolunteeredcon-

siderabletimeandefforttorecommendrevisionstotheexistingAIMRafter-taxstandards.4LeePricewasagainasignificantcontributortothisprocessandasaresultshouldbeforeverknownasthefatherofafter-taxreporting.TheAIMRboardadoptedthemodificationstotheafter-taxstandardsonFebruary8,2003.Followingthisaction,theInvestmentPer-formanceCouncil (IPC)thenendorsedthe modifications onMarch 6,2003.WhileeffortsbytheSEC(inregardtomutualfunds)andAIMR(inregardtoseparateaccounts)havepavedthewayforafter-taxstandardsintheUnitedStates,itishopedthattheIPCwillsoonrespondwithaglobal

initiativesothatothercountriescanadoptappropriateafter-taxstandardswithrelativeeasebasedontheirrespectivetaxcodes.Thusfar,AustraliaandCanadahaveshowninterest.

After-tax standards for separate account reporting composites areoptional,asnotallfirmsmanagetaxableaccounts.TherevisionstotheexistingAIMRafter-taxstandardstookeffectJanuary1,2005.Firmsfo-cusedonservingtheneedsoftaxableinvestorshavetakenactionandhavealignedthemselveswithserviceproviderstoallowthemtoprovideafter-

taxreturnsforindividualaccountsaswellasforcompositeconstructionforuseinmarketingpresentations.FIGURE7.1isfromtheafter-taxprovi-sionsoftheAIMRPerformancePresentationStandards. 5

TobeincompliancewiththeAIMRstandardsforafter-taxreporting,fiverowsofinformationbeyondwhatisrequiredforbefore-taxreportingmustbeprovided.Theserowsareshadedintherequiredsectionofthetemplate.

Therearealsothreeadditionalrowsofrecommendedinformationthatmaybeprovidedifafirmbelievesitcanaddvaluebeyondtheman-datory elements.The first item, adjusting for nondiscretionarycapitalgains,isintendednottopenalizethemanagerforarequesteddistribu-tionfromanaccountthatisbeyondthemanagerscontrol.Thistypeofrequest frequently happens with high-net-worthfamilyaccounts whenthereisaneedtopaytaxesorfundamajorpurchase,suchasbuyingasecondhome.Whentheportfoliomanagerrespondstoarequesttoliquidatefundsofthisnature,despiteattemptstominimizetheimpactoftaxes,inevitablysomegainswillberealized.Sincethismeasurecan

onlyworktotheadvantageofthefirm,itispossibleforthemanagertogamethesituationbyclassifyingcertaingainsasnondiscretionarythatperhapsarenot.Inallinstances,theportfoliomanagershouldworktothebenefitoftheclientandincludeonlythosegainsthataretheresultofspecificrequests.Foradetaileddiscussiononthistopic,seeCalcula-


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SeparateAccountAfter-TaxReporting 79

tionandReportingofAfter-TaxPerformancebyLeeN.Price6andtheInterpretativeGuidancesectionoftheAIMRStandards.7

Thenextrecommendeditemofinformationistheafter-taxbenchmarkreturn.Currently,thereisnocentraldepositoryforafter-taxreturnsonthe

FIGURE7.1 SampleAIMR-PPSCompliantPresentation

foranAfter-TaxComposite

XYZU.S.EquitiesAfter-TaxComposite

2004 2005 2006 2007 2008

REQUIRED(IFCOMPLIANTWITHAIMR-PPSSTANDARDSANDSHOWINGAFTER-TAXPERFORMANCE)

After-TaxTotalReturn(%) 21.99 31.03 25.02 22.02 6.17

After-TaxCompositeDispersion(%) 3.1 5.1 3.7 3.2 2.4

Before-TaxTotalReturn(%) 24.31 34.02 27.33 24.03 8.44

Before-TaxBenchmarkTotalReturn(%) 22.95 33.35 28.58 21.04 9.01

Before-TaxCompositeDispersion(%) 2.9 3.3 2.6 1.8 1.5

%ofUnrealizedCapitalGains

toCompositeAssets 9 25 37 43 19

%ofTaxablePortfoliosIncludedin

BoththeU.S.EquitiesAfter-Tax&

Before-TaxComposites 75 78 81 79 82

Dollar-WeightedAnticipatedTaxRate 44.2 44.3 44.5 44.1 43.9

NumberofPortfolios 26 32 38 45 48

TotalAssetsatEndofPeriod(U.S.$millions) 165 235 344 445 420

PercentageofFirmAssets 33 36 39 43 37

TotalFirmAssets(U.S.$millions) 500 653 882 1,035 1,135

RECOMMENDED

After-TaxReturnAdjustedfor

Non-DiscretionaryCapitalGains(%) 21.99 31.07 25.25 24.12 5.99

After-TaxBenchmarkReturn(%) 21.78 32.05 27.78 20.21 9.37

PercentageBenefitfromTaxLoss

Harvesting 0.00 0.00 0.00 0.00 3.51

Source:AIMR/CFAInstitute


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purchaseataxablebondiftheinitialafter-taxyieldtomaturityisgreaterthanthereturnfromatax-exemptbondofsimilareffectivematurity.Intheseinstances,applyingthemaximumfederaltaxratefortheclienttype

wouldresultinafter-taxreturnsthatwouldnotreflectthemanagersabilitytoaddvalue.Third,firmsthatwerecalculatingafter-taxreturnsdiscoveredthat their performance measurement professionalswere actually calcu-latingand maintainingtwo separateafter-tax returnsfor each account,andtheamountofworkrequiredtodothiswassimplyoverwhelming.After-taxreturnsusingthemaximumfederaltaxratewerebeingusedforcompositepurposes,yetclientswereprovidedinformationusingthepre-ferredanticipatedtaxrates,whichweremoreinlinewiththeiractualexperience.Sincethereisadeductionatthefederallevelforthepayment

ofstateandlocaltaxes,theanticipatedtaxrateislessthanorequaltothesumwhenmorethanonerateisconsidered.Theformulatocalculatetheanticipatedtaxrateis:

TRanticipated=TRfederal+(TRstate[1TRfederal]) +(TRlocal[1TRfederal]),

whereTRstandsfortaxrate.Iftheclientissubjecttoa35percentfed-

eraltaxrate,10percentstatetaxrate,anda2percentlocaltaxrate,thentheanticipatedtaxrateisequalto42.8percentasshownbelow:

35%+(10%[135%])+(2%[135%]),or 35%+(10%0.65)+(2%0.65),or 35%+6.5%+1.3%=42.8%

Theseratesshouldbemaintainedforeachclientportfoliointhecom-posite.Inreality,theclientsactualtaxratewillbeacombinationoftheanticipatedtaxratesforordinaryincome,short-termcapitalgains,quali-fieddividends,andlong-termcapitalgains.Tocomeupwiththismorepreciseweightedratewouldbeextremelytime-consuming.Besides,thetaxinformationforseparateaccountsislot-specific.Therefore,useoftheanticipatedtaxratebasedontherateofordinaryincomeatleastgivesthereviewerofthecompositeinformationaframeworkastohowinvestmentdecisionsmayhavebeenaffectedbytheleveloftaxation.Therearelegiti-matecases,likewraprelationships,wheretheclientdoesnothaveaccess

tothisinformation.Intheseinstances,usingthemaximumfederaltaxisacceptableandshouldbeencouraged.

Advocatesofusingthemaximumfederalratesclaimthatuseoftheanticipatedtaxdoesnotfacilitatecomparingafter-taxresultsofmultiplemanagers.Thisimpliesalevelofaccuracythatissimplynotobtainableor


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exhibitsarepartofthequarterlycommuniquthatParametricsendseach

ofitsseparateaccountclients.ThePortfolioPerformancesectionofthecommuniqustartswithpretaxandafter-taxcomparativeresultsagainstanappropriatebenchmarkforthecurrentquarter,year-to-date,andsinceinceptionoftheaccount(Figure7.2).Thiscanbeviewedastheincomestatementofthereport.Inthecolumnlabeledyeartodate,youcanseethattheportfoliolaggedtheperformanceoftheS&P500by0.5percentbeforetaxes,butitoutperformedonanafter-taxbasisby1.0percent.Thishighlights the potential ofa tax-lossharvesting strategy, which ispara-mounttothesuccessofParametricandotherfirmsfocusedonthisnicheof the market. Note that the since inception annualized value-addedfrom the process is+2.5percent (4.1 percentafter-tax return for Para-metricascomparedto1.6percentfortheS&P500).ThisexampleisforperiodsendingDecember31,2003.ItshouldbenotedthatParametricisoneofthefewfirmsthatattemptstocalculatetheactualafter-taxreturnforacomparativebenchmarkportfolioofsecurities.Todothisproperlyrequiresrunningbenchmarkportfoliosforthedifferentinceptiondatesforallaccountsundermanagement.

ThePortfolioValuesectionhighlightsthebalancesheetoftheaccountfromataxaccountingperspective(Figure7.3onthefollowingpage).Asshown,theportfoliohaslessthan0.2percentinunrealizedlosses.Thistellstheclienttwothings.First,Parametrichasbeendiligentintax-lossharvesting.Second,unlesssomeoftheholdingsfallsignificantlyinprice

FIGURE7.2 PortfolioPerformanceIncomeStatement

ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport

FOURTH YEARSINCEINCEPTION(10/23/1998) QUARTER TODATE CUMULATIVE ANNUALIZED

PretaxPerformance

Portfolio 11.7% 28.2% 13.3% 2.4%

Benchmark 12.2% 28.7% 11.9% 2.2%

After-TaxPerformance

Portfolio 11.6% 29.4% 23.4% 4.1%

Benchmark 12.1% 28.4% 8.5% 1.6%

Source:ParametricPortfolioAssociates


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during the months ahead there will be less opportunity to add valuethroughtax-lossharvestinginsubsequentperiods.

TheIncomeandRealizedGainssectionofthecommuniquservesasthecashflowstatementofthereport(Figure7.4).TheParametricformataddressesthethreekeyareasessentialtotaxplanningforacommonstockportfolio:dividendincomeandnetrealizedshort-andlong-termcapital

gains.Bytrackingtheyeartodatecolumn,membersofthequalifiedtriumvirateservingtheclientareabletomakebetter-informeddecisionsastohowthenetlossescanbemosteffectivelyutilized.Additionalinfor-mationcanbeprovidedtohighlightthecriticalportfoliocharacteristicsthatreflecttheparticulartypeofstrategy.ForafirmlikeParametricthat

FIGURE7.4 IncomeandRealizedGainsCashFlow

StatementParametricPortfolioAssociatesSampleQuarterlyPerformanceReport

INVESTMENTFLOWS FOURTHQUARTER YEARTODATE CUMULATIONS

DividendIncome $13,751 $49,402 $196,860

NetRealizedGains

ShortTerm 0 $73,784 $555,053

LongTerm 0 $26,458 $287,224

FIGURE7.3 PortfolioValueBalanceSheet

ParametricPortfolioAssociatesSampleQuarterlyPerformanceReport AT12/21/03

MarketValue $3,366,382

CostBasis $2,283,892

UnrealizedGains

ShortTerm $152,440

LongTerm $934,995

UnrealizedLossesShortTerm $660

LongTerm $4,286

Source:ParametricPortfolioAssociates

Sou

rce:ParametricPortfolioAssociates


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hopestoreducetrackingerrortoadefinedbenchmark,itemssuchasthenumberofsecuritiesintheportfolioandsectorweightingsareimportant.Otherfirmsmaywishtofocusoncharacteristicssuchasdividendyield

andvaluationmetricstoemphasizeaparticularstyleororientation.Todevelopaclientperformancereportofthisqualityrequiresasignificantcommitmentofresourcesonthepartofthefirm,butlikeGratrywithitsafter-taxcompositeinformation,Parametricthoughtitwasworththeefforttohighlightthevalueofitsprocessanddemonstrateitsdistinc-tivecompetence withtheone document that is most importantto itsclients.

After-taxreturnsshouldbeasourceofprideforafirm.Therefore,firmsthatunderstandthevalue-addedpropositionfromtax-awareinvest-

mentmanagementaretheonesmostlikelytoprovideafter-taxreturns.Serviceprovidersrespondingtotheneedsoffirmscanbesegmentedintothefollowingcategories:

Portfolioaccountingstand-alonesystems IDS Osprey Shaw Sungard

Separateaccountsupplementalsystems iKindi Meradia PricePerformanceSystems Systemsdevelopmentandsupport AccountingfirmswithAIMRauditingpractices CutterAssociates Meradia Osprey TowerGroup

Theseareproviderstheauthorisawareofasofthesummerof2005.Thelistdoesnotrepresentanendorsementofanyfirm.Theremaycer-tainlybeotherwell-qualifiedprovidersavailable,andadditionalfirmsarelikelytooffersimilarservicesinthefuture.

Stand-alonesystemsarethecalculationandreportingenginefortheassetmanagementfirm.Supplementalsystemsworkinconjunctionwith

informationprovidedfromthestand-alonesystemorcustodialreports.Price Performance Systems offers an equity-oriented product, whereasiKindihasundertakenthechallengingtaskofprovidingtheabilitytocal-culateafter-taxreturnsforfixedincome,takingintoaccountamortizationandaccretionofpremiumsanddiscounts.


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havenaivelyconcludedthatthemanagerssecurityselectionandsectoral-locationwasnegativefortheperiod.However,thesecuritymayhavehadasubstantialshort-termunrealizedcapitalgainposition,andsellingtheposi-

tionwouldhavebeendetrimentaltotheclient.Resolvingthisquandarycan potentially integrate attribution with the portfolio decision-makingprocess.Bydoingthisproperly,theperformancemeasurementprofessionalwouldbecomepart ofaforward-lookingvalue-addedpropositionratherthanjustprovidingbackward-lookinginformationtoexplainpasteventsandactivity.13

SinceLeePricefirstrespondedtoclientsrequestsintheearly1990s,substantialprogresshasbeenmadetomastertheartofafter-taxreport-ing.Wenowhaveacceptedafter-taxreportingcalculationmethodologies

andstandardsthatenablebothtaxablemutualfundinvestorsandseparateaccountinvestors tomakebetter-informedinvestmentdecisions.Fortu-nately,thereareaselectgroupofsoftwareprovidersthatprovedthatthestandardscanbesuccessfullyimplemented,giventhedesireandresources.It takes a meaningful commitment of resources toachieve anafter-taxreportingcapability,butevensmallboutiquefirmshaveaccomplishedit.Therefore,thereisnolongeravalidexcuseforinvestmentmanagersnottoofferthiscapability.Firmsthatembraceafter-taxreportinginitiallywill

mostlikelybethosethatwillbenefitbycommunicatingtheirresultsac-cordingtoanacceptedformat,allowingotherstoevaluateandconfirmtheirvalue-addedpropositioninwaysneverbeforepossible.

ChapterNotes

1. Muchofthediscussiononseparateaccountafter-taxreportinghasbeentakendirectlyorsummarizedfromtheauthorsarticlewithSeanW.Egan,Evaluating

andClassifyingTaxableAccountManagers,JournalofWealthManagement (Fall2004):4962.

2. ThefirstAIMRSubcommitteeforAfter-TaxReportingconsistedofco-chairsLeeN.PriceandRobertE.PruyneandScottR.Abernethy,MichaelS.Caccesse,RobertH.Jeffrey,CatherineM.OConnor,JohnR.OToole,andDouglasS.Rogers.

3. Association for Investment Management and Research,AIMR PerformancePresentationStandardsHandbook, 2ded.(Charlottesville,Va.:AIMR,1997).

4. TheAIMRSubcommitteeforAfter-TaxReportingreconstitutedin2000waschairedbyDouglasS.Rogers.MembersincludedJenniferP.Cahill,ThomasF.Drumm,PaulJ.Jungquist,SeanS.Keogh,DanielW.Koors,DavidA.Krause,JamesPoterba,NeilE.Riddles,DavidM.Stein,RonaldJ.Surz,andCeciliaS.Wong.LeeN.Priceservedasanobserver.


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5. AIMR Performance Presentation Standards (AIMR-PPS)Amended andRestatedastheAIMR-PPSStandards,theU.S.andCanadianversionofGIPSandInterpretiveGuidanceontheAIMR-PPSAfter-TaxProvisionsContainedinSection9,February8,2003,23.

6. LeeN.Price,CalculationandReportingofAfter-TaxPerformance,JournalofPortfolioManagement(Winter1996):613.

7. AIMR Performance Presentation Standards (AIMR-PPS)Amended andRestatedastheAIMR-PPSStandards,theU.S.andCanadianversionofGIPSandInterpretiveGuidanceontheAIMR-PPSAfter-TaxProvisionsContainedinSection9.G.,February8,2003,2526.

8. JeffreyL.Minck,Tax-AdjustedEquityBenchmarks,JournalofPrivatePort-

folio Management (Summer 1998): 4150; James M. Poterba, After-Tax Per-formance Evaluation,AIMR Conference Proceedings: Investment Counseling forPrivateClients(Charlottesville,Va.:AIMR,1999),92-105;DavidM.Stein,BrianLangstraat,andPremkumarNarasimhan,ReportingAfter-TaxReturns:APrag-maticApproach,JournalofPrivatePortfolioManagement (Spring1999),1021.

9. RonL.Surz,indiscussionswiththeauthorduringspeakingengagementsandtheAIMRSubcommitteeforAfter-TaxReportingwherethesubjectofshadowportfolioshasbeenraised.

10. Lee N. Price, presentation on after-tax return calculation methodologies,1995.

11. Peter N. Gunder, directorinsurance consulting, for Cardinal InvestmentAdvisors,indiscussionwiththeauthor,August3,2004.

12. DouglasS.RogersandLeeN.Price,ChallengesWithDevelopingPortfo-lioAccountingSoftwareforAfter-TaxReporting,JournalofPerformanceMea-surement(Supplement2002):1218;JohnD.Simpson,SearchingforaSystemtoMeetYourAfter-TaxPerformanceReportingNeeds,JournalofPerformance

Measurement(Supplement2003):2228;DouglasS.Rogers,TheChallengesofAfter-TaxPerformanceReporting,JournalofPerformanceMeasurement(Spring2000):1015;DouglasS.Rogers,TheStateofAfter-TaxReporting.Monitor(November/December2003):2627.

13. Douglas S. Rogers, A Call to Arms!The Next Frontier forTaxable Ac-countsAfter-Tax Return Performance Attribution, Journal of Performance

Measurementvol.9,no.3(Spring2005):4346.


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losses.Third,itcantdifferentiatebetweengoodandbadturnover,aswediscussedinchapter3.However,evenwithitsweaknesses,somefirmshavefounditusefultocommunicatetotheirclientsacommit-menttotax-awareprinciples.

Captureratio:Thismeasureiscertainlytheeasiesttounderstandand

waswidelyacceptedbytheconsultingcommunityalmostwithoutques-tionuntil2000.Whenthebefore-taxreturnis10percentandtheafter-taxreturnis8percent,themanagerhascaptured80percentofthebefore-taxreturn.Itssimplicityiswhatmakesthecaptureratiosoattractivewhencommunicatingtaxefficiency.Unfortunately,theusefulnessofthecaptureratiodiminisheswhenreturnsareotherthantheidealupward-sloping,smoothshapeorwhatiscalledthehockeystickmarketandwhenthemagnitudeofreturnsdeviatessignificantlyfromaverageannualhis-toricalreturns.

ThefirsttworowsinFIGURE8.1makesense,buttheresultsinthelastthreerowsaredifficulttoexplaintoclientsandhavelittleornorelevance.

Relativewealthmeasure:TherelativewealthmeasurewasdevelopedbymembersoftheAIMRSubcommitteeforAfter-TaxReporting.Theireffortwasindirectresponsetothefrustrationwiththeweaknessofthecaptureratio.Anequationwasproposedandsimplifiedtothecurrentform.Ratherthancallingitaratio,theSubcommitteedecidedtolabelitmoreappropriatelyasameasure.Therelativewealthmeasureisarange

boundbyaroughestimateofthemaximumtaxrateapplicabletotheclient portfolio. Forexample, if the client is subject to the 35 percentfederalmaximumtaxrateonordinaryincomeandtheportfoliorealizedamaximumamountofshort-termcapitalgains,therelativewealthmeasureisroughly35,butmorepreciselyitis31.8.Ontheotherhand,ifthe

FIGURE8.1 ChallengeswiththeCaptureRatio

RETURNBEFORE-TAX AFTER-TAX CAPTURERATIO

10.0% 9.0% 90.0%

10.0% 11.0% 110.0%

2.0% 1.0% 50.0%

1.0% 1.0% 100.0%

8.0% 6.0% 75.0%

Source:DouglasS.

Rogers


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MeasuresofTaxEfficiency 97

portfolioharvestedthemaximumamountoflosses,themeasurewouldbe+35,or+31.8tobeexact.Ifthereisnonettaxliabilityorcredit,thenthemeasureis0.

Thebeautyoftherelativewealthmeasureisthatitdeliversreasonable

resultsregardlessofthedirectionormagnitudeofthemarket.Therefore,itovercomesthemajorshortcomingofthecaptureratioandhasservedtoadvancetheunderstandingoftaxefficiency.However,itisabitchalleng-ingtoexplaintoclientswhentheyencounteritforthefirsttime.

Morningstartax-costratio:Thisratiowascreatedaftertherelativewealthmeasureandprovidesameaningfulimprovementoverotherratiosandmeasures.AsshowninthefourexamplesinFIGURE8.2,theMorn-ingstartax-costratioisaderivationoftheAIMRsubcommitteesrelativewealthmeasure.

Theseriesofnumbersisthesameineachcalculation.Thedifferencesaretheplacementofthedecimalpointandwhethertheresultispositiveornegative.Asyoucansee,therelativewealthmeasurehasanegativesignwhentheresultisdetrimentaltothetaxpayer,whereasthetax-costratioispositive. Morningstar intendedthe ratio tobea percentage ofaninvestorsassetsthatarelosttotaxes,orthedifferencebetweenthebefore-taxandafter-taxreturn.4Thus,thepositivesignoftheoutputoftheequationmakessense.Thismethodologyiseasiertoexplaintoclients

and,therefore,wellsuitedtomoreretail-orientedmutualfundinvestors.DonPhillipssharedastoryaboutreceivingacallfromadisgruntledinves-torwhenMorningstarlaunchedthetax-costratio.Theinvestorsconcernwasthatourcountrywasinapension-fundingcrisisandfuturemarketreturnswouldmostlikelybelowerthaninthelate1990s.Nowthatthe

FIGURE8.2 ComparisonofRelativeWealthMeasureand

Tax-CostRatio AIMRSUBCOMMITTEE MORNINGSTAR RETURN RELATIVEWEALTH TAX-COST

BEFORE-TAX AFTER-TAX MEASURE RATIO

0.100 0.090 9.091 0.9091

0.100 0.110 11.111 1.1111

0.080 0.100 18.519 1.8519

0.100 0.080 22.222 2.2222

Source:Doug

lasS.

Rogers


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98 A

Documents

Tax Aware Investment Management