Navigating U.S. After-Tax Performance: Best Practices in Tax-Managed Strategies

Advancements in technology and reduced trading costs have transformed tax management strategies in the U.S. into a fundamental component of wealth management. The primary goal of tax management is to strategically minimize and defer investors' tax liabilities, thereby maximizing after-tax returns and maintaining a low tracking error relative to the intended benchmark or strategy. By strategically timing tax events and tailoring strategies to individual needs, investors can significantly improve their long-term financial outcomes. Deferring tax liabilities allows investor assets, which would otherwise be used to pay taxes, to remain invested and continue participating in the market.

Tax management strategies provide significant benefits that are not always clear in a standard performance methodology, but performance metrics are essential to accurately assess the strategy’s effectiveness. Advisers often present performance for tax strategies using a composite, which is an aggregation of one or more portfolios that are managed according to a similar investment mandate, objective, or strategy. These performance metrics provide a clear view of an investment manager’s ability to manage portfolios in a tax-efficient manner. By quantifying the impact of tax strategies on investment returns, performance metrics not only validate the success of these approaches, but also showcase the manager’s skill of enhancing client value through smart tax management.

This article will detail best practices for effectively measuring and presenting performance, aligning with industry standards to help ensure that tax management strategies are both accurately evaluated and clearly communicated.

What makes after-tax performance unique?

Tax management strategies have long been a staple for investors looking to minimize their tax burden. For decades, firms have tailored strategies to cater to investors who prioritize tax savings or avoidance. Traditionally, methods included holding onto stocks long enough to take advantage of lower long-term capital gains tax rates, using losses to offset gains, and investing in tax-free vehicles like municipal bonds. These approaches are straightforward and generally did not consider each investor's unique financial situation.

Today, the approach to tax-sensitive investing has evolved significantly. The rise of brokers offering free trading has made it easier for investors to adjust their portfolios frequently without the concern of incurring high costs. Coupled with advancements in technology and deeper analysis of individual investor profiles, modern strategies like direct indexing can now facilitate more effective tax loss harvesting and precise timing of transactions. These developments allow for personalized adjustments that specifically address each investor's tax needs, helping to improve after-tax returns while adhering closely to their investment goals. This shift towards highly personalized tax management underscores the uniqueness of after-tax performance as a critical metric.

Pre-tax performance measures the returns prior to any taxes being deducted and is generally indifferent to the original cost basis of the position(s). However, after-tax performance accounts for the individual tax situations of specific portfolios can vary widely based on factors such as tax rates and the initial cost and cost basis of their investments. The timing of an investor's entry into various positions can greatly affect the cost basis of those investments, influencing the amount of taxable gains or deductible losses upon their sale.

Example

Consider two investors who are both invested in the same tax-managed strategy but have differing durations and entry points:

• Investor A has been invested for 10 years. During this period, the strategy has utilized tax-loss harvesting and other tax management techniques to minimize tax liabilities. However, the long-term nature of their investment has gradually reduced the cost basis in several core holdings to a very low level. This significantly limits current opportunities for tax-loss harvesting because most individual investments now represent substantial unrealized gains. For example, if they bought a stock 10 years ago, the cost to purchase would have been $25.50. Today, the stock is now worth $80.68, which would result in a $55.18 taxable event if sold now. Substantial capital gains taxes could impact the after-tax returns.
• Investor B, in contrast, entered the same strategy only a year ago. Their portfolio's cost basis is relatively high, reflecting recent market prices. In this example, the purchase of the stock would have been $53.16 which would only result in a $27.52 taxable event if sold now. This gives Investor B more flexibility to utilize tax-loss harvesting opportunities, especially in a volatile market where recent purchases might be at a loss. This flexibility can be used to offset other gains, potentially reducing current tax liabilities significantly.

The differences in these two examples emphasize that the investor experience can vary drastically at any given time depending on the timing of the initial investment, contrasting sharply with traditional pre-tax performance measures. Unlike after-tax performance, pre-tax performance metrics typically do not consider the timing of an investor’s entry into a strategy. The experience for investors in pre-tax scenarios is generally consistent regardless of when they initially invested, as these calculations focus solely on the returns generated without accounting for tax impacts. To accurately convey the impact of tax management strategies on after-tax performance, additional statistics, customized composite rules, and careful education through disclosure may be necessary.

Key assumptions and best practices for after-tax performance

Given the unique nature of after-tax performance, it is crucial for advisers to understand the key assumptions and best practices involved in calculating and marketing these metrics. The last meaningful industry guidance was issued back in 2011 and now lacks the detail needed to address all of the complexities of today’s market. It is important to ensure the performance data presented not only adheres to the available standards, but also remains meaningful and relevant to prospective clients, ultimately aiding them in making informed investment decisions.

While the industry continues to navigate the challenges posed by outdated standardized guidelines, there are common assumptions and best practices that have become the cornerstone of presenting after-tax performance effectively. These foundational elements help ensure that the performance metrics communicated to investors remain transparent and comparable.

Focus on federal taxes over state and local taxes

An early decision many firms grapple with is whether to include state or local taxes in performance calculations. Balancing the need for comparability with the desire to provide a true representation of the full tax impact presents a significant challenge. The reality is that many firms opt to exclude state and local taxes because they introduce a high degree of variability in performance results. For example, an investor in Oregon who has state income tax will experience markedly different tax impacts compared to an investor in Washington who does not levy state income tax.

While these differences are significant, they often lie outside the manager's control, and in many cases, managers may not be privy to the specific state and local taxes that apply to an individual investor. This lack of detailed tax information makes it impractical to accurately reflect such taxes in performance metrics.

Additionally, including different state tax codes in calculations for composites can significantly complicate matters. It might necessitate the creation of multiple composites based on where accounts are domiciled, which introduces considerable complexity. The intent behind using composites in marketing is to present the composite that an account would be eligible for. However, it becomes impractical to maintain separate marketing materials for each possible scenario and to identify the appropriate composite during the early stages of the sales process. This could lead to a scenario where diverse tax assumptions apply to different accounts within the same composite, resulting in unreliable and non-comparable performance results. Consequently, this complexity leads many firms to exclude the impact of state and local taxes from their performance calculations.

Actionable steps:

• Develop clear guidelines: Establish firm-wide guidelines to consistently exclude state and local taxes from performance calculations across all performance marketing. This approach helps maintain uniformity and comparability across a diverse client base.
• Educate clients through disclosure: Clearly disclose to clients that state and local taxes are excluded from performance calculations. This typically involves detailed notes in investment statements and reports explaining the reasons for the exclusion and how it impacts the reported performance. Providing this information helps set accurate expectations and ensures clients understand the basis of their performance evaluations.

Utilization of highest federal tax rates

The next consideration would be whether to apply actual investor tax rates or the highest federal tax rates in performance calculations. This choice involves balancing the need for clarity and consistency in tax impact presentations with the practical challenges of obtaining and maintaining accurate tax data from investors. Many investment firms decide to use the highest federal tax rates because they simplify the process, offering a uniform standard that minimizes the risk of underestimating potential tax liabilities.

Obtaining accurate and current tax information from all investors is often impractical due to the variability in personal tax situations and the complexities involved in tracking changes, such as income adjustments and tax legislation updates. As a result, many firms choose the highest federal tax rates as a default to ensure comprehensive coverage of potential tax impacts.

However, this approach can lead to an overstatement of the benefits of tax management strategies, such as tax-loss harvesting. By applying the highest tax rates, the improvement in after-tax performance may appear more significant than it would under lower tax rates, potentially misrepresenting the effectiveness of these strategies to investors in lower tax brackets.

Actionable steps:

• Evaluate and decide: Firms should carefully evaluate their client base and the complexity of maintaining accurate tax information versus the benefits of using actual tax rates. Deciding whether to use the highest tax rates or attempt to apply actual rates should be based on this assessment.
• Document practices: It is essential for firms to document their decision-making process regarding tax rate usage in performance calculations. This documentation should clearly outline the rationale behind the choice and should be readily accessible for both internal use and regulatory review.
• Communicate clearly: Firms should ensure transparent disclosures are provided to all prospective and current clients discussing the tax assumptions used in performance calculations. Explaining why the highest tax rates are used and how they might impact the representation of after-tax performance can help set realistic expectations.

Pre-liquidation vs. post-liquidation performance

Investment firms typically favor pre-liquidation metrics when assessing and presenting after-tax performance. Pre-liquidation metrics reflects the ongoing management of investments without assuming the sale of assets, aligning with most investors’ strategies of holding assets to realize long-term gains. In contrast, post-liquidation metrics consider the impact of taxes that would be incurred if the assets were sold at their current value. This approach reflects the tax impact that investors might face if they decide to liquidate their investments at that point.

The pre-liquidation perspective allows for the portrayal of a portfolio’s growth potential by deferring the realization of gains, and consequently, the associated tax liabilities. This deferral enables the compounding of returns on the full amount of the portfolio as taxes that would have reduced the investment balance are instead left to generate further gains. Over time, this strategy can significantly enhance the overall growth of the investment portfolio.

However, a key concern in using pre-liquidation metrics is the accumulation of unrealized gains, which equates to deferred tax liabilities. It’s vital for firms to clearly explain that while the deferral of taxes allows investments to compound and grow, these taxes are merely postponed, not eliminated. Investors should be aware that the increased portfolio value from compounding will eventually be subject to taxes when the investments are sold. Clear disclosure for all communications that include performance, such as marketing and client reports, can help clarify that these future tax liabilities will impact their cash flow down the line.

Actionable steps:

• Develop clear disclosures: Implement policies that ensure all marketing materials and client reports clearly describe whether pre-liquidation or post-liquidation metrics are used. If pre-liquidation metrics are chosen, it's important to clearly document the implications of deferred tax liabilities. These disclosures should be prominently featured in performance marketing materials to maintain transparency and build trust.
• Educational initiatives: Create and distribute educational materials that outline the benefits and risks associated with the deferral of tax liabilities. These should highlight how deferring taxes affects investment growth and future tax obligations, helping prospective clients understand the long-term implications. Consider hosting webinars, creating informational videos, and providing detailed guides as part of your marketing strategy.
• Incorporate comprehensive metrics: Consider adopting metrics such as Net Unrealized Appreciation (NUA) and Tax Savings Growth Rate. NUA shows the total unrealized gains in the portfolio, providing insight into potential tax liabilities if these gains were realized today. Meanwhile, Tax Savings Growth Rate calculates the compound growth rate of the tax savings achieved by deferring taxes on these gains. These metrics can help current and prospective clients visualize both the short-term benefits and the long-term tax obligations, offering a balanced view in your marketing materials. When presenting these additional metrics, it's important to carefully consider the intended recipient, ensuring the information is relevant to their financial situation and investment goals. Depending on the metrics provided, regulatory bodies may classify the information as hypothetical performance, requiring thorough disclosures and supporting policies.

Composite construction

Investment firms typically construct composites using only cash-funded portfolios when assessing and presenting after-tax performance. This approach ensures that all included portfolios start with a clean slate, without pre-existing securities that could complicate tax and performance calculations.

Portfolios funded with securities rather than cash often come with pre-existing unrealized gains or losses, which can significantly influence the portfolio's tax obligations and the manager's ability to fully execute the intended investment model. The presence of these assets can restrict the manager’s strategies, particularly when aiming to defer gains due to existing tax implications. It is standard onboarding practice for managers to assess a client's ability to incur tax liabilities in a given year. This assessment helps determine how closely the portfolio can align with the intended index or strategy. Completely liquidating these assets to conform to a new strategy not only triggers immediate tax consequences, but may also deviate from the investor’s broader financial goals or risk preferences. As a result, including these portfolios in a composite can lead to skewed performance results and provide an inaccurate comparison.

Focusing on cash-funded portfolios for composites allows firms to achieve a more uniform performance result of similarly managed portfolios. This approach sidesteps the complications associated with managing low-cost basis stocks, making it easier to evaluate the true effectiveness of an investment strategy and its tax management capabilities. Additionally, by standardizing the starting conditions of portfolios, firms can help ensure a fair comparison with other managers, providing investors with clear, apples-to-apples performance data that is important for making informed decisions.

However, a key consideration in this approach is the potential exclusion of valuable information from security-funded portfolios, which often represent the majority of a firm’s assets under management. These portfolios can provide critical insights into tax-efficient strategies and real-world investment outcomes. Excluding them will limit the firm's ability to showcase the full capabilities of its tax management techniques and investment strategies. Many prospects, particularly those with substantial existing investments, are keen to understand how these strategies can be adapted to their situations. Including some analysis of these portfolios, where feasible, could enrich the firm's overall performance presentation by demonstrating the adaptability and effectiveness of the firm’s strategies across a range of investment scenarios.

Actionable steps:

• Assess onboarding procedures: Conduct a thorough review of the firm's onboarding procedures to understand how new clients with security-funded portfolios are currently integrated. Develop inclusion policies that align with these procedures, ensuring that they facilitate the management of different portfolio types effectively. This assessment should focus on how well the existing procedures accommodate the integration of these portfolios into the firm's overall investment strategies, including tax management.
• Transition to cash-funded policy: For firms considering adopting a cash-funded only policy for their composites, evaluate the existing composites alongside back-office capabilities to determine the feasibility of this transition. Carefully assess and model the impact this change would have had on historical performance results. If a full transition proves too disruptive or undermines the integrity of historical data, consider creating a new composite specifically for cash-funded portfolios. This new composite can then become the standard for future marketing materials, ensuring that all new client engagements align with this updated policy.
• Ensure clear disclosures: Make sure to include clear disclosures to communicate the adoption of a cash-funded only policy for composites. These disclosures should explain the rationale behind this policy and how it impacts performance results.

Conclusion

Managing after-tax performance metrics requires careful attention, particularly when these metrics are built on assumptions and aimed at a more retail investor audience. It's crucial for firms to present these metrics in a way that aligns with current regulations to avoid any potential compliance issues. This ensures that representations are not only fair and balanced, but also free of misleading statements that may invite regulatory scrutiny.

The CFA Institute is currently assessing investment advisers to determine if there is a need for formal guidance for U.S. after-tax performance. If formal guidance is provided, it would help the industry move towards a single source for best practices and increase credibility with investors.

Such standards would support more transparent and reliable communications, benefiting both firms and investors.

How we help

ACA has worked with firms presenting after-tax performance and understands the associated issues. Combining our investment performance expertise along with the peer knowledge that comes with our large client base, we can help firms tackle after-tax performance calculations and metrics.

If you have any questions about after-tax performance or how we can help you launch, grow, and protect your firm, please contact us here.

Contact us