Tax Aware Investment Management


Douglas S. Rogers


new yo rk

© 2006 by Douglas S. Rogers. All rights reserved. Protected under the Berne Convention. Printed in the United States of America. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews. For information, please write: Permissions Department, Bloomberg Press, 731 Lexington Avenue, New York, NY 10022, U.S.A. or send an e-mail to [email protected].


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This publication contains the author's opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the author, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader.

Firsteditionpublished 2006 1 3 5 7 9 10 8 6 42

Library of Congress Cataloging-in-Publication Data

Rogers, Douglas S.

Tax-awareinvestment management:theessentialguide/ DouglasS. Rogers, p. cm.

Summary: " Illustrates how investment strategies for tax-exempt accounts don't work for individuals subject to taxes. Offerstechniquesforcomparingtax-efficiencyof mutualfunds, hedgefunds,and investment managers,and presents more-sophisticatedstrategiesforoffsettinggainsagainst losses in wealth planning, portfolio management,andestateplanning. Includes resultsofhistorical research, 1 0 0 tables andcharts"—Provided by publisher. Includes bibliographical referencesandindex. I SBN l-57660-180-3 (alkpaper) 1 . I nves tments—Taxation—United States—Handbooks, manuals,etc.2. Portfolio management-Handbooks, manuals, etc. I. Title.

HG4910.R655 2006 3 32 . 6--dc22



Acknowledgments v i i

In tro ducti on ix


1 The Evolution of Tax-Aware Investment Management 3

2 The Sources and Impact of Taxes on

I nve stment Returns 11

3 Seminal Research 21

4 The Tax-Aware Practitioner 33

5 Creating the Triumvirate of Qualified

Professionals 45



6 Mutual Fund After-Tax Reporting 57

7 Separate Account After-Tax Reporting 77

8 Measures of Tax Efficiency 95



9 Outperforming the Index Fund 103

10 Quantitative Tax-Aware Portfolio Management and Concentrated Stock 117

11 Practices of Elite Tax-Aware Equity Active Managers 133

12 Practice s o f Elite Tax-Aware Fixed Income

Active Managers 149

13 The Hedge Fund Dilemma 167

14 Amending the Search Process for Tax-Aware

Manager Selection 175



15 Challenges With Traditional Investment

Policy Development 191

16 Developing After-Tax Asset Class Assumptions 209

17 Why the Style Box Hurts Taxable Investors 225

18 Positioning Assets by the Tax Characteristics o f the Entity 243

19 The Role of Systems Solutions in

Tax-Aware Investing 271

Summary 281

Appendix 283

^^ Continuing Education Exam 287

Index 29 4


Tax-Aware Investment Management: The Essential Guide embodies the collective wisdom of many people with whom I have been fortunate enough t o interact during my investment career. I want to acknowledge those who have supported my efforts and provided me many of the insights neces-s ary t o complete this work. I apologize to anyone I may have inadvertently missedin myattempt to give credit whereitis due.

I ext end my gratitude to Ralph Rittenour Jr., to Jeffrey Grubb, and to my other associates at CTC Consulting for their backing of this project.

I am especially mindful of the support of Don Lindow and Chris Arvani who recognized early on in my career my desire to take on new and exciting research pertaining to the nuclear decommissioning trust (NDT) industry. My participation at NDT conferences and my interaction with Aland Brusven, David Krause, James Meehan, Joanne Howard, Mary Jo Dempsey, Thomas Tuschen, Eric Knause, Mary Miller, and others only he ighte ned my enthusiasm. Michael Brilley and Gene Sit encouraged me t o s ubmit my first article for publication on tax-aware investment management, which set the stage for other projects to follow. Similar appreciation is ext ended to Louise Wasso-Jonikas and Michael Radford for encouraging my involvement in CFA Institute (formerly AMR) activities and public sp eaking.

Lee Price has always been a respected mentor, and to serve with him on both AMR Subcommittees on After-Tax Reporting has been an honor and privilege. I will always be indebted to the members of the Subcommittee. Their response to the SEC proposal for after-tax returns on mutual funds and recommended revisions to the existing s tandards would not have been p ossible without the assistance of Pauline Pilate and Alecia Licata. Stanley Lee and Liz Miller of the New York Society of Security Analysts have been consistent s upporters o f this topic and related issues.

I am truly thankful for the willingness of Tad Jeffrey, James Garland, Robert Arnott, Joel Dickson, Jack Bogle, Peter Bernstein, Marc Moulton, Brian Langstraat, David Stein, and Bob Breshock to share their experiences on critical research and product development. Jay Whipple III, Ron Surz, James Hollis, and Matt Schott have played critical roles in furthering my understanding of systems technology. Robert Gordon and

Thomas Boczar played a similar role with tax issues as they relate to hedge fund inves ting. Leslie Giardani and her research offered valuable insight into the fu tu re di rection o f the insuran ce in dustry. Tony Rochte and his ass o dates at Barclays shared their knowledge of exchange-traded funds, as did Gary Gastineau. William Reichenstein, William Jennings, and James Poterba were thoughtful enough to introduce me to the leading contributors from academia. Don Phillips was gracious enough to allow the use o f afte r-tax return data from Morningstar Principia. While stock pickers always s eem to take center stage over those whose special expertise is in fixed income, it has been a joy to share ideas with passionate bond portfolio managers like Guy Davidson, Christine Todd, and Paul Jungquist.

Harold Evensky was instrumental in introducing me to Jared Kieling, who has supported the project with sage editorial advice. Jeffery Yablon was kind enough to share his quotes from Tax Notes that appear as epi-grap hs throughout the book.1 Encouragement from Nancy Jacob, Jean Brunel, and Dave Spaulding to continue to publish has been a driving fo rce that hasculminatedinthis effort.

This book could not have completed without the continued encour-

m n n d n d e e L n d m o m p o t n h n my children and my wife, Soon Hee, for their unwavering support and s acr ifices made during the many evenings and weekends that were needed m p

Chapter Notes_

1. The tax-related quotations that open each part and chapter were compiled and arranged by Jeffery L. Yablon, "As Certain as Death: Quotations About Taxes (2004 Edition)," Tax Notes vol. 102, no. 1 (January 5, 2004): 99-116.


The Importance of Tax-Aware I nvestment Management

Our Constitution is in actual operation; everything appears to promise that it will last; but nothing in this world is certain but death and taxes.

—Benjamin Franklin Founding father

Taxes have been a permanent part of the social-political landscape in the United States since the Sixteenth Amendment to the Constitution was ratified in 1913- Soon thereafter, President Woodrow Wilson approved the form of federal income taxation that we know today. Initially affecting only the wealthy, it was not until after World War II that the federal income tax began to have a significant impact on the economic well-being o f the average citizen.1

Athough no one enjoys paying them, taxes serve an important pur-p o s e . Taxes are the s o urce of revenue that enables the government to build h n e n m n n n d n n u and to provide for the common defense. And like the prices of securities, t axes will change! The prices of securities fluctuate daily as market participants assess the importance of the various forces affecting the economy, whereas tax rates change more slowly, reflecting government policies and sp ending. Since the adoption of the federal income tax, tax policy has b eco me an increasingly important stimulus tool with each successive adm n n T e e m n n d the norm rather than the exception. For this reason, tax-aware investment p e n m m n we h

Tax-aware investment management refers to the application of sound u m n h e n m e u e n h e n p aid. It is not about avoiding the payment of taxes through questionable acco unting or estate planning or simply attempting to pay no tax. Rather, i t is about maximizing what is left after taxes have been paid. For example, if an investor has the choice between two securities with similar features, it is fo o 1 ish to avoid purchasing the one that will require a tax payment if it o ffe rs a s uperior net overall result. If the investor receives a higher after-tax return through effective tax-aware investment management, the money manager makes a reasonable profit, the government collects its revenue, and we have achieved the best of all worlds—everyone involved in the process hasgainedsomething of value.

I n the more than ninety years that the federal income tax has been with us, you would think that academic institutions and professional certification programs would have paid sufficient attention to tax-aware investment management to train people and develop products to serve the needs of the taxable investor. Unfortunately, this is not the case. A shortage o f educators and trained professionals in tax-aware investing persists b ecaus e o f an earlier emphasis on retirement plans and charitable organizations, which are exempt from the payment of taxes.2 All too often, modern portfolio theory concepts that have emerged from the tax-exempt acco unt arena as gospel are naively applied to taxable accounts by well-intentioned individuals, resulting in less-than-optimal, costly solutions. The lack of attention to taxes in the investment process is so severe that most professionals in the investment management industry are unaware h u h h n n Un d

States are s ubj ect to taxatio n.

Fortunately, it is not all gloom and doom for individual taxpayers, trus ts , and corporations with significant taxable assets. There are several bright spots. First, over the past decade, a group of dedicated practitioners has emerged to make significant contributions to the body of knowledge needed to serve taxable accounts. Second, uniform standards for reporting returns on an after-tax basis are now in place for most mutual funds, and a growing number of separate account managers3 are adopting them fo r their clients and for the purpose of constructing composite results for marketing purposes. Third, some managers are modifying buy-and-sell decis io ns to incorporate the impact of taxes, and innovative tax-efficient p roducts, such as exchange-traded funds, are rapidly gaining recognition and acceptance. Fourth, traditional methods are being analyzed in order to better position assets in both taxable and tax-exempt accounts for ultimate wealth creation. Furthermore, advancements in systems technology are currentlyimprovingthecapabilityandscaleofthese processes.

Tax-awareinvestment managementinvolvesfourcriticalelements:

1 Util izingafter-taxassumptionsintheassetallocation process

2 Alocating asset classes and managers/funds according to the char-acteris tics o f eachinvestmententity

3 Tax-awareequity manager positioning

4 Identifying tax-aware managers/funds

I mplementing these steps has the potential to add from 0.5 to 2.5 p erce nt annually to bottom-line performance or wealth creation. The ex-ac t amount of value added can vary significantly between taxable account rel at ionships for each element, ranging from 0 to 1.5 percent or more depending on the complexity of the investment opportunity. The four elements interact and complement one another. For example, you may aliocate a tax- inefficient manager to a tax-exempt account where lack of atte ntion to tax management is not an issue or replace the manager with another strategy that may create tax benefits that can be used beyond the replacement manager. This process lends itself to creativity and innovative solutions all within a simple understanding of the tax code. A taxaware solution will take into account the investment time horizon, tax characteristics of the investment entities involved (e.g., personal taxable acco unt assets, 401 (k) retirement plans, and individual retirement ac-co unts), the client's tax profile, projected returns, permissible asset classes, and structure (e.g., funds vs. separate accounts vs. limited partnerships) o f the investment portfolios. Most important, it takes a knowledgeable and experienced professional to implement and orchestrate a tax-aware investment management process. It is not unrealistic for a high-net-worth family to gain approximately 0.5 percent from using after-tax assumptions fo r as s e t all o cat i o n, 1.0 percent from locating managers/funds according t o the characteristics of each investment entity, 0.4 percent from optimally co mbining equity managers in a manner quite different than the pension-co nsulting approach, and 0.6 percent from using tax-aware managers for the taxable accounts. All four of the elements are important and ignoring o ne or more leadstoalessthanoptimalsolution.

Tax-aware investing is equally important to investors regardless of the magnitude of wealth. If an ultra-affluent family with $100 million in liquid assets does not take advantage of the benefits of tax-aware investing, it is unlikely to change their lifestyle. However, it will certainly impact the wealth of future generations and, if not employed, lessen the chances of achieving and perpetuating a family dynasty. For a twenty-five-year-old investor, a 1 percent advantage on a $10,000 portfolio will mean having an additional $4,889 for retirement some four years later. With a 2 percent enhancement the initial investment doubles in slightly more than thirty-five years, and the individual will have $12,080 extra at retirement. Thus, for the average investor, properly employing the critical elements of t ax- aware investing can mean the difference between enjoying retirement acco rding to plan or perhaps having to continue to work well beyond age s ixty- five. Whether you are an investor, a portfolio manager, or a financial adviser for taxable clients, employing the elements of tax-aware investment management will allow you to significantly improve net after-tax results to the benefit of wealth creation and maintenance. This is the distinguishing value proposition between the management of traditional tax-exempt ac-co unts and the evolving body of knowledge pertinent to achieving optimal res ults withtaxableaccounts.

With interest rates bottoming in 2003, and the Federal Reserve con-t inuing to increase the funds rate, the fixed income markets are unlikely to achi eve c o mpelling returns anytime soon. Although the equity markets ex-

n o e n n n d n n n improved measurably, valuations are still at high levels when compared with historical norms. Thus, the consensus of strategists at the beginning o f 2005 is that the markets are unlikely to deliver their previous averages o f 1 1 p erce nt for stocks and 6 percent for government bonds over the next ten years. Furthermore, no strategists are predicting a repeat of the u e u h e d d n h n d n h market environment, the impact of taxes accounts for a greater percentage o f the total return.

The taxpayer in the United States has experienced three years of fa-vorab 1 e t ax 1 e g isl at i o n (from 2001 through 2003) and the second Bush d m n n e d e m p n h

Moreover, the president hopes to make permanent the tax code changes m p m n d d u n h fi m n d p n m n h tax al to ge ther. The annual government budget deficit is looming at $400 billion, however, and the financial soundness of the Social Security system remains a concern. For these reasons, many are questioning Congress's ab ili ty t o maintain the favorable maximum federal tax rate of 15 percent o n qualified dividends and long-term capital gains. These and other tax is-u w h d b d n h e h d b u n o n m fi d with the status quo. For both the taxable investor and the adviser serving taxable accounts, personal beliefs regarding the tax code are not important. What does matter is how maximum value can be extracted from the available opportunities. This is especially true today because we are n w e n n o n m n n d h we n p n w e s olution or not can result in an annual difference of 2 percent or more. A working knowledge of the evolution of the tax codes, reporting standards, portfolio construction, and allocation of assets in a tax-aware manner is as valuable today, if not more so, as it was when the federal income tax was es tabl ished.

Chapter Notes_

1. Touis Allen Talley, "CRS Report on History of Federal Taxes," CRS Report for Congress, January 19, 2001, 1-8, ( access ed July 7, 2004).

2. Under Section 4940 of the Internal Revenue Code, charitable organizations may besubjecttoataxof 2 percenton netinvestmentincome.

3. Throughout this book the term separate account is used in its traditional meaning, i.e., an established account with a money manager, rather than the retail-oriented wrap account industry where a bundle of investments and services is provided forasingle fee.

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