“Don’t let the tax tail wag the investment dog.”

We believe there is some merit to that adage, which cautions against making investment decisions solely based on tax considerations. However, investors should not be entirely agnostic to the tax implications of capital gains and income (e.g., interest and dividends). In multi-asset portfolios comprising several distinct strategies, understanding the interaction of performance, volatility and tax efficiency can be a cumbersome and complex process. More specifically, one should not focus entirely on investment performance, volatility management or tax minimization because doing so may result in unintended consequences (e.g., performance chasing leading to short-term gains, or tax minimization leading to an unrepresentative risk profile or asset allocation). Leaning too far in one direction can expose the portfolio to more volatility than necessary, while leaning too far in another can lead to less efficient performance after taxes.

Turnover is a measure of how frequently managers buy and sell securities within a given investment strategy. There are multiple ways to calculate turnover, though it can be thought of simply as total purchases plus total sales divided by 2 and then divided by the strategy’s net asset value. Turnover is an important variable for a few reasons:

• Strategies with higher turnover experience higher transaction costs relative to lower turnover strategies.
• Higher turnover also tends to lead to higher realization of capital gains.
• Turnover can provide a window into a manager’s investment philosophy (e.g., investing for the long term or arbitraging short-term market inefficiencies).

A starting point for analyzing turnover and concomitant tax effects is understanding the various dimensions of portfolio construction and which parts of the portfolio are more likely to result in undesirable turnover that could lead to capital gains taxes. We build on this view by considering the possibility that not all turnover is bad turnover. In addition, investors should accept that some asset classes are not tax-efficient in general. Tax efficiency alone will not lead us to exclude an investment, as we also will place value on the investment’s return, volatility and correlation profiles. Following are some high-level observations of turnover and tax implications across a portfolio.

Asset class observations

For taxable investors, it is helpful to understand the dynamics of turnover, income and capital gains for a multi-asset portfolio. As could be expected, cash equivalents and bonds derive most of their total return from income versus capital gains and tend to exhibit low to moderate turnover. Municipal bonds are the most tax-efficient since they are generally exempt from federal taxes and possibly state taxes. In contrast, investment-grade corporate bonds, high-yield bonds and international bonds are less tax-efficient since the yield is typically taxed at ordinary income tax rates.

Equity returns differ from bonds in that most of the total return typically is represented by capital appreciation, with modest amounts attributable to dividends. Moreover, equity strategies have historically experienced higher levels of turnover. In fact, equity strategies with turnover of 100% or more, meaning the average holding period of the investments in these strategies is less than a year, are not uncommon.

By emphasizing strategies that focus on longer-term fundamental theses, investors could reduce the amount of return that is diminished by taxes. Alternative investments typically comprise strategies that focus on absolute return, real assets and private equity, each with distinct attributes. In the case of absolute return, the return profile is typically tax inefficient given that a bulk of the performance is subject to taxes, with a large portion of the tax composed of short-term capital gains. Publicly listed real estate companies are typically real estate investment trusts, whose legal structure allows them not to be subject to corporate income tax but requires them to distribute at least 90% of their income to shareholders as nonqualified dividends that are subject to an individual’s effective income tax rate. Private equity returns are predominantly taxed at long-term capital gains rates, and private equity typically is more tax-efficient than its alternative-classified peers.

Capitalization relationships

Market capitalization is defined as the product of the total shares outstanding and the stock price. While there are no standard industry definitions, typically large cap stocks have a market cap greater than $10 billion; mid caps, $2-$10 billion; and small caps, $300 million-$2 billion. Smaller companies tend to exhibit higher growth rates but also experience higher degrees of volatility. In addition, successful small cap companies tend to grow to be mid and large cap companies and eventually may need to be sold by a small cap manager who wishes to remain style pure. As a result, it is common to see small cap equity strategies generate higher turnover, and this could lead to a larger tax drag on performance.1

Fundamental and quantitative strategies

Investment strategies can generally be divided into two categories: fundamental and quantitative. Fundamental strategies perform business analysis and forecast growth, earnings and cash flow to derive a valuation. Quantitative strategies are typically less concerned about the details of the business and instead focus on certain quantitative characteristics such as valuation, capitalization, growth, leverage, profitability and so on. In addition, quantitative strategies typically hold more names and rebalance the portfolio frequently to maintain the desired characteristics. The more frequent rebalancing across more names typically leads to higher turnover, which could generate more capital gains recognition. That said, not all turnover is bad turnover, in our view. When losses occur, some quantitative strategies are quick to recognize the losses to reduce net capital gains.

Growth and value

Another line of distinction across equity strategies is growth versus value. Growth managers are likely to work to identify companies with a strong brand, product cycle or secular growth opportunities. These trends can occur over a multiyear holding period, allowing gains to compound over a longer time horizon. Value managers, on the other hand, may look for short-to-intermediate term dislocations, expecting valuation to mean revert. Once the discount to expected value dissipates, the manager usually sells the company and moves on to another targeted company. This approach may lead to shorter holding periods, causing a bit more “churning” in the underlying holdings.2 In addition, dividends tend to comprise a larger proportion of total return for value strategies relative to growth strategies, resulting in more of the gain subject to tax on an annual basis. We acknowledge these are broad brushstrokes, and some managers in both growth and value may embody characteristics different from what has been outlined here.

Preferred portfolio constituents relative to peer groups

Glenmede builds multi-asset class portfolios tailored to client preferences. Some portfolios may be composed entirely of stocks and bonds. Others could include the full complement of asset classes, including real estate, absolute return and private equity. The primary objective is to identify strategies that generate competitive risk-adjusted returns over time. We also want to be cognizant of the potential tax leakage that can occur, reducing the net return realized by our clients. Tax leakage can yield a significant cumulative effect over the long term, as seen in Exhibit 1 comparing three tax scenarios over a 20-year horizon. Balancing risk-adjusted returns and taxes while maintaining a robust portfolio construction is not an easy task.

Exhibit 1: Comparison of Three Tax Scenarios Over a 20-Year Horizon

To further test some of the above observations, we reviewed various equity investment strategies and their associated tax burdens. Our study focused on U.S. large cap mutual funds, U.S. small cap mutual funds and foreign large cap mutual funds, as defined by Morningstar. We broke down each cohort into three standard investment style classifications: blend (i.e., funds that own a mixture of growth and value stocks), value and growth.

To calculate tax burdens, we compared the annualized total return (i.e., pretax) to the annualized post-tax return preliquidation total return (i.e., post-tax) over a 5-, 10- and 15-year period. The preliquidation after-tax return reflects the tax effects of fund distributions such as short-term capital gains, long-term capital gains and dividends. The preliquidation after-tax return does not reflect the capital gains and losses investors might realize from selling the mutual fund at the end of the time period.

The effective tax rate is computed by taking the difference between the return of a tax-exempt investor (in this case the total return pretax) and the return of a taxed investor (post-tax return preliquidation), and then dividing that difference by the return of the tax-exempt investor. Thus, the effective tax rate measures the proportion of the tax-exempt investor’s performance that would have been consumed by taxes. This definition of effective tax rate is consistent with how Israel and Moskowitz3 defined effective tax rate in their study of tax consequences of practitioner portfolios (Exhibit 2).

We find that over a 15-year period, on average, the sampled large cap managers are more tax-efficient than their small cap peers. Additionally, we find that over a 15-year period, on average, the sampled growth managers are more tax-efficient than their value-oriented peers. While investors will ultimately have to pay additional taxes upon liquidating their ownership in a fund, the power of gains deferral cannot be overstated, especially over longer time periods.

Exhibit 2: Summary Table

Potential tax policy changes and the impact on our observations

In the coming months, the Biden administration may sign into law new legislation that is likely to increase tax rates on corporations and some individuals. The higher tax rates are likely to incrementally weigh on after-tax returns relative to the current tax code. Glenmede will be monitoring potential changes in tax legislation and will evaluate any necessary portfolio adjustments.