This is the second article in a two-part series on tax-efficient
investing. In the following interview, Glenn S. Freed, Ph.D.,
vice president of tax-managed investment services at Dimensional
Fund Advisors in Santa Monica, CA, USA, discusses equity strategies
to maximize after-tax returns for institutional investors.
AIMR Exchange: What is the basis of tax-efficient investing
for institutions?
Dr. Freed: The key is to have a broadly diversified portfolio
where taxes are a major factor in the choice of investment strategy.
Strategies that require high portfolio turnover generate high
trading costs and result in the frequent recognition of capital
gains. Tax-efficient investing dictates low-portfolio-turnover
strategies implemented with broad market-like portfolios combining
stocks in value-weighted proportions. Such portfolios require
limited trading to maintain desired risk and return characteristics.
If the investor wants a portfolio with higher expected returns
than the market, the portfolio can be tilted toward size and
style factors with small increases in portfolio turnover.
Are there misconceptions?
Some taxable institutional investors believe tax-efficient
investing is buying the S&P 500 because the index doesn't
have much turnover. The problem is that the S&P 500 is reconstituted
as a result of various corporate actions and may trigger the
realization of capital gains in a portfolio tracking the index.
Another drawback to the S&P 500 is that some of these large
companies pay a substantial cash dividend, and institutional
investors might want to defer the taxes on dividends. We say,
"You're leaving a lot on the table when you accept dividend
income without managing dividends. If you could trade capital-gain
income for dividend income, that capital-gain income could be
deferred until realized. If you have unrealized capital-gain
income, you will have a greater after-tax return."
On the flip side, some institutional investors may want more
dividend income due to the corporate-dividends-received deduction,
but tracking the S&P 500 does not allow the investment strategy
to increase the dividend yield of the portfolio.
What are some strategies for optimizing after-tax returns?
We want to minimize the impact of capital-gains tax and dividend-income
tax on the return of the portfolio. The hard part is doing that
without altering the investment objective. We start with a well-diversified
portfolio of stocks, giving us a continuous supply of gainers
and losers to harvest so we can remain capital-gain neutral.
The key is to strategically harvest losses while avoiding any
violation of the "wash sales" rules.
We offer tax-managed mutual funds and separate accounts that
seek to maximize after-tax returns. The mutual funds are structured
to capture specific size and style factors that drive returns,
while minimizing the tax costs associated with mutual-fund investing.
Typical small-cap and value mutual funds generate substantial
taxable income because of normal turnover in these investment
strategies. The average annual return lost to taxes can be as
high as 2 to 4 percent annually.
The down side is that, if there are losses in the mutual fund,
they cannot flow outside the mutual fund. You cannot take full
benefit of tax-efficient investing by using losses in that diversified
portfolio to offset gains outside the portfolio.
Institutional clients can invest in a customized tax-managed
separate account that is coordinated with other investments.
Many of our clients have fixed-income portfolios. As interest
rates have come down, some have had capital gains from their
fixed-income portfolio. By investing in a tax-managed separate
account versus a tax-managed mutual fund, we can harvest some
losses from this diversified portfolio to offset gains in their
fixed-income portfolio. Clients can pinpoint their desired asset-class
exposures and create a broadly diversified portfolio that is
managed to maximize after-tax returns. The ability to tailor
exposure to the factors that drive returns gives investors a
wider range of possibilities than pure indexing or active management.
