With the market experiencing volatility and an environment of reduced growth, one asset manager sees an opportunity to dust off and promote long-standing tax-managed funds to advisors. But it says that doing so will first require an educational effort about tax strategies on the part of asset managers.
Russell Investments' annual advisor survey found that more than half of advisors reported increased tax burdens on their clients last year, but their conversations about managing taxes on investments actually decreased.
One reason why advisors are missing that opportunity, says Rod Greenshields, a consulting director at Russell, is because times were so good, few paid attention to tax strategies. The slowdown in growth has reignited interest, he tells Money Management Executive.
What issues prompted Russell to undertake this study?
What we found was in the midst of the global financial crisis and for a couple years after, frankly no one cared about taxes because they were still reeling from the painful market experience.
But because most of the equity markets around the globe were so strong coming out of the recession, essentially all of the losses were carried in portfolios.
When you think about how the funds work and when they experience losses, those losses can offset gains, so investors were getting very high returns and very modest tax bills on their mutual funds, and that can only go on so long before you run out of those losses to offset the gains.
What we found was earlier last year, when clients were getting their tax forms, they started to see taxes much higher than the last few years. Now, they weren't necessarily any worse than previously longer-term historical trends, but they hadn't experienced that in the last few years, and the only thing we know about most investors is it's easier to pay attention to what happened recently and extrapolate that as the trend. So seeing that was a cause for alarm.
What's the asset manager's responsibility then in this case?
One is that there are ways to help advisors more efficiently address the problem of managing taxes.
You can try and change the tax rate that investors pay and a simple example is moving from a short-term gain taxed at a higher rate to a long-term capital gains and there's the investment in such a way that's mindful in taxable accounts, and that makes a huge difference. The second thing is deferring taxes to the future. Even if you had to pay taxes at some point, keeping that money longer helps it to compound in the market.
Those are basic levers. The challenge is that it becomes very challenging for an advisor to do on an individual client-by-client basis to manage the specific tax circumstances.
Is this a marketing opportunity right now for asset managers?
We certainly believe so. It has been very fruitful for us to help pick a pain point the advisors have and partner with them on a real client need. We started to see an up-tick in awareness in the industry, but there haven't been a lot of products helping with this need.
There are separately managed accounts. That's been around for quite a while, and always pitched as being fairly tax-friendly with different tax levers. The challenge is they've been fairly cumbersome to use and very time-consuming. So, advisors may sell them to clients on the benefits of the tax efficiency, but then not really follow through with it, and so it ends as not serving clients not very well.
How do asset managers then make these separately managed accounts more efficient for an advisor to use?
The challenge with separately managed accounts is advisors have to manage those accounts more on an ongoing basis, and it's really more of an operational platform. Typically there's an overlay manager - somebody who's responsible for looking at multiple managers in the account - and then on either a systematic basis or when certain tolerances are reached, who looks for opportunities to harvest securities that had a loss, and then offset that loss with gains from other securities in the portfolio. That requires good reporting, good systems and a consistent monitoring and action on the portfolio.
That sounds costly, which is something else clients want to avoid.
Technology has helped drive that down, but it is still more of a labor intensive process and like I said, for very high-net-worth clients, it can be a cost-effective service to provide them, but for more mass affluent clients, they're still in a reasonable high tax bracket, they still have strong returns in their portfolios and the challenge we find is a solution that's more scalable for that middle range of wealth.
Aren't ETFs filling that need because they're transparent and tax efficient?
Certainly passive investing whether it's an index fund or an ETF is more tax-efficient than a lot of active strategies. What we find is those strategies are passive from the investment standpoint, which helps keep the low turnover relatively tax friendly and pretty cheap, but they're also passive on the tax management capabilities. When we're entering the markets like we have more recently where there's been more volatility, there are actually more opportunities to pull more tax levers along the way if you're active about that. And so, we think that passive investing can be a very good strategy for a lot of investors, but being active about passive as well as investment decisions van be very beneficial.
Our research shows the average tax drag of the entire universe of active managed funds and the universe of passive funds, and some of the products that we've looked at we've actually been able to meaningfully lower the tax drag by being more active with some of these levers we could pull.
In terms of support, what do advisors want from asset managers?
There is a wide spectrum of advisors. For the more sophisticated advisors who are already more aware of tax managed strategies, I would say that the biggest opportunity there is to help them understand what are ways they can do this with more scale and more efficiently for a broader group of their clients instead of doing separate accounts, or maybe the top 20% of their book that represents the bulk of their assets.
Newer advisors typically have lower net worth clients, so getting them to focusing on after tax wealth is a big benefit.
Our industry pays very little attention to that. Almost all of our performance and reporting numbers are pre-tax numbers, but that's not the return the client gets. They get a tax return. Only in the mutual fund world, only products that are explicitly built as tax-managed products, those are the only ones that have to report a pre- and post-tax return.
So for example, all of the tax managed mutual funds that we run, we published three returns - the standard pre-tax return, there's an after tax pre-liquidation and then there's an after tax post-liquidation and it gives you a great idea how much of a tax hit you might have if you help up an investment over a different period of time.
Because of this, everyone focuses on pre-tax return and doesn't care about taxes as much. A lot of this is an awareness issue quite frankly.
What can asset managers do specifically to educate advisors?
Some of the things we've done is we have created more marketing collateral, both supporting the products we sell and general educational content on the importance of taxes and the importance of hosting an active tax wealth and we think that's part of it.
We have done over the last couple of years is many more of both seminars for advisors, as well as helping advisors do seminars for their clients.
The typical area that's fruitful is providing advisors with content to do seminars for different CPA referrals - there's a great synergy obviously between accountants who are focused on taxes, and advisors who are aware of that process.
We have found that to be a very beneficial partnership to help two areas of the client's professional sources.
Can you put together a good accountant for a good advisor to work together if there's a gap and understand on tax aware investing?
Absolutely; for the client, having both of those professionals and making sure that both are on the same page thinking about after-tax wealth for clients, we have found that to be very successful.
Also there are some online tools. We created a simple tax calculator for advisors to understand if they had a client portfolio and they managed taxes a bit more efficiently, what type of effect might that have over a longer time period?
You may look at shaving .2, .3 or .4%, off a return as some modest amounts, but when you're compounding that over 5, 10, 20 years that adds up to some meaningful differences in wealth.
What sorts of tax managed funds is Russell offering?
In the mutual fund space we have five funds that are addressing broad asset class coverage. We've had three of those for 20-plus years; basically tax-managed large cap, tax-managed small cap, and then a tax-exempt bond fund.
We launched the tax-exempt bond fund in 1985, and the tax-managed large and small in the late '90s, so we've been doing this for a long time. And frankly nobody cared for quite a while. We launched two more recently to try and extend the coverage to tax-managed international. There's also a tax-managed high-yield fund to complement the bond portfolio holding in muni bonds.
It's very easy to launch a product because it had great performance last year. But focusing and building products on outcomes gives you a product that's going to stick around for a while, and when you think about most investors, improving their after-tax takeaway is a big important outcome. That is subtly different than giving them a high enough return. It's what they keep. From a business standpoint, that's the type of approach that is not going to be a flash in the pan.
I think that the ETF product category is a very interesting one, where it started being very broadly diversified and now it is sort of this subset of the investing world that can typically add strong recent performance. They became marketed like crazy and then an ETF either gets lucky and works a little longer or it doesn't and then the next thing rotates through.
We found in the mutual fund world and in the ETF world as well, in some ways they are straying from some of the original benefits and principles that made those pretty solid products.