As the markets turn decidedly bearish for the first time in years, advisors who have experienced only bull markets over the course of their careers may be understandably stressed about how to help clients interpret an apparent decline in their portfolio values. While positive returns may be harder to find during a recession, it’s still a good time for advisors to help investors understand why they may owe capital gains tax even when their mutual fund balances decline and how to prevent this paradox in the future.
Volatile markets present opportunities to improve portfolio outcomes. One avenue to consider is separately managed accounts (SMAs), which allow advisors to improve tax outcomes for clients and help ensure tax-optimal treatment of client-driven changes. Higher-net-worth clients often prefer SMAs to pooled investments, such as mutual funds and ETFs, because SMAs offer unique customization and tax advantages not available with pooled investments.
Tax Risks With Mutual Funds
In the current market environment, many investors are focused on the declining value of their index funds, ETFs and mutual funds, but they may face an equally unpleasant surprise at year-end: capital gains taxes. In a declining market, investors who maintain their holdings in mutual funds outside of a qualified retirement plan could potentially face a tax liability for their share of each fund's realized capital gains at the end of the year, despite negative investment performance. Since December 2021, assets in index mutual funds and actively managed mutual funds have declined significantly. Investors who have remained invested in those funds while other investors departed are likely to face steep capital gains tax bills come year-end, because their fund managers have had to sell appreciated positions to meet other investors’ redemptions.
The reason for this seeming contradiction is that when multiple investors redeem their mutual fund shares at the same time, as often happens during pronounced market declines, a fund must liquidate securities to satisfy redemptions. If any security in a mutual fund is sold at a realized gain, perhaps because it was purchased a long time ago, that gain is distributed across the shareholders remaining in the fund at the end of the year. This means that those remaining in the fund end up paying taxes on gains realized to meet the redemptions of those leaving the fund. And it’s not the fund company or TV broadcasters that have to explain to the investor why they owe capital gains taxes on funds that have declined in value – it's you, their advisor.
Think of it this way: The turmoil that ensues in a bear market, with some investors selling their mutual fund holdings (in taxable accounts) while others stay invested, resembles a run on a bank. When it comes to tax liability, those investors who are first to get out of the pooled funds will not be responsible for capital gains. Those who stay invested in the mutual fund are left with capital gains taxes. This affects only mutual fund holdings in taxable accounts; fund holdings in nontaxable accounts (such as qualified retirement accounts) generally have no annual tax liability.
Some advisors who have built their practices on ETFs and mutual funds have never experienced a market correction like the one we are in now. Explaining to clients why they are receiving a 1099 from their fund companies for shares that declined in value is a tough conversation for which many advisors are unprepared.
SMAs and Tax-Loss Harvesting
Managing clients’ portfolios in SMAs rather than pooled investment vehicles gives advisors much more control over the timing and amount of realized gains (and losses) within the portfolio. Within an SMA, the investor owns all the individual securities, providing much more flexibility and ability to optimize tax outcomes. This does NOT require the advisor to be a tax expert, but it does enable the advisor to have a dialogue with the client about his or her expectations for annual capital gains tax bills. It also gives the advisor tools to communicate those expectations to the third-party manager who is managing and trading the SMA portfolio. This helps to avoid surprises and build trust, as well as improve client outcomes.
Maintaining tax-lot-level detail for the individually owned securities within a portfolio allows the manager to capture tax losses when the opportunity arises throughout the year. This is especially advantageous within direct-indexing SMAs because the number of holdings and available substitutes are not as constrained as they would be in an actively managed portfolio.
Realized tax losses from harvesting activities can be used to offset realized capital gains elsewhere in a client’s portfolio, improving the after-tax performance of a client’s entire account. If no gains are available to be offset, harvested losses can reduce a client’s taxable income by $3,000 per year or carried forward for use in future years.
Overlay Management
If a client owns multiple SMA strategies in separate accounts, tax inefficiencies can still exist, such as when a value manager purchases a stock recently added to a value benchmark just as a growth manager is selling it. The resulting wash sale can deprive the client of a tax loss that might otherwise have reduced taxable gains elsewhere in the portfolio or been carried forward for future use. Combining multiple SMA strategies into a unified managed account (UMA) — even integrating active managers and index-based strategies — can help to avoid the tax inefficiency (and operational inefficiency) of multiple separate accounts. Typically, a single party — the advisor, someone in a wealth management firm home office, or a third-party firm — acts as the “overlay portfolio manager” overseeing and quarterbacking all of the trading and rebalancing across the underlying SMA managers and index(es).
Advisors looking to protect clients from a tax loss can preserve tax optimization opportunities by looking for the best execution of a particular trade across a client’s entire portfolio. The overlay manager can move tax lots between managers to achieve the most tax-advantageous treatment for the client of each overlapping security transaction. Overlay management also helps to improve outcomes when rebalancing accounts that have strayed from their target allocations or when raising cash to satisfy a withdrawal request or investing new cash into the account. This becomes another opportunity for tax-loss harvesting and optimizing tax outcomes throughout the year.
Client Event-Driven Tax Optimization
Most SMA portfolios, whether actively managed or mirroring an index, are not static over time. Clients have life events that can inject new funds into a portfolio or require a distribution of funds, necessitating trades and rebalances.
Advisors (or overlay managers) can tax-optimize these life events to match a specific client’s needs, such as gradually diversifying a concentrated position like a company stock, donating to charity after a large cash bonus or inheritance, terminating an active SMA manager or funding a vacation property.
While many independent advisors understand the tax benefits of SMAs, they haven’t adopted them to the extent that wirehouse advisors have. To help clients in a down market, many advisors may want to consider SMAs as an option. As a tool to mitigate the effects of a down market and bring value to portfolios, SMAs can help attract new client assets and, for firms that are recruiting, help attract new advisor talent. Taking advantage of the many potential tax benefits of SMAs requires advisors to both fully understand the utility of this kind of portfolio and efficiently communicate those advantages to the end investor. If they can do that, they also better position themselves to serve a higher-net-worth clientele.
David Gordon is a Senior Vice President for Direct Indexing at Vestmark, www.vestmark.com.