Tag Archives: Taxes

Why Congressionally-mandated FIFO accounting will adversely impact your clients – and what you can do about it.

This past Saturday morning, the Senate passed their version of the Tax Cuts and Jobs Act bill. One of the lesser known provisions in the Senate bill, was the elimination of an investor’s choice to identify which shares of securities they may wish to sell or donate. The provision states that the only way securities may be disposed of is through use of an accounting method commonly referred to as First-in First-Out (FIFO) where the oldest shares purchased are the first ones an investor may sell. Because of the protracted appreciation of the securities market, the first shares purchased are likely to be the lowest cost and therefore carry the most gain (and resulting tax penalty).

The House version did not include this particular provision. And because there exists so many differences between both versions of the bills, this past Monday, Congressional Republicans went to a Conference Committee to begin reconciliation efforts on the various differences between the two tax bills. Led by House Ways and Means Committee Chairman Kevin Brady, and Senate Finance Committee Chairman Orrin Hatch, there are a number of hot topics that will need to be negotiated – including individual tax rates, the handling of AMT, child tax credits, corporate tax rates and repeals to the Affordable Care Act.

Because of the number of big-ticket and high visibility items included in the bill coupled with the pace the legislation is advancing, some experts fear that the FIFO provision may be overlooked and ultimately absorbed into the reconciled bill as collateral damage to bigger-picture negotiations.

However, we at Adhesion believe that this would be shortsighted as the provision is damaging to the very investors and savers that it is purports to protect. The provision has virtually no impact on the $1.7 trillion funding gap the bill creates as it is currently scored at generating just $2.4 billion over 10 years. As inconsequential as those revenues may sound they don’t even consider the expense side of the equation – no official estimates exist thus far on the offsetting expense associated with infrastructure retrofit needed to operate, report, comply and monitor the changes thrust upon the industry. And it certainly does not consider expenses associated with policing and adjudication of these matters.

Interestingly, the Investment Company Institute, the powerful lobby representing the mutual funds and ETF industry, were granted an 11th hour carve-out reprieve in the Senate bill to allow mutual funds and ETFs to continue to sell specific tax lots within their pooled investment vehicles. It is important to note this carve-out exemption for institutional investors does not extend to those retail investors purchasing and selling these instruments, only how the fund itself accounts for the gains and losses within their portfolios.

We feel there are some other anti-competitive and unwarranted elements in this provision that members of Congress, investment advisors and end-investors should be gravely concerned about. Specifically –

  • When the Senate proposed a carve-out provision that protected the institutional fund companies and ETF providers while ignoring the retail investor class, they created an uneven playing field that is heavily tilted against retail investors. Through this provision, the institutional investor will be afforded a significant advantage as they may exit any tax lot they wish. With the freedom to select tax lots, the institutional investors can sell at will, whereas the retail consumer will be locked-up due to tax costs associated with their low-basis FIFO shares. This sort of unfair playing field is analogous to suggesting institutional investors can trade commission-free yet retail investors must always pay commission. The provision creates an enormously unfair and artificial trading barrier that will heavily disadvantage retail investors.
  • With this barrier in place, end-investors will likely open up different brokerage accounts or have paper certificates issued to them. In both cases, there is no reasonable method to enforce or monitor for this type of behavior. This will drive up operational costs for advisors and custodians which will ultimately be passed through to the end investors. And by exploiting this loophole, the revenue projections for this provision are likely to fall even shorter than expected.
  • By adding friction to the retail investor’s ability to liquidate securities through a FIFO provision, one should assume that there will be less selling – which leads to less liquidity and efficiency in our capital markets. This also means that retail investors will be less inclined to eliminate assets in an attempt to seek diversification. This will ultimately lead to concentrated and highly appreciated holdings in client portfolios which runs in stark contrast to tried and true investment principles of diversification, rebalancing and buy-low/sell high for retail investors. This introduces the potential of an enormous loss during a market correction as well as introducing excessive levels of portfolio risk – all while stifling the efficiency of the capital markets.
  • This provision disproportionally burdens older investors who likely have a more extensive tax history and on average maintain a lower cost basis than younger investors. This FIFO tax also represents an unplanned expense that retirees had not budgeted for – which will erode retirement savings at a time when retirees have very little time to recoup this new, unanticipated retirement gap.
  • This provision also disproportionally disadvantages middle- and upper-income investors who are more likely to hold FIFO-eligible securities. Contrast that with ultra-high net worth and institutional investors who frequently hold real estate, hedge funds and other sheltered ‘accredited investor’ assets, which can be exempted from FIFO provisions as a result of the Senate’s proposed carve-out clauses.
  • Lastly, if legislation is advanced, one unintended consequence facing mutual funds and ETF providers is that retail investors will likely seek to avoid concentrated positions so as to have more choice on which shares to dispose of. Mutual funds and ETFs are pooled investment vehicles, and as such, they are generally far more concentrated in a client portfolio than individual equities. We believe advisors and investors will wisely consider diversifying out of concentrated mutual fund and ETF holdings into a larger basket of diversified equities so as to have multiple tax lots to sell. So rather than purchase Coke multiple times, an investor may consider purchasing Coke, Pepsi, Dr. Pepsi and Constellation Brands. Security prices and equity valuations may no longer be dictated based on rational, sound fundamentals, but rather from a desire to exploit loopholes in heavy-handed government legislation.

For a bill that is intended to promote simplification and fairness, we think it does just the opposite. It unfairly penalizes the retail investor with a FIFO tax while introducing liquidity friction and complicated recordkeeping. At the same time, it rewards the large institutional and ultra-high net worth investors with flexibility to use their own preferred inventory accounting methods. Most would argue that if framed properly and viewed in its totality it would be difficult to defend.

So what can you do? We think this particular provision just needs a bit of sunlight so that it can be evaluated and debated in the open. With enough voices we think we can make this happen and we encourage you to get involved.

First off, encourage your clients to take action.  Consider directing them to TD Ameritrade’s Legislative Action Committee site, which has done a fantastic job of highlighting the issue.  From this site, they may contact their local representatives .

Next, as investment fiduciaries we would urge you to read the Money Management Institute’s position on the Senate version of the tax reform legislation.  On their site, the MMI chairman, Craig Pfeiffer shares talking points and a number of template letters you can use to contact your elected officials.  Similarly, the Investment Advisor Institute – an advocacy group for SEC-registered investment advisory firms has developed a site to contact elected officials and communicate your concerns of FIFO legislation.  Adhesion has also drafted an open letter to Congress which can be found here.  Feel free to use it or modify it and share it with your elected officials.

Also, as we head into year end, consider generating losses through active tax harvesting.  These losses can be used to unwind concentrated mutual fund or ETF holdings or buffer against future taxable gains resulting from potential inflexibility associated with this bill.  For more information on the value of tax harvesting and how it can add value to a client portfolio, feel free to watch this webinar

Lastly, we think now is a good time to dump concentrated mutual fund and ETF holdings to spread those proceeds into a diversified pool of equity holdings.  If you are interested in active equity managers, please consider Adhesion’s Asset Manager eXchange which can be found here.

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Barron’s: Tax-Overlay Trading Boosts Returns

This article originally appeared on Barron’s website on May 17, 2014.

Tax-Overlay Trading Boosts Returns

Wealth managers are using sophisticated programs to minimize taxes on capital gains and dividends.

By Karen Hube
May 17, 2014

Superior total returns have always generated Wall Street and investor bragging rights, with scant attention paid to how much an investor gets to keep after squaring up with the IRS. No longer. From independent investment advisors to big private banks like Morgan Stanley and U.S. Bank Wealth Management, wealth managers are adopting sophisticated tax-management software known as “tax overlay” to monitor portfolios for opportunities to minimize taxes on capital gains and dividends. (For an example, see our related story on wealth manager Veritable, “Unvarnished Returns.

“Investment advisors are realizing that it’s very difficult to outperform a benchmark, but they can consistently add value by minimizing taxes,” says John Longo, who teaches at Rutgers University and is the chief investment officer of MDE Group, an investment advisory firm in Morristown, N.J. “Taxes are the largest transaction costs investors face.”

He has a point. Between 1990 and 2012, investors in stock funds in taxable accounts gave up 1.12% of their average annual return to taxes, according to a study by Clemens Sialm and Hanjiang Zhang from the University of Texas at Austin.

It’s also important to note that this is an era when after-tax returns really count. The Standard & Poor’s 500 has soared over 150% since its March 2009 low-point, while the top rate on long-term capital gains rose from 15% to 23.8%, and short-term gains went from 35% to 43.4% for top taxpayers. Dividend taxes, meanwhile, were increased from 15% to 23.8%.

Tax-overlay technology is made possible by the widespread use among wealth managers of unified managed accounts. A UMA consolidates an investor’s various accounts, traditionally a mix of funds and separately managed accounts, each with multiple (often overlapping) holdings, and varying purchase prices, or cost bases.

Once using UMAs, wealth managers buy portfolio models from investment managers, and invest client assets themselves. As changes are made to the portfolio — daily, weekly, whenever — the investment manager supplies the wealth manager with a revised model, and the wealth manager makes the necessary trades.

Controlling the trading gives wealth managers executing the portfolio concept the added ability to manipulate individual portfolio holdings through the overlay software, to minimize the trade’s tax consequences. Some big firms like Morgan Stanley and Bank of America Merrill Lynch have built their own in-house systems; small or independent advisors typically hire third-party overlay managers, such as Parametric, Smartleaf, Adhesion Wealth Advisor Solutions, Managed Portfolio Advisors, and Placemark Investments.

The major purpose of an overlay system is to identify the most tax-advantageous way to carry out trading instructions. “Our system recognizes that securities are purchased at different times and prices,” says Chris Scott-Hansen, Morgan Stanley Wealth Management’s head of trust and tax-management services. “Say you bought Johnson & Johnson with different managers five years ago, three years ago, and this year, and now one manager wants to sell. We look at the stock holistically to see which shares to sell for the best tax outcome.” And as gains are realized, the software also finds potentially offsetting losses.

“Say you have $50,000 in realized capital gains. If you can reach into a portfolio and identify losses that can eliminate those gains, you avoid paying tax, and that can be a significant performance benefit,” Scott-Hansen says.

But the software is more than just a flagging system, says Jerry Michael, president and co-founder of Smartleaf.

When a security tanks, the system suggests selling a cluster of the stock for tax reasons, and then recommends a substitute investment. And there are nuances: If a manager reduced “a stock weighting from 1.5% to 1%, but that would mean a hefty short-term gain [and taxes], then we might only sell to 1.25%,” says Jared Gray, director of centralized portfolio management for Parametric, a Seattle-based overlay manager.

Conversely, if the tax managers tamper too much with the investment manager’s model, returns may turn to dribble.

Low deviation rates combined with high tax alpha — the added return due to tax management — is the ultimate goal, says Rick Pitcairn, chief investment officer of the Philadelphia-area family office Pitcairn. Even with the tax overlay’s tweaks, Pitcairn says the performance of his portfolios are within 10 basis points (0.1 percentage point) of the pure investment strategy’s returns, while providing an extra 1.1-percentage-point advantage, due to lesser taxes, every year since 2008, when the Pitcairn overlay system was put in place.

But the UMAs and tax-overlay programs don’t enchant all wealth managers. Iain Silverthorne, a partner and wealth advisor at Evercore Wealth Management in New York, says the explosion in use of UMA overlay technology is a sign that there is a problem in the industry to begin with.

“There is an inherently tax-inefficient process in place that they are trying to make more tax efficient,” he says. At Evercore, a single customized streamlined portfolio is created so that tax management is possible without institutionalizing or automating the process. The UMA overlay platform is simply a Band-Aid that layers on added fees, he says.

AH, YES — THE FEES. Watch out. UMA platforms cost between 1% and 1.2%; typically, there is an added cost for tax overlay of 0.1% to 0.2%. The UMA and overlay fees are, ahem, overlaid on top of both your wealth manager’s advisory fees and the fees charged by the investment managers.

But that might not be as bad as it sounds. Investment managers charge less for models than managing the assets themselves; an equity manager’s fee can drop from 1.2% to 0.5%, for example, if your banker is using a UMA and executing the investment manager’s trades. So the reduced investment-management fee may compensate for the cost of the UMA and overlay.

Still, it’s hard to say to what degree smart tax management will pay off. It can boost returns in excess of 1% in some years for some, but produce negligible results for others. “If anyone promises a specific amount of high annual tax alpha, that’s like promising performance. It can’t be done; it’s so individualized,” warns Patrick Newcomb, senior analyst at Cerulli Associates, a Boston market-research firm.

Meaning? In most years, tax overlay systems will add value.

But it’s not guaranteed.


See the full article here.

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