What is the value of tax management in legacy portfolios?

Aperio’s research and analysis

Tax loss harvesting is broadly recognized as a means to generate positive alpha over an index in the form of tax savings. However, most of the extensive research on the value of loss harvesting in separately managed accounts assumes that portfolios are funded with cash. It is also not uncommon for loss-harvesting providers to produce composite reports that include only accounts that start with cash.

In practice, about half of Aperio’s clients with taxable accounts fund those accounts with securities. For these “legacy” portfolios, Aperio’s active tax management provides two main tax benefits. First, at inception, they transition the client’s holdings to an Aperio strategy using tax-aware optimization, aiming to lower tracking error to a benchmark while minimizing gains. Second, after the portfolio’s inception and throughout its life cycle, they continue to harvest losses to generate tax alpha.¹ Tax alpha in legacy accounts is typically lower than in those that start with cash, as a highly appreciated initial holding may never convert to a loss. In this note, Aperio analyzes these two benefits by looking at the distribution of tax savings on transitions and the tax alpha attained from loss harvesting.

Tax savings on transitions

In most cases, transitioning legacy positions to an Aperio strategy provides an up-front benefit in the form of deferred taxes.⁴ By building a more diversified portfolio around existing positions, we help avoid a full liquidation of the portfolio—and the significant capital gains that can result (see Figure 1). In fact, almost all of our taxable legacy portfolios enjoyed the benefit of migrating without the need for a full liquidation. The average saving was 8.0%, with half of the observations falling between 3.2% and 12.0%.

Illustration of tax savings on transitions

Tax alpha from loss harvesting

The ratio of cost basis to market value (CB/MV) at inception is a good predictor of a portfolio’s potential to generate tax alpha (see Figure 2). As anticipated, tax alpha rose along with the initial CB/MV. We saw a four-fold increase in tax alpha in portfolios that started from cash relative to the lowest CB/MV group (<40%).

Illustration of 5-year average annualized tax alpha

Conclusion

A large portion of the capital gains taxes embedded in a legacy portfolio can generally be deferred by transitioning to an Aperio strategy in a tax-efficient manner. Subsequent loss harvesting provides additional tax alpha, which tends to be higher for portfolios with fewer embedded gains at inception. With tax-aware optimization, a portfolio goes through a powerful transformation. Losers are sold, yielding a potential tax benefit to the investor in the presence of outside gains, and replenished with new securities while maintaining close index tracking. Through the deferred realization of capital gains and disciplined loss harvesting, clients may enjoy the tax benefits of their investments.