Key takeaways
Maximizing after-tax returns is a key goal for high net worth clients, and advisors have new tools at their disposal given recent innovations in the financial industry. Building direct indexing, option overlay and private investment strategies into client portfolios help reduce taxes, manage risk and with a goal to reach for higher returns.
Taxes are one of the biggest pain points for clients with substantial investments in taxable accounts. Federal taxes can be as high as 40.8% for short-term gains and 23.8% for long-term gains. Some U.S. states such as California and New York impose capital gain add-ons which can push an investor’s short-term tax rate above 50%.
At these rates, the expected impact of taxes may easily deter an unadvised investor from implementing portfolio adjustments that would have been beneficial for their long-term outcomes. This creates an opportunity for you as an advisor to add value for high-net-worth clients as higher tax rates mean your portfolios decisions may have a greater impact on your client’s tax bill.
While tax-loss harvesting is not a new practice, there are now more efficient ways to do it. Instead of rushing to sell underperforming investments toward year end, high-performing advisors are using direct indexing strategies in separately managed accounts (SMAs) to harvest tax losses throughout the year without having to adjust their strategic asset allocations. Additionally, the tax losses generated by direct indexing SMAs can be used to offset gains reported on Schedule D, including gains on the sale of a business or non-primary home.
Another recent innovation is the use of option overlay SMAs to help reduce risk without selling any holdings and thus not triggering taxable events.
Option overlay SMAs provide varying levels of risk management on individual holdings or on equity portfolios and can be customized based on clients’ goals. These strategies can be effective in different scenarios, including 1) rebalancing portfolio risk when a client’s risk tolerance changes, and 2) reducing single-stock risk when a client holds a concentrated position.
1. Rebalance portfolio risk
Let’s say you need to dial down risk for a client who holds an equity-heavy portfolio. Trimming the equity allocation would result in the realization of capital gains, which could mean significant tax costs for a high net worth individual. Instead of selling down the client’s equity holdings, you can implement an option overlay strategy to limit stock market risk and effectively adjust the overall risk profile of the client’s portfolio.
2. Limit concentrated stock risk
Many wealthy investors hold concentrated stock positions. They may have accumulated the stock as a senior executive for the company where they built their career and personal wealth, or they may have inherited a multi-generational stock position. Either way, these concentrated positions can drive significant portfolio risk.
While there are many individual stocks that have outperformed markets over time – sometimes in a very big way – most stocks do not. And, in fact, many underperform significantly. According to Aperio Research and MSCI, the top decile stocks in the Russell 3000 Index produced significant excess returns over a 36-year period, but performance drops off meaningfully below that top decile – and 70% of stocks underperformed the index.
A concentrated stock position rarely wins
Average excess returns on stocks in the Russell 3000 Index by decile, 12/31/86-4/30/24
Source: Aperio Research and MSCI. Past performance is not a guarantee of future results. Includes 12,104 securities.
Despite the glaring risk in holding a concentrated stock position, many high-net-worth investors are reluctant to reduce their position either because they have an emotional attachment to the company, or because they are deterred by the tax implications of selling a low-cost-basis holding while subject to very high tax rates. And in some cases, both reasons apply.
If a client feels strongly about maintaining a concentrated stock position, you can manage the individual security risk with option overlays without necessarily needing to sell the stock. If a client agrees to liquidating their concentrated stock position, either partially or entirely, there are ways that you can ease the pain of taxes. If you plan to gradually reduce the position, option overlay strategies may generate tax benefits that can soften the blow of realizing gains on the shares you sell while limiting the single-stock risk associated with the shares you still hold. If you earn money on the options, those proceeds may help offset the tax cost of realizing gains on the underlying security. If you lose money on the options, you can net those losses against the realized gains.
You can also help offset the tax cost of selling the concentrated stock by taking advantage of tax-loss harvesting strategies in other parts of your portfolio. If you have cash on hand to invest, putting it to work in a direct indexing SMA could generate losses that help offset the gains realized as you liquidate the concentrated stock, which may make it easier to reduce the position more quickly.
Lastly, don’t forget about charitable giving. If your client chooses to donate shares of the concentrated stock to a qualified charity, the fair market value will be deducted from the donor’s taxable income and neither the donor nor charity will be taxed on the capital gain.
Private market investments have long been a staple in institutional portfolios. They offer investors the potential to earn above-market returns in exchange for liquidity constraints. Both private equity and private credit have outperformed their public counterparts over the past 8 years.
Private markets have outperformed public markets
Annualized returns from 9/30/15-12/31/23
Source: as of 12/31/23. Asset class comparison is used to demonstrate private market performance compared to public market performance during comparable time periods. There are material differences in individual index/ manager universe methodologies (both public and private) and differences in the way public and private market performance is calculated; the comparisons shown may not fully reflect these differences. In general, public market indexes are unmanaged, represent a group of constituent securities which may change over time, reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses. Private market manager universes and indices often rely on self-reporting by managers. Therefore, there may be survivorship bias given that fund managers have discretion to report, or to discontinue reporting for various reasons (e.g. due to liquidation), and therefore private market manager universes and indices may reflect a bias towards funds with track records of success. Private Equity represented by the Burgiss Private Equity Manager Universe. Burgiss data reflects quarterly time-weighted returns. Burgiss data is sourced from limited partners of these private funds and calculates results net of fees and carried interest, providing results that are updated and published on a quarterly basis. Private Credit represented by the Cliffwater Direct Lending Index. Private credit reflects rolling quarterly returns. Past performance does not guarantee or indicate future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an unmanaged index.
Until recently, access to private market investments has been limited to qualified institutional buyers. However, the introduction of private market interval funds opens the door to accredited investors and presents fewer logistical challenges – with generally lower investment minimums, quarterly liquidity, and easier tax reporting via Form 1099 vs. K-1.
If you’d previously written off private market exposures, it’s worth revisiting for your high-net-worth portfolios where suitable for the client.
Build innovative portfolios for your high-net-worth clients
As the financial industry evolves, exciting innovations may continue to present new ways to build portfolios for better after-tax returns. Direct indexing SMAs, option overlay strategies, and private market exposures may all play significant roles in driving better portfolio outcomes.
BlackRock can help you construct well-diversified portfolios for your high net worth and ultra-high-net-worth clients. Contact your BlackRock representative for more information or explore our online investment tools and resources.
Explore the Advisor Outlook – BlackRock’s monthly market outlook for financial advisors – for more details on our latest market and portfolio insights.
Obtain exclusive insights, CE courses, events, model allocations and portfolio analytics powered by Aladdin® technology.
Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. Actual investment outcomes may vary. There is no guarantee that these investments strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product or strategy will or is likely to achieve profits.
Spider Rock Advisors, LLC (“SRA”), an investment adviser registered with the SEC and a commodity trading advisor registered with the CFTC, provides discretionary options overlay investment strategies. SRA is an indirect wholly owned subsidiary of BlackRock, Inc.
The Aperio strategies discussed are made available by Aperio Group, LLC, a wholly owned subsidiary of BlackRock, Inc., which is a registered investment adviser.
Options involve risk and are not suitable for all investors. There is no guarantee that any investment strategy illustrated will be successful or achieve any particular level of results. This material is not intended to be relied upon as a forecast, research or investment advice and is not a recommendation or offer or solicitation to buy or sell any securities or to adopt any investment strategy. Refer to Characteristics & Risks of Standardized Options.
Due to the complexity of tax law, not every single taxpayer will face the situations described herein exactly as calculated or stated; i.e., the examples and calculations are intended to be representative of some but not all taxpayers. Since each investor’s situation may be different in terms of income tax, estate tax, and asset allocation, there may be situations in which the recommendations would not apply. Please discuss any individual situation with tax and investment advisors first before proceeding. Taxpayers paying lower tax rates than those assumed or without taxable income would earn smaller tax benefits from tax-advantaged indexing or even none at all compared to those described.
© 2024 BlackRock, Inc. All Rights Reserved. BLACKROCK is a trademark of BlackRock, Inc. or its affiliates. All other trademarks are those of their respective owners.
USWAH0724U/S-3703762
