Tax Alpha Measurement: 1.8% Improved After-Tax Portfolio Return

Tax Alpha Measurement: 1.8% Improved After-Tax Portfolio Return

Executive Summary

Summit Capital, a leading RIA firm, faced the challenge of quantifying the value of their active tax management strategies for clients. To address this, they implemented a robust methodology to track and measure tax alpha generated through techniques like tax-loss harvesting and strategic asset location. This approach allowed them to demonstrate a concrete 1.8% improvement in after-tax portfolio returns for clients, solidifying the value proposition of their services and enhancing client communication.

The Challenge

For many clients, the tangible benefits of active tax management can be difficult to grasp amidst the complexities of portfolio performance and market fluctuations. While Summit Capital consistently delivered superior financial planning and investment advisory, clients often struggled to fully appreciate the value generated through proactive tax strategies. This lack of clear understanding posed several challenges:

• Difficulty in Justifying Fees: Clients sometimes questioned the value of active tax management fees when investment returns were being primarily driven by overall market performance. They needed a way to see how tax management provided an additional layer of benefit.
• Lack of Differentiation: In a competitive landscape, Summit Capital needed a way to demonstrably showcase their expertise in tax-efficient investing. Simply claiming superior tax management wasn't enough; they needed data to back it up.
• Client Retention Concerns: Without a clear understanding of the value provided through tax optimization, clients might be more inclined to switch to lower-fee, passive investment strategies, potentially overlooking the significant long-term tax benefits.
• Example Scenario: Consider a client with a $1,000,000 portfolio in a taxable account. A 7% gross return might seem adequate, but if the client pays 25% in taxes on gains, their after-tax return is only 5.25%. Summit Capital believed they could significantly improve this, but needed a way to quantify and communicate the improvement. A 1% improvement after taxes on a $1,000,000 portfolio is $10,000 directly to the client.

Summit Capital understood that quantifying tax alpha was crucial for enhancing client communication, differentiating their services, and demonstrating the tangible benefits of their proactive tax management approach.

The Approach

David Park, lead advisor at Summit Capital, championed a new approach focused on rigorous measurement and transparent reporting of tax alpha. This approach centered around the following key components:

1. Defining Tax Alpha: Summit Capital explicitly defined tax alpha as the difference between a client's actual after-tax return and the after-tax return of a comparable, tax-unmanaged benchmark portfolio. This benchmark was chosen to reflect the client's risk tolerance and investment objectives, but without any active tax management strategies.
2. Identifying Tax Management Strategies: The team clearly defined the range of tax management strategies they employed, including:
   • Tax-Loss Harvesting: Systematically identifying and selling losing positions to offset capital gains, thereby reducing current-year tax liabilities.
   • Asset Location: Strategically placing different asset classes (e.g., high-dividend stocks, bonds) in different account types (e.g., taxable, tax-deferred, tax-exempt) to minimize overall tax burden.
   • Wash-Sale Avoidance: Implementing procedures to avoid the wash-sale rule, which disallows the deduction of a loss if the investor repurchases a substantially identical security within 30 days before or after the sale.
   • Tax-Efficient Trading: Considering the tax implications of all trading decisions, such as minimizing short-term capital gains and prioritizing long-term gains when appropriate.
   • Charitable Giving Strategies: Including donation of appreciated securities to qualified charities.
3. Benchmark Portfolio Construction: For each client, Summit Capital created a hypothetical benchmark portfolio with the same asset allocation as the client's actual portfolio, but without any active tax management. This benchmark served as the "control group" for measuring tax alpha.
4. Performance Tracking and Reporting: Using their performance reporting software (Addepar), Summit Capital meticulously tracked the performance of both the client's actual portfolio and the benchmark portfolio, including all realized gains, losses, and tax liabilities.
5. Tax Alpha Calculation: They then calculated the after-tax return of both portfolios, subtracting all applicable taxes from the gross return. The difference between the client's actual after-tax return and the benchmark's after-tax return represented the tax alpha.
6. Transparent Communication: Finally, Summit Capital presented this information to clients in a clear and concise manner, highlighting the specific tax management strategies employed and their impact on after-tax portfolio performance.

Technical Implementation

The technical implementation involved leveraging Addepar to automate the performance tracking and tax alpha calculation process. Key steps included:

• Data Integration: Integrating data feeds from custodians (e.g., Schwab, Fidelity, Pershing) into Addepar to ensure accurate and up-to-date portfolio information.
• Benchmark Portfolio Setup: Creating benchmark portfolios within Addepar for each client, mirroring their asset allocation but excluding any tax-managed trades. The benchmark portfolio must be kept static.
• Transaction Classification: Ensuring that all trades were properly classified within Addepar to distinguish between tax-loss harvesting trades and other investment decisions. The classification allows for appropriate attributions.
• Tax Calculation Engine: Utilizing Addepar's built-in tax calculation engine to estimate tax liabilities based on realized gains and losses, dividend income, and other taxable events.
• Custom Reporting: Developing custom reports within Addepar to display the tax alpha calculation in a clear and visually appealing format. This report showed the client's actual after-tax return, the benchmark's after-tax return, and the resulting tax alpha.
• Formulaic Breakdown: The key formula implemented was:

  Tax Alpha = (Client After-Tax Return) - (Benchmark After-Tax Return)
  
  Client After-Tax Return = (Gross Return - Taxes Paid) / Beginning Portfolio Value
  
  Benchmark After-Tax Return = (Gross Return - Hypothetical Taxes) / Beginning Portfolio Value
  

  Where "Hypothetical Taxes" are calculated based on the benchmark portfolio's gains and losses assuming no tax management.

Results & ROI

Implementing this methodology yielded significant results for Summit Capital:

• Average Tax Alpha of 1.8%: Across all client portfolios, Summit Capital demonstrated an average tax alpha of 1.8% per year over a 3-year period. This means that clients who utilized Summit Capital's tax management services realized an average of 1.8% higher after-tax returns compared to a comparable, tax-unmanaged portfolio.
• Quantifiable Value: This methodology allowed Summit Capital to quantify the value of their tax management services in concrete terms, providing clients with a clear understanding of the benefits they were receiving.
• Enhanced Client Communication: The transparent reporting of tax alpha facilitated more meaningful conversations with clients about the value of active tax management. Clients were now more engaged and appreciative of the strategies being employed on their behalf.
• Improved Client Retention: By demonstrating the tangible benefits of their services, Summit Capital significantly improved client retention rates. Clients were less likely to switch to lower-fee, passive investment strategies when they could see the value being generated through proactive tax management.
• Concrete Example: For a client with a $2 million portfolio, a 1.8% tax alpha translates to an additional $36,000 in after-tax returns per year. Over a 10-year period, this can compound to a substantial difference in wealth accumulation.
• New Client Acquisition: The ability to demonstrate quantifiable tax alpha also became a powerful tool for attracting new clients. Summit Capital could showcase their expertise in tax-efficient investing and differentiate themselves from competitors who could not provide such concrete evidence of their value.

Key Takeaways

Other advisors can learn from Summit Capital's approach by:

1. Prioritizing Quantifiable Value: Don't just claim to provide superior tax management; develop a robust methodology to quantify the value you're delivering.
2. Leveraging Technology: Utilize performance reporting software to automate the performance tracking and tax alpha calculation process. Addepar, Orion, or Black Diamond offer features to facilitate this process.
3. Focusing on Transparency: Communicate the results of your tax management efforts to clients in a clear and concise manner, highlighting the specific strategies employed and their impact on after-tax portfolio performance.
4. Benchmarking Aggressively: Choose benchmarks that are realistic and match the asset allocation to provide realistic context of impact.
5. Refine and Iterate: Continuously review and refine your tax management strategies to ensure you're delivering the maximum possible value to your clients. Tax law changes and market conditions require ongoing adaptation.

About Golden Door Asset

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