Optimizing the tax efficiency of hedge funds in Charitable Remainder Trusts

Advisor's client had $300MM across multiple Charitable Remainder Trusts (CRTs), including a significant allocation to hedge funds. Aperio designed a "tax arbitrage" strategy to track the MSCI All Country World Index expected to save the client an estimated $32.7MM in taxes over 10 years.

Challenge

Advisor's client had $300MM across multiple Charitable Remainder Trusts (CRTs).
The CRTs were created by the client and a previous advisor with low-basis stock from an IPO. Given the low basis and holding period, all distributions would have been taxed as long-term capital gains. The new advisors desired a more diversified asset allocation that included both long-only equity and a significant use of hedge funds. Because CRT distributions are taxed at the highest rate incurred inside the trust, the hedge funds threatened to make all distributions taxable at the higher short-term capital gains rates.

Aperio solution

Aperio designed a "tax arbitrage" portfolio for the long-only equity allocation to offset the short-term gains of the hedge funds. Given the tax properties of the CRT structure, Aperio implemented a variation on tax loss harvesting called tax arbitrage.

Mechanics: Tax arbitrage sells all securities that have a loss on day 365 (creating short-term losses) and all securities that have a gain on day 366 (creating long-term gains). These short-term losses offset the short-term gains from the hedge funds.Meanwhile, the long-term gains created no incremental tax cost because the original low-basis stock would have caused CRT distributions to be taxed at long-term gains rates anyway.

Impact

Aperio strategy expected to save the client an estimated $32.7MM in taxes over 10 years. Because of the difference between short-term and long-term tax rates, the client saved an estimated $32.7MM in taxes over 10 years. Tax savings translated into an incremental 2.05% annually in estimated after-tax performance.

Related content

­ Hedge Funds versus Taxes: The Dilemma of Charitable Remainder Trusts