Heightened investor sophistication that took decades to evolve has finally forced the financial services industry to come to terms with how much fees can eat into returns.1 Naturally, the industry has resisted fee pressure since, in the case of active management versus indexing, cost savings for investors can mean less revenue for managers, a potential conflict of interest that’s pretty well understood. As if the recent hemorrhaging of assets weren’t upsetting enough for proponents of the active approach, looming on the horizon is another potential tsunami for the industry as taxable ultra-high-net-worth (UHNW) investors wake up to a further potential conflict of interest (albeit a nuanced one) around the tax impact of various investment strategies.
Let’s start with calendar year 2018 as a particularly aggravating example of what we’d argue reflects the intentional avoidance by some UHNW wealth advisors of the tax impact of active investing. As investors experienced the first decline in a calendar year for US equities2 since the 2008–2009 financial crisis, the average US equity mutual fund suffered a loss of 5.66%. While losing money in a down year reflects normal stock market risk, having to pay taxes while losing money reflects an inherent drawback of active management. For taxable UHNW investors in the highest bracket, in addition to losing 5.66% before tax, they lost another 2.05% from the taxes on capital gains realized by their fund managers.3 Now, 2018 may have proved a particularly painful year for investors with taxable gains in a time of declining stock values, but the impact of the tax penalty from active management has consistently brought significant harm to taxable investors in active strategies.4 While many taxpaying investors remain unaware of the extent to which damage to their wealth from taxes can be avoided, we view the next big shift in UHNW investor perceptions and behavior as waking up to that negative impact.
Almost all wealth managers for taxable investors will tell you that they focus on after-tax returns for their clients, and some truly do. Advisors to the UHNW taxable investor will also tell you that the tax complexity of individual UHNW investors makes it difficult to optimize for taxes, a point that does carry some validity. However, at a fundamental level, the same conflict of interest that drives much of the investment industry to resist passive investing as a threat to revenue may also fuel a lot of the subtle preference for some of the least tax-efficient strategies.
Often, the strategies with the most sizzle and sex appeal introduce the greatest tax drag for taxable investors. Certain hedge funds and many active strategies can generate enough tax drag to undermine the promise of outperformance. That danger can lead to resistance to after-tax measurement. We’ve heard a number of advisors admit off the record that they don’t really want their UHNW clients understanding the full tax impact for certain strategies like hedge funds. Their thinking reflects a wariness that clients might be less impressed about not only a more tax-challenged strategy itself, but also, by extension, the entire value proposition offered by the advisor. To be sure, individual hedge fund strategies may in fact prove to be quite tax efficient, but an incentive remains for advisors that their clients not fully understand the tax implications of active versus passive strategies.
Obviously, this focus on after-tax returns becomes moot for institutional or other tax-exempt or tax-deferred vehicles. However, the investment industry has been resistant to educating its clients as to how differently taxable and tax-exempt portfolios need to be managed. As we argued in “What Would Yale Do If It Were Taxable?,”5 the asset allocation for taxable versus tax-exempt investors can require radical overhaul, not just tweaking at the edges.
Since we at Aperio view the vast majority of UHNW advisors as highly ethical people, this avoidance of measuring after-tax performance isn’t a problem of sleazy behavior. Instead, there’s a subtler but still insidious tendency at play where some advisors aren’t comfortable emphasizing the tax impact out of fear that doing so could undercut the perceived value they add. We’d argue that investors, who eventually did figure out that fees matter a lot to performance (both pre- and after-tax), are going to wake up to the impact of taxes on their net worth and start requiring a higher level of incorporating taxes into asset allocation and strategy selection. Like gravity, certain forces in the world eventually so dominate our perceptions that, once seen as radical, they become conventional wisdom. Many advisors have gotten ahead of the curve by embracing the new focus on fees, and tax awareness may represent the next opportunity to lead clients rather than wait until they force the issue. As Dan diBartolomeo, founder of Northfield Information Services, puts it:
Although it is clear to everyone in the industry that after-tax returns are what economically matter to taxable investors, many firms continue to take the view that ‘we can ignore taxes entirely as long as our competitor managers do the same.’ In our view, this position of intentionally providing less than the best available services to separate account clients is unsustainable in the long run, and borders on a breach of fiduciary responsibility.6
David Swensen, the justifiably renowned head of Yale University’s endowment, weighs in just as forcefully, “In an industry guilty of many crimes against investors, ignoring the tax consequences of portfolio transactions ranks among the most grievous.”7
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