Have you ever heard the phrase tax efficiency or tax efficient portfolio? Whenever I hear it my muscles tighten up, I get a little nervous, I lean forward to hear better and prepare to be wowed. Not long after, whatever the opposite of wowed is, I am. Once I realize that nothing has changed on this topic since the advent of governments taxing people on their investments, I scold myself for allowing this topic to capture so much of my attention. Nevertheless, I have never written a piece on this topic and thought I would share my thoughts. I urge you to prepare for some wow.
The Efficient Market Hypothesis
I hate the phrase "tax efficient" because the word efficient is a relativistic word and in the world of investing. Relativism is either a subliminal sales technique, a subtle way to say you have no idea what you are talking about, or a nuanced message that falls on deaf ears. For example, there are those that believe in the Efficient Market Hypothesis. It is a great name and the ultimate in relativism. I remember it today like it was yesterday the first time I heard the term. I thought, that’s all well and good but I have no interest in an Efficient Market Hypothesis; I want to learn the Most Efficient Market Hypothesis.
The Efficient Frontier
Why aren’t they teaching me that one? What are they keeping from me? Later I learned about the Efficient Frontier and once again, all I could think is, I don’t want my portfolio to be positioned on the Efficient Frontier, I want it on the Best Frontier Possible.
In the real world, you may have efficient energy sources but we still must find more sources of this efficient energy. You may create efficient machines but they aren’t perpetual motion machines. The point is, the term efficient is just used to compare something to something else. So let’s see if we can make sense of this with our money.
Two Extremes of Portfolio Tax Efficiency
We are lucky to be able to capture the two extremes of portfolio tax efficiency. We can have a portfolio that pays no taxes, which is the ultimate in tax efficiency, and a portfolio that pays the most taxes possible, which is the antithesis of tax efficiency. Unfortunately, there is no way to determine based on this information alone, which is better. It is for this reason that I often cringe around this topic.
For example, if one wanted they could invest all of their money in tax-free municipal bonds, pay no income taxes whatsoever and make or net 2 percent. Instead, they could trade a portfolio, make 10 percent gross, pay 4 percent in taxes at the highest rate possible and net 6 percent. I would be the person that prefers to pay 4 percent in taxes and keep 6 percent than the one that makes 2 percent. There you have it folks, an everyday run of the mill example that is played out every year across America. What does this mean? It means that tax efficiency is a phrase you can strike from your repertoire. But you need something else to replace it that actually matters. What matters to investors is the after tax rate of return. The bigger the after tax rate of return, the better.
Unfortunately, we can’t just say we want the largest after tax rate of return on our portfolios without considering the consequences. Most investors know that stock returns are a combination of two things, the price appreciation of the stock and the dividend it pays. What if we invested in stocks that didn’t pay dividends, to avoid taxes on dividends, and we held the stocks to capture their capital appreciation? If we did this, could we have years or even decades where we avoid paying taxes altogether?
The answer is yes we could. We could, and what a wild and volatile ride it would be since one of the main characteristics of stocks that don’t pay dividends is their extreme volatility. We then get an idea. We could reduce the volatility of a no dividend portfolio of stocks by adding tax-free municipal bonds to the portfolio. However, the price of doing this is we would be reducing the potential returns from stocks just to reduce volatility. Depending on the allocation between no dividend stocks and municipal bonds in this perfectly tax efficient portfolio you would arrive at an after tax rate of return. If you’ve gone down this path so far, it would only be logical to analyze alternative portfolio constructions to determine if there are alternatives that can either make you more with equal risk or make you the same with less risk. When you perform this analysis, which is very complex and well beyond the goal today, you find there are countless techniques that qualify and why the no tax portfolio construction has gone by the wayside.
So let’s refocus. A tax-efficient portfolio is a relativistic portfolio where you can’t determine if paying no taxes or paying the maximum amount in taxes is better since all that matters is the after tax rate of return. If the only thing that matters is after tax rate of return then the only thing that matters is finding a portfolio construction, portfolio style or asset allocation that meets your objectives and temperament. The conclusion is simple; find a portfolio construction style that works for you and implement it. It doesn’t mean you can neglect tax consequences, but it doesn’t mean that taxes should be the main driver.
Let’s touch on what you can do to reduce your taxes and make most any portfolio style you choose more tax efficient. It is tax loss harvesting. How tax loss harvesting works is mechanical and there are many subjective and objective or computer driven models to tax loss harvest correctly. Tax loss harvesting means, selling your losers before the end of the year and replacing them with proxies or other securities that you expect will perform the same as the loser you just sold. Some people confuse this technique with the phrase tax efficient portfolio. I can see why they do but it is just a technique and not a conscious decision as to how to construct a portfolio. Tax loss harvesting is a standard for most any portfolio construction one chooses to implement. Do it.
Let’s look at a classic case to understand where the relativism of tax-efficiency matters. Let’s compare an S&P 500 index fund, a passive investment, to an actively managed mutual fund. Which one is more tax efficient? In almost all cases, the passive index fund is more tax efficient. Actively managed mutual funds turn over their portfolio more frequently than passive funds. This turn over creates greater tax consequences than index funds. It is for this reason that we do not recommend active mutual funds for our clients. We would rather trade passive investments and control taxes than to have an active mutual fund tell us what our tax bill will be.
In closing, please note that if you have your money in a qualified account or tax-deferred account such as an IRA or employer sponsored retirement plan then tax efficiency does not matter. It only matters for non-qualified accounts.