Your Take: Upending Portfolio Management

Gerard Michael, president and co-founder of Smartleaf Asset Management, takes on traditional tax management strategies for client portfolios.

Reviewed by: Jeff Benjamin
Edited by: Ron Day

Damon-PolistinaIf your job was to manage only one portfolio and you had eight hours a day to do it, you’d be fine. You don’t. And you aren’t. If you’re like most advisors, a lot is falling through the cracks.

How do we know? We see that when firms implement a more systematic approach to tax management, they see reductions of over 60% in their clients’ capital gains tax bills. More surprising is that they also see a 60% reduction in the return dispersion of accounts with similar risk objectives.

This shouldn’t be possible. It makes sense that portfolios would have a trade off between taxes and dispersion. The fact that advisors can simultaneously improve tax outcomes and dispersion has a sobering implication: most return dispersion is not caused by customization or tax management. It’s just noise. An indicator of just how bad the industry is at the basics of portfolio management.

How can you do better? Here are three ways, all of which can be largely automated:

Implement year-round tax loss harvesting.

Year-end tax loss harvesting is not good enough. Our studies estimate that year-round loss harvesting, on average, generates roughly 75% more losses versus year-end harvesting.

Manage portfolios holistically, without sleeves/partitions/subaccounts.

Taxes and risk are properties of portfolios as a whole, not individual subsections. By managing portfolios holistically (without sleeves), you can simplify operations and simultaneously lower both dispersion and taxes. Sleeve and sub-accounts are operationally complex, requiring a separate workflow for cash in, cash out and asset class rebalancing. This approach limits the ability to manage portfolio-level tax and risk.

View direct indexing as a competence, not a product.

Most advisors view direct indexes as a product—an SMA subaccount you have managed by a third-party asset manager. This is a mistake. The purpose of direct indexing is to maximize personalization and tax efficiency. As we noted earlier, this is undermined by a subaccount structure.

There’s a better way. If you have this general competence to manage personalization and tax—a competence that can be applied to any portfolio, of any combination of ETFs, mutual funds, direct indexes and actively managed equity strategies, etc.—then managing a direct index simply drops out. There’s no separate workflow. It’s just something you do. And working with direct indexes becomes literally as easy as working with ETFs.

How do you know you’re doing well?

For most clients, you should be able to document that you save or defer more in taxes than you charge in advisory fees. Most advisors fail before they even begin becasue they lack the ability to document the value they provide through tax management, much less demonstrate that it is larger than their fees.

It is possible to do better. Virtually every aspect of tax management can be automated. And if you automate something, you can do more of it. You can provide every client, of every size, with tax optimization and high levels of personalization. At the same time, you can lower costs and strengthen compliance. Most importantly, you can have more time with clients and prospects.

Do you have an opinion that you want to share with other members of the financial planning community? We encourage financial professionals to send us their ideas for a Your Take column to us at [email protected].

Financial advisors and other industry insiders share their unique perspectives on specific issues related to wealth management and portfolio construction through this regular Your Take series.

Your Take gives readers a direct connection to thought leaders who share their thoughts on a broad range of topics most relevant to the financial planning industry.

Do you have an opinion that you want to share with other members of the financial planning community? We encourage financial professionals to send us their ideas for a Your Take column to us at [email protected].