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// NEWS: HEADLINES
• Optimal Window Closing for Tax-Efficient Allocation Changes
• Overlay Fulfills SMA Promise of Tax Efficiency, Customization
• Candidates Proposal to Increase the Capital Gains Tax Rates Should Encourage Advisors to Act Now
// Optimal Window Closing for Tax-Efficient Allocation Changes
Expected Increase in Capital Gains Rates Offers Advisors Prospecting Opportunity
Denver, CO – March 26, 2008 – The current 15% maximum long term capital gains rate is likely to disappear when a new administration takes office in 2009 or shortly thereafter. This means that inaction could be costly, especially for high-net-worth investors needing to change allocations or diversify a concentrated portfolio. However, it does create an opportunity for advisors who cater to wealthy investors.
If no new tax laws are passed, the current tax rates on dividends and capital gains created by President George W. Bush’s Economic Growth and Tax Relief Reconciliation Act of 2001 will sunset and tax rates will return to the old rates of 20% on capital gains and as high as 35% on dividend income in 2009. In addition, the media have reported that presidential candidates Barack Obama and Hilary Clinton have strongly supported increasing the capital gains tax rates, with some reports suggesting investors could see a return to 39.6% tax rate for top income brackets.
For high-net-worth investors, this difference between the 15%, 28% and 39.6% rates is significant. Consider the impact on liquidating a portfolio with $1 million in imbedded capital gains in order to diversify:
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Capital Gains Tax Rate
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Capital Gains Taxes
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% Increase
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15%
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$150,000
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0%
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28%
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$280,000
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87%
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39.6%
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$396,000
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164%
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Such figures illustrate the closing window of opportunity for advisors to high-net-worth investors. Investors most impacted by the increase in capital gains tax rates include:
• Single stock or concentrated portfolios
• Exchange funds that must be liquidated
• Assets held among multiple advisors
• Any pool of assets needing diversification
“Tax used to be just a year-end discussion or unpleasant certainty, but for savvy advisors it’s becoming a competitive advantage,” says John Phoenix, founder of Metamorphosis Money Management, a tax overlay manager. “Advisors need to see the expected increase in capital gains tax rates as an opportunity to prospect high-net-worth investors about strategies that can unlock tax frozen assets, making it possible to consolidate assets held away or implement asset allocation changes.”
About Metamorphosis Money Management
Metamorphosis Money Management, or M3, is a tax overlay manager that offers advisors a low cost, turnkey solution that can minimize the impact of capital gains taxes for clients who hold individual stocks in Separately Managed Accounts. By minimizing the impact of capital gains taxes, M3 delivers potentially higher absolute returns while also significantly reducing the advisor’s administrative burden. Learn more at www.metam3.com.
Michael Gelormino, River Communications, 914.686.5599
// Overlay Fulfills SMA Promise of Tax Efficiency, Customization
By John Phoenix, President and CEO, Metamorphosis Money Management
Based on recent media coverage and conversations with financial advisors around the country regarding separately managed accounts (SMAs), it’s clear that the SMA players have done an excellent job marketing these products and pushing their benefits. Probably every self-respecting advisor knows the purported benefits of SMAs: tax efficiency, customization, tax control, risk control, and simplified reporting.
But what most advisors may not realize is that only approximately 12% of taxable separate accounts actually receive some kind of tax treatment, according to Cerulli Associates Inc, and industry estimates show that only 24% of accounts benefit from tax customization. This is due to the fact that the industry has neither technology nor the man power to deliver on the promise that was made when the account was sold[1]. This is particularly painful for high-net-worth investors since tax is their single largest obstacle to long term growth. To understand the solution for these investors, we need to take a closer look at the underlying inadequacies in the SMA industry.
Customization vs. Scalability
The SMA business has frequently boasted about the advantages of using a separate account structure over pooled vehicles claiming customization and tax management as its winning combination. In reality the SMA industry has come to mirror the mutual fund world in many ways and the promise of customization and tax management, in most cases, has not been delivered upon. Why?
From the manager’s perspective mutual funds are far more attractive to manage due to the fact that their structure eliminates customization or tax management at the individual client level. As a result the margins on running funds are substantially higher than those on separate accounts.
For decades the industry has utilized separately managed accounts, but until the 1980’s reserved this vehicle primarily for large institutional clients. With the advent of the wrap account, the structure was introduced to the high-net-worth investor in the late 80’s on a mass scale, however, the popularity of the vehicle was limited due to the initially high investment minimums. With the introduction of “mass customization,” otherwise known as the “models approach,” minimums fell precipitously and assets under management began to grow.
Using this technique the manger simply created one “ideal” model and mandated that all accounts they managed conform to it. Although each client owns individual securities, their account does not differ from the thousands of other accounts under management in the strategy at the firm. The AIMR compliant returns posted by every separate account manager in the business bears this out. In this report, the manager states assets under management, performance, benchmark performance and dispersion for each of their products. Dispersion simply states the difference in performance from the best to the worst performing accounts. (Ask your favorite SMA manager to see their AIMR report to see for yourself.)
This SMA methodology was introduced primarily to benefit the nontaxable institutional investor whose sole concern was and is investment performance. Firms with low dispersion could assure these institutions that the performance was consistent among their accounts and that the institution would get what the manager had advertised. Firms strived for low dispersion. Unfortunately, this demand for consistency flew in the face of what the SMA industry had promised the high-net-worth community. Customization and tax management at the individual client level would most certainly lead to high dispersion. The SMA managers had essentially created a mutual fund with a lot of different account numbers.
Customization and tax management also led to scale problems that the SMA industry could not handle operationally. A simple example of the challenge faced by a manager would be to look at two hypothetical clients. Client A invested with an SMA Manager in January of 2007, who at that point purchased 10 shares of IBM for $10 per share on the investor’s behalf. One year later, client B invests with the same manager who still owns IBM which is now worth $6 dollars per share. If the manager harvests the $4 loss for client A, two issues arise:
• What should be purchased with the proceeds from this sale?
• Who is responsible for making sure that IBM isn’t repurchased within 31 days?
If the manager does in fact conduct this trade, now client A’s and client B’s accounts are different and cannot be traded in bulk. The dispersion will increase. This problem compounds exponentially as the number of accounts and positions owned grows.
The Overlay Solution
In the past five years advances in technology have brought the idea of alpha, tax management and customization back together in the SMA industry in the form of the overlay manager. The solution’s roots date back almost 100 years to Henry Ford and his assembly line. His revolutionary idea was to have workers specialize in a certain aspect of the construction of a car. This focus approach allowed them to master their specific craft and allowed Ford to turn cars out at a frenetic pace. With the SMA business the solution is identical – separate the process into its component parts: alpha generation or stock selection and tax management/customization or trading and allow each entity to master its craft. The concept is quite simple: allow the stock pickers to pick stocks and identify a trading manager to execute on these ideas with an eye to tax. The concept has further matured by allowing the investor to combine multiple managers into one account and allowing the overlay manager to trade them all simultaneously.
Early on, overlay managers faced the same challenge of scale as the SMA business. The recent development of batch order trading systems, smart technology and quantitative trading tools tailored to the taxable client is making it possible to deliver customization at the individual level for the mass market. Today, the client of an overlay manager can designate the investment managers they want to use, the capital gains tax budget they are willing to realize annually and the restrictions that they want in place at the security level. Additionally, if the client is changing strategies or advisors, they can dictate the level of realized capital gains taken in transition. Gone are the days when tax management was relegated to tax loss selling in the last days of December. As the market moves, beneficial tax trades can be made daily on the individual client level. With overlay management, the industry’s focus on simply beating a benchmark has shifted to providing the client the best absolute return (investment – fees and taxes) possible.
No taxation without optimization™!
© Copyright 2007 Metamorphosis Money Management, LLC (“M3”). All rights reserved. The examples used herein are for comparative and demonstrative purposes only and are not being offered to assist any person in making his or her own decisions as to which securities to buy, sell, or when to buy or sell. Past investment performance is not a guarantee of future results. No investment decision should be made until a prospective client has consulted with professional legal, tax, financial and other advisors.
[1] As Reported In: Investment News, “SMA Biz Makes Tax Management Easier for Advisers,” Dec. 10, 2007
// Candidates’ Proposal to Increase the Capital Gains Tax Rates Should Encourage Advisors to Act Now
By John Phoenix, CEO Metamorphosis Money Management
When selecting investment managers for their clients, many advisors take into account the manager’s overall expenses. The goal is obvious; they want their clients to earn as high a return as possible. Even a slight difference in fund expenses can have a major impact on the investor’s portfolio over time. Yet strangely, so few advisors utilize a tax manager. That’s striking when you consider that for most clients the current long term capital gains rate can take a 15% bite out of their long term gains and a horrifying 35% out of their short term gains.
And the news probably won’t get any better. These rates are likely to grow when a new administration takes office in 2009. Candidates’ proposals during the primaries to raise the maximum long term capital gains rate have ranged from 25-30%. This could have a devastating impact on high net worth investors’ portfolios, particularly those investors who need to rebalance, make allocation changes, or diversify concentrated or single stock portfolios.
There is good news that can guide advisors, however. The concept of tax overlay management is gaining appreciation due to managers’ ability to add demonstrable value to investors’ portfolios. New tools and methodologies for managing tax burdens in transition have also given the advisor a new weapon in the battle against capital gains taxes – not to mention a great new prospecting tool for the high net worth market.
Tax Overlay for Separately Managed Accounts
For years, Separately Managed Accounts (SMAs) have operated on the platform of providing tax efficient, customized portfolios while controlling risk for their clients. Unfortunately, many SMAs were designed to accommodate institutions; largely formatting their investment models for tax-exempt portfolios. Because of the operational complexities of managing SMAs for the taxable investor, especially during transition, and because taxable investors often have multiple managers for different asset classes, many SMAs haven’t delivered on their original promises when it comes to managing the portfolios of their high-net-worth clients.
This is where the tax overlay manager comes in. The responsibility of the overlay manager is to monitor and coordinate the trading done by each account manager to ensure that decisions are being made in the most tax efficient manner. The basic premise here is about specialization. Let your investment managers focus on what they do best – picking stocks – and let a tax manager enable your clients to keep more of those gains.
The Three Phase Tax Transition
In the past, the capital gains tax burden discouraged wealthy investors from making a needed transition, whether it was to diversify holdings or change overall allocations. That’s because most separate account managers execute essentially a two phase transition, which misses opportunities to capture higher absolute returns by reducing the impact of capital gains taxes. In the first phase, most managers typically liquidate the existing portfolio, largely ignoring tax implications and transaction costs. In the second phase the manager often relegates tax management to year-end tax-loss harvesting at the advisor’s request. By harvesting solely at year-end, the advisor misses many opportunities during the year to harvest losses that will eventually help offset realized capital gains, which can be large as a result of an initial liquidation.
A tax overlay manager, on the other hand, focuses on tax as a critical component to absolute return when diversifying a portfolio. The overlay manager works with advisors to develop truly customized portfolios that offer investors more control over their capital gains taxes. The key is employing a models-based approach where the overlay manager is able to obtain other managers’ investment models at a fraction of the cost of a traditional SMA relationship. This enables the overlay manager to create portfolios, at the advisor’s direction, that track the selected managers’ portfolios while retaining trading authority over all the investor’s holdings. As a result, the overlay manager and the advisor have the ability to make and execute strategic investment decisions that have the potential to generate significant tax savings known as tax alpha.
In order to generate tax alpha, new generation tax overlay management strategy uses a three phase transition that seeks to meet investors’ diversification and realized tax goals while simplifying the reporting function.
In phase one, the adviser selects investment managers who have proven, long-term track records of excellent returns from investing in individual stocks. Next, the tax manager develops a plan to begin moving the existing portfolio to the target portfolio while keeping the capital gains taxes within a budget established by the investor. At this point, tactical liquidation of optimal tax lots of the concentrated stock positions begins.
In phase two, stocks are bought incrementally from the list of securities held by the SMA managers, creating a hybrid portfolio that increasingly tracks the target portfolio as more of the concentrated stock positions are sold. Instead of simply buying all the securities held in the targeted portfolio, purchases are made using a quantitative model that factors in risk and correlation. The idea is to create a hybrid portfolio, within the capital gains budget of the client that most closely resembles the targeted model.
In phase three, active tax overlay management takes place. This means taking continuous (not just year end) tax losses in the hybrid portfolio to either offset the realized gains from the initial liquidation or to use the losses to further diversify out of the low basis securities.
The following case study is an example of how the three phase transition can add tax alpha to a portfolio, while at the same time keeping capital gains taxes within a predefined limit.
The Three Phase Transition Process at Work
The client, who was introduced by a multi-family office, was a retired physician. Having accumulated significant equity positions over the last 20 years, he was now focused on generating income and protecting his principal, but he still wanted to grow his assets through some market exposure.
His $16.5 million portfolio had $7.4 million of embedded gains. He owned no fixed income, small cap, international or alternatives, and 42% of the portfolio was concentrated in pharmaceuticals. Exacerbating his situation, the client had developed relationships with four advisors and as a result was confounded quarterly by over 280 pages of statements.
The client’s goals were clear:
• Generate a more stable income flow
• Lower risk
• Diversify
• Simplify reporting by consolidating to one advisor
• Minimize realized capital gains in transition
The need to generate cash in order to buy fixed income presented an additional challenge. In order to achieve his goals, the overlay manager and the advisor needed to develop an asset allocation model and transition strategy that would generate roughly $7 million in cash while creating a diversified portfolio. This had to be achieved while working within the client’s established realized capital gains budget – his tax tolerance – for the initial transition of no more than $500,000 in taxes or no more than $2 million in realized capital gains, based on the federal capital gains rate of 15% and his state tax rate of 9%
Having assessed and created a consolidated view of the client’s assets, the overlay manager worked with the advisor to develop a proposed target portfolio and select managers willing to provide their models for the equity transition. The proposed equity allocation included four managers: Large Cap, Mid Cap, Small Cap, and International.
Once approved, the process of transitioning the existing portfolio to a hybrid portfolio that would increasingly perform like the target portfolio began. How closely the hybrid portfolio exactly matched the target is measured by Tracking Error. Tracking Error has an inverse correlation to realized capital gains, so the lower the tracking error the greater the tax bill.
During the initial transition, the overlay manager had successfully created roughly $7 million of liquidity to fund fixed income, improved tracking error while staying within the capital gains budget:
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Taxation Estimates:
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Total Retained Gains
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$5,413,483
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Taxes Deferred (15% Fed, 9% State)
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$1,299,235
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Tax Alpha (as % of total transitioned assets):
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13.30% (1)(2)(3)
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Total Realized Gain
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$2,004,957 (3)
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Taxes Due (15% Fed, 9% State)
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$481,189
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Tracking Error Summary:
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Initial
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7.25%
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Predicted
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4.96%
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Improvement
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2.29%
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As a result of the Three Phase Transition, the client’s portfolio was successfully diversified over five styles, three capitalizations, internationally and domestically and in fixed income securities. The overlay manager was able to transition $7 million into bonds, generating income and reducing the risk profile of the client’s portfolio. All this was done while staying within the predefined $500,000 capital gains budget set by the investor. As an added benefit, the client received one 1099 and a 24 page statement, rather than a 280 page quarterly report sent out by each individual SMA.
With the window on the 15% capital gains rate potentially closing, now is the time to take action to protect your high net worth clients. It’s also the time to take a look at how a tax overlay manager can minimize the impact of capital gains burdens to help your clients keep more while you help them earn more.
No taxation without optimization™!
© Copyright 2007 Metamorphosis Money Management, LLC (“M3”). All rights reserved. This document is prepared for the use of M3’s clients, potential clients, and their professional advisers and may not be redistributed, retransmitted, or disclosed, in whole or in part, or in any form or manner, without the express written consent of M3. Receipt and review of this document constitutes your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this document. The information contained herein (other than disclosure of information relating to M3 and its affiliates) was obtained from various sources, and M3 does not guarantee its accuracy.
The graphical representations used herein are for comparative and demonstrative purposes only and are not being offered to assist any person in making his or her own decisions as to which securities to buy, sell, or when to buy or sell. Past investment performance is not a guarantee of future results. No investment decision should be made until a prospective client has consulted with professional legal, tax, financial and other advisors.
Under applicable U.S. Treasury Regulations we are required to inform you that any advice contained in this document is not intended or written to be used, and cannot be used, either (i) to avoid penalties imposed under the Internal Revenue Code, or (ii) for promoting, marketing, or recommending to another party any tax-related matter addressed herein.
(1) Investors should note that income from investments, if any, may fluctuate and that price or value of securities and investments may increase or decrease. Accordingly, investors may lose some or all of the value of principal initially invested.
(2) Model results will differ in relation to each individual(s) portfolio.
(3) The figures represented in this example maybe higher or lower based on the client’s total management fee inclusive of all management fees, commissions, trading cost and custodian fees.
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