Beta With A Twist Lets Advisors Earn Their Pay

With passive investments in control of the market, the ability to squeeze additional after-tax performance out of the index takes center stage as a differentiating factor.

[caption id="attachment_12803" align="alignright" width="107"] Brandon Thomas, Founder & CIO, Envestnet | PMC.For a more detailed discussion of Envestnet | PMC Quantitative Portfolios, click HERE for a recent webinar replay.[/caption]

Wealthy investors have embraced indexed vehicles over the last decade, leaving their advisors to figure out how to incorporate passive exposure into their own historically value-added proposition.

Last year’s surge of over $130 billion into indexed ETFs, portfolios and mutual funds according to Morningstar – accompanied by a net flow out of their actively managed counterparts – only demonstrates the depth of the hunger in the market for beta.

But while beta strategies tend to be extraordinarily efficient in terms of cost structure, it is difficult for many advisors to communicate the value they are adding by picking the right index at the lowest fee drag.

To give our client advisors a clear differentiator in the investor marketplace, we have combined the passive portfolio construction approach with vehicles that enable active tax management, adding a layer of efficiency that plays an alpha-like performance-enhancing role.

Benchmark investing, only better

The theory is that advisors who can systematically apply tax-sensitive tactics to a passive portfolio have the ability to deliver richer short- and long-term after-tax, or “take home,” returns than their actively oriented competitors – a detail that generally impresses existing clients and prospects alike.

Academic research indicates that tax-optimized passive portfolios can generate the equivalent of 60 basis points a year or more in additional after-tax performance, effectively and consistently “beating the benchmark” from the client’s perspective.

Even when the broad market stagnates, every basis point of performance becomes especially precious when shepherded efficiently through the tax process. And while printing a negative year is never flattering, the tax-aware advisor can at least pass on smarter capital losses to offset as much normal income as possible or reserve for more bullish environments down the road.

Moreover, active tax management gives advisors an advantage when it comes to satisfying non-performance-based investor expectations. A 2009 study revealed that 76% of taxable clients believe their accounts are already being managed with tax conservation in mind while barely 11% of their advisors actually report performance in after-tax terms.

Advisors who can demonstrate that they are part of that 11% can simultaneously give investors what they overwhelmingly say they want while taking the wind out of rivals.

But while the theory should be attractive to many Trust Advisor readers, the application has remained largely in the province of academics and specialists.

The structure of many conventional indexed vehicles (i.e., ETFs and mutual funds) defeats many of the classic tax management techniques – from loss harvesting to holding period management – due to structural reasons: investors in those vehicles don’t own the individual tax lots of the underlying securities.

Optimized beta that feels like “alpha”

We found that the separately managed account (SMA) and unified managed account (UMA) structures allowed our team to optimize model portfolios in such a way that they still track major benchmarks while remaining flexible enough to support intervention when necessary to reduce tax liability.

We built seven equity‑based strategies here at Envestnet | PMC alongside our colleagues at Envestnet | Tamarac, a division of Envestnet, who contributed advanced risk analytics that further honed benchmark tracking and baseline tax efficiency.

Few if any other portfolio designers could draw on that unique combination of technology and expertise, ensuring that these products go well beyond the vanilla ETF.

The constituent pools are streamlined in order to simplify the work of populating the accounts and limit turnover, benchmark drift and ultimately minimum account size. As a result, we have been able to offer tax-optimized SMAs for investors with as little as $60,000 to allocate.

Reducing turnover is obviously a factor in augmenting holding periods and so allowing taxable gains to mature to the point where they qualify for long-term treatment.

However, the flexibility of these accounts allows individual advisors plenty of room to display initiative and talent.

Quantitative Portfolios, or “QPs”, can be optimized for a wide range of tax situations, including client age and stated income.

When the after-tax calculations make sense, and losses can be harvested, our proprietary model will identify a security with similar characteristics to the one being sold so that the portfolio continues to closely track the index.

For longer-term considerations like legacy concentrated holdings and socially responsible investment requirements, the advisor is also free to substitute one position for another in order to keep realities and ideals in alignment. We currently support 17 SRI mandates and have the ability to customize further. QPs are very useful in custom situations where the client wishes to tax-efficiently transition from a concentrated portfolio of low cost basis positions into something more diversified.

The end result is a foundation-class vehicle biased toward significantly higher after-tax performance. As tax rates reflate to something more like historical norms, this proposition is more relevant to investor outcomes than it has been in over a decade.

Rising taxes only make the numbers more compelling. And tax efficiency is one of the few factors that advisors -- looking for more compelling numbers in a market that many consider overbought and ominously complacent -- can actually control.

Author’s disclaimer: The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Diversification does not guarantee a profit or guarantee protection against losses.

For Investment Professionals only. It is not intended for Private Investors


Envestnet, Inc. is a leading provider of unified wealth management technology and services to financial advisors. Our open-architecture platforms unify and fortify the wealth management process, delivering unparalleled flexibility, accuracy, performance and value. Envestnet solutions enable the transformation of wealth management into a transparent, objective, independent and fully-aligned standard of care, and empower advisors to deliver better results.

Envestnet’s Advisor Suite® software empowers financial advisors to better manage client outcomes and strengthen their practice. Envestnet provides institutional-quality research and advanced portfolio solutions through our Portfolio Management Consultants group, Envestnet | PMC®. Envestnet | Tamarac™ provides leading rebalancing, reporting and practice management software.


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