Innovations in Tax Aware Investing

Below is a webinar we recorded on November 19, 2020 titled “Innovations in Tax Aware Investing.” With potential changes in tax law, specifically centered on an increase in capital gains rates, we think this presentation is pertinent for those with capital gains exposure.

What you will hear today is, in our opinion, the future of portfolio and tax management. Stokes Family Office is one of 9 innovative investment firms nationally who partnered with O’Shaughnessy Asset Management to launch the first ever custom indexing solution.

Custom Indexing is a technology, and technology often removes barriers. Co-mingled mutual funds and ETFs sit in between investors and the stocks they own. Mutual funds and ETFs have been good to investors and were wonderful technologies in their own rights. However, Custom Indexing software and zero commission trading mean that in the future, more investors will own their shares directly rather than through mutual funds and ETFs.

As many of our clients know, we have long been proponents of low-cost indexing strategies. In fact, our firm’s single largest position is Vanguard’s Dividend Appreciation index. Custom indexing is a technology which unbundles co-mingled mutual funds, index funds, and ETFs in a simple, tax and cost efficient way.

Why is unbundling important? The drawback of bundled strategies like a mutual fund, index fund, or ETF, is the accrual of unrealized capital gains as the value of the strategies increase. Ultimately, when the position is sold, a capital gain tax is owed on the growth.

Research shows that around 1/3 of stocks deliver negative returns each year. So, even if the market is increasing, around 1/3 of the stocks that make up the market are decreasing on average. There in lies the opportunity. Under a mutual fund or ETF structure, investors are unable use this volatility as an advantage. However, under a custom index, investors can harvest losses in the 1/3 of stocks which are in negative territory. Based on O’Shaughnessy’s research, this could add between .50% and 1.0% to after-tax annual return versus the index benchmark.

Additionally, mutual funds, index funds, and ETFs are “one size fits all.” The custom index can be personalized to manage around very common issues and preferences we see with clients. We have used this technology to build strategies that are completely unique to our firm’s evidence-based investment philosophy and our client’s individual preferences. We can recreate our firm’s strategies more tax-efficiently to attempt to improve the strategies’ after-tax performance over time. We can manage around concentrated stock positions, and we can use harvested losses to offset gains elsewhere (sale of a business or other asset, mutual fund distributions, etc.).

Lastly, we can customize around specific philosophical preferences (termed in the industry as “ESG”). Some investors care exclusively about the elimination of tobacco. Others seek to avoid a companies which produce various unhealthy consumer products. And others want to adjust their portfolio for a whole wide range of issues important to them, their families, or their foundation’s mission. We don’t have a strong view as a firm that these factors will do much to returns in a portfolio. All we know is that the stricter the ESG settings, the higher the portfolio’s deviation will be from the benchmark. But for many, that is a fine and a fair trade-off.

These are just a few of the reasons why we believe this is the future.

Let’s take a step back and remember that the overarching goal of long-term portfolio management is growth of capital. Growth of capital can be summarized in three distinct areas – (1) capital appreciation, (2) dividends, and (3) tax efficiency.

So, when you’re listening to the presentation, please know that capital appreciation, dividends, and harvesting tax losses are not mutually exclusive. They can be used together to improve a portfolio’s after-tax performance over time via a simple, automated, tax-efficient, and low-cost investment account.

We hope you enjoy.

Please note this presentation is for informational purposes only and should not be taken as personal tax or investment advice. Investing in the strategies mentioned carries risk of loss, and investment results are not guaranteed. Please consult a tax or financial professional before implementing any of the strategies mentioned.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends. 

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.