Voices

Practical tips for tax professionals on client investment trends

The importance of a tax professional’s role will increase as robo-advisory takes hold and algorithms replace investment advisors. Your role as tax and compliance expert will broaden to include “financial quarterback,” charged with tax-aware investment consulting.

Over time high-net-worth clients will grow to rely on their tax professionals to provide thoughtful counsel on key vulnerabilities including the growth of passive investing.

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According to the Financial Times, index-like equity investment now comprises over a third of the market, and this does not fully account for “closet indexers” or those who closely track a benchmark but are reluctant to acknowledge it. With robo gaining substantial traction that percentage is sure to grow. A recent Deloitte research report forecast $5 trillion of robo (exchange-traded fund) market share growth over the next decade in addition to the current allocation of $3 plus trillion in ETF investments overall. This combined $8 trillion represents nearly 30 percent of current household wealth by Deloitte’s measure. Further, the majority of ETF growth is likely to flow into inexpensive equity indexes supported by a few bulge bracket firms. Enormous inflows into index-like equity ETFs, especially at or near the top of the market, will increase the potential for unforeseen consequences.

Several tips that may help you support improved client outcomes are listed below.

Portfolio Management Best Practices Tips

Be sure to encourage tax-aware best practices, including the use of separately managed accounts, or SMAs, with taxable assets, asset location management planning, realized gain budgeting, tax-loss harvesting, and HIFO (highest in, first out) accounting. Employing a client-customized combination of both active and passive strategies in core high net worth portfolios with the goal of achieving the best possible risk-based outcome should be the goal of all advisors and tax professionals.

Beware, passive stock indexes were never intended to be templates for investment products. Valuation inefficiencies (under and over valuations) in index-like investment products are likely to grow over the next several years and this is sure to impact the results they achieve. Investors should avoid the boom and bust cycles that commonly occur with overly popular investments and now confronts passive index-like investment products.

Active management must exist in order for passive investable index products to remain viable. Passive investments are likely to lose valuation efficiencies in the absence of sufficient active management. We believe that over-investment in passive index-like investments will lead to mispricing and inefficiencies over time and ultimately underperformance.

Index-like equity funds are market cap size-weighted, which can create mispricing. Within investable stock indexes, capitalization-based weighting will cause larger capitalized corporations to attract greater investment, creating the potential for both concentration and momentum risk to become a problem in rising markets.

Passive index-like stock returns are less likely to outperform active managers over time. Once central bank activity returns to normal, fundamentals should once again drive performance and active management revitalization.

Structured, index-like separately managed accounts typically hold far fewer securities than the indexes they are designed to imitate and thus are even more susceptible to concentration and momentum risk. Tracking error (deviation from the index) is more apt to be a problem as these accounts hold only a representative fraction of the stocks contained in the index. During bear markets, price volatility can remain elevated for extended time frames, which may lead to relative performance issues.

Behavioral Finance Best Practices Tips

Index-like funds lack professional management and therefore the capability for portfolio intervention in challenging markets. Risk exposure is not managed in index-like stock funds. Risk (volatility) can increase exponentially in a market downturn, as was the case in the 2008 and early 2009 bear market. With no ability to alter risk exposure, raise cash or emphasize defensive sectors during periods of heightened volatility, the potential for behavioral miscues such as quitting or unsuccessful attempts at market timing grows. Likewise, Prospect Theory (developed by Kahneman and Tversky in 1979) builds on the notion that investor losses are twice as disturbing as gains are rewarding, and this can lead to quitting as well. Parental guidance from active asset managers (as well as advisory and tax professionals) can be a crucial support mechanism when investor emotion runs high.

In a low-return environment index-like returns may be insufficient to reach essential retirement objectives. Persistent inferior portfolio returns may encourage investors to increase allocations to risk assets, which could end badly. Conversely, they could also simply decide to quit the market. While market returns cannot be controlled, thoughtful, consistent behavioral coaching can provide meaningful support in helping clients reach their financial goals.

Be aware of adverse return sequencing (large unexpected market declines) and its potential impact on client behavior. Behavioral miscues are far more likely when significant market declines occur along with a spike in price volatility. This is especially true with passive investment lacking professional management. We believe it unwise to rely upon new, vintage index-like investment in the later stages of a bull market. Regardless of market conditions, it is important to help clients stay the course and not quit or try to time the market.

Tax-Aware Best Practices Tips

A “one size fits all” offering is not a customized “after-tax” focused solution. Client specific customization is not an option with ETFs as indexes are generic representations defining both risk and reward in a pre-tax context. Equally important, many individual investors, especially retirees, are more risk averse than a standardized index can readily support and thus index ETFs may not be suitable.

Passive investment fund vehicles (such as ETFs) can be tax-efficient but are not tax-aware. Passive investments such as ETFs may be tax-efficient as fewer transactions limit gain realization, but they are not tax-aware as there can be no specific after-tax client customization. Tax-loss harvesting with ETFs is an all or nothing proposition as it requires liquidation of fully representative shares, not specific stocks (as is the case in an SMA), and is therefore highly inefficient.

While near universal adoption of passive equity investment has been a reasonable investor reaction given the poor performance of active management of late, it may not continue. The advent of fintech (robo advisory), increased regulatory burdens on investment advisors (the remaining live ones) and the recent decoupling of stock fundamentals from valuations have created a tsunami of demand for algorithmic-driven, index-like investment solutions. With fewer advisors, your role as financial quarterback will broaden to include investment counsel in addition to tax and compliance expert. Over time, high-net-worth clients will grow to rely on your tax-aware financial acumen and thoughtful counsel on important investment issues. Unfortunately, the growth of passive investing is highly likely to become one of these issues. Tax professionals beware: Index-like investing is no panacea!