Tax Alpha or Tax Savings?  What’s the difference and why does it matter?

Avatar photo by Hiren B. Patel, Head of Advisor Solutions

Key Takeaways

  • Tax savings is the difference in the tax bill a client realized for a portfolio that utilizes tax-loss harvesting versus another without tax-loss harvesting.
  • Tax alpha is the difference in investment performance between a client’s portfolio that utilizes a tax strategy versus its benchmark.  

The market volatility seen over the last year has created heightened awareness and appreciation for the use of tax-loss harvesting as a means of creating value during uncertain times. So, when you talk of the extra value that tax management offers, that’s broadly considered to be “tax alpha” in the industry today, but another measurement is by “tax savings”. We at 55ip believe there’s a need for clarity between the two.

As a firm, we understand the importance of tax alpha, but that term can fall short of properly explaining the benefit a client may receive. Instead, we choose to highlight the value of tax savings and tax alpha.

Let me share our view on the difference between the two and how as advisors you can best educate clients on the value you are delivering to them.

Confusion can be created when throwing around the term “tax alpha”

First, let’s talk about what is tax alpha: tax alpha is the outperformance that an investor can achieve by taking advantage of all available tax-savings strategies. Many activities advisors and asset managers pursue can be claimed as providing “tax alpha”. Decisions such as asset location, do I put money in my 401k or take it to my paycheck, is a type of tax alpha decision.  Similarly, product choice within retirement and investment accounts, like ETFs or Mutual Funds, that take advantage of differing tax benefits can be claimed as legitimate activities in pursuit of tax alpha. And of course, tax-loss harvesting is often a component of tax alpha.

Tax alpha

The industry typically presents tax alpha as the active pursuit of delivering results above a benchmark. This is often accomplished either by the activities taken by a portfolio manager or through tax-loss harvesting, these activities create the alpha that is added to a portfolio. 

So, if a benchmark such as the S&P500 is negative 20%, but the after-tax performance of a client’s direct indexing portfolio using tax-loss harvesting is only down 10%, then using simple math, the tax alpha delivered to a client’s performance is 10%. 

As an example, direct indexing is an area in which a client’s portfolio is directly compared to a benchmark and tax alpha is often utilized to describe the impact active tax management is providing on top of the benchmark.

Clients want to know what the advisor did to keep money in their pockets. Remember, it’s not what you earn it’s what you keep that matters.

Clarity is provided when the focus is on the value to investors

Unique to the situation, however, is when a client’s portfolio doesn’t directly reflect a benchmark.  Much of the industry today utilizes mutual funds, actively-managed ETFs, or custom model portfolios advisors build with asset managers.  In this scenario, there is a built-in sense of “alpha” in the bias an advisor or portfolio manager has placed in their strategies.  To manage for this bias, we were determined to create a measurement that was repeatable, reportable, and clearly defined the “savings”  tax-loss harvesting activities can deliver for an investor. With that in mind, we focused on reporting a 55ip tax-savings figure. Let’s take a closer look at what this means.

Tax savings

Client portfolios are often chosen or created by the advisor or portfolio manager to fulfill a specific objective.  Because of this, 55ip is not comparing an individual client’s portfolio against an illustrative benchmark to create a measurement of performance.  There are too many variables to achieve a standardized measure.  Instead, we’re showing the advisor and their client what value is produced from their specific account using our systematic approach to tax-loss harvesting.

Here’s how we do this: On the very day a client account is loaded onto our platform, we create a separate “shadow account” that contains all the same dimensions and parameters of the live account, except the shadow account receives no tax-loss harvesting.  In our models we use tax savings to compare the two portfolios that started at the same time with the same value. The difference in the two tax bills is how we calculate our tax savings numbers.

Systematic and ongoing tax-loss harvesting can provide meaningful savings over time.

While some years, like 2022, have seen an increase in attention to tax-loss harvesting, we believe an “always on” approach makes the most sense. For example, during 2022, our results delivered an average tax savings of 2.70%. While some years are better than other years in terms of results, since we’ve been using this methodology, the average annual benefit we’ve delivered for our clients is 2.66% tax savings.

Advisors that try to “time the market” with their tax-loss harvesting activities may be missing out on opportunities and could over the long term, under deliver tax savings for their clients. The year 2021 is a great example in which the S&P 500 finished the year finish the year significantly positive.  However, nearly 52% of the positions in the S&P 500 saw a 15% or greater drawdown at some point in the year. Advisors can schedule a review of their account’s performance through their Advisor Success Manager.  If you are not a client but would like to learn more about 55ip’s approach to tax-management, please contact us.

Footnotes

55ip is the marketing name used by 55 Institutional Partners, LLC, an investment technology developer, and for investment advisory services provided by 55I, LLC, an SEC-registered investment adviser. 55ip is part of J.P. Morgan Asset Management, the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. 

The impact of a tax-loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates. The results shown in these materials are illustrative and do not represent actual investment decisions.

The tax-loss harvesting service is available for an additional advisory fee and the results shown represent the net effect of the advisory fees but may not consider the impact of fees charged by others, including transaction costs or other brokerage fees. The information contained herein is subject to change without notice, is not complete and does not contain certain material information about the investment strategy, including additional important disclosures and risk factors associated with such investment and information about fees, trading costs and taxes. Neither the U.S. Securities and Exchange Commission nor any state securities administrator has approved or disapproved, passed on, or endorsed, the merits of this document. More information at www.55-ip.com.

2.66% reflects the estimated annualized average tax savings for accounts which received a Tax Savings Report for period from Q12020 through current quarter using 55ip’s tax-smart technology.  The estimated annualized average tax savings is based on an arithmetic average of each quarterly tax savings. The quarterly tax savings of all accounts in a respective quarter are summed and divided by the number of years represented. The aggregated percent tax savings for each quarter is taken as an average and annualized to determine the estimated annualized average tax savings referenced above. 

2.70% reflects the estimated average tax savings for all accounts which received a Tax Savings Report for period from Q12022 through Q42022 using 55ip’s tax-smart technology.  The estimated average tax savings is based on the aggregate of all account’s value saved in comparison to the aggregate of average account values through the above referenced period.  

Calculation methodology: Average tax savings are calculated by comparing the client’s actual account activity with a shadow account created by 55ip. The shadow account has the same inception date and is invested in the same model as the client’s actual account but does not incorporate 55ip’s tax-smart technology for rebalancing. Gains and losses are accrued for both the client’s actual account and shadow account to produce the estimated tax bill. The tax rate applied to the client’s actual account and the shadow account are provided by the client’s advisor. If no tax rate is provided, then the highest applicable federal tax rate (20% for long-term gains/losses and 37% for short-term gains/losses) is assumed and an additional 3.8% net investment income tax rate is applied to both accounts. The estimated tax bill of the client’s actual account is then compared to the estimated tax bill of the shadow account, and the shortage of the former amount is the client’s estimated tax savings. There is no guarantee that the estimated tax and subsequent projected tax savings will equal the actual tax liability/tax savings achieved by the client. J.P. Morgan and its affiliates and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions. 

Telephone calls and electronic communications may be monitored and/or recorded. Personal data will be collected, stored and processed by 55ip in accordance with our privacy policies at https://www.55-ip.com/email-disclaimer/.

 

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