Tax Alpha Measurement Improves Returns by 0.7%

Tax Alpha Measurement Improves Returns by 0.7%

Executive Summary

Luminary Wealth Partners recognized that while they were implementing tax-aware investment strategies, they lacked a concrete measurement of the tax alpha generated for their clients. This absence of quantifiable data hindered their ability to demonstrate the true value of their tax planning expertise. By partnering with Golden Door Asset and implementing a robust tax alpha measurement methodology, Luminary Wealth Partners improved a specific client's portfolio returns by 0.7% annually, solidifying their value proposition and strengthening client relationships.

The Challenge

Many Registered Investment Advisors (RIAs) intuitively understand the importance of tax-aware investing, but struggle to quantify its precise impact on client portfolios. This was precisely the situation at Luminary Wealth Partners. While they incorporated strategies like tax-loss harvesting, asset location optimization, and qualified dividends prioritization into their investment management process, they lacked a standardized way to track and report the incremental return generated from these tax-smart decisions – the tax alpha.

One specific client, a successful entrepreneur named Robert, had a diversified investment portfolio valued at $5 million. Robert was in the highest tax bracket (37% federal income tax and a 3.8% net investment income tax), making tax efficiency a critical concern. Luminary Wealth Partners had been managing Robert's portfolio for several years, employing various tax-aware strategies. However, when reviewing Robert's annual performance, the team realized they could only qualitatively describe the tax benefits. They couldn't definitively say how much more Robert had earned compared to a purely tax-unaware approach.

Robert's initial returns averaged 8% annually pre-tax. While this was a solid return, Luminary Wealth Partners suspected that poor tax management could significantly erode this gain. A cursory calculation showed that without any tax optimization, Robert could potentially lose over $140,000 annually to taxes (3.8% + 37% = 40.8%; 40.8% * (8%*$5,000,000) = $163,200). The challenge was to quantify how effectively Luminary's existing tax strategies were mitigating this potential tax burden and, more importantly, identify opportunities to further improve Robert's after-tax returns. Without a clear benchmark, Robert's portfolio performance wasn't truly optimized, and Luminary wasn't able to showcase its full value. This also risked client attrition as clients may not fully appreciate the advisor’s tax management prowess.

The Approach

To address this challenge, Luminary Wealth Partners partnered with Golden Door Asset to implement a structured approach to measuring tax alpha. Their strategy consisted of the following steps:

1. Establishing a Tax-Unaware Benchmark: The first step was to create a hypothetical "tax-unaware" benchmark portfolio that mirrored Robert's actual asset allocation. This benchmark would serve as a baseline representing the portfolio's performance without any tax considerations. This benchmark was constructed using similar asset allocations as Robert’s actual portfolio, but ignoring any asset location benefits (e.g., placing tax-inefficient assets in tax-advantaged accounts).

2. Calculating After-Tax Returns: Luminary meticulously calculated the after-tax returns of both Robert's actual portfolio and the tax-unaware benchmark. This involved accurately accounting for all taxable events, including realized capital gains, qualified dividends, and ordinary income. They used historical tax rates relevant to Robert's income bracket to ensure accuracy.

3. Defining Tax Alpha: Tax alpha was then defined as the difference between the after-tax return of Robert's actual portfolio and the after-tax return of the tax-unaware benchmark. A positive tax alpha indicated that Luminary's tax-smart investment decisions were generating incremental value for Robert.

4. Identifying Optimization Opportunities: By analyzing the sources of tax alpha, Luminary could identify specific areas where they could further optimize Robert's portfolio. This involved evaluating the effectiveness of tax-loss harvesting, asset location strategies, and other tax-aware techniques. For instance, they reviewed all realized gains for the year and explored alternatives to avoid triggering capital gains taxes. They also looked at asset placement within tax-advantaged and taxable accounts to optimize returns.

5. Continuous Monitoring and Reporting: The tax alpha calculation was integrated into Luminary's regular performance reporting process. This allowed them to track the impact of their tax strategies over time and communicate the value of their services to Robert in a clear and quantifiable manner. Regular review meetings were scheduled to discuss tax optimization strategies and how they impacted portfolio performance.

Technical Implementation

The technical implementation involved leveraging existing tools and integrating new processes:

• Black Diamond Integration: Luminary Wealth Partners used Black Diamond as their portfolio management system. They leveraged Black Diamond's reporting capabilities to track portfolio performance and generate reports on realized gains and losses. Black Diamond’s open API was used to pull data into a customized tax alpha calculation module developed in-house.

• Tax Alpha Calculation Module: Golden Door Asset provided guidance on the development of a custom tax alpha calculation module. This module ingested data from Black Diamond and calculated after-tax returns for both the actual portfolio and the tax-unaware benchmark. The module considered:

  • Capital Gains Tax Rates: Accounting for short-term and long-term capital gains tax rates, varying by year.
  • Qualified Dividend Tax Rates: Applying the appropriate qualified dividend tax rates.
  • Ordinary Income Tax Rates: Calculating the impact of ordinary income generated by the portfolio.
  • Net Investment Income Tax (NIIT): Factoring in the 3.8% NIIT on investment income.
  • State Income Taxes: Although not directly included in the initial analysis, the framework was built to accommodate state income tax considerations in the future.

• Tax-Loss Harvesting Automation: The module also tracked opportunities for tax-loss harvesting. It automatically identified securities with unrealized losses and alerted the team to potential harvesting opportunities, while taking into consideration wash-sale rules and other relevant regulations.

• Benchmark Construction: Creating the tax-unaware benchmark required careful selection of similar securities with comparable risk profiles. This was done manually using a combination of Morningstar and Bloomberg data. The benchmark was rebalanced periodically to maintain a consistent asset allocation.

Results & ROI

The implementation of the tax alpha measurement methodology yielded significant results for Robert's portfolio:

• Improved Annual Returns: Over a three-year period, Robert's portfolio returns improved by an average of 0.7% annually due to the active management of tax alpha.

  • Year 1: Initial tax alpha was measured at 0.45% before the new methodology was implemented. The new methodology improved the tax alpha to 0.7%.
  • Year 2: The tax alpha was further improved to 0.75%
  • Year 3: The tax alpha stabilized at 0.65% due to market conditions.

• Increased After-Tax Wealth: Over the three-year period, the 0.7% improvement in annual returns translated into an additional $105,000 in after-tax wealth for Robert (0.7% * $5,000,000 * 3 years = $105,000, ignoring compounding effects).

• Enhanced Client Communication: The quantifiable tax alpha data allowed Luminary Wealth Partners to communicate the value of their tax planning services more effectively to Robert. The clear and concise reports demonstrated the tangible benefits of their expertise, strengthening the client relationship. Robert expressed significant satisfaction knowing that Luminary was actively working to maximize his after-tax returns.

• Reduced Tax Liability: Through targeted tax-loss harvesting and asset location strategies, Luminary significantly reduced Robert's annual tax liability. In one year, they harvested $50,000 in capital losses, offsetting gains and reducing his tax bill by approximately $10,000 (assuming a 20% long-term capital gains tax rate).

• Improved Client Retention: Quantifying the value provided via tax optimization led to higher client satisfaction, which directly translated into improved client retention rates for Luminary Wealth Partners.

Key Takeaways

Here are some actionable insights for other RIAs looking to improve their tax efficiency:

1. Measure What Matters: Don't just implement tax-aware strategies; actively measure and track their impact. Tax alpha measurement provides a concrete way to demonstrate the value of your tax planning services.

2. Establish a Benchmark: Create a tax-unaware benchmark portfolio to accurately assess the incremental return generated by your tax-smart decisions. This is crucial for quantifying tax alpha.

3. Leverage Technology: Utilize technology tools to automate the tax alpha calculation process and identify tax-loss harvesting opportunities. Integration with portfolio management systems is key.

4. Communicate the Value: Share tax alpha data with your clients in a clear and concise manner. This strengthens client relationships and justifies your fees.

5. Focus on Continuous Improvement: Regularly review your tax strategies and identify opportunities for further optimization. Tax planning is an ongoing process, not a one-time event.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors quantify the impact of their investment decisions, identify tax optimization opportunities, and communicate their value to clients. Visit our tools to see how we can help your practice.