It’s April: Time to Talk Taxes

It’s April: Time to Talk Taxes

Anu Rajakumar: In recent years, tax-efficient investing has transitioned from being a niche strategy to a cornerstone of portfolio management for many investors. With heightened market volatility, increasing adoption of direct indexing, and the rise of more complex investment vehicles, the landscape of tax-managed investing is evolving rapidly. As advisors and investors seek to balance pre-tax performance with after-tax wealth compounding, innovative tools like tax loss harvesting, long short strategies, and options are taking center stage.

How can investors harness these strategies to align their portfolios with long-term goals? What opportunities are emerging as demand for customization and tax efficiency grows, and what challenges should investors be mindful of? My name is Anu Rajakumar, and joining me today is Jacob Greene, head strategist for NB Custom Direct Investing. Jacob, welcome back to the show.

Jacob Greene: Thanks for having me, Anu.

Anu: Jacob, it's great to have you back on Disruptive Forces. I believe the last time you were on it was January 2024. I wanted to start off today with a quick refresher for those who maybe missed that episode. Remind us what tax-managed investing is and why is it so important in today's environment.

Jacob: At a high level, tax-managed investing is seeking to maximize after tax wealth for investors. When I like to think about it, it's similarly looking at your investment returns as you do your paycheck. In practice, what we're doing is every portfolio being custom built and managed based on each individual investor's objectives, their tax rates, and their cost basis. In the case of how we manage portfolios, it's building individual stock mandates that seek to track a benchmark, and then on a go-forward basis, as positions go down in value, realized losses as positions go up in value, defer gains, and align these with the client's objectives.

The reason for doing this is you can use losses to offset outside capital gains. This reduces the tax payment in the current year, allows more wealth to grow tax-deferred, and, as you noted, compound over time. All of this is done to align portfolios with the long-term objectives of clients to manage their tax liabilities and results in what the industry calls Tax Alpha. A lot of research has been done to show this has a value of 1% to 2% annualized, and this is really meaningful on a long-term basis.

Anu: Terrific. I think we can all get on board with trying to maximize our after-tax investment returns, but let's talk about markets. We've seen so much volatility recently. How does that create opportunities for tax-managed investing?

Jacob: In short, volatility's great. What we like to call out is that when we're talking about loss harvesting, we're not looking for markets to go down. We ultimately want markets to go up, but the volatility we're seeking is dispersion of stocks, meaning some stocks are going up, some stocks are going down, which tends to play out over most market environments and harnessing this volatility to work on behalf of clients in the form of tax savings. We long-term want markets to go up into the right, we want clients' assets to grow, we just want them to take advantage of the volatility as it comes.

If we look in the rear-view mirror, 2023, 2024, we're talking about great markets for investors in US large cap. The market's up 25% each of those years, but if we click into what the actual returns of, say the S&P 500 look like, you had 170 stocks in each of those years that were down at the end of the year, even in a 25% up market. That tells you there's opportunity to do some loss harvesting. We want to look at as close a basis as possible, so you look month by month, week by week, day by day. This is the type of dispersion that can just be icing on the cake for investors by realizing losses, deferring gains along the way. 2025 has been a little bit more of a clear example. We have day-to-day whipsaw markets.

Needless to say, there's a lot of trading that can be done right now, and if the markets do end up going down, it's making sure the clients that are at least having that down market have some benefit to them. Again, hoping in the long term that the markets will go up. What begins to happen is, as we've realized, losses, deferred gains, portfolios appreciate, it's looking to move into the deferring the tax payment, allowing that after-tax compounding. This type of benefit that we offer, it's really what I would refer to as structural alpha because it's alpha that can only be managed if the portfolio is tailored to each investor. It's not something that commingled vehicles like ETFs and mutual funds are able to offer.

Anu: Terrific. I feel like this is a really great case of work smarter, not harder-

Jacob: Exactly.

Anu: -when it comes to your portfolio. Jacob, you've mentioned a couple of times the importance of deferring the gains. Just explain a little bit more why is that such a powerful strategy, and how can that fit into an investor's overall set of investment objectives?

Jacob: Every time you realize a gain, you're creating a tax liability that needs to be paid. For us, it's balancing the need for tracking the pre-tax performance of whatever benchmark a client has, but seeking to do so while deferring these gains, deferring the tax liability further out, and allowing that compounding to take place. What this does in the near term is aligns portfolios and gives clients flexibility to have their investments alongside whatever they're doing in the near future. That could be portfolio rebalancing, minimizing the level of gains being appreciated.

Think about adjusting allocations in the 60-40 portfolio concept. It could be they're thinking about when to start planning for their estate and how to realize those gains. Some of it is flexibility and aligning there. We have a number of clients that come to us and talk about charitable giving of when do they want to make those distributions and how, and gifting out single stocks. These are all reasons to be mindful of when you realize taxes, and that's the power of deferral.

Then you look at the longer term objective, it is what are you eventually going to do with this wealth? Are you going to give it away charitably? Are you going to pass it through your estate, or are you waiting until a later date when you need to naturally draw it down? Aligning how the portfolio is managed from a gain realization perspective is incredibly valuable to each individual client.

Anu: Absolutely. Now, we've seen a huge evolution how advisors and investors are really thinking about tax management. I feel like it's just, again, increasing adoption of what you've been saying. Now, we've seen an incredible evolution in how advisors and investors are thinking about tax management. Jacob, what changes have you been noticing in this space?

Jacob: Increased adoption at large, and we're seeing the industry take note and the industry call these out. FTSE Russell put out a survey last year that looked at the industry and said, "Only 21% of advisors are currently using direct indexing, and about 50% expect to in the next five years." Meanwhile, Cerulli expects assets in direct indexing to surpass 800 billion by 2025. That tells me that there's only a small subset that are actually using it. Those that are are using it very widely. There's a great opportunity to both sit with investors, sit with intermediaries and talk to them about how powerful this tool can be.

That's where a lot of education needs to happen, a lot of talking about taxes, which none of us want to talk about and can make you uncomfortable, but can have a meaningful impact on clients. Also, we've been predominantly talking about the US. Our team here at Neuberger has an office in Canada where we work with clients there. Canadian investors, it's still very early days, they haven't stepped into it, but their tax code is not significantly different than the US, and so there's a great opportunity there to grow. You're going to start to see this grow outside of just the US, and that's going to only allow more investors to access it.

The client profiles have historically been high-net-worth individuals, maybe family offices. Insurance companies on the institutional side have some value because they're taxable investors as well. You're seeing a broadening of who's actually using it, and that demand's continuing to grow. Then the reasons for why that is, is clients are starting to use private equity, private credit alts a lot more. These are all gain generating vehicles, and they're doing it because it has a great pre-tax opportunity. We believe that tax-managed investing alongside them help protect those returns on an after-tax basis.

This is much different than 5, 10 years ago when I might go sit down with an advisor and everything they did was passive ETFs across the board, so they didn't have the need for losses. Advisors, clients are definitely having more of a need there. There's also the idea in coming around to the scalability and efficiency of doing this. When we talk about tax management, we talk about customization. Those sound like very time-consuming things.

Us using the right technology, the right resources, there's a great amount of scalability and efficiency that everyone can gain from an advisor who has dozens of clients, a family that has managed their assets in one place, institutions, endowments, these types of organizations, all of them can find great efficiency. The last item of note is direct indexing has historically been the term. We call direct investing the way to do tax management. The reason being is that active investors are being invited to the party. Now, it's thinking about active investing, which is inherently tax inefficient of buy low, sell high. Having that with tax management overlaid is allowing more and more investors to access it.

Anu: Terrific. Now, I think so far what you've been speaking about has been in a long only context-

Jacob: That's correct.

Anu: -in terms of equity portfolios. How do advanced strategies like tax-managed long-short strategies come into play, perhaps for investors with more complex needs?

Jacob: Tax-managed long-short has been one of the newest evolutions in this space, and it's been growing quite rapidly. First and foremost, long-short investing has to be done with a pre-tax lens. You have to want to outperform after tax by going long stocks that I believe will outperform, short stocks that I believe will underperform. That you're going to have a pre-tax reason for doing so, but it can really help clients address outside tax liabilities.

The reason being if you're long and you're short in any market environment, you do have positions that can result in a loss, and you have more overall market exposure. There's greater opportunities to realize losses over time. This is more useful for those clients that I mentioned outsized tax situation. Clients who need to enhance both their pre-tax and after-tax returns, maybe a client that's preparing for a business sale, also clients who may have an appreciated portfolio or position that needs to be diversified, and they need the right path to get them there.

Anu: Yes. Terrific. Then you mentioned Canada a little while ago. I'm just curious, how did these strategies expand beyond North America? Are there other opportunities for tax-managed strategies in other jurisdictions around the world?

Jacob: The expansion to Canada really happened because the Canadian tax code is very similar in the fact that losses can be used against gains. It's also a bit different than the US in the fact that ETFs in Canada are more likely to distribute capital gains than they are in the US. Clients need to be more tax thoughtful, more open to separately managed accounts. Very early days there, but a strong growing interest.

The other piece is starting to have individuals in Canada talk to clients in Canada rather than US investment companies selling to Canada specifically. We are starting to see it grow globally. Anywhere that tax code does allow for losses to be offsetting capital gains, where there is the capital gain concept rather than just income. We've had early discussions in areas like Australia, Japan, Italy, Mexico.

When you leave North America, one of the big factors is whether or not that area has a separately managed account infrastructure, and not all countries do. In some countries, the idea of holding many stocks, trading many stocks is just not operationally possible. It may be early days. It may be early innings until we start to see that adoption grow.

Anu: Terrific. To wrap up here, Jacob, for those listeners who are at the beginning of their exploration of tax-managed investing, what would you say is the best way to get started? Are there any resources or insights that you'd recommend for those who want to learn more?

Jacob: The gray part is that with the growth, there's been more and more resources being thrown at it. Start by understanding the basics of tax management, of tax loss harvesting, of gains, understanding how losses can offset your gains, how that planning can be done and adjusted over time, collaborating with experts to align strategies with long-term objectives, so there are more and more individuals starting to implement these capabilities, and making sure that each individual client's objectives are being put out there.

We at Neuberger Berman have a number of recent insights, most recently, put out a piece on how tax loss harvesting doesn't only work in down markets, how it works in the up markets. Some great research there. Some upcoming publications we have on family office use cases as well as tax-managed long-short.

Anu: Terrific. Jacob, thank you so much for that. I can't let you go without a quick bonus question. We focused our conversation today on tax management and tax loss harvesting, a very straight edge topic, but this episode is coming out right around April 1st, April Fool’s Day. My question to you is, have you ever been pranked, or have you ever pranked someone else, or in short, have you been a pranker or a prankee in the past?

Jacob: Growing up with three older brothers, I'm sure I've been through quite a number of pranks. In terms of performing pranks, the most notable for me was in high school, a group of friends and I, got together we lifted another friend's VW Bug on cinder blocks. So a group of us all lifting that up, putting the blocks under and then leaving that for him to come find.

Anu: How did he get it off?

Jacob: He claims he drove it off, I’m not sure any of us still believe that, I think there may have been a little pride in that but had to be a struggle to get that off for sure

Anu: That is pretty epic though. That is a good high-school story, I like that.

Jacob: What about you?

Anu: Gosh, when I was an undergrad in college, I shared a room with another girl as well and one day she was out for a few hours, we planned this in advance, but four of us ended up Saran wrapping every single thing in this girl’s room, from the full bed frame down to every single pencil and sharpener and eraser, like every single thing on her side of the room. So, my side of the room was completely untouched and hers was completely Saran wrapped and that was a lot of fun

Jacob: Wow, how did she react to that?

Anu: She walked in and she was very surprised, and basically said, you guys are taking this all back down again, you guys are unwrapping every single thing in here but we had a good laugh about it, she laughed about it as well and it was one of my favorite memories from college.

Jacob: That’s amazing.

Anu: Well, speaking of wrapping things up, Jacob, just wanted to say thank you again for joining us today on Disruptive Forces you have shed much light on the growing importance of tax-managed investing in today’s dynamic and volatile financial landscape. You've spoken about employing advanced strategies like tax-managed long-short and most importantly highlighted how these tools can help investors balance their pre-tax performance with their after-tax wealth compounding. So, thank you again for your time and we are looking forward to having you back on the show soon.

Jacob: Thanks so much for having me.

Anu: To our listeners, if you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces where you'll find previous episodes as well as more information about our firm and offerings.