Rey Santodomingo is director of investment strategy and tax-managed equities at SEC-registered Parametric Portfolio Associates, which is based in Seattle, WA, and owned by Eaton Vance.

Financial professionals generally start thinking about taxes near the end of the year. Clients are often counseled to sell losing stocks and use the losses to offset realized capital gains and deduct up to $3,000 in ordinary taxable income. Additionally, holding on to winning stocks for at least one year is preferable since the gain is taxed at the federal long-term capital gains rate rather than at the higher ordinary income rate, which tops out at 39.6 per cent.

Other strategies include investing in tax-efficient mutual funds and exchange-traded funds (ETFs). The goal of many of these funds is to minimize capital gain distributions by offsetting realized gains with realized losses. An alternative investment strategy is tax-managed indexing using separately managed accounts, which offers 1) potential tax management opportunities through systematic loss harvesting and (2) customization that mutual funds and ETFs can’t.

Systematic loss harvesting entails monitoring and trading to capture tax benefit opportunities throughout the year. Assuming highest marginal federal tax rates, research and experience both show that systematic loss harvesting can potentially add as much as 1-2.5 per cent annualized after-tax performance over a 10-year period. The potential may be even greater in high-tax states such as California and New York.
 
Take, for example, a tax-managed portfolio benchmarked to the S&P 500 Index. Initially, the portfolio is invested in about 250 securities selected to track the index. The securities and weights are selected so the portfolio resembles the index in terms of sector and industry weights. After the initial portfolio is invested, it is continuously monitored for benchmark tracking, as well as tax loss harvesting opportunities.

Excess losses realized by a tax-managed index portfolio can be used to offset realized gains which may exist elsewhere in an investor's overall portfolio. Taxable gains may be generated from the investor's active manager investments, hedge fund investments, or the sale of real estate or concentrated stock. In the end, the goal is to reduce the investor's tax bill, keep more of their money invested and exploit the benefits of tax deferral and compounding.

Compare this approach to passive index mutual funds and index-based ETFs which are considered to be tax efficient, and we see that ETFs in general, tend to be slightly more tax efficient than mutual funds because they are able to avoid some capital gain realization through in-kind redemptions, and because mutual funds are often forced to realize (and distribute) gains when clients redeem shares. Some mutual funds that are labeled tax advantaged do strive to reduce capital gain distributions by realizing losses to offset gains, but can’t distribute valuable excess losses the way tax-managed separate accounts can.

Unlike ETFs and index funds, capital losses realized in a separately managed account pass through to the individual investor. Realized capital losses are valuable because they can be used to offset capital gains, thereby reducing an investor's tax bill. A tax-managed separate account can be designed to seek returns similar to those from an ETF or mutual fund, but with the additional potential benefit of excess realized losses.

Unlike ETFs and mutual funds, separate accounts can support a wide array of customized implementation. A commonly requested customization is for the transition of an existing portfolio of stocks to an index-type exposure. When transitioning a portfolio of stocks, there exists a trade-off between tax cost and tracking error. A careful analysis of the portfolio is required to provide clients with estimates of tax cost and tracking error for a range of possible solutions. By contrast, an unmanaged transition from a portfolio of stocks to an ETF or mutual fund could require full liquidation of the existing positions which results in the client bearing the full liquidation tax cost.

Another common customization is to restrict certain stocks or groups of stocks from the portfolio. This can be a values-driven decision where the client desires to restrict securities associated with companies with business involvement in certain industries ( alcohol and tobacco, for example). Or, the investor may have concentrated stock in a certain economic sector such as finance or technology and wish to exclude that sector from their portfolio to avoid double exposure.

With tax year 2014 well behind us, now is a good time to revisit investment tax strategies.