Use Tax Alpha To Add Value to Your Portfolio

Filing tax returns is a revealing process for investors because they can see the extent to which the government helps itself to their investment income. But it also serves as a reminder that there are a number of tax credits, exemptions and deductions that can significantly soften the blow. 

Tax-efficient investing has long been a key element of good portfolio management. In Canada, this requires making the most of tax-savings tactics like offsetting capital gains with losses and utilizing the dividend tax credit, tax-free savings account (TFSA) and registered retirement savings plan (RRSP). An important part of this process is allocating various investments among taxable and non-taxable accounts to full fiscal advantage. At a more sophisticated level, other elements can include the impact of foreign withholding tax and the making use of trusts or corporations to hold investments.

Tax-Efficient Alpha’s True Alpha

Tax efficiency evaluation as a primary tool of its investment analysis for Parametric Portfolio Associates LLC, a U.S.-based portfolio manager. “By comparing the portfolio’s after-tax return to a benchmark, rather than simply its pre-tax return, we’re able to more clearly discern the manager’s skill from the normal variation in tax-management opportunities,” the firm states in a recent report.

But just how much is to be gained through tax-efficient investing? Is there a way this can be measured?

The relative success of a security or portfolio is gauged by comparing its performance to that of its benchmark index. A Canadian portfolio is considered to be in good shape if it beats the TSX Composite Index; ditto for a U.S. investment versus the S&P 500 Index. If high tax efficiency plays a role in this success, it can be quantified by determining its tax alpha – the ability of an investor to outperform by taking advantage of tax-saving strategies. This is measured by subtracting an investment’s excess after-tax return (concerning its benchmark) from its excess pre-tax return. However, this requires creating a customized version of a benchmark index that estimates its after-tax return – no easy feat due to the potential variables that would have to be included in the calculation.

Tax alpha is a term that has gained momentum among U.S. investors, but is not used widely in Canada,” says Carol Bezaire, vice-president, tax and estate planning with Mackenzie Investments. “But the concept itself is always part of the discussion with Canadian investors and their financial advisors. Tax planning is a natural fit with holistic financial and investment planning and good advice and planning can produce higher after-tax returns for client portfolios.”

Selling Skill is Key

Capital-loss harvesting – the practice of selling losing investments to produce capital losses for the purpose of offsetting gains realized by the sale of other investments – is a key tool for a tax-efficient portfolio. Falling markets can provide the best opportunities to increase tax alpha. This approach can be enhanced by monitoring investment volatility, thus producing opportunities to sell an investment when its price dips.

Some professional investors claim tax alpha can increase returns by one percentage point or more a year, Bezaire says. This is dependent on market volatility and what tax bracket an investor is in when they invest and then again when they liquidate a position. We speak often about the timing of investing and liquidation as a concept that investors should consider when triggering capital gains. This all ties into good advisor advice.

Keep it in Perspective

While some advisors may wish to introduce individual retail investors to tax alpha as a formal concept, Bezaire says this should not take precedence over more fundamentally important factors such as risk and diversification. What’s more, computing tax alpha for a benchmark index is difficult. Thus, most investors prefer to focus on tax-efficient investing in a broader context. A skilled investment advisor can achieve this using the strategies and tax-savings tools mentioned above.

Tax-Positioned Products

In addition, there are mutual funds that focus on tax efficiency in addition to investment fundamentals, such as Mackenzie Tax Managed Global Equity Fund. “This fund employs a proactive tax-overlay strategy with the aim of limiting taxable distributions,” Bezaire says. “It invests in high-quality companies around the world, diversified by country, sector and industry,” but also includes several key tax-management considerations:

• Dividend yield. Preference is given to companies with lower relative yield, weighted against their risk-adjusted return potential.
• Portfolio turnover. Longer-term investment opportunities are favoured over shorter-term opportunities in order to limit unnecessary capital gains.
• Gain/loss monitoring. Individual holdings’ gain and loss positions are reviewed continually, and the portfolio is actively managed to reduce distributions through techniques like tax-loss harvesting.
  
  

Exchange-traded funds (ETFs) that are based on market indices tend to be tax-efficient investments due to their passive nature, which generally restricts transactions to rebalancing in order to maintain their index mirror. Such ETFs, like other passive index funds, have low-turnover rates and hence realize few capital gains. This in turn minimizes the fund’s capital gains distributions to investors at the end of each year.

Bezaire recommends that Canadian investors looking for international investment exposure through ETFs should generally use a Canadian-listed ETF that invests directly in foreign securities. This will avoid a complicated process in which you must claim a foreign tax credit on your income tax return in order to offset the foreign tax withheld by countries in which the foreign holdings are based.

An exception is a U.S.-listed ETF with U.S. equity exposure that is held within an RRSP. “Withholding tax in this situation does not apply due to a tax treaty between Canada and the United States,” Bezaire says. “But it is important to note that withholding tax will apply if that same fund is held inside a TFSA, registered education savings plan (RESP) or in taxable account.”

For U.S. fixed-income securities held within a U.S.-listed ETF, you must file a claim with the U.S. Internal Revenue Service to recover withholding tax on that income. However, this can only be done for income received within a registered account; withholding tax is non-recoverable if the investment is held in a taxable account.

Consider the Tax Cost Ratio

A useful tool for assessing a mutual fund’s overall tax efficiency is Morningstar’s tax cost ratio, available in Morningstar Direct. This online tool shows how much a fund's annualized return is reduced by the taxes that investors pay on distributions. Mutual funds regularly distribute dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions for the year in which they were received.

Like a fund’s management expense ratio (MER), which states a fund’s overall management fees, the tax cost ratio is a measure of how one factor can negatively impact a fund’s performance. Also like an MER, it is usually concentrated in the range of zero to 5%. Zero indicates that the fund had no taxable distributions, while 5% indicates that the fund was less tax efficient. For example, if a fund had a 2% tax cost ratio for a three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis (and because the returns are compounded, the after-tax return is actually only 7.8%.)