EquityInvestmentStrategies: Taxes,TaxEfficiency,andAfterTaxReturns

Highertaxratesarestartingtoattractinvestorsattention.Rateincreaseshave
increasedthetaxespayableondividendincomeandonshorttermandlongtermrealized capitalgains.Withfewornotaxlosscarryforwardstoshelterfuturegainsagainsttaxes, manyinvestorsarenowwonderingwhethertheyshouldchangetheirapproachtoequity investing. Theaccumulationoflargepotentiallytaxablecapitalgainsisahighqualityproblemabout whichtobeconcerned,particularlysincesuchgainshavesocloselyfollowedsharpcapital lossescreatedduringthestockmarketdeclineoflate2007toearly2009.However,notall investmentstrategieswithinanassetclassproducethesamepatternoftaxliabilities.Equity indexfundsandETFs,forexample,aregenerallymoretaxefficientthanactivelymanaged equityportfoliostrategiesonanannualbasis.Taxlossharvestingstrategiescanalsohelp investorsmanagetheirinvestmentrelatedtaxesbyoffsettinggainsproducedelsewhere.But bothofthesestrategiesstillexposeinvestorstopotentiallylargetaxbillswhentheyarelater liquidated. ThisreportexplorestherelativetaxefficiencyofindexfundsandETFswhilealsodebunkinga beliefthatthischaracteristicmakessuchstrategiesinherentlyfarsuperiortoactivelymanaged equitystrategies.Italsoanalyzeshowdifferentinvestmentstrategiescouldaffectinvestors futuretaxbills,andoffersconclusionsonhowinvestorscanbeststructureequityportfoliosto managetheiryearlyandcumulativetaxliabilities.Werecommendthatinvestorsconsulttheir taxadvisorsforadviceonhowtheconclusionswedrawhereinapplytotheirparticular situations.

March2014

IncreasesinU.S.incometaxrateswhichtookeffectincalendaryear2013arestartingtoattractthe attentionofinvestorsastheyseetheimpactofthesechangesreflectedontheirpersonalincometax returns.Formanyinvestors,theirtaxobligationshavebeensomewhatexacerbatedbytheexception allystrongU.S.equitymarketrally.Salesofappreciatedinvestmentshaveconsumedmostorallofthe taxlosscarryforwardsthathadshelteredtheirrealizedcapitalgainsfromtaxesinrecentyears.This paperaddressescommonquestionsthathaverecentlybeenputtousbymanyclientsaboutincome taxesandinvestmentsindiversifiedequityportfolios.Itexplorestherelativetaxefficiencyofindex fundsandexchangetradedfunds,evenasitdebunksacommonlyheldbeliefthataftertaxreturnson suchfundsareinherentlyfarsuperiortoactivelymanagedfunds.Thepaperalsolooksatthepotential contributionsoftaxlossharvestingstrategiestooverallreturnsonataxableequityportfolio.

ChangingTaxRates
ThetablebelowillustratesthetopFederaltaxratesappliedtoordinaryincome(andtoshortterm capitalgains),qualifieddividends,andlongtermcapitalgainsfortaxyearsstartingin2013in comparisontothetopratesthatprevailedformuchofthepriordecade.1 TopMarginalFederalTaxRates

OrdinaryIncome QualifiedDividends ShortTermCapital Gains LongTermCapital Gains

2013+ Pre 2013 39.6% 35.0% 23.8% 15.0% 39.6% 35.0% 23.8% 15.0%

Thesubstantialrecentincreasesintaxratesiscausingmanyinvestorstorethinkthecompositionof theirinvestmentportfolios,includingthemixofstrategiesthatcompriseholdingsofequitysecurities heldinsidetaxable(ascomparedtotaxdeferred)investmentaccounts.

TaxEfficiencyofIndexMutualFundsandETFs
Beyondtheirattractiveinvestmentcharacteristics(i.e.,closelytrackingtheperformanceofan underlyingmarketbenchmarkatacomparativelylowcost),equityindexmutualfundsarewidely acknowledgedasaparticularlytaxefficientwaytoinvest.Largely,thisisbecausethetypicalturnover (purchaseandsaleofsecuritiescomprisinganindexfundsinvestmentportfolio)forthesefundsismuch lowerthanitisformostactivelymanagedequityfunds.Lowerturnoverleads,onbalance,tolower annualrealizedcapitalgainsthatarethentaxabletofundholders.ExchangeTradedFunds(ETFs)and someindexfundsalsotakethistaxefficiencyonestepfurther.Largeredemptionsthatwouldotherwise forceafundtosellsecurities(theadverseconsequenceofwhichcouldbetherealizationofadditional capitalgainsthatarepassedalongtoallfundshareholders)caninsteadbefundedinkindwith portfoliosecurities.Withthisprocess,thefundorETFcanfurtheraugmentitstaxefficiencybygiving therecipientofthesesecurities(typicallyaninstitutionalmarketmaker)thosesharesinwhichithasthe lowestcostbasis. ThetwoVanguardETFsthatcompriseacoreholdinginmanyMCCAclientportfoliosareparadigmsof suchannualtaxefficiency.Thetwofunds,forexample,reportedturnoverof25%(VanguardValueETF) and32%(VanguardGrowthETF)in2013.Thiscomparestoamedianturnoverratioof44%foractively managedlargecapU.S.equityfundsacrossthesametimeperiod.2Neitherunderlyingfundhas distributedataxablecapitalgaintoshareholderssincetheETFsrespectiveinceptionsin2004,during whichtimethetwoinvestmentvehicleshavegeneratedtotalreturnsof+104%(Value)and+111%
1

Thetoptaxratesonearnedincomeandshorttermcapitalgainsarenowcomparabletothoseineffectfrom19932003.The analysispresentedhereindoesnottakeintoconsiderationanyuniquetaxcircumstances(e.g.,theimpactofnetinvestment incomeonthephaseoutofitemizeddeductionsandpersonalexemptions)ormateriallyhighertaxburdensimposedbycertain stateandlocalgovernments. 2 Source:MorningstarAdvisor

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(Growth).Asrequiredbylaw,bothfundshavedistributedalloftheirnetincome(largely,dividends earnedlessfundexpenses)toshareholdersannually.Thesedistributionsaretaxabletofund shareholdersasreceived,producingthefollowingtaxadjustedreturnsandtaxefficiency(aftertax returnsasapercentageofpretaxreturns)acrossthemostrecent5and10yearperiods:3 HistoricLongerTermTaxEfficiency,VanguardLargeCapIndexFunds 10Years,12/31/2013

Pre Tax Return AfterTax Return TaxEfficiency

GrowthETF 5Yrs 10Yrs 20.2% 7.9% 19.9% 7.7% 99% 98%

Value ETF 5Yrs 10Yrs 16.1% 7.4% 15.6% 6.9% 97% 94%

Thisyearbyyearandannualizedtaxefficiency(i.e.,fundinvestorsinthesefundshaveretained9498% of10yearreturnsaftertaxes)comparesfavorablytothatofmostactivelymanagedlargecapmutual funds.Thesefundsaftertaxreturnsaretypicallyasmallerpercentageoftheirpretaxreturns,the consequenceofhavingtodistributeturnoverinducedrealizedgainsaswellasnetincometotheir shareholdersannually.Thetablebelowcomparesthehistorictaxefficiencyofauniverseoflargecap growthfundstothatoftheVanguardGrowthETF: HistoricLongerTermTaxEfficiency,ActiveFunds 10Years,12/31/2013

Active GrowthFund VanguardGrowthETF Turnover 54% 32% Tax Efficiency 1Yr 5Yrs 90% 96% 99% 99% 10Yrs 91% 98%

Mostcomparativetaxefficiencyargumentsdonotextendbeyondtheannualandlongerterm annualizedcomparisonsmadeabove.However,theseanalysesignoretheimpactoftaxesdueuponthe ultimatesaleofaninvestment.Havingincurredrealizedgainsalongtheway,aninvestorsholdingsin activelymanagedstrategieswilltendtohavelowerunrealizedgains(therebygivinginvestorsahigher taxbasis)thananindexfundinvestment.Thisproduceslessofafinaltaxobligationonanactive strategywhenitissoldincomparisontoanindexfundinvestment.Consequently,thepostliquidation differencesintaxefficiencybyunderlyingstrategy(activeversusindex)arenotasdramaticallydifferent asmanyinvestorsbelievethemtobe: PostLiquidationReturnsandTaxEfficiency 10Years,12/31/20134
HighTurnoverStrategy MedianActiveManager LowTurnoverStrategy VanguardETF AnnualizedReturns PostLiquidation Overall Tax Pre Tax AfterTax Tax Cost Returns Liq.Cost Efficiency 7.66% 6.87% 0.79% 5.94% 0.93% 78% 7.45% 6.73% 0.72% 5.81% 0.92% 78% 7.75% 7.13% 0.62% 6.08% 1.05% 78% 7.93% 7.68% 0.25% 6.42% 1.26% 81%

EquityPortfolioConstructioninaHigherTaxEnvironment
Investorsmostlycareabouttotalreturns(beforeandaftertaxes)thanabouttaxefficiency.Accordingly, weundertookresearchtocalculatethefutureannualizedexcessreturnsactivemanagerswouldneed
3 4

Source:VanguardGroup,VanguardU.S.StockIndexFunds:LargeCapitalizationPortfoliosAnnualReport,12/31/2013

Source:MorningstarAdvisorandMCCAcalculations.Assumesinvestmentwassoldafterbeingownedfor10yearperiod ended12/31/2013,andthattaxeswerepaidatmaximumtaxratesineffectwhensold.Dataanalyzedincludes312funds categorizedaslargecapgrowthfundswithperformancetrackrecordsofatleast10yearsasof12/31/2013.

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togenerateacrossa10yearholdingperiodtoproducethesamepostliquidationreturnsasanindex fundstrategygiventhetoptaxratesnowbeingappliedtodividends,shortandlongtermcapitalgains. Wemodeledtwotypesofactivemanagerstrategies:aHighTurnoverstrategy(70%annualturnover) generatingasubstantialpercentageofrealizedgainsannuallythatwouldbetaxedathighshortterm capitalgainstaxratesandaLowTurnoverstrategy(45%annualturnover)realizingasmalleramountof shorttermgains.WeusedthetwocomponentsofourcurrentlongtermU.S.equityreturnforecast priceincreasesanddividendyieldsasthedriversofpretaxtotalmarketreturns5. Asreflectedinthetablebelow,theamountofannualizednetexcessreturnsrequiredtoproducean aftertax,postliquidationvalueequaltothatofanindexfundstrategywascomparativelysmallerthan mightbeexpectedgiventaxesincurredannuallyonrealizedgains.TheLowTurnoverstrategy,though lesstaxefficient,wouldmatchtheindexwithonly+38basispointsofannualizednetexcessreturns.The HighTurnoverstrategy,thoughdemonstrablylesstaxefficientonbothanannualandapostliquidation basis,wouldneedtodeliver+69basispointstomatchtheindexstrategysnetreturn: ModeledPreandPostTaxReturnsandTaxEfficiency
Strategy Index Strategy LowTurnoverActive HighTurnoverActive AnnualizedReturns Tax Post Liquidation Overall Tax Pre Tax AfterTax Tax Cost Efficiency Returns Liq.Cost Efficiency 9.00% 8.38% 0.62% 93% 7.19% 1.19% 80% 9.38% 7.38% 2.00% 79% 7.19% 0.19% 77% 9.69% 7.27% 2.42% 75% 7.19% 0.08% 74%

Thechartbelowillustratesthatthecumulativeoutcomesofbothactivestrategieslookrelativelyless attractiveonayearbyyearbasis,giventheimpactofannualcapitalgainstaxesontheiraccumulated values.Butuponliquidation,theimpactoflongtermcapitalgainstaxesonbothstrategiesismaterially lessthanontheindexstrategy,resultingintheequivalentlongtermaftertaxinvestmentoutcomes: ComparativeYearEndValuesandLiquidationValues

225 200 175 150 125 100 75 Yr0 Yr1 Yr2 Yr3 Indexed Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 Liq.Value LowTurnoverActive HighTurnoverActive

Puttingthisanalysisintorealdollarterms,thetablebelowcomparestheestimatedaverageannual incometaxesincurred(ondividendsand,asapplicable,realizedshortandlongtermcapitalgains)by strategyacrossthefirst9yearsandinthe10thyearonaninitialinvestmentof$1.0milliondollars.All threestrategies,andaBlendedPortfoliocomprisedofthethreestrategies,produceanendingvalueof $2.0millionnetofalltaxes.Butconsistentwiththetaxefficiencyconclusionssummarizedabove,the Indexstrategyproducesamuchlower(approximately$19,000to$24,000less)annualtaxburdenthan

5

Forcomparabilityacrossstrategies,weassumedthatallthreegeneratethesameannualreturnfromdividends;differingprice returnsaccountfordifferencesinannualtotalreturnsacrossthethreestrategies.

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thetwoActivestrategies.Absenttherealizationofcapitalgains,dividendpaymentsaretheonlysource oftaxliabilitiesontheIndexstrategyuntilitisliquidated.Assumingthistakesplaceinyear10,the Indexstrategywouldincurnearly$245,000intotaltaxesinthisfinalyear.WiththeActivestrategies havingincurredandpaidmorecapitalgainstaxesacrossthefirst9years,thetaxburdenforthese approacheswouldbe$170,000to$185,000lessinyear10: ComparisonofAnnualTaxBurdens,10YearHoldingPeriod

Strategy Index Strategy LowTurnoverStrategy HighTurnoverStrategy BlendedPortfolio*

Avg.Taxes Years19 $7,600 $ 26,245 $ 31,600 $ 19,600

Taxesin Year10 $244,700 $ 74,850 $ 58,500 $140,300

*40%Index,45%LowTurnover,15%HighTurnoverstrategies

Ofcourse,fewinvestmentprogramsarecomprisedsolelyofoneequitystrategyorholdmultipleequity strategiesthatarestartedandendedatthesametime.MCCAtypicallyallocatesclientassetsacross multipleactiveequitystrategiesandweinvestinindexstrategiesasacoreofsuchportfolios.We havelongdonesobecauseindependentoftaxconsiderationswebelievethatthismixproducesthe bestcombinationofreturnsandrisksatthemostreasonabletotalcosttoinvestors.Butasshowninthe tableabove,suchaBlendedPortfolio(mixofactiveandindexstrategies)approachcanalsosmoothan investorsannualtaxburden.Annualtaxesarelowerversusanallactiveapproachthroughoutthe investorsholdingperiodand,atliquidation,materiallylowerthanwouldbethecaseifsubstantiallyall capitalgainshadbeendeferreduntilthattime.

TaxLossHarvestingStrategies
Investorswithsubstantialinvestmentportfolioscandirectaportionoftheirequityallocationstoatax lossharvestingstrategy.Suchstrategiesconstructdiversifiedequityportfoliosthatseektoexactly matchtheriskcharacteristicsandreturnsofamarketindexwhilealsotakingadvantageofthevolatility ofindividualstockpricestolockintaxlossesduringtheyear.Thestrategymight,forexample,sella positioninExxonatarealizedlossandreplaceitwithacomparablysizedpositioninChevron.These realizedlossescanthenbeusedtooffsetrealizedgainselsewherewithinaportfolio,reducingthe investorsoverallyearlytaxburden. Asillustratedinthetablebelow(reflectingthesamehypotheticalreturnandtaxassumptionsasthe prioranalysis),reducingtheannualtaxburdenofanequityportfoliothroughtheuseofataxloss harvestingstrategyratherthananindexstrategyproducesasomewhatmoreefficientblended portfolio.However,thereisalongtermtradeofftosuchastrategy.Thedifferencebetweenan investorscostbasisinataxlossharvestingsubportfolioanditsmarketvaluewidensovertime.This createsalargerfinaltaxburden(incomparisontoanindexstrategy)thatultimatelyoffsetsagood portionoftheannualtaxsavingsandtaxefficiencycreatedbytherealized(harvested)losses: ModeledPreandPostTaxReturnsandTaxEfficiency
Strategy Index Strategy BlendedPortfolio Tax LossHarvestPortfolio** AnnualizedReturns Tax PostLiquidation Overall Tax Pre Tax AfterTax Tax Cost Efficiency Returns Liq.Cost Efficiency 9.00% 8.38% 0.62% 93% 7.19% 1.19% 80% 9.28% 7.78% 1.50% 84% 7.19% 0.58% 78% 9.28% 8.04% 1.24% 87% 7.26% 0.77% 78%

**40%TaxLossHarvesting,45%LowTurnover,15%HighTurnoverstrategies

Notefromthetableabovethatthepostliquidationportfolioreturnsaresomewhathigher(+7basis points,annualized)thanboththeIndexandBlendedStrategyinvestmentoptionspreviouslyanalyzed despiteunchangedannualreturnassumptionsfortheunderlyingstrategies.Recallthatweforcedthe modelintoproducingsimilarpostliquidationannualizedreturnsbysolvingforthebreakevenrateof

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returnrequiredfortheactivestrategiestodoso.TheincrementalreturnsproducedbytheTaxLoss HarvestPortfolioarethedirectconsequenceofthereducedoverallannualtaxburdenofthisapproach priortoliquidation,ascapturedinthetablebelow6.Lowertaxesleavemorecapitaltocompoundovera longinvestmenthorizon.Butwithastrategyofactivelyharvestinglossesresultinginaloweroverall taxbasisfortheunderlyinginvestments,theblendedTaxLossHarvestportfoliothenincursalarger capitalgainstaxwhenitisultimatelyliquidated: ComparisonofAnnualTaxBurdens,10YearHoldingPeriod

Avg.Taxes Taxesin Strategy Years19 Year10 Index Strategy $ 7,600 $ 244,700 BlendedPortfolio $ 19,600 $140,300 Tax LossHarvestPortfolio $ 16,200 $175,000

HoldingPeriodsandaSteppedUpCostBasis
Thechoiceof10yearsasanappropriateinvestmentholdingperiodforthecomparativeanalysis summarizedabovemaynotbeappropriateforallinvestors.Normaytheassumptionthataninvestor ultimatelysellslowcostbasispositionsineitheranindexstrategyorataxlossharvestportfoliofitall cases.Thebestaftertaxinvestmentoutcomesarelikelyachievedbyholdinganindexstrategy(orits counterpart,ataxlossharvestingstrategy)untildeath,atwhichtimetheinvestorsestategetsa steppedupbasisintheinvestment.Thiseliminatesanytaxliabilityonaccumulatedbutunrealized gains,evenassomeoralloftheinvestmentsvaluemaythenbesubjecttoestatetaxes.Alternatively, someortheentiretaxburdenmightbeavoidedbygiftingsuchhighlyappreciatedinvestmentsto charity. Inourexperience,twokeyfactorsmitigateagainstinvestorsactinginthemostefficientmannerpossible asitrelatestostructuringtheirequityportfolios.Thefirstoftheseisthechangingrewardsandrisksof globalequitymarkets;investors(andprofessionaladvisorsactingontheirbehalf)typicallyseekto benefitfromsuchchangesbytacticallyshiftingsomeportionoftheirassetsacrossdifferentsubasset classes.Sourcingtheseassetclassshiftsonlyfromanotherwiseallindex(andlowbasis)equity portfoliostrategycouldpotentiallyresultintherealizationofoutsizedcapitalgainstaxes.Thesecond factoristhetendencyofmostinvestorstostructuretheirinvestmentportfoliosmoreconservatively (e.g.,bygraduallyreducingequitymarketexposurefrom65%to40%ofassets)astheymovebeyond theassetaccumulationphaseoflife.Havingonlylowbasisassetsuponwhichtodrawastheystartto reduceportfolioriskspotentiallyexacerbatesinvestorstaxbills(andlowersportfoliovalues)atatime whentheyareincreasinglysensitivetosuchusesoftheircapital. Formostinvestors,risingtaxratesdonotchangeourstrategicrecommendations.Acore(3550%) equityportfolioallocationtolowturnover,marketmatchingequitystrategiesremainsacostefficient andriskmanagedmeansofparticipatingfullyincapitalmarketoutcomes.Fortaxableaccounts,an appropriatelysizedallocationtotaxefficientstrategiescanalsominimizecurrenttaxeswhile maximizingthelikelihoodthatsomeifnotalloftheequityportfoliocorecanbemaintainedacross theinvestorslifetimeandthenbenefitfromasteppedupcostsbasisupondeath.

Conclusions
Baseduponouranalysisofhistoricdataandourmodelingofpotentialfutureoutcomesgivencurrent highertaxrates,weconcludethefollowing: Highertaxratesmeanthatinvestorsarestillbestservedbyholdingthemosthighlytaxedasset classes(e.g.,taxablefixedincomesecurities,higherturnoverstrategiesgeneratingshortterm

Alternatively,thepostliquidation,aftertaxreturnsfortheTaxLossHarvestportfoliowouldbeidenticaltothoseofthe BlendedPortfolioiftheincrementalcostofthetaxlossharvestingstrategywereapproximately35basispoints(0.35%)peryear higherthantheIndexstrategy.

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capitalgains)withintaxdeferredaccountswherepossible. Theannualtaxburdenforactivelymanagedstrategiesgenerallyincreaseswithportfolio turnover.Forequitiesheldwithintaxableaccounts,theexcessreturnsbarishigherforhigh turnoveractivemanagerswhogeneratesubstantialshorttermcapitalgainsthanitisforlow turnoveractivemanagers. Someinvestorscantakeadvantageofataxlossharvestingstrategytooffsetsomeorallofthe capitalgainsproducedbyactivemanagers,loweringtheirportfoliosannualtaxburden.How ever,thetaxburdenincurredwhensuchastrategyisultimatelyunwoundislikelytobegreater thanonanindexstrategy. InvestmentsinmutualfundsandETFsthatpursueindexmatchingreturnsandriskswhile generatinglowtonoannualrealizedcapitalgainsarecomparativelymoretaxefficientuntilsuch investmentsaresold.Shortofholdingsuchinvestmentsforever(literally,untildeathdous part)oruntilcapitalgainstaxratesdecline(possiblebutnotbankable),taxesonlarge accumulatedgainsareultimatelypayableuponliquidation,substantiallynarrowingthetax efficiencyofthesestrategies. Forsomeinvestors,minimizingcurrenttaxesandleavingconcernsaboutfuturetaxobligations toanotherdayisapreferredoutcome.Forsuchinvestors,anequityportfoliocomprisedmostly ofindexstrategiesoramixofactiveandtaxlossharvestingstrategiesisthebestmeansof keepingthetaxmanatbayfornowevenasitmayproscribetheirabilitytotaxefficiently executetacticalportfoliochanges.

publicationhasbeenpreparedbyMillCreekCapitalAdvisors,LLC(MCCA).Thepublicationisprovidedforinformation This purposes onlyandisnotintendedasspecifictaxadvice.Youshouldconsultyourtaxadvisorforguidanceonhowyourparticular financialsituationmaybeaffectedbycurrentinvestmenttaxlaws.Theinformationcontainedinthispublicationhasbeen obtained fromsourcesthatMCCAbelievestobereliable,butMCCAdoesnotrepresentorwarrantthatitisaccurateorcomplete. The viewsinthispublicationarethoseofMCCAandaresubjecttochange,andMCCAhasnoobligationtoupdateitsopinionsor theinformationinthispublication.WhileMCCAhasobtainedinformationbelievedtobereliable,neitherMCCAnoranyoftheir respectiveofficers,partners,oremployeesacceptsanyliabilitywhatsoeverforanydirectorconsequentiallossarisingfromany useofthispublicationoritscontents.Unlessotherwisenoted,allmarketandpricedataisthroughDecember31,2013.Data inthepreparationofthisreportwasdrawnfromavarietyofsources,includingBarclaysCapital,BloombergLP,Citigroup, used HFRI,andZephyrAssociates.

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