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One for You, 19 for Me

Advisors' tax tools have come a long way.

Don Phillips, 10/30/2008

We value your feedback. Send comments, questions, and criticism to advisorquest@morningstar.com.

U.S. income-tax rates may not be as steep as the 95% U.K. rate that George Harrison lamented in the Beatles' Taxman, but most indications are that they're headed up, especially for the wealthy, which means that advisors will be even more focused on providing intelligent tax advice. Tax issues, of course, never go completely off the radar screen, but their relative importance does ebb and flow with the level of rates. In the high-tax 1970s, taxes were center stage, and financial advisors were forced to explore limited partnerships and other means of tax avoidance to serve their clients. Many of these solutions were costly and of dubious merit -- it was not the industry's proudest moment. Now, however, the financial-services industry offers advisors a much better set of tools for navigating a higher-tax environment.

For one, municipal bonds are currently priced quite cheaply relative to taxable alternatives. Vanguard Intermediate-Term Tax-Exempt VWITX yields more than the firm's Intermediate-Term Treasury VFITX. The same is true for Vanguard's Long-Term Tax-Exempt VWLTX relative to its Long-Term U.S. Treasury VUSTX. These yield advantages are on an absolute basis. When the added tax savings are factored in, municipal bonds are significantly cheaper than Treasuries. For investors concerned about rising tax rates, here's a great, simple, low-cost way to lower taxes without sacrificing returns. Advisors who move client monies that have been sheltered in Treasuries into munis could create great value without complex tax-sheltering strategies. This alone makes this market far better for advisors than the high-tax 1970s.

Second, index funds and ETFs have proliferated in recent years, giving advisors a robust set of options for building tax-efficient portfolios. There are 1,650 indexed funds in Morningstar's databases, when you count all share classes. Nearly 800 of these are ETFs. While some of these options are silly or ill-conceived, there are still ample numbers of solid, well-diversified, low-cost index funds with which to build tax-efficient portfolios. Such tools simply weren't available to advisors in the 1970s but are readily so today. The opportunities to be tax savvy without forking over fat fees to lawyers and slick salesmen who design complex tax shelters is a huge boon.

Finally, there's been a sea change in how active managers deal with taxable distributions. Perhaps because index funds have raised the bar or perhaps because of the growing pressure for managers to invest in their own funds, active fund managers today seem much more sensitive to the tax impact of their trades than did their peers of the past few decades. Earlier fund managers often operated from an institutional mind-set and were used to serving pensions and other tax-exempt entities. These managers were compensated on pretax returns and generally had little incentive to consider the tax impact of their trades. All of that has changed. Taxes are on the radar screen for active managers today, and actively managed funds are apt to be managed with greater attention to taxes for the foreseeable future.

Aiding this cause, most mutual funds aren't sitting on big imbedded gains today, meaning that taxable fund distributions are likely to be relatively small over the next few years. In the late 1990s, the average U.S. equity fund had a potential capital gains exposure of 37%, which would imply that if the manager were to sell all of a fund's holdings, 37% of the assets would be distributed to shareholders as a taxable event, even for shareholders who had just bought the fund. This was common in the late 1990s and plagued investors jumping on the tech bandwagon and getting saddled with the tax bill for gains in the early 1990s that they didn't participate in. Today, the likelihood of these unexpected tax hits is far lower. The average U.S. equity fund has a negative 17% potential capital gains exposure, meaning that tax-loss carryforwards outweigh imbedded gains at many funds and that future gains can be offset by tax losses already on the books.

Funds like Longleaf Partners LLPFX, Selected American Shares SLASX, and Oakmark Select OAKLX, which are run by long-term, buy-and-hold investors, have their lowest capital gains exposure in years. Buying in today might mean not only buying quality funds when they are out of favor, but it may also mean buying them at a point of great tax-efficiency. For the more venturesome, Legg Mason Opportunity LMOPX has a negative 54% potential capital gains exposure, meaning that it will likely be extremely tax-efficient for years to come. It takes courage to make such an investment today, but a skilled manager with an out-of-vogue strategy in a tax-efficient vehicle can be a great recipe for long-term wealth creation.

One can debate whether markets are efficient. We know for a fact that the tax code isn't. Lessening taxes' bite is a low-cost, low-risk means of enhancing the client experience. Guiding investors safely through these complex choices is a way that advisors can earn their fee many times over without exposing their clients to additional risk. The markets can deal out some tough hands. Fortunately, advisors today have reasonably good cards to play.

Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.

We value your feedback. Send comments, questions, and criticism to advisorquest@morningstar.com.

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