5 Takeaways from Basis Northwest on Taxable Wealth Problems - Tax-Aware Long Short and Other Solutions
Seattle was the backdrop of the Basis Northwest conference.
This post is for educational purposes only and is not investment, tax or legal advice. The strategies discussed in this post are extremely complicated and have numerous risks and are only appropriate for high net worth investors who have significant risk tolerance. You should consult an experienced financial advisor, tax advisor and attorney before committing to any of the strategies and techniques discussed in this post.
I attended the Basis Northwest conference in Seattle last week, and at least for me, there is a lot to process.
The agenda of the conference was focused on one theme: how to deal with situations of either significant unrealized gains, concentrated stock positions, large planned upcoming one-time realizations of capital gains and / or simply minimizing ongoing taxable investment income.
The “problem” in all these cases is largely the same: taxes.
In many of these situations, a client would like to do something, like diversify their portfolio or sell a family business. However, there is just one problem: taking the desired financial planning or investment planning action would result in a large recognition of capital gains or other income. And, in general, people don’t like paying taxes.
Moreover, the potential for the step-up-in-basis at death provides a tempting incentive for high-net-worth investors to try defer taxes as long as possible until passing.
Like many advisors serving high-net-worth clients, I have struggled to come up with a framework for deciding which strategies to use in which situations. And there are no easy answers for these challenges. Every client situation is different, and the right set of solutions depends on the particulars of the client’s situation, the client’s investment risk tolerance, and, for many of the solutions discussed at the conference, the client’s tolerance for “structural risk” or “idiosyncratic risk.”
To be clear, few of the solutions discussed are “innovative;” many of the solutions have been around for years in some form or another. What has changed in the last few years is the number of providers who offer these solutions and, for some products, the sophistication of these solutions. But there remains significant idiosyncratic risk: many of the solutions discussed are built on either advanced tax planning techniques that rely upon current provisions of tax law (which can change!), complex computing and trading systems or riskier-than-average underlying structures or assets.
The best thing about the conference was the people. In particular, the sophistication of the wealth managers in attendance was outstanding. There was a show of hands during the conference asking how many wealth advisors had adopted tax-aware long short strategies as part of their practice, and about half raised their hands. That is a much, much higher proportion than among wealth managers overall. Moreover, the wealth manager attendees were super sharp. They came into the conference very well-informed and in many cases having practical experience with some of the solutions discussed.
All of this made the conference very informative and highly productive for wealth manager attendees. There was a lot learned not just from the presenting attendees but from other wealth managers, and here are the five takeaways that I took from the conference.
1. The Strategies Are Mostly about “Tax Deferral,” Not “Tax Elimination”
A majority of the strategies discussed at the conference were primarily focused on accomplishing one goal: deferring recognition of gains, and it’s important to recognize and to emphasize to clients that “deferment” of taxes is not elimination of taxes. Instead, it is merely “postponing the time at which the investor needs to make a decision on whether to recognize gain.”
And there was an implicit assumption in many of the solution vendor presentations: tax deferral is, by definition, a valuable thing.
On a standalone basis, this is mathematically true. There is a real benefit from tax deferral even if taxes will be recognized later, because deferring tax recognition will lead to slightly higher after-tax wealth even if the marginal tax rate in the future is the same.
But my view is that this benefit of deferment is often not very meaningful in the larger scheme of a client situation, especially relative to an intentional one-time recognition of tax for larger strategic purposes. Most investors who would contemplate advanced tax deferment solutions will be in the top marginal brackets for most of their remaining lives, so tax deferment doesn’t really provide truly impactful financial benefits, especially relative to other potential financial planning and investment planning moves. In other words, if a client is deferring recognizing gains at a 37% rate now to recognize gains at a 37% marginal rate later, it’s important to ask if the value from deferment is sufficient relative to alternative, simpler approaches, especially on a risk-adjusted basis.
The one scenario where deferment becomes a lot more interesting is where step-up-on-death is a potential nearer-term event. In this scenario, deferring gains recognition can offer significant value, especially for assets that have very low cost basis.
2. The Base Case Option: Just Recognize the Capital Gain
The #1 rule of taxable wealth, especially for concentrated or ossified portfolios, is that there is a very easy solution to many taxable wealth problems: just recognize some or all of the unrealized gains!
While this option was not discussed much at the conference because it is so obvious, the smart wealth managers in the room recognized that this is a serious alternative to consider, at least for a portion of the assets.
Yes, an investor will have to pay capital gains taxes in conjunction with gain recognition, and yes, this might lead to an investor ending up with a bit less after-tax wealth relative to deferring.
But the benefits of intentionally recognizing gains on at least a portion of low-basis assets are significant, specifically:
A lot more flexibility in how to re-deploy capital (especially in a situation where a client needs to reduce portfolio risk)
Not locked into an inflexible strategy for many years that has higher-than-average intrinsic risks
Hedges the risk associated of future tax hikes
On that last point, there is one set of clients for whom, in my opinion recognizing some gain is particularly attractive: clients in states with no income taxes. Will a top-marginal rate investor have to pay 23.8% in capital gains and net investment income tax? Yes. But that is often not a bad price to pay for the benefits in terms of flexibility, especially for assets that will be used during the client’s lifetime for personal expenses or acquisition of personal real assets.
3. The Two Most Important Client Considerations: Risk Tolerance and Net Worth
Another less emphasized but important point understood by the wealth managers at the conference is that the client circumstances matter in deciding whether any of the complex strategies discussed at the conference are appropriate.
There isn’t too much to say about risk tolerance: simply put, many of the advanced strategies at the conference are not appropriate for clients with lower risk tolerance. This is especially true of a strategy like tax-aware long short (discussed below). A majority of the advisors that I talked to at the conference agreed that advanced strategies with significant structural or idiosyncratic risk or significant leverage were not appropriate for clients with lower risk tolerance, and I think many of the investment managers at the conference would tacitly agree with this perspective.
Similarly, I think the appropriateness of many of the solutions at the conference really depends on whether is client is in the “low very high-net worth range” ($5-15 million of assets) or the “ultra high-net worth” range (greater than $25 million of assets). Let’s say that a household has $10 million of investable assets. For most people, that’s a lot of money. But for households that have $10 million of investable assets, the psychological cost of losing 40-50% of that amount would be significant, and even though they would still have a decent amount of wealth after such a loss, their standard of living would undoubtedly be affected. That’s usually less true for households with tens of millions of dollars of investable assets. The point is: in practice, ultra high net worth households have more capacity to take greater risks with the advanced and more risky taxable wealth solutions.
4. Tax-Aware Long Short - The Good, the Bad, and the Uncertain
By far the most discussed topic at the conference was tax-aware long short strategies. This was not surprising given how much these strategies have been in the news and how much assets under management in these strategies have grown over the last couple of years.
The Good
Several of the tax aware long short vendors presented their analysis of backtested “tax alpha” of their strategies. It is important to note that tax alpha very much depends on how you define the exit. Many strategies might offer up to 3-6 percentage points of annualized tax alpha in a good market environment while the assets remain in the strategy, assuming a 200/100 strategy. However, the “realized tax alpha” following an exit from the strategy is significantly lower, because exiting the strategy involves exit tax costs from deleveraging / recognizing built-in gains. These exit costs are somewhat reduced in a step-up-on-death scenario, but they don’t get eliminated completely because of the built-in gains.
The Bad
Fees: figure all-in a total of 2-3% of AUM fees and financing costs depending on the manager and the borrowing environment.
To get access to that tax alpha, you have to take on the significant risks of the tax-aware long-short strategy, including:
Risk of a significant unplanned gain recognition due to deviation from expected correlations of holdings in the vendor’s tax-aware long-short model
Risks related to a significant decline of stock price of a concentrated stock position in the strategy
Risks related to leverage
Risks related to active management: the amount of tax alpha generated depends significantly on how good the investment manager is with its stock picking on both the long and short side of the portfolio
Many other risks…
Many of the backtest analyses of tax alpha presented at the conference were based on the last 10-25 years of actual stock market performance. “The problem” is that the last 10-25 years of stock market performance has been very strong, and recent times have been a business environment where profit margins have grown tremendously. But the next 10-25 years of performance might not be as strong, and in a weaker market environment, the tax alpha may be meaningfully lower. In fact, prior market downturns resulted in these strategies delivering negative tax alpha.
Another potential downside from entering into a tax-aware long short strategy is wash-sale risk. Because loss-recognizing trades are constantly happening in a tax aware long-short strategy, there is the potential for wash sales when trades are also happening outside the strategy. Hence, most tax aware long-short managers prefer that ALL ASSETS (including even qualified assets?) come under management of the tax-aware long short vendor to minimize wash-sale risk. That comes, of course, with additional investment management fees, which need to be factored in to the total costs of the strategy.
A few states with state income taxes do NOT allow investors to either fully offset losses with gains or to carry forward losses to future years.
The Uncertain
As noted above, for these strategies to make financial sense, the investment manager likely has to deliver some amount of “investment alpha.” The amount of tax alpha generated is correlated with the amount investment alpha, because more investment alpha provides more capacity to generate losses. And so while it’s called “tax alpha,” it feels like there is a lot of “beta” in that tax alpha.
Fidelity recently stopped allowing new long-short SMAs. And in general, the significant increase in long-short strategies appears to have put some financial pressure on brokers, who themselves have to manage their risk. To the extent that brokerages increase borrow rates in the future either to manage risk or because of the macro / regulatory environment, that would undoubtedly result in less favorable tax alpha outcomes.
Net-net
Tax-aware long short strategies are not for clients who are faint of heart. These strategies entail significant risks over which a client has little control. In addition, these strategies are intended to be held for at least a decade (if not longer), and they especially shouldn’t be terminated in the middle of a stock market crash, because that will likely result in a very poor investment and tax outcome.
In the real world, however, market crashes are exactly the time that clients want to get out, and wealth managers need to be very aware of a client’s risk tolerance and ability to weather the storm before recommending these products.
5. Macro Client Portfolio Implications of “Leverage / Concentration / Beta In Just Another Guise”
When wealth managers create an overall investment strategy, one of primary things they are solving for is a capped amount of expected overall portfolio volatility. Typically, wealth managers manage this volatility by allocating an appropriate proportion of higher-risk equities and lower-risk fixed income assets.
But portfolio volatility can come from many other sources, including:
Leverage
Concentration risk
Single manager risk
For instance, let’s say that an investor puts 30% of their wealth into a Qualified Opportunity Fund to take advantage of the many potential tax benefits of Qualified Opportunity Funds. Such an action would significantly affect the client’s overall portfolio by having a significant amount of assets in few real estate properties in low-income areas and have significant leverage on those real estate properties. And any smart wealth manager knows what concentration and leverage in any form does: increase volatility of returns.
So wealth managers who use tax aware long short or leveraged / non-diversified private funds as part of their investment strategy need to consider how the inclusion of these strategies in the portfolio affects what the wealth managers do in the rest of the client portfolio. Specifically: the adoption of these advanced products results may necessitate a reduction of risk in the rest of the portfolio to keep expected volatility consistent with the investment policy.
And more generally speaking, and not just for tax-aware long short, many of the strategies discussed in the conference offered tax benefits…but the value of those benefits were often correlated with market performance. So does that mean that the tax alpha is really just more beta and more volatility?
These are all very interesting issues for wealth managers to consider, and I hope that next year’s conference will provide more space for wealth managers to offer perspectives on how they think about integrating many of the advanced strategies affects the overall investment strategy for the clients, especially for investors who may have “moderate” risk tolerance.