Cost-consciousness is a crucial component when building and managing a sound investment portfolio.
After all, clients only get to reap the rewards of portfolio returns after investment costs are paid. Oftentimes overlooked, in addition to the drag of investment expenses, is the drag of taxes.
When working to maximize net portfolio returns, being mindful of tax efficiency while constructing and managing a properly diversified investment portfolio is absolutely crucial.
Building a tax-efficient portfolio goes well beyond the basic concept of owning tax-free municipal bonds inside a taxable account. In fact, every individual investment should have its relative tax efficiency or inefficiency analyzed when evaluating and optimizing the composition of a portfolio.
Ideally, each investment should be held in the account type (taxable, tax-deferred or tax-free) that will position the aggregate portfolio with the highest opportunity for after-tax returns.
For example, it is often appropriate to hold ETFs, such as those that track the total U.S. stock market, in “regular” taxable accounts, as they are generally very tax-efficient.
Why? ETFs typically have relatively low turnover, meaning less trading is occurring, resulting in much lower capital gains activity than actively managed funds.
Additionally, ETFs tend to produce lower levels of dividend and interest income relative to other investment vehicles such as individual bonds.
On the other hand, it is essential to focus on holding investments that generate higher levels of investment income within a tax-deferred (traditional individual retirement account) or tax-free (Roth IRA) retirement account. Excellent examples of this type of investment are real estate investment trusts, which are inherently very tax-inefficient, given the high level of ordinary dividends that they generate.
Comparing and and ranking assets according to their tax-efficiency is easy to do online.
Morningstar’s tax analysis metrics, for example, provide specific tax information on an investment-by-investment basis: pretax return, tax-adjusted return and tax cost ratio. Although each of these metrics has its advantages and imperfections, they can be quite powerful when considered within a properly diversified and tax-optimized investment portfolio.
Although minimizing the drag of income taxes is extremely important, we continue to subscribe to the investing adage, “don’t let the tax tail wag the investment dog.” In other words, while none of us like paying taxes and while it is clearly prudent to strive for a tax-efficient portfolio, advisors shouldn’t sacrifice the fundamentals of building a diversified portfolio aligned with a client’s risk and return characteristics and long-term financial goals while doing so.
This story is part of a 30-30 series on tax-advantaged investing.
