The Secret Ingredient To Managing Taxes

People seem to love to shorten language into acronyms. FAANG, CAGR, EPS – and now we even have DOGE! – need I say more?

When it comes to designing portfolio management systems, we think plenty of asset managers and financial advisors think of the acronym as RRE, whereas we believe it has to be RRET:

• Return
• Risk
• Execution
• Taxes

Returns and risk are the usual, almost unarguable priorities.  

Outside of those two goals, execution is also an important consideration. For example, one might design a great system, but it may fall flat if it is very difficult to implement in real time due to the assets used or the technology required.

With risk, return, and executability solved for, we think there is yet another critical piece that must be incorporated: taxes.

Capital Gains Can Hold Financial Advisors Hostage

Let’s say you’ve built a robust portfolio management system that has been executed flawlessly in a given year, providing solid returns for an appropriate level of risk. As a reward (I use “reward” sarcastically here), you likely now face a substantial tax bill since most of the returns were short term in nature. On a before-tax basis you may have outperformed a reasonable benchmark, but on an after-tax basis you’re likely underperforming. Needless to say, this is suboptimal.

At Blueprint Investment Partners, our goal is to create portfolio management systems that operate at the optimal tangent between RRET (return, risk, execution, AND taxes).

However, the real secret to our ability to be successful within a client’s accounts lies with our firm’s partnership with financial advisors. With even a great system, clients need a quarterback to explain and coordinate the game plan. The benefit of this partnership is often felt most strongly when it comes to maximizing after-tax returns, since so much of the tax situation is unique to each client. Asset managers, including Blueprint Investment Partners, simply do not have enough computing power to overcome the need for the personalized service of an advisor.

Impact of Systematic Investing on Pre- and After-Tax Returns

There are two aspects of the tax puzzle that a well-designed systematic investing system has the most potential to benefit:

1. Systematic tax-loss harvesting
2. Managing large unrealized gains

As a trend-follower asset manager, the Blueprint Investment Partners strategies are designed to take losses quickly and let winning trades run. This allows a client to hopefully build up losses that can be carried forward to offset future gains.

Along the way, the risk-management component of our strategies will also periodically realize long-term gains. In doing so, accounts rarely accumulate large, unrealized gains. This helps avoid ballooning tax bills. It also reduces the chances an advisor feels held hostage to positions that may no longer be compelling long-term holds but whose large gains can make them difficult to move on from. When it works according to plan, there are enough losses accumulated and carried forward to fully cover the gains from years of high returns, such as 2024 thus far.

It is important to note here that we will never let the acronym flip from RRET to one that starts with T. We do not let taxes drive risk management. In our opinion, and according to our research, avoiding large drawdowns is the more important priority when seeking to accomplish long-term financial goals.

The Financial Advisor Factor

While systematic investing strategies can bring much to the table in terms of minimizing the long-term tax drag, there are other areas where a financial advisor can further enhance after-tax performance.

First and foremost, an advisor who deeply understands their client’s specific situation can work with the client and/or a CPA to structure accounts in an optimal way. Sophisticated advisory practices often take this a step further by partnering with an asset manager, like Blueprint Investment Partners, that is equipped to help them take additional steps. For example, in some circumstances advisors can minimize interest income (which could be taxed as ordinary income) in favor of dividends (which may be taxed at lower rates or be deductible).

Another scenario we have seen play out is where an advisor will complement Blueprint Investment Partners strategies with other alternative investments that defer taxes or offer favorable tax treatment. While there may be some loss of liquidity or even higher expenses in these accounts, when the aggregate performance and tax reduction benefits are considered, it could be worth it for some clients.

Talent Win Games, Teamwork & Intelligence Win Championships

The preceding examples reinforce the importance of teamwork in making the dream work: between advisor and asset manager, as well as between advisor and client.

Clients can lose sight of the forest when they get caught up in the trees (e.g., noise created by the media, friends and family, and other advisors trying to win their business). They need an advisor they can trust to execute the overall plan and communicate tirelessly.

Similarly, trying to balance the sometimes-competing interests of the R, R, E, and T can create a game of whack-a-mole for financial advisors who lack a strong partnership with an asset manager equipped to manage all four.

At Blueprint Investment Partners, we hold advisors in high regard, and everything we do is intended to better serve them. We do not create portfolio management systems to have the best performance, lowest risk, or any other single outcome. Rather, we design our entire business to maximize the odds a financial advisor can help a client reach their goal. In a year like 2024, the need for this is apparent in the area of taxes.