The Future of Tax-Managed Investing
Brad Jung, CIMA®, CPWA®, AIF®, is head of North America, advisor and intermediary solutions, Russell Investments. In this role, Brad leads the business unit focused on developing and executing strategies for Russell Investments’ advisor partnerships, along with the firm’s client relationships in the wealth management and retirement channels. Brad is a member of Russell Investments’ global operating committee. He reports directly to the firm’s CEO and is based in the Seattle headquarters.
Rob Kuharic, CFA®, is director, tax-managed solutions, Russell Investments. In this role, Rob oversees key aspects of the implementation of tax management in client portfolios for Russell Investments. In addition, Rob is a keynote speaker for Russell Investments and frequently presents to the media, industry professionals, and clients. His ability to convey how tax management can benefit a client’s after-tax wealth, including how this can benefit financial advice and planning practices, has made him among the most sought-after speakers at Russell Investments. Rob has over 25 years of financial industry experience, with most of this time focused on creating innovative and ground-breaking tax managed strategies and solutions. He has integrated this approach to tax management in portfolios that are readily available and easily implemented by investors who seek to improve their after-tax wealth.
I spoke to Brad and Rob on June 29.
How have taxes on investments evolved over the years and how have you responded?
Brad Jung: Historically, advisors have built investment solutions and financial plans for individual clients, with portfolios that encompassed both qualified and non-qualified assets. As investors’ needs have evolved, so have products, and qualified and non-qualified investments have been decoupled. Advisors are now using tax-managed products for tax-sensitive clients. These tax-managed products aim to maximize the after-tax returns for investors to help them get to their goals with greater certainty.
Rob Kuharic: It all comes down to tax drag. This is the number-one issue that impacts investors. We're very much focused on how we can improve clients’ after-tax rate of return. At Russell Investments, we have evolved and expanded our tax-managed solutions over the years. We've introduced new tax-managed funds to better diversify clients' portfolios. More recently, we launched Personalized Managed Accounts (PMAs) to take tax management and personalization to the next level.
On top of that, education is essential. People don't always understand the impact that taxes have on their investments. There's a need to improve education and the types of materials that are available for financial advisors so they can have better conversations with their clients on this subject.
Your tax-managed portfolios recently celebrated their 20th anniversary. Congratulations. How has that journey transpired and have there been key changes that you've undergone along the way? What were the driving factors behind those changes?
Rob Kuharic: Our tax-managed journey started in 1985 with the introduction of our tax-exempt municipal bond fund. About 10 years later, we introduced our large-cap and small-cap tax-managed funds. In 2003, we introduced our tax-managed models to make it easier for advisors to implement solutions for their clients. From that point on, the reception we've had from financial advisors, investors and clients has been fantastic regarding the results they've experienced.
We now have the opportunity to think deeply about the questions: "How do we evolve from here? How do we make this a truly transformative journey, especially with this 20-year celebration?" In the 2010s, we took things to the next level by centralizing the internal tax management of the funds with some innovative trading strategies. Later we introduced tax-managed international and tax-exempt high-yield funds and a tax-managed real asset fund. Today, our models are 100% tax-managed top to bottom, and we feel that's important for investors and advisors when it comes to building retirement and savings nest eggs, so investors can have a better overall after-tax outcome.
Brad Jung: The one word that sticks out is innovation. Russell Investments has been an independent, objective money manager since its foundation. When you look at our investment products, they are not “set it and forget it.” Innovation is extremely important in the tax-aware investing space, as products, tax laws, and access to different types of return patterns are changing constantly. Our process is about continual innovation, including the types of investment managers we use within our products, and tax-optimization strategies.
Investors these days have better access to tax-managed solutions. Money managers have started looking at ways to be more tax aware in their investment process. That has allowed us to shift the funds in our tax-managed models from 81% to 100% tax-aware over the past 20 years. We were innovative not only in the optimization but in our fund-manager lineup. We've extended our five basic models to encompass all types of financial plans and different risk tolerances. We've also incorporated state-specific solutions for California and New York, which help advisors build more tax-efficient portfolios for investors in those high tax states.
What are the compelling reasons that an advisor should consider incorporating tax-managed investing? What opportunities does it present for the advisor and for their clients?
Brad Jung: Advisors who incorporate tax-smart planning into their investment and financial-planning process can potentially add substantial value, as our annual Value of an Advisor Study shows.
Of the $27 trillion invested in open-ended mutual funds, $12.7 trillion of that is held in taxable accounts1, representing a huge opportunity for advisors. Many advisors don't realize that a lot of investors need help in this area. Most advisors aren't using tax-sensitive or tax-smart solutions and planning in their practices. We see this $12.7 trillion as a big opportunity for advisors to acquire new clients, deepen relationships with existing clients, look at asset location and bring assets into their practice, and help them run better portfolios.
Rob Kuharic: Tax management improves the probability of success for clients by controlling their tax costs. It can help reduce the risk of a shortfall later in life, and it has the potential to reduce their current tax bill. We've done a lot to educate and illustrate for advisors the value that tax management brings to their practice. If it's done right, it results in more satisfied and comfortable investors. It's a win-win for everyone.
For financial advisors, using tax-managed models helps to free up their time to focus on additional value-add opportunities, because Russell Investments takes care of the heavy lifting by doing a lot of the tax management work that's complex, difficult to implement, and time-consuming. That allows the financial advisor to work more closely with clients on other problems and put their best foot forward while providing a better overall solution.
There are a lot of investment products that are marketed as tax-sensitive solutions for investors. What sets your tax-managed solutions apart? What is your unique value proposition?
Brad Jung: Most advisors have traditionally looked at either U.S. or global mutual funds as the chassis to build tax-aware solutions for investors. Those could incorporate anything from low-turnover managers or funds that have more index-like returns. But what we see is that these traditional products come with a tax drag, and that lowers the probability of achieving the goals in an investor’s financial plan.
In our Value of an Advisor Study, based on the tax drag or tax-cost ratio, we found that the optimal place for advisors to build tax management in the mutual fund space is by using tax-managed mutual funds. These funds have the explicit purpose of managing taxes to maximize the after-tax return. Most other products have tax drag, including passive investments. Over the last five years ending December 2022, the average passive U.S. equity fund had a tax drag of 1.16%.2 That lowered the probability of investors achieving their financial goals. At Russell Investments, we have an advantage in this area because of the way we run separate accounts rather than a fund of funds, as well as our ability to leverage our 20 years of experience in the tax-optimization process.
We make it simple for advisors. We do continuous tax-loss harvesting and optimization, starting January 1 every year. Most advisors do episodic tax-loss harvesting in the fourth quarter in conjunction with their accountant. They try to do everything late in the year, along with trying to estimate taxes or capital gains and dividend distributions from the investment products they own. With continuous, 365-day-a-year tax optimization, we differentiate our tax-managed solutions from our competitors. We also free up advisors’ time so that they can focus on client acquisition, servicing existing clients, and looking at ways to help investors with their financial plans.
Tax management is extremely complex. We leverage our 20-plus years of experience and make the complex simple for advisors so that it frees up their time to invest in their business instead of on their business. That's what a partnership with Russell Investments does.
Rob Kuharic: Tax management is a specific phrase that has an action statement attached to it. A lot of what we've seen in the asset management industry are phrases that don't have an action attached to them – like tax-smart, tax-aware, tax-advantaged, or tax-efficient investing. What do those mean? If tax management means you're doing something, what does tax-aware mean? A lot of those phrases are just marketing ploys. When you look at many other fund solutions, there is tax drag. We’ve focused on that tax drag through our active tax management.
As Brad said, you must think about this as a year-long problem. It's almost a lifelong problem. You need to be thinking about taxes and how you address them every step of the way, literally every day of the week. We work to educate advisors and investors, helping them understand the value that tax management brings to them from an after-tax outcome and a differentiation perspective. Doing all these things in combination is the unique value proposition that we bring to the table and is the reason why a lot of financial advisors enjoy a partnership with us.
Tell me more about the process that underlies the construction of your tax-managed portfolios.
Rob Kuharic: Our claim to fame is that we are a manager of managers. We don't build what the industry refers to as a “fund of funds.” We don't buy funds, package them together and sell them. We literally build our funds with individual, institutional, and separately managed account managers. That is a unique ability, especially when it comes to tax management because it allows us to unpack what you can do in a separately managed account and put it in a mutual fund format.
In a traditional separately managed account, when advisors would transition from manager A to B in a very short period, they would do so in a very clunky way, client by client. In our fund structure, this transition is neat and orderly. By introducing some of the techniques that we've learned on our institutional trading side when it came to transition management, we can move to a new manager cost-effectively and can control liquidity and trading, as well as consider the tax ramifications of the change.
We can lower the subsequent tax bill by holding onto some securities a little longer because they had short-term-gain status and get long-term status instead. We can substitute other securities while avoiding the wash-sale rule. We do so in a way that is efficient, structured, and systematic, and allows us to amplify the tax efficiency and tax management component when doing something as mundane as making a manager transition.
We continually ask ourselves: How can we make that transition better, more efficient, and more structured so the client gets an overall better outcome? That is something we still to this day haven't seen our peers do.
Our country's tax code has become increasingly complex over time. How has that complexity influenced the development and the features of your tax-managed solutions, considering the diversity of tax situations that individuals face?
Rob Kuharic: Over the years we have changed and improved our models, our funds, and the way our tax management works within our funds. This has given us more control over what happens in the portfolio, but it also has allowed us to be nimbler. We can pivot much more quickly than a lot of our peers when tax laws change to make sure that we're providing clients with the result they are expecting. A lot of it comes down to our external servicing model. The team that we have is, in my opinion, the very best at providing education and knowledge, and working with advisors on those client problems every day.
Brad Jung: The value of advice and of a partnership is extremely important. At Russell Investments, we add value by helping advisors acquire clients who may benefit from tax-managed investment solutions. We offer tools and resources to help advisors understand the problem. For example, we can help them review their clients’ tax forms, whether that's the 1099 or the 1040 form. We also work on business opportunities. We give advisors ways to find sources of assets that could benefit from a tax-managed approach. We not only help them uncover these opportunities but help them incorporate tax-managed solutions to their practice. We provide advisors with our tax-management interactive tool. We have a tax resources webpage on our website that helps advisors understand the tax issues that their clients may be facing, and it helps investors find answers to the questions they may have on investment taxes.
One of the biggest benefits we offer is our annual After-Tax Wealth Advisor Handbook, produced in partnership with Deloitte. As tax laws change, we work with Deloitte to share the handbook with advisors, so they have an easy reference tool at their fingertips. We also make servicing clients easier for advisors. We have quarterly review materials that allow an advisor to go back to the client to talk about what's happening in the macro environment, in their portfolios, and how their portfolios are positioned, helping increase their confidence that they're going to get to their financial goals.
Rob Kuharic: The big reason why we do this is simple: Taxes are hard and complicated. We know that, and we know that it's difficult for financial advisors and investors to make sense of the tax code and the tax impacts they face. Everything that Brad highlighted, with regards to the form 1040 and 1099 guides and the After-Tax Wealth Handbook, makes it easier for people to understand how investments are taxed and what they can do about it. That way we can provide not just different solutions, but education.
One of the hottest trends today in the advisory profession has been direct indexing. How do your direct indexing solutions compare to what most advisors are seeing in the marketplace?
Rob Kuharic: One of the things I've told advisors is, "Even though that phrase is hot, investors still don't fully understand what it is, so we need to focus on the outcomes of direct indexing rather than the topic of direct indexing." Direct indexing offers a portfolio that is customized and personalized in a way that isn’t possible with a solution like an ETF. ETFs and passive investing are very impersonal. Direct indexing is very personal. It offers risk control or lower tracking error in an investment solution customized for the specific tax needs of the client.
Brad Jung: The first benefit of direct indexing is the level of customization possible, as the portfolio can be based on individual preferences and investment goals.
The second benefit of direct indexing is tax efficiency. Unlike mutual funds or ETFs that are required to distribute capital gains to investors, direct indexing allows you to control when and how your clients realize capital gains. Additionally, mutual funds or ETFs can’t distribute net losses. The big tax benefit of DI is the realization of losses that the investor owns and can use to transition their portfolio or offset gains from other parts of the portfolio.
Third is risk management. You can use direct indexing to complement a portfolio and diversify exposure. You can manage a client's true appetite for risk in a portfolio that is aligned to their financial plan. For investors who want their investments to reflect their values, they can personalize their choices.
Finally, direct indexing can simplify charitable giving. Direct indexing allows clients to donate individual stocks and obtain a tax break. That is an area of continued interest that advisors and investors can take advantage of. Some people say, "Well, wait a minute, we have passive investing already, and we have passive ETFs." There's some tax efficiency there, which is great. But direct indexing lowers the cost of active management, provides significant customization, tax and risk management, and provides the potential for charitable giving potential.
The one caveat is that every direct indexing solution is not created equal. Investors and advisors have to be aware and educated on what direct indexing is and how they replicate index products.
What is your vision for the future of tax-managed investing? How is Russell Investments preparing to adapt to potential changes and trends in this field?
Rob Kuharic: The future is massive in terms of the $12.7-trillion opportunity for financial advisors and for firms like us. Those are taxable assets in mutual funds, and very little is being done to address their tax implications. Here at Russell Investments, we're going to continue to improve, innovate, and evolve. That's what we do, that's what we've done, and that's what we're going to continue to do. It comes down to the way we're looking at the solution and investment perspective, making sure that we fully understand the problem so that our solutions provide what clients want.
More needs to be done so that investors understand exactly what is going on in their portfolios and their tax problems. We want to bring light and transparency to that. We're going to continue to improve and evolve that.
Brad Jung: Personalization is a trend that's going to continue. Technology's a great equalizer in life and in this industry. At Russell Investments, we have kept up with technology. Technology allowed us to take the optimization and the tax overlays that we do on mutual funds and allowed advisors to build investor portfolios using active and lower cost direct-index investments. Regardless of their price point, their belief in active or passive, or their belief in tax-managed or non-tax management, we allow advisors to match those portfolios or financial plans.
For advisors who want to add value beyond a traditional ETF or mutual fund product, we can help them build customized portfolios. At Russell Investments, we built a product lineup that encompasses a multi-manager, active SMA coupled with a lower cost, direct-index option. If you want that for a retirement or a qualified account, you can build it that way, or you can personalize it with a tax overlay. If an investor is a technology professional who doesn't want and cannot have too much technology exposure, we can restrict exposure to technology in their portfolio. You can have a low-cost-basis stock that has been on your books for 20 years (if you were an early investor in Amazon) and now want to tax-efficiently reduce that exposure to create a more diversified portfolio. Those solutions allow us to build a transition plan to minimize the tax impact while diversifying that exposure over time.
Our personalization strategies extend our leadership in the model strategy and tax-managed universe to those clients who may be looking for a more personalized approach to their unique situation. Values-based investing means something different to everybody. Our process allows us to build on what we've done for the largest pools of capital in the world – Institutional investors – and go downstream, and now we can help advisors build a personalized tax investment strategy.
Our goal at Russell Investments is not to tell advisors what to do and how to do business with us. It's for us to ask the question, "How do you want your Russell Investments?" It’s our job to remove the friction from manager research and product manufacturing and allow advisors to choose how they want to do business with us. We can serve investors who have a $1,000 portfolio or a $20 million portfolio. We can offer one-stop shopping, strong servicing capabilities, strong regional sales-team support, and a deep partnership few firms can provide.
Robert Huebscher is the founder of Advisor Perspectives and a vice chairman of VettaFi.
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1 Source: 2022 ICI Factbook. Including taxable non-household accounts, taxable household accounts, and tax-exempt funds.
2 Data Source: Morningstar. Tax Drag: Pre-tax return Less After-Tax Return (pre-liquidation). Calculated arithmetic average for pre-tax, post-tax return for all shares classes as listed by Morningstar. Including all U.S. equity funds that are indicated by Morningstar as passive or an ETF.
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First Used: July 2023 RIM-02858