We’ve put a great deal of effort into making each taxable SMA as tax-efficient for a US investor as possible.
In our core SMA product for taxable investors, we re-balance each investor’s portfolio every 40 days (i.e. 9 times per year), and our systematic rebalance algorithm attempts to optimize between minimizing realized short-term taxable gains, maximizing realized short-term taxable losses, keeping the portfolio within certain bounds of our target risk allocations, and minimizing transaction costs. We also try to minimize realized long-term capital gains, but we place significantly less emphasis on this relative to the focus we put on short-term gains. Because many of the dozen-or-so core risk markets we invest in are related, and several instruments are generally available per market, we can often achieve a much better tax result for our investors than if we just naively re-balanced each market without thinking about taxes.
Despite the higher expected turnover of our dynamic approach compared to a static approach that re-balances back to fixed weights, there are several subtle but significant effects that, together, yield high expected tax efficiency. First, the momentum overlay is what generates most of the additional turnover compared to a static approach, and its nature is to generate frequent but small short-term capital losses punctuated by less frequent but large long-term capital gains. Second, our portfolio turnover generally takes the form of buying and selling a small ‘top’ slice of the portfolio, which typically has relatively low built-up gains or losses. Beneath this ‘top’ slice, there will tend to be a more static base layer of the portfolio that can hold a buildup of unrealized long-term capital gains.
By default, all taxable SMA investors benefit from automated tax-loss harvesting, and our system automatically works to prevent tax-adverse wash sales between groups of linked accounts. We also try to earn as much income as possible in the tax-preferred form of Qualified Dividends.
Please be aware that tax performance in a particular instance will strongly depend on the specific path of the market and the investor’s entry point (or points, in the case of multiple investments), and also that tax law will change over time in ways that are impossible to predict. We discuss how tax considerations impact portfolio re-balancing in more detail in this note here, and we discuss in detail the tax efficiency of a historical Elm investment in this note here.