Tax-Efficient Portfolio Transition: A Tax-Aware Relaxed-Constraint Approach to Switching Equity Managers

Abstract

For a taxable investor with a highly appreciated equity portfolio, replacing the portfolio manager is likely to trigger substantial tax liabilities. We focus on transitioning an appreciated equity portfolio to an actively managed strategy. We compare transition from an appreciated portfolio to a traditional long-only tax-agnostic equity strategy with transition to equity strategies utilizing more advanced portfolio management techniques such as tax-aware rebalancing and relaxed-constraint portfolio construction. We find that transition to a tax-aware relaxed-constraint strategy results in both high implementation efficiency and tax efficiency both during and after the transition. As a result, a tax-aware, relaxed-constraint, post-transition strategy significantly outperforms a traditional tax-agnostic, long-only strategy in its ability to preserve and grow the investor’s after-tax wealth over the long term. We also discuss risks and limitations of the tax-aware, relaxed-constraint approach.

TOPICS: Portfolio management/multi-asset allocation, equity portfolio management, portfolio construction, Long-term/retirement investing, wealth management

Key Findings

• ▪ For an individual taxable investor with an appreciated equity portfolio, the tax costs of replacing the portfolio manager may be highly punitive, far outweighing the transaction costs of such replacement.

• ▪ Advanced portfolio management techniques can help alleviate the tax burden of portfolio transition resulting from manager replacement: We show that transition to a tax-aware relaxed-constraint strategy results in high implementation efficiency and tax efficiency both during and after the transition, leading to strong after-tax performance.

• ▪ We also show that tax-aware portfolio transition is a complex bespoke solution and stress the need for a careful evaluation of the client-specific situation by a client’s investment advisor and a prospective manager. Nonetheless, our results demonstrate that a tax-aware transition to a relaxed-constraint strategy has the potential for providing a substantial benefit to a taxable investor “locked-in” into a highly appreciated portfolio.