Tax-smart investing and defining the goal: 2022 Case Study

If it looks like a duck, swims like a duck and quacks like a duck, then it is likely a duck. Or is it? This expression came to mind during a conversation with an advisor this week when she asked the difference between tax-smart, tax-managed, tax-aware? In my mind, they are all the same: a duck.  

But it is not so obvious. Not all tax-oriented strategies have the same goal. To Frontier Asset Management, the goal of all three is the same: higher after-tax wealth. However, not all investment processes see it the same way. A duck is not always a duck.    

Is the goal to have a low tax bill or to have more money after-tax? At Frontier, avoiding tax is not the financial goal. I have not met anyone with taxable assets who has said, “I may have less dollars in my investment account this year, but by golly, I didn’t pay the government any money.” Ok – I have a met a few who say this, but that will be a different blog for another day.  

To me, simply avoiding a tax is not the path to meeting one’s financial goal. No one wants to pay more taxes than they have to pay. That is a given.  

There are many examples of looking to maximize after-tax returns, but this year we have an example that is so illustrative, it is worth highlighting as we head into capital gain season. (See our recent blog on upcoming capital gains.) 

Managed Futures 

• What are they? Funds that are able to follow trends by taking long or short positions in stocks, bonds, currencies and commodities. Historically, they have done well when markets trend in a specific direction and have struggled in choppy markets.  
• How are they taxed? The majority of Managed Future funds are taxed as futures contracts with all contracts marked to market at year end. So even if you don’t sell at year-end, the positions will be treated as if they were sold. And per the Internal Revenue Service, the gains will be treated as 60% long-term capital gain (LTCG) / 40% short-term capital gain (STCG). If the fund is in a loss position, the net loss would be carried forward into future years at the fund level.   
• Is this bad for taxable investors? Having to recognize a gain when you don’t sell is not great, but not the end of the world. Plus getting 60% of the return treated as LTCG is materially better than all of the return being treated as STCG.  
• What’s not to like? During 2022, the returns have been quite desirable. Even with having to recognize the tax hit, the after-tax return will likely be very additive to portfolio returns in 2022.  See Exhibit 1. 

U.S. Stocks: S&P 500 Index, U.S. Bonds: Bloomberg U.S. Aggregate Index, Managed Futures: BTOP50 Index which seeks to replicate the overall composition of the managed futures industry with regard to trading style and overall market exposure.

• If we take the year-to-date gross of advisory fees return of 21.3% and assume that the gain is taxed as described at a blended tax rate of 18.6% (Married Filing Joint/$240,000 of taxable income / 24% for STCG and 15% for LTCG), the after-tax return would be reduced to 17.3%. 
• You had 4% of tax drag from paying taxes on the distributions, but your after-tax return was +17% in a period when stocks and bonds were down -18% and -16% respectively! Again, what is the goal? To avoid having to pay a tax or invest in something that provided a positive return and was a strong diversifier in a challenging year. Of course, this will not always be the case, nor will the allocation percentage to managed futures in our strategies, but this is a great example of the goal for tax-smart investing.  
• Can every strategist use Managed Futures? Nope. The universe of Managed Futures funds is reasonably limited. Frontier Asset Management’s open architecture approach allows us to consider virtually all mutual funds and ETFs for inclusion in our strategies. We are not limited to proprietary funds or a hire list of funds from an outside party. We are free to add/remove when our Downside First Focus® approach leads us in a given direction. Few strategists out there can say this. 

Putting it together 

Tax-smart, tax-aware, tax-managed: If it looks like a duck, swims like a duck and quacks like a duck, then it is likely a duck. And like a lone duck on the opening day of duck season, successful tax-aware strategies should be easy to spot. I have been involved in taxable portfolios for 15 years and I’m still not clear on the difference between the varying tax-managed terms. To Frontier Asset Management, the goal is clear: to maximize after-tax returns – and Managed Futures are a worthy consideration for this goal. We are working to maximize after-tax returns, and in 2022, Managed Futures have fit that (duck) bill.