As we’ve said before, and will no doubt say again, portfolio decisions justifiably vary based on individual objectives and circumstances. It’s usually prudent for investors to utilize tax-advantaged accounts like 401(k)s whenever possible and to the extent allowable. Managing investments in taxable accounts presents an additional opportunity to benefit from gains over time, but also presents an additional layer of tax complication.

Regardless of how taxable portfolios are structured, in order to mitigate the impact of capital gains taxes, their different sources must be fully understood. This blog is the second in our “Understanding Capital Gains” series, following the first titled, “The First Step to Better After-Tax Outcomes”.

Capital gains are simply the profits from the sale of an asset that’s increased in price. Sometimes that sale is the result of a decision made by an investor with their advisor, whereas in other cases, investors can be impacted by the tax consequences of decisions made by others and events outside their direct control or view.

Sometimes an expensive surprise, there’s little that can be done once the tax bill is due. Taxes may be one of two of life’s inevitabilities. But whether we’re talking about mutual funds, SMAs, or model portfolios, a forewarned investor may be appropriately forearmed.

Navigating the Tax Challenges of Active Management

The Double-Edged Sword of “Pass Through”

A mutual fund investor may sell fund shares for more than what they paid for them, realizing a gain—no surprises there. But just as a mutual fund is required to pass through income from a stock or bond portfolio to the shareholder, so too must it pass through capital gains incurred within the fund, whether or not the investor sells their shares.

In 2022, a year most investors would prefer to forget, about two-thirds of equity mutual funds made capital gains distributions that averaged 7% of assets (with significant dispersion within this average), despite a decline of 18% for the S&P 500.* A bad year was made considerably worse. Importantly, taxable distributions are typically made in December. An investor buying fund shares with embedded gains before that distribution also bought tax liabilities accrued over the entire year (and sometimes longer). That’s right. It’s possible for an investor to pay taxes on gains they may not have even benefited from.

Say an equity mutual fund suffers through a brief period of underperformance, but that underperformance causes significant outflows. Once cash in the portfolio is depleted, the fund’s manager must sell securities to fund the redemptions. Where possible, the first securities sold will be those with few, if any, capital gains. But should outflows continue, stocks with larger gains would have to be sold. And therein lies the problem—existing fund shareholders may be hit with a tax bill resulting from those shareholders who exited the fund.

The catalyst for pass-through capital gains may not be underperformance. A change in fund structure or fees can be the harbinger. In one recent example, significant outflows were caused by the creation of a new, cheaper share class of a fund primarily used in tax-advantaged accounts. As retirement money flowed to the new share class, investors holding the fund in taxable accounts were met with an unpleasant, unscheduled, and rather significant tax bill.

While the structure of ETFs can provide advantages (more on this below), ETFs themselves may be a contributing factor to the problem. Flows from legacy mutual funds into newer, perhaps cheaper, ETFs could trigger similar tax consequences.

SMAs and Models: Tax Headwinds as Byproducts of Change

ETF and mutual fund-based model portfolios offer advantages to investors and advisors alike. Model portfolios are scalable, customizable, and built on a foundation of asset allocation and manager selection rigor. But as risks and opportunities ebb and flow, so too can tactical and strategic allocations. Although model portfolio changes are made with the intent of achieving intended investment outcomes, for taxable portfolios, these decisions could realize gains as appreciated positions are rebalanced, trimmed, or sold completely. The headwinds for model portfolios containing mutual funds could be stronger still for reasons we’ve already discussed earlier.

The structure of SMAs—direct ownership of individual shares—enables a high degree of customization and precise management. But as with model portfolios, portfolio-manager-driven turnover has the potential to realize gains and thus incur taxes.

The Solution: Tax-Smart Strategies and Tax-Wise Thinking

So, what should a concerned investor do? Granted, taxes are important, but certainly not the only factor in making informed investment decisions. But no matter the desired outcome, there are a few options—both structural and opportunistic—that can add value when and where it’s needed. Mutual funds with lower turnover and smaller embedded gains can be a starting point. In many cases, ETFs can lower operating costs and provide greater transparency than open-ended mutual funds. Their structure can also provide important tax benefits by reducing capital gains distributions.

As ETF shares are bought and sold by investors, they’re also created and redeemed by Authorized Participants (APs). This process ensures that aggregate demand for ETF shares matches aggregate supply, and that each ETF’s share price fully aligns with the basket of securities within the ETF. But unlike with mutual funds, ETF shares are created and redeemed in-kind. This enables fund managers to move appreciated shares out of the fund via ongoing in-kind redemptions and thus reduce taxable events. Today, active tax management can be an impactful complement to active investment management. Tax-smart technology has changed the game, the rules, and often the outcome.

With SMAs, the portfolio manager’s strategy and objectives are key determinants of tax impact. The more active the strategy, the more potential for realized gains. But today, the individual ownership of securities in SMAs offers a compelling potential benefit to tax-wise investors. By continually monitoring granular portfolio positions, tax-smart technology can identify opportunities for pairing and offsetting security-level gains against losses across multiple tax lots. The net effect of an ongoing systematic approach to tax-loss harvesting can markedly improve after-tax performance—without overly impacting portfolio composition or detracting from a manager’s value.

Model portfolios can similarly benefit from tax-wise thinking and tax-smart management. And again, technology plays an important role. Structurally, the use of ETFs within portfolios can reduce the impact of passed-through gains. Tactical (and strategic) allocation changes can be made by managers in a tax-smart manner by being cognizant of the tax impact. While the positioning/allocation itself is paramount, tax technology can be an invaluable tool to help evaluate and mitigate tax impact. In the same way that gains and losses of individual securities in SMAs can be offset, the same principle works with—and across—allocation sleeves and the funds within them.

Navigate the Challenges

For investors with taxable accounts, a full understanding of the tools, strategies, and technology available can help investors and their advisors close the gap between what portfolios make and what investors keep. For advisors, the opportunity to address a critical need and add value and differentiation is at hand. Across markets, J.P. Morgan Asset Management is committed to being the industry standard for personalized, tax-smart investing and helping investors improve their after-tax outcomes.

* “Your Investment Lost Money last Year. So Why the Big Tax Bill?”, The New York Times, January 27, 2023.