Traditional investment advice normally focuses on allocation into buckets. These buckets could be traditional mutual funds, or ETFs, or managed accounts holding individual stocks. In most cases, the allocation buckets are tactically rearranged, and the securities within mutual funds and managed accounts are also actively rearranged.

This process of rearranging can easily result in realized capital gain, which truthfully, creates an optional tax. Choosing to rearrange is the cause of the tax. Even if intentionally deferred to a one-year hold period to get lower capital gains tax rates, the process itself creates friction that decays return. Additionally, the aggregate value of this realized gain might have eventually resulted in a tax-free step up at any owner’s death if handled differently. This means the traditional methods might be squandering the tax-free step up as a natural byproduct of their efforts to improve things. Considering that studies like the SPIVA Report from Standard & Poor’s routinely show that the vast majority of active managers underperform their benchmarks over any discernable timeframe, it makes you wonder what master “traditional advice” is serving.

Long Hold Periods

Considering the friction points outlined above, one could easily construct several reasonable scenarios where long hold periods are coupled with low costs and low expectations for “rearranging” to construct a slipstream for tax efficiency. Long hold periods alone can add a fourth to compounded return over time. This is before you consider the possibility of a tax-free event at death, the likelihood of which also increases with long hold periods.

This step-up event can triple the advantage of prior compounding derived from long hold periods; possibly resulting in a doubling effect to prior returns. This means that two investors could both earn 8% and both pay all their taxes due over thirty years, and both die, but the one with an anti-tax method could easily have twice the money.  Not only would they have experienced that during their lifetime, but their death ratifies the advantage for all future generations of the family. If this becomes a family tactic, this can create generational wealth that might have been squandered by simply being unaware or unintentional.

Returns and Results

Of course, a traditional advisor may throw darts and caveats to disprove my position since they have a vested interest in the status quo. IRAs are a great exception to my argument because they don’t get a tax-free step up. Fair enough, but that disproves nothing because IRAs would not be harmed by lower turnover anyway. My firm is also guilty of eroding returns by occasionally rearranging things ourselves. Even so, our philosophy of less trading and longer hold periods tends to result in significantly less taxes being paid by clients compared to holding an actively-traded traditional mutual fund with the same performance. 

Our process also avoids a layer of fee that a fund might charge to create their tax friction, which comes back to the investor as incremental return. Considering how low the unrealized gain portion is on most statements we are asked to review, our competition does not normally think like us. Remember also that these tax advantages would take an act of Congress to change, resulting in tangible, dependable, and repeatable benefits through exploiting the rules. It is true that the tax-free step-up at death rule was recently challenged for the fourth time in the past century and failed to gain traction yet again. Since farmers with big properties and low cash vote with vigor, it won’t come up again until their memories fade and their blood pressure subsides. Ask your active manager if he can offer you similar assurances that his active rearranging process can guarantee you enough incremental results to offset the friction of his process. I think not.  

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