The value of a tax aware advisor: Where robotics get terminated

Robo Advisors beware. . .the value of an advisor who delivers comprehensive planning, wealth management and tax aware investments can deliver even more value beyond the selection of investments only. End of story.

But wait, let’s prove how powerful an advisor is who enhances their practice with both tax aware planning and investment strategies.

Value of an advisor is worth more than 1%

Background. In my earlier blog post on the 2015 Value of an advisor study, I wrote that the value an advisor could deliver beyond investment-only advice may be:

Annual Rebalancing: 0.30%
Investor Behavior: 2.00%
Basic Investment Cost: 0.25%
Additional Services/Planning: 0.85%
Advisor Value: 3.40%

But wait!  Look at this equation again.  What is missing?  What is the importance of tax aware planning and investment strategies to the $6.0 trillion of taxable (non-qualified assets)1 invested in open-ended mutual funds? 

The answer is simple: a lot.

With tax rates at the federal, state and local levels going up, what is an investor to do?

Most of our investment community, including ETFs, reports investor returns “pre-tax.” Morningstar® should be credited for helping investors understand the “tax-drag” on investments by publishing the after-tax return and tax cost ratios for both mutual funds and ETFs.

Look at the following chart on the annual tax drag for U.S. Equity and U.S. Fixed Income mutual funds.

annual tax drag

Basis points (bps): A unit of percentage measure equal to 0.01%. For example, 112 bps is 1.12%.

Wow!  Look at the 10 year tax drag numbers, and this includes the 2008-2009 time period we all remember. All mutual funds were given a multiple year capital gain “tax holiday” post-2008 from all of the losses built up in the funds due to tax loss harvesting.  Specifically:

  • For the 10 years ending June 2015, the average U.S. equity mutual fund surrendered 112 bps each year to taxes. During this period, this represented 12% of the total return lost to taxes.
  • For the 10 years ending June 2015, the average taxable bond fund as reflected in Morningstar’s taxable bond universe surrendered 173 bps each year to taxes.

So do taxes matter to an investor who has assets in a taxable account? Absolutely! Advisors can address taxable issues during the annual financial plan development, review and adjustment meeting.

Value added by a tax aware advisor

Tax aware advisors build and implement a personalized, comprehensive tax/investment plan: I believe financial advisors, not robo-advisors, are better equipped to deal with each client’s personal situation to maximize their after-tax returns in their taxable accounts. Simply put, tax planning is hard and complex for affluent investors.

Advisors who develop a comprehensive financial plan, use all investment options to maximize the after tax wealth for clients. . .becoming their tax advocate and further improving the quality of their advice in the implementation of their plan.  Creating higher after-tax returns for investors can also help by protecting their taxable wealth (along with an increased standard of living) and improving the confidence in achieving their financial goals.

Tax aware advisors do more than simply buying ETFs: The ETF industry and robo-advisors have done great work in marketing and promoting how tax efficient their investment strategies are over those of actively managed mutual funds, separate accounts and even individual stocks.

However, they are missing the mark when it comes to reality as these are simply one of many investment strategies an advisor can use when helping clients maximize after tax wealth. Other products such as separate accounts, insurance products, individual stocks and tax aware mutual funds have the potential to do much better (due to their lower turnover or their focus on tax efficiency), especially when used in context by an advisor building a customized investment solution that aligns with their clients’ financial objectives.

dialing down tax drag

Universe averages*: Created table of all U.S. equity mutual funds, ETF’s and municipal bonds as reported by Morningstar. Calculated arithmetic average for pre-tax, post-tax return for all shares classes as listed by Morningstar. Passive is defined as being an index fund as reported by Morningstar or part of an ETF Category.
Morningstar Categories included: U.S. ETF Large Blend, U.S. ETF Large Growth, U.S. ETF Large Value, U.S. ETF Mid-Cap Blend, U.S. ETF Mid-Cap Growth, U.S. ETF Mid-Cap Value, U.S. ETF Small Blend, U.S. ETF Small Growth, U.S. ETF Small Value, U.S. OE Large Blend, U.S. OE Large Growth, U.S. OE Large Value, U.S. OE Mid-Cap Blend, U.S. OE Mid-Cap Growth, U.S. OE Mid-Cap Value, U.S. OE Small Blend, U.S. OE Small Growth, U.S. OE Small Value, U.S. OE High Yield Muni, U.S. OE Muni California Intermediate, U.S. OE Muni California Long, U.S. OE Muni Massachusetts, U.S. OE Muni Minnesota, U.S. OE Muni National Intermediate, U.S. OE Muni National Long, U.S. OE Muni National Short, U.S. OE Muni New Jersey, U.S. OE Muni New York Intermediate, U.S. OE Muni New York Long, U.S. OE Muni Ohio, U.S. OE Muni Pennsylvania, U.S. OE Muni Single State Intermediate, U.S. OE Muni Single State Long, U.S. OE Muni Single State Short.

Value of a tax aware advisor: By the way, did you see that there is tax drag passive funds (which include ETFs)? While it is true that ETFs and passive funds do lower the tax drag on investment returns against the average actively managed mutual fund, there still is a tax drag. Other products such as separate accounts, insurance products, individual stocks and tax aware mutual funds have the potential to do much better. . .especially when used in context by an advisor building a customized investment solution that aligns with their clients’ financial objectives.

tax drag for 10 years

Tax-Managed: funds identified by Morningstar to be tax-managed. Universe averages*: Created table of all U.S. equity mutual funds and ETF’sas reported by Morningstar. Calculated arithmetic average for pre-tax, post-tax return for all shares classes as listed by Morningstar.
Morningstar Categories included: U.S. ETF Large Blend, U.S. ETF Large Growth, U.S. ETF Large Value, U.S. ETF Mid-Cap Blend, U.S. ETF Mid-Cap Growth, U.S. ETF Mid-Cap Value, U.S. ETF Small Blend, U.S. ETF Small Growth, U.S. ETF Small Value, U.S. OE Large Blend, U.S. OE Large Growth, U.S. OE Large Value, U.S. OE Mid-Cap Blend, U.S. OE Mid-Cap Growth, U.S. OE Mid-Cap Value, U.S. OE Small Blend, U.S. OE Small Growth, U.S. OE Small Value

So, what is the value of a tax aware advisor? Here you go: The difference between the tax drag of the average fund not managed for taxes and the tax drag for the average tax-managed fund, gives us the minimum value an advisor can add to the investment portion of an advisor’s value.

Average Tax Drag of U.S. Equity Mutual Funds = 1.10%

Average Tax Drag of U.S. Tax Managed Mutual Funds = 0.60%

Value of a Tax Aware Advisor is:    Minimum of: 0.50%

 

The True Value of a Tax Aware Advisor is—

Annual Rebalancing: 0.30%
Investor Behavior: 2.00%
Basic Investment Cost: 0.25%
Additional Services/Planning: 0.85%
Tax Aware Planning/Investing: 0.50%
Tax Aware Advisor Value: 3.90%

Done. Yet another way for you to add value beyond your fee.

The bottom line

Not only are you worth more than your 1% fee, you could likely add at least .50% to the value you bring to a client by simply adjusting your services to include delivering customized tax planning and comprehensive tax aware investment solutions.

Hope you now see clearly. You can add even more value when looking beyond mere investments and your value further increases when you transition to a tax aware advisor.

Robots and technology can add only so much value in a relationship. . .Advisors, “I’ll be back.”

1 Source: 2014 Investment Company Factbook

*Methodology for Universe Construction: From Morningstar, extract U.S. equity and fixed income mutual fund and ETF’s for reported period. Averages calculated on a given category. For example, average after-tax return for the large cap category reflects a simple arithmetic average of the returns for all funds that were assigned to the large cap category as of the end date run. For funds with multiple share classes, each share class is counted as a separate “fund” for the purpose of creating category averages. Morningstar category averages include every type of share class available in Morningstar’s database. Large Cap/Small Cap/Municipal Bond determination based upon Morningstar Category. If fund is indicated by Morningstar as passive or an ETF, the fund is considered to be passively managed. Otherwise, the fund is considered to be actively managed. Tax Drag: Pre-tax return Less After-Tax Return (pre-liquidation)
The Morningstar categories are as reported by Morningstar and have not been modified.

© 2015 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results.Indexes are unmanaged and cannot be invested in directly.

Morningstar, Inc., Morningstar, the Morningstar logo and Morningstar.com are registered trademarks of Morningstar, Inc. All other Morningstar products and proprietary tools, including Morningstar Category, Morningstar Rating, Morningstar Risk, Morningstar Return, and Morningstar Style Box are trademarks of Morningstar, Inc. All other brands and names are the property of their respective owners.

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Copyright © Russell Investments 2015. All rights reserved.

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