It takes a village: The challenges of raising an international equity portfolio to a tax-friendly level

August 21, 2018 Categories: Portfolio Corner
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We recently shared a podcast on the topic of international tax-smart investing within an equity portfolio—and thought it would be beneficial to recap the highlights of this here as well. So, without further ado, let’s cut to the chase.

At Russell Investments, we’re obsessed with tax-smart investing—but we grant that it’s not something most advisors ponder on a daily basis. Typically, when advisors in the U.S. think about constructing a tax-friendly portfolio, they focus on strategies involving tax-loss harvesting, turnover and yield. These all apply in the international equity space too—but they’re much more complex, due to foreign tax codes, different currencies and different market cycles.

That said, we believe that in order to manage an equity portfolio in the most tax-friendly way possible, whether inside or outside the U.S., there are two key things to steer clear of:

  1. Avoid any distribution of capital gains. If you do distribute, make the gain long-term instead of short-term.
  2. Avoid any unnecessary dividend yield. In particular, avoid yield that might be non-qualified, such as real-estate investment trusts or dividends from countries that don’t have tax treaties with the U.S. (this tends to be more of an issue in emerging markets).

When it comes to international tax-friendly investing, in addition to the above, we believe it’s also vital to:

  • Be aware of every single security in your portfolio, including the country it’s listed in and what tax rules apply.
  • Be aware of currency. Currency gains can sometimes be treated as income. So, be aware of how you’re engaging in currency transactions when buying foreign stocks.

The case for including emerging markets

We believe it’s valuable to include emerging market equities in an international tax-friendly portfolio, from both a potential return and diversification perspective (over the long run). We believe that emerging markets may offer positive returns that can potentially boost a portfolio’s overall return. Right now, we specifically like the allocations from emerging market equities in the shorter term—12 to 18 months out—based on our cycle, valuation and sentiment assessment.

From a tax-efficiency standpoint, tax treaty issues can make things challenging—but it’s the volatility in emerging markets that can really make things interesting. In a nutshell, the extra volatility in emerging markets means heightened odds that any given stock price will likely change rapidly and unpredictably—or any given equity region—may have gone down over a short period of time. It’s that cross-sectional volatility of stock prices moving up and down that serves as the fuel for tax-loss harvesting—helping investors avoid paying capital gains at year’s end.

What to look for in active money managers

When putting together an international tax-smart portfolio, a key benefit we see is that investors can be relatively unconstrained in the types of money managers they use so long as they have a process for executing the tax management aspects in a centralized fashion across the managers’ accounts. While there are some approaches that lead to high portfolio turnover—and subsequently, potentially lots of short-term gains—these are typically few and far between.

How do passive alternatives hold up?

When assessing how to build a tax-managed portfolio, there are other options in the international marketplace—chiefly, going passive entirely, or picking a mutual fund that’s not tax-managed. In both cases, however, you tend to see very large tax drag. For instance, according to Morningstar, the average passive international fund had lost 1% of its return to taxes every year for the past three years as of June 30, 2018. That’s even more than the average actively-managed international equity fund lost (0.81%) over the same time period.1

At first glance, this may seem surprising, given that passive funds are generally considered tax-friendly. However, this belief likely stems from the misconception that in after-tax investing, low turnover rates are always good, and high turnover rates are always bad. In reality, we believe a balance between the two is typically preferred to hit that Goldilocks sweet spot of just right.

In addition, when passive funds do trade, they tend to be agnostic to tax consequences. Anything that they hold, they probably hold for a while—often at a gain. Furthermore, because a passive solution typically means exposure to an entire market, investors are typically exposed to all securities—including both higher dividend yield and non-qualified dividend yield securities. This, of course, flies in the face of constructing a tax-friendly portfolio.

Market volatility: A friend to tax-smart portfolios

It’s no secret that volatility in markets can suit a tax-smart portfolio well, due to the tax-loss harvesting opportunities that abound. Take, for instance, the example of early 2016. A growth scare in China led to a dramatic sell-off across international markets, particularly in emerging markets. This can be viewed as both an investment and tax opportunity. Why? In our view, it was a great chance to allocate more exposure to emerging market equities at attractive prices—and also to allocate to active managers that we believed could potentially exploit the extra volatility in stocks for gain.

Although markets have since recovered, we firmly believe it pays to maintain a constant laser-like focus on individual market areas, or individual stocks, that might be trading off and could therefore provide tax-loss harvesting opportunities. The fact is that even in an up market, there will always be some stocks that have gone down in value. Put simply, if you have a broad and diversified portfolio, there may always be a potential opportunity to exploit some cross-sectional volatility. Bear in mind that it’s critical to not wait until year’s end, like so many investors do, to see if there are losses to harvest. The example of early 2016 shows that sitting tight until December to harvest losses would have been a less-than-stellar move. The historic low volatility of 2017 made loss harvesting trickier, too. We believe tax-smart investors should be nimble and at-the-ready when those rare moments of volatility presented themselves. Fast-forward to 2018, the dramatic sell-off in early February, and the bout of volatility that followed. We believe savvy investors would have been wise to consider the tax-loss harvesting opportunities that presented themselves as the market struggled to recover.

Other tax-friendly strategies to consider employing in an up market

With markets more or less continuing to churn upward, it’s also important not to overlook the basics. For example, a security might get taken over in a portfolio, and realize a fairly large gain that could amount to a short-term gain. In this case, simply delaying the sale of that security until it amounts to a long-term gain is instrumental. This is standard blocking and tackling that tax-sensitive investors may want to consider.

The bottom line

There’s no question that designing a tax-smart international equity portfolio takes skill and brainpower. There’s a reason, after all, why we refer to it as tax-smart investing. This is why it makes all the difference, in our opinion, to surround yourself with a team of experts and specialists—underlying money managers, strategists, portfolio managers, expert traders and the like. Because when it comes to investing in international equities, it really does take a village to raise your portfolio to a tax-friendly level.

 

Disclosures:
1Morningstar average annual tax drag for 3 years ending June 30, 2018.  Performance quoted represents past performance and should not be viewed as a guarantee of future results. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Passive is defined as being an index fund as reported by Morningstar or part of an ETF Category.

Morningstar tax drag number sources: U.S. Fund Large Blend, U.S. Fund Large Growth, U.S. Fund Large Value, U.S. Fund Mid-Cap Blend, U.S. Fund Mid-Cap Growth, U.S. Fund Mid-Cap Value, U.S. Fund Small Blend, U.S. Fund Small Growth, U.S. Fund Small Value, U.S. Fund China Region, U.S. Fund Diversified Emerging Markets, U.S. Fund Diversified Pacific/Asia, U.S. Fund Europe Stock, U.S. Fund Foreign Large Blend, U.S. Fund Foreign Large Growth, U.S. Fund Foreign Large Value, U.S. Fund Foreign Small/Mid Blend, U.S. Fund Foreign Small/Mid Growth, U.S. Fund Foreign Small/Mid Value, U.S. Fund India Equity, U.S. Fund Japan Stock, U.S. Fund Latin America Stock, U.S. Fund Miscellaneous Region, U.S. Fund Pacific/Asia ex-Japan Stock, U.S. Fund World Large Stock, U.S. Fund World Small/Mid Stock

The Morningstar categories are as reported by Morningstar and have not been modified. © 2018 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 no guarantee of future results.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments in global equity may be significantly affected by political or economic conditions and regulatory requirements in a particular country. International markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation. Emerging or frontier markets involve exposure to economic structures that are generally less diverse and mature. The less developed the market, the riskier the security. Such securities may be less liquid and more volatile.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

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