The Stewardship of Wealth: Successful Private Wealth Management for Investors and Their Advisors, + Website

Designing Portfolios from an After-Tax Perspective

Most financial advisors design client portfolios using expected gross returns for each asset class to be included in the portfolio. If we were pension plans, that would be fine. But as family investors, most of our assets are likely to be subject to the complicated regime of investment taxes—short-term gains, long-term gains, ordinary income taxes, the alternative minimum tax, plus whatever nightmares our state and city of residence have cooked up for us.¹

If we think about this for a minute, we will quickly realize that each asset class will be affected somewhat differently by this crazy quilt of taxes. To take two very opposite examples, returns on private equity tend to be extremely tax advantaged: Our money comes back to us taxed at long-term capital gains rates and, in addition, the payment of the tax is delayed, representing an interest-free loan to us from the tax authorities. On the other hand, the return we receive on hedge funds is typically tax disadvantaged: These returns are taxed mainly at short-term capital gains rates and we pay the tax right away.

Given the differing impact of taxes on the different asset classes, it's clear that portfolios designed using expected gross returns will be highly inefficient for taxable investors. If a family investor wishes to obtain the same expected return as a tax-exempt investor, it will have to accept more risk. If a family investor wishes to maintain the same risk level as an ...