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By Jeremy MillesonDirector, Investment Strategy, Parametric

Seattle - Two words may set off more alarm bells with investors than any others: taxes and tracking error. Investors in separately managed accounts (SMAs) can find themselves hearing those hot-button words from their advisors on a regular basis.

That's why we think it's vital to help investors manage their taxes while also understanding the role that tracking error plays in potentially lowering their tax burden. Once investors understand how tax management and tracking error work hand in hand, we find those alarm bells tend to fade away.

The importance of tax management

Taxes can have a major impact on the long-term growth of a portfolio. For many high-net-worth investors, taxes often represent a larger drag on returns than fees or trading costs. The timing of cash flows and the gains or losses embedded in the portfolio may also affect a portfolio's long-term growth.

While some managers tend to ignore investment taxes and focus instead on pretax performance, we think it's after-tax returns that truly matter for taxable investors. Any opportunity to moderate taxes should be a welcome one, and that's what often draws investors to tax-managed SMAs.

SMAs allow taxable investors to focus on managing their after-tax returns by using realized losses on the sales of individual securities to offset gains in their overall investment portfolios. Investors can also use SMAs to pursue additional tax management strategies — like matching gains and losses, accelerating the realization of gains, transitioning assets or gifting specific tax lots to charity.

Because SMAs allow investors to select the type of tax management that meets their needs, they have become a popular tool for taxable investors.

The role of tracking error in tax management

By choosing to use a tax-managed SMA, investors will inevitably experience tracking error. This may be an uncomfortable concept for any investor who doesn't want an error showing up in their portfolio. But as we discussed in our previous blog, tracking error isn't actually an error, nor is it necessarily good or bad. It merely measures how closely a portfolio tracks its benchmark.

To recap, tracking error is formally defined as the standard deviation of the difference between the portfolio returns and benchmark returns, or the dispersion of the excess portfolio returns compared with its benchmark. It's typically expressed both as an annualized number and as a percentage.

For example, a portfolio might have a tracking error relative to its benchmark of 1% per year. If we assume that portfolio has a normal bell-shaped distribution of excess returns and an annualized tracking error of 1%, we can expect its return to be within 1% of its benchmark return in approximately two out of every three years.

Managed portfolios, like SMAs, behave slightly differently from their benchmark indexes on a day-to-day, month-to-month and year-to-year basis. When an SMA is managed to harvest losses, transition assets, incur tax efficiently or realize gains, it would inevitably diverge from its stated benchmark — resulting in tracking error.

How tracking error occurs in tax-managed SMAs

Let's look at how tracking error might arise in a tax-managed SMA that's benchmarked to the S&P 500® Index and designed to pursue tax-loss harvesting opportunities. The portfolio is initially invested in about 250 to 400 securities selected to mimic the benchmark in terms of sector and industry weights. The portfolio is built to exhibit low tracking error, and it resembles the benchmark in terms of risk factors such as yield, market capitalization and beta (or risk relative to the benchmark). Once the initial portfolio is invested, it's monitored for risk and tax-loss harvesting opportunities.

Tax-loss harvesting opportunities arise over time as the market value of various securities falls below their cost basis. When this happens, tax lots exhibiting material losses are sold, and they're replaced with newly purchased securities. The SMA is performing as expected — it's closely tracking the benchmark on a pretax basis, while also producing excess realized losses.

But when the investment manager implements a tax-loss harvesting strategy and sells securities, the portfolio naturally ends up with underweights in those particular securities relative to the benchmark. We also see a natural deviation from the benchmark in the opposite case, if an investor decides to hold an appreciated security to defer the realization of a gain. Then the portfolio may hold those securities as overweights relative to the benchmark.

How to manage tracking error in a tax-managed SMA

While tracking error in these cases may be inevitable, it can also be managed to match an investor's risk tolerance. Investors can work with their advisors to balance tax management techniques, with a resulting tracking error that suits their risk tolerance and long-term financial goals.

For instance, investors who want to balance their risk tolerance with their tax management efforts can target a fairly standard tracking error of 1%. Those who are more aggressive can allow their tracking error to drift higher, closer to 2%, allowing for more potential loss harvesting and gain deferral.

While tax management introduces tracking error into an SMA, the goal is for the portfolio to provide returns similar to the benchmark while helping investors pay less in taxes. The compounding effect of this tax deferral can be quite powerful over time — even with the existence of tracking error.

Bottom line: Customizing a portfolio through tax management inevitably leads to tracking error. But advisors can work with clients to strike a comfortable balance between a portfolio's tax management techniques and its deviation from the benchmark. At the end of the day, while tax-managed portfolios may result in tracking error, they also allow investors to keep more of their money invested while helping to maximize their after-tax returns.

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S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.