The Only Form of Pure Alpha

Originally published at www.linkedin.com.

Beating the market: To judge from the amount of marketing dollars and media attention devoted to the subject of beating the markets, you’d think that nothing in the realm of finances is even remotely as important.

But while investment “alpha” may appear to garner the sizzle (yet leave many of Wall Street’s sheep simply shorn), the more sublime impact of tax management can have a far greater effect on a wealthy family’s overall wealth. Considered over multiple generations, the capital preserved through “estate tax alpha” will almost undoubtedly dwarf long-term market gains.

We understand that few will argue that tax is a sexy subject. But unlike the hunt for investment alpha — an expensive pursuit that ultimately hinges on an unlikely outcome — tax liabilities are an area where we can actively control outcomes. That’s why we call tax advice “the purest form of alpha.” Pure alpha equals an increase in net results with zero increase in portfolio risk.

Part of tax alpha can be delivered through investment management. Tax-loss harvesting, for example, allows investors to neutralize the taxes on realized gains by selling portfolio losers and replacing them with appropriate proxies. Asset location, in which investment assets are carefully distributed between taxable and tax-deferred accounts, is another tactic for limiting taxes. But there’s an even bigger opportunity for families of significant wealth.

A Tale of Two Advisors

Estate planning is an area where a skilled financial advisor can make a truly enormous difference. And, generally, the work associated with effective planning is little more than moving assets from a client’s left pocket to the right pocket. Let’s look at a hypothetical example, involving two $10-million portfolios, each in the hands of a different advisor.

Advisor A is a skilled investor; she adds 1% per year in investment alpha to the portfolio, delivering an 8% annualized return (as compared to the market’s 7% return). Over the client’s lifetime of 40 years, the original $10 million will grow to $217 million. Estate taxes, however, take almost $82 million from that number. In total, the next generation inherits a little more than $134 million.

Now let’s look at Advisor B. While only an average investor using index funds, he is skilled in estate planning. By year 40, the portfolio Advisor B manages is worth $149 million. However, by using a generation-skipping transfer trust at inception, the advisor eliminated the transfer tax. In the end, the family client of Advisor B is $15 million ahead when inheritance tax is considered.

Advisor B can further increase the advantage of good planning by using assets eligible for a discount. By doing this, the advantage over Advisor A is closer to $80 million; an amount that increases exponentially over time as a result of the generation-skipping exemption.

There Is No Spoon

So, why don’t you hear more about tax alpha? Well, one reason is that it doesn’t attract the eyeballs that the media craves. The idea of beating the market is sexier, even if it’s often a fool’s errand.

The other reason the subject of tax management is on the sidelines is that it’s not a product. Wall Street is set up to sell you things — like investments and insurance — that they can earn commissions on. To put it simply, tax planning just isn’t as lucrative for the investment industry.

The best advisors will take a holistic view of a client’s finances, a view that’s at least as concerned with preserving capital — a person’s financial legacy — as they are with growing it. It helps if there are no economic incentives that cause an advisor to focus predominantly on performance or AUM.

I’m not suggesting that seeking investment gains isn’t worth your attention. To the contrary. Solid returns can make a significant impact in one’s financial life — as long as you avoid taking excessive risk in pursuing them. Instead, I’m saying: Why not have both?

Wealth, accrued through work and investments, is only valuable to the extent that you can keep it in your family’s hands and out of Uncle Sam’s. And good tax planning does not require any change to portfolio allocations, but rather a change in asset location. With no increase in risk, but significant increase in net results to your family, tax planning is the only form of pure alpha.