by Lars Kroijer
Tax adviser or accountant
Tax planning is an area of investing where I highly recommend getting expert advice, if you have enough assets so that the cost of getting advice will be covered by the savings you can hope to achieve from the advice. I am a non-domiciled UK resident, being a Danish national. Over the years I have tried to keep track of applicable tax rules for myself, my family and the businesses I was involved with. After initially fancying myself a bit of an expert on the topic I soon gave up. The rules were changing too quickly and I had a day job to keep. I found myself in the situation where knowing things were ‘sort of OK’ was a bad solution, and that I was either not entirely sure that what I was doing was 100% correct, or I was not being particularly clever about it.
Keep in mind that at the end of the day the rational portfolio consists of a few relatively simple products. While the logic and theory of why it makes sense may be complex, the end result is not: it is simple. Taxes, however, are not simple.
On top of everything, taxes change continuously and it is your responsibility to ensure on-going compliance. By the time you read this, the optimised tax thinking at the time of writing may out of date, or even illegal.
Finding the right tax adviser may seem daunting. Below are a few things to ponder as you look at various candidates.
Do they understand your situation and have experience of it?
Are they transparent about how they make money from you – you don’t want them to make commissions from any investment products they sell you. This additional indirect fee still happens to an unbelievable degree although rules are increasingly in place to prevent it, such as the UK retail distribution review that led to greater transparency in the charges you face from an adviser.
Are the charges in line with the competition? What are the charges compared to the kind of tax savings you could hope to make? Do you get a sense that they charge less because they think they can sell you other products like special tax structures? If so that is a concern as they may not be entirely objective.
Are they up to date on latest tax changes and how those affect you?
Will they be with you for a while and understand your whole picture, potentially including family and inheritance tax issues?
Do they have correct authorisations and membership of the right bodies? If not, why not?
Is there good chemistry between you? Do they pass the gut test?
Will they save you time and money?
Can you talk to their existing clients for references?
A friend was making good money in a growing IT business. She paid her taxes and was more concerned with being a successful business woman than a tax planner. In the early days of the business she had been more preoccupied with making sales than optimising her company’s tax structure, which she regretted now things were going well as it was hard to change the tax structure. She recently succumbed to the relentless persistence of some people that wanted to help her minimise taxes. A whole new and complex world showed itself. She knew that it would be a labyrinth of complexity and on-going fees once she entered. But she was also getting to a level of assets and income where the fees were worth it. So she went ahead and hired a tax firm. It made sense now, but it hadn’t earlier.
Ask your adviser
In addition to the tax advantages specific to the rational portfolio outlined above here are a few more potential ways to save money on taxes. Like anything in the area of tax, clear these with a tax adviser, just to ensure that changes in rules have not rendered any of them ineffective or illegal.
Different accounts Many investors will have different accounts that in aggregate add up to their investment portfolio. One may be a fully taxed normal deposit account whereas another is tax-free (e.g. a UK ISA). Generally, different accounts may have different tax characteristics; by putting the high-income generating investments (typically fixed income) in the tax-free accounts you may lower your overall tax burden. Being informed about which investments fit best into various accounts can save you taxes. In the UK, for example, if you pay tax it almost always make sense to have an ISA account and benefit from its tax advantages.
Tax efficient proxies In some countries certain government bonds are tax advantageous. For example, in the US certain municipal bonds are exempt from certain taxes. If you are able to take advantage of such tax relief these bonds may be a more tax-efficient way to gain the virtual equivalent of the minimal risk asset. In other words, in this case you may not be holding US government bonds in the way you would be if there were no tax issues, but the municipal bonds are fairly similar and the tax advantage renders this compromise well worthwhile.
Enterprise Investment Scheme (EIS) or equivalent In the UK there are certain tax advantages or government subsidies in making start-up and certain types of clean-tech investments. Depending on your tax rate these are well worth knowing about. Your tax adviser should know all about them (these are outside the scope of this book).
Gifts Instead of realising a capital gain it may be advantageous to gift securities to your spouse and have him or her make the sale (thus utilising your spouse’s CGT allowance). Likewise, think about gifting relatives instead of them incurring inheritance tax. (You can’t do this just before death so check the rules!)
Realise losses When realising the capital gain on your portfolio you may be able to sell another security at a loss (to offset the gain) and reinvest the proceeds from the sales in a very similar investment. The rules on how similar the investment can be depends on the country, but be sure to stay compliant. You may, for example, sell an investment in the S&P 500 and reinvest the proceeds in the Wilshire 5000 index to get a different product with substantially the same exposure.
Create trading lots Keep track of your investment lots. If you buy 100 shares at £10 and later another 100 at £15 your average price is £12.50. If you later sell 100 shares at £20 you want your tax to be due on the second lot (i.e. a £5 gain) instead of your average gain of £7.50 per share. You can do this by designating each lot you buy separately and making clear that you are selling the lot bought at £15 per share.
Tax schemes If you enter into a tax-saving scheme of some sort, make sure in your planning that you calculate a realistic probability of it being found non-compliant and the fine this implies. Too often I have seen people involved with the tax authorities who find the whole thing incredibly draining both from a financial, emotional and time perspective, far beyond any potential tax savings are worth. Being the protagonist in a Kafka novel is never worth it.
It’s hard to generalise about something as specific as tax. The potential to minimise tax is often very specific to the individual person or institution, but always important. In addition to the points above, you need to keep as much flexibility in your tax planning as possible and avoid locking yourself in. Not only might your individual tax circumstances unexpectedly change, but the tax regimes that you operate under may also change. This ‘option’ on future changes is another reason not to pay your taxes sooner than you have to. It may be difficult to estimate the probability of such events, and some people have no options or flexibility in their tax planning, but for others the advantages could be great.
Rational portfolio adjustment
Throughout this book we have discussed the rational portfolio. While one of its many advantages is its simplicity, taxes can hinder this simple portfolio.
As an unrealistic example, imagine you are a US-based investor who would be taxed at 0% on dividends or capital gains if you invested only in US securities, and 50% tax in the case of foreign investments. Let’s say that there was no way to get around this geographic tax (e.g. by buying US-listed securities that invest abroad). What should you do? It would make sense to create a US-only portfolio, rather than incurring the tax. You could have your minimal risk asset in the short-term US government bonds and your equity exposure in the US equity markets. In this instance you would have compromised on geographic diversification, but since the altern
ative would be to pay 50% of your profit it would be worth it.
If you consider the equity risk premium to be 4–5% a year in addition to a minimal risk rate of 0.5% and annual inflation of 2% (because we pay tax on nominal amounts, inflation causes us to pay extra tax, you would expect your annual equity return to be around 7% (0.5 + 4.5 + 2.0) and the tax you pay on that is zero in the US and 3.5% abroad after the 50% tax. In simple terms, you would then be deciding if the diversification benefits from investing in the world equity markets as opposed to only the US one would be worth 3.5% tax a year.
A similar argument can be made for expensive tax wrappers. If the only legitimate way to gain the cheap, broadly diversified portfolio was through a complex wrapper, again you would have to consider the all-in costs of a rational portfolio. Did the annual charges from the wrapper in addition to an adverse ruling from the tax authorities really merit the benefits from the rational portfolio? If not, then perhaps we would be better off with an alternative portfolio that did not incur those costs. However, if someone tells you that you can’t have a rational portfolio because of your specific tax or other situation, but suggests what looks like an expensive alternative, then ask: ‘Can I buy quoted securities through this structure?’ If yes, then ask: ‘Is an ETF not just another quoted security even if it represents an underlying exposure to a broader equity or bond portfolio?’ Well, yes it is!
There is a reason that so many product providers offer tax-sheltered or optimised products; many investors are in the same boat. Some of the products charge far too much, particularly in on-going fees, but similarly many would work well for the rational portfolio while being tax optimised. Since many products change frequently, make sure you are up to date on developments in this area.
Those that claim that you should not consider your investments in the context of your tax situation in my view are just plain wrong. Each tax situation is specific but the point applies broadly. There are certainly situations where taxes may mean that it makes sense to have a tax-optimised imperfect portfolio rather than a tax-inefficient perfect portfolio. But hopefully you will be able to have both. Most people can.
1 Some investors see the opportunity to invest in multiple jurisdictions as an opportunity not only to minimise current tax, but also as a way to be less liable to a sudden increase in taxes in one jurisdiction.
chapter 12
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Liquidity
Perhaps one of the most underappreciated advantages of the rational portfolio is its excellent liquidity. The rational portfolio will outperform most actively managed portfolios in the long run, while being tax efficient and tailored to our individual risk profile. But it is also advantageous from a liquidity perspective.
Liquidity is one of those things you mainly hear about in a negative context because things went wrong and there wasn’t enough of it. The rational portfolio is also affected by liquidity issues in the market; times of decreasing liquidity are typically synonymous with declining markets. And the rational portfolio with some risky equity exposure will probably lose money in declining markets, like most other portfolios with risky assets. But compared to most portfolios the rational portfolio is less at risk from a liquidity perspective as the index-tracking investments are very liquid.
The importance of having liquidity in your portfolio depends on your circumstances. One friend commented to me that liquidity is his number one requirement when considering new investments, while some endowments and foundations have predicted their capital needs decades into the future and are more relaxed about being able to sell their investments for cash within days or hours. Most investors are perhaps between the two extremes regarding liquidity requirements. Some investments that are meant to be held for the very long term, perhaps for retirement, but there is also a desire to have available liquidity for unexpected needs.
Selling your investment
Liquidity is really a question of how quickly you can transact your investment portfolio. If you hold 10,000 shares in Microsoft that may be a lot of money to you (about $300,000 at the time of writing) and a significant share of your investment portfolio. But if you needed to sell the stock, you could do so in minutes without moving the share price. Around 50 million Microsoft shares trade every day so your entire holding represents a tiny portion of a day’s volume.
If on the other hand you owned $300,000 worth of shares in a company that trade only $100,000 worth of stock every day, then you would have a problem if you needed the money quickly. Let’s say the share price is $20 and there are 5,000 shares traded every day, then you own about three days’ volume of the stock. But as a rule of thumb you can trade about 10% of the average volume of a stock without affecting the price too much, so in normal markets you would own 30 days’ volume of shares, not three.
Suppose you were looking at your illiquid investments in the middle of a crisis like the one in 2008–09. You knew that the stock was illiquid, but in your mind there was no need to sell quickly. You had other stocks and generally felt good about the portfolio.
Now the world has changed and you need liquidity. You look at this stock and to your horror see that it is no longer a $20 stock, but a $15 one (see Figure 12.1). But not only has the $300,000 investment become a $225,000 one, but the liquidity in the market has dried up, and the bid/offer spread has widened massively.1 To make matters worse the bid/offer spread looks erratic and selling now will really affect the share price. These are panic markets and everyone worries that there is something about the company that they don’t know. They are jumpy at any suggestion of bad news, including the prospect of other investors needing liquidity – why are they selling? Who knows how low a stock like this one can fall?
You are now panicking. The value of the company and your ability to raise cash from selling the stock is evaporating simultaneously. If you didn’t before, you now certainly realise why you should have a broadly diversified portfolio and not just be holding potentially illiquid investments. But not only that, this is probably all happening at the same time as everything else is going wrong in your life.
A similar version of this could be faced by the manager of a fund that invests in small- and medium-sized companies facing redemptions from many investors. While she has more stocks that she can choose to liquidate from, she also has more potential investors that want to sell when things are bad (and if she sold only the most liquid stock, the remaining portfolio would be even less liquid). So even if you are one of the investors in the fund who doesn’t have to liquidate in the crisis, the performance of your investment will still be hurt as other investors in the fund scramble for the door.
Figure 12.1 You don’t want to have to sell 1,000 shares by the end of the day!
Compare that to the Microsoft investors. They have also taken a hit as the stock is down of about the same magnitude as the smaller company, but although liquidity has also declined, they can still realise the value of their holdings quickly. And when panic hits the market, cash is truly king!
Minimal risk liquidity
The minimal risk asset consists of high-credit-quality government bonds. There are literally trillions of dollars of these government bonds outstanding and many billions in each currency and maturity, and the trading of them is extremely liquid. But also, consider for a moment what actually happens during a crisis. People sell their risky assets like equity investments, sometimes in a complete panic, and realise cash from their investments. The cash from the sale will be deposited into an account with their bank or custodian once the trade has settled. Now what? Particularly after the last few crises many people are, quite rightly, not content to leave a lot of cash sitting in an account; they want to move the money into something secure. And there are no investable assets more secure than the minimal risk asset.
As a result of the flight to safety that happens during any crisis the value of the minimal risk asset typically goes up in value with the longer-term bonds experiencing the greatest gains.2 People worry less
about the low return on offer and more about not losing more money. Minimal risk assets become like a bullet-proof insurance policy and they often go up in value.
The equity portfolio and ‘risky’ bonds are highly liquid
The world equity portfolio is among the most liquid of investments you can find. Let’s remind ourselves that a large fraction of the world equity portfolio consists in part of the largest traded companies in the largest economies of the world. As a result the portfolio consist of companies like Apple, Exxon, Vodafone, PetroChina, General Electric, Nestlé, Google, IBM, Royal Dutch Shell, Petrobras, etc. While you also have some exposure to smaller companies in the broadest equity indices, the proportion of those stocks in the portfolio is far below what it would be in a portfolio of exclusively small- or medium-sized companies.
