Your Take: Tax Efficiency in Conservative Portfolios

With the new year upon us, some feedback we’ve heard advisors share in 2024 centers around the high level of cash in many clients’ taxable portfolios. The drag that an elevated level of cash and short-term bond instruments can have on portfolio returns coupled with the significant tax inefficiency of most traditional conservative strategies makes it a fraught subject for many advisors. Still, they’ve been made to watch as money market fund assets have continued their climb, taking in about $2 trillion over the past two years and recently surpassing $7 trillion for the first time.

Money market funds are taxed at normal income rates. Assuming a client is in the top federal tax bracket (37%), a 4.25% to 4.5% MMF yield turns into less than 3% after federal income taxes and MMF fees. On a real basis after accounting for inflation (core PCE is 2.8%; core CPI is 3.3%), investors are taking a neutral or money-losing proposition. Short-term Treasury notes and bond fund yields are taxed as ordinary income, too.

Inflation Concerns Linger as Cash Yields are Falling

Then there are the declining yields on cash following the Federal Reserve’s recent jumbo 50-basis-point cut in September and further 25bps parings in November and December. MMF yields have quickly been trimmed from the 5.25%-5.5% range to around 4.4% in alignment with the Fed funds rate. More decreases could be ahead, though the monetary policy path is highly uncertain and expectations for the Fed funds have been marked by volatility.

Relatedly, many bond investors don’t think inflation has been tamed and are increasingly referring to themselves as vigilantes again. Since 1981, the 10-year Treasury has climbed the most since a first rate cut, treating investors of intermediate and longer duration assets to price losses recently—on top of historic volatility. All the while, the longest-ever drawdown in the Bloomberg US Aggregate Bond Index continues.

It’s also been a painful period for overly cautious investors who could’ve benefitted from more equity exposure. The stock market saw a second consecutive year of impressive growth, with the S&P 500 continuously hitting new highs after 2023’s 26% rise.

Taken together, there is a large segment of advisors looking for new tax-efficient solutions for the conservative portion of client portfolios. They want the opportunity to outpace inflation, preserve capital and reduce volatility, all while lessening the burden come tax season.

Tax Efficiency and Options-based Equity ETFs

For this role, options-based equity ETFs that protect capital are worth a look. Capital-protected growth strategies tie investors’ upside to equities, to a cap, while providing 100% downside protection—if they’re bought at starting NAV and held over a set outcome period.

Because of the embedded tax efficiency of the ETF vehicle, options-based ETFs are taxed at capital gains rates only at the point that an investor sells shares. If an investor holds a capital-protected growth-equity strategy in an ETF for more than a year, any gains are taxed only at the long-term capital gains rate, which top out at 20%.

With more normalized interest rate levels, the capital-protected equity strategy provides risk-conscious investors and their advisors a way to potentially grow capital well above the rate of inflation combined with favorable tax treatment. Upside caps for such strategies in the ETF wrapper have been in the 8% range lately.

Investors can potentially get greater upside with capital-protected ETFs than parking in traditional safe havens—but worry less about both the big losses equities are feared for and the tax bills that come with cash and bond allocations.

Do you have an opinion that you want to share with other members of the financial planning community? We encourage financial professionals to send us ideas for a Your Take column to [email protected].