2019 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

Taxes and Private Wealth Management in a Global Context

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Private wealth managers have the basic goal of maximizing after-tax wealth subject to a client’s risk tolerance and portfolio constraints. Portfolio managers can add value in a number of ways, such as buying undervalued securities, selling overpriced securities, and improving asset allocations. This is challenging in highly efficient markets where informational advantages are difficult to exploit as market participants compete with each other in search of abnormal returns. Managing a portfolio efficiently from a tax perspective, however, is a reasonable goal in almost all markets. In most economies around the world, taxes have a significant impact on net performance and affect an adviser’s understanding of risk for the taxable investor. Tax rates, particularly those for high-net-worth (HNW) individuals, are non-trivial and typically affect returns more than portfolio management costs.

Despite a long history of high tax rates on investment returns, most modern portfolio theory is grounded in a pretax framework. This phenomenon is understandable because most institutional and pension portfolios are tax-exempt. As more wealth becomes concentrated with individuals, it is important to examine the impact of taxes on risk and return characteristics of a portfolio and wealth accumulation. The purpose of this reading is to outline basic concepts that serve as the foundation for building tax-aware investment models that can be applied in a global environment.

The approach developed here is valuable for several reasons. First, it can be applied in a broad range of circumstances representing different taxing jurisdictions, asset classes, and account types. Second, it can provide a framework with which advisers can better communicate the impact of taxes of portfolio returns to private clients and develop techniques to improve their after-tax performance. Third, tax codes change over time. The models developed here provide the adviser a framework to manage changes should they occur.

Learning Outcomes

The candidate should be able to:

  1. compare basic global taxation regimes as they relate to the taxation of dividend income, interest income, realized capital gains, and unrealized capital gains;
  2. determine the effects of different types of taxes and tax regimes on future wealth accumulation;
  3. explain how investment return and investment horizon affect the tax impact associated with an investment;
  4. discuss the tax profiles of different types of investment accounts and explain their effects on after-tax returns and future accumulations;
  5. explain how taxes affect investment risk;
  6. discuss the relation between after-tax returns and different types of investor trading behavior;
  7. explain tax loss harvesting and highest-in/first-out (HIFO) tax lot accounting;
  8. demonstrate how taxes and asset location relate to mean–variance optimization.


Taxes can have a significant impact on investment returns and wealth accumulation, and managing taxes in an investment portfolio is one way advisers can add value. Taxes come in various forms and each country has its own tax code. Nonetheless, many jurisdictions share some common salient features, and many of those common elements can be identified. This allows one to define regimes that include countries with similar rules of taxation and to build models that capture the salient features of these regimes. That is the approach taken here and the resulting analysis suggests the following:

  • Taxes on investments can take at least three primary forms as discussed here. They can be based on:
    • returns—accrued and paid annually;
    • returns—deferred until capital gains are recognized;
    • wealth—accrued and paid annually.
  • The impact of taxes on wealth accumulation compounds over time
  • Deferred taxes on capital gains have less impact on wealth accumulation than annual tax obligations for the same tax rate.
  • An investment with a cost basis below its current market value has an embedded tax liability that may reduce future after-tax accumulations.
  • Wealth taxes apply to principal rather than returns and in consequence wealth tax rates tend to be much lower than returns-based tax rates.
  • Investments are typically subject to multiple forms of taxation. The specific exposure depends on the asset class, portfolio management style, and type of account in which it is held.
  • An accrual equivalent after-tax return is the tax-free return that, if accrued annually, produces a given after-tax accumulation.
  • An accrual equivalent tax rate is the annually accrued tax rate that, when applied to the pretax return, produces a given after-tax accumulation.
  • Sometimes the type of investment account overrides the tax treatment of an investment based on its asset class.
  • Tax-deferred accounts allow tax-deductible contributions and/or tax-deferred accumulation of returns, but funds are taxed when withdrawn.
  • Tax-exempt accounts do not allow tax-deductible contributions, but allow tax-exempt accumulation of returns even when funds are withdrawn.
  • By taxing investment returns, a taxing authority shares investment risk with the taxpayer. As a result, taxes can reduce investment risk.
  • The practice of optimally placing particular asset classes in particular types of accounts is called asset location.
  • Tax loss harvesting defers tax liabilities from current to subsequent periods and permits more after-tax capital to be invested in current periods.
  • When short-term gains are taxed more heavily than long-term gains, it can be difficult for a short-term trading strategy to generate enough alpha to offset the higher taxes associated with short term trading.
  • Traditional mean–variance optimization can be modified to accommodate after-tax returns and after-tax risk.
  • Otherwise identical assets held in different types of investment accounts should be evaluated as distinct after-tax assets.
  • An after-tax portfolio optimization model that optimizes asset allocation also optimizes asset location.

1.5 CE

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