Dimensional Fund Advisors offers separately managed accounts that meet the needs of taxable entities and individual investors. The goal in separate accounts is to increase after-tax returns for given risk exposures. This is a long-term objective. Focused portfolio design, tax management, broad diversification, low trading costs, and low management fees achieve it.
The client faces a complex set of trade-offs. Analytical tools assist in setting the balance among the client's attitude toward risk and return, preference for capital gains and dividends, and need for diversification. Each separate account is customized according to the client's objectives, risk tolerances, and tax circumstances. It manages scheduling and amounts of capital gains or losses and the dividend stream.
What we know about the dimensions of returns assists in portfolio design, while our tested tax-management techniques and efficient trading methodology can help increase after-tax returns. Tax-managed separate accounts afford investors opportunities to build customized, diversified portfolios structured to their specific objectives:
Some rebalancing is accomplished without tax consequences. For instance, new contributions of cash permit purchases that do not need to be funded by sales. Coordinated management of the client's tax-deferred and taxable accounts can also create tax-free rebalancing opportunities if trades producing gains can be confined to the tax-deferred account. Charitable contributions of appreciated securities can also create tax-free rebalancing. Carefully planned redemptions facilitate rebalancing and tax management.
Rebalancing often requires selling assets that have appreciated, which can result in realized capital gains. Effective management of capital gains is essential for increasing after-tax rates of return.
The ability to generate a supply of capital losses is another advantage of diversification. In concentrated portfolios, few capital losses may be available for harvesting. This can make the tax costs of portfolio adjustments prohibitive and cause an investor to remain locked into a few stocks with large unrealized gains.
Realized losses within an account can be used to offset realized gains outside the account. Tax efficiency increases when Dimensional coordinates management of the account with any gains and losses outside the account.
Trading costs erode returns and hinder the accumulation of wealth. Once a managed portfolio is in place, discretionary trades are carefully made only to rebalance and harvest capital losses.
The client faces a complex set of trade-offs. Analytical tools assist in setting the balance among the client's attitude toward risk and return, preference for capital gains and dividends, and need for diversification. Each separate account is customized according to the client's objectives, risk tolerances, and tax circumstances. It manages scheduling and amounts of capital gains or losses and the dividend stream.
What we know about the dimensions of returns assists in portfolio design, while our tested tax-management techniques and efficient trading methodology can help increase after-tax returns. Tax-managed separate accounts afford investors opportunities to build customized, diversified portfolios structured to their specific objectives:
- Portfolios can be market-like or they can be tilted toward small or value factors, traditionally considered too costly for taxable investors, to increase expected returns.
- Capital gains are controlled. Realized losses offset realized gains whenever practical. Tax-lot accounting and loss harvesting limit capital gains taxes.
- Dividend income can be decreased or increased while maintaining broad diversification and target risk exposures.
- Dimensional's trading techniques produce improved execution and lower costs.
Mutual Funds Compared to Separate Accounts
| MUTUAL FUNDS | SEPARATE ACCOUNTS | |
|---|---|---|
| Timing of capital gains and losses |
Determined by portfolio manager. | Determined by investor or advisor. |
| Capital gains legacy | Investor may face tax liability for capital gains distributions while experiencing loss on total fund investment. |
Capital gains determined by investor's cost basis. |
| Charitable gifting | Investor cannot control disposition of specific stocks. | Investor can donate highly appreciated securities. |
| Diversifying low-cost positions | Offer the quickest way to achieve broad diversification. |
Reduce tax liability from unwinding low-cost-basis position by harvesting losses over time in rest of portfolio. |
| Investment breadth | Access to broad set of asset classes. | Account size and transaction cost determine investment breadth. |
| Net realized capital losses | No pass-through; can only be carried forward. | Deductible in year realized; can offset other income. |
| Deductibility of expenses | Fully deductible in computing net investment income. |
Only expenses exceeding 2% of AGI are deductible. No deductibility under Alternative Minimum Tax. |
Rebalancing
Rebalancing adjusts a managed portfolio's holdings in order to more closely match the risk/return characteristics of a client's target portfolio. Dimensional usually rebalances the domestic equity portion of each separate account at thirty-one-day intervals.1 Because of higher trading costs, international holdings are rebalanced less frequently.Some rebalancing is accomplished without tax consequences. For instance, new contributions of cash permit purchases that do not need to be funded by sales. Coordinated management of the client's tax-deferred and taxable accounts can also create tax-free rebalancing opportunities if trades producing gains can be confined to the tax-deferred account. Charitable contributions of appreciated securities can also create tax-free rebalancing. Carefully planned redemptions facilitate rebalancing and tax management.
Rebalancing often requires selling assets that have appreciated, which can result in realized capital gains. Effective management of capital gains is essential for increasing after-tax rates of return.
Managing Capital Gains
The objective of tax management is to control the timing and amounts of tax liabilities for the purpose of increasing after-tax returns. Taxes that can be deferred are deferred, and taxes that can be avoided are avoided. Some capital gains must be realized when most new accounts are opened and in subsequent rebalancing. Capital losses can offset some or all of these gains.
- Individuals and corporations may use realized losses to offset realized gains either within or outside the account.
- Individuals may carry forward a surplus of realized losses over realized gains in one year to offset realized gains in future years, and may carry forward these losses for unlimited time periods.
- Corporations may carry forward a surplus of losses to offset future earnings for up to five years. Corporations may also carry backward a surplus of losses to reduce previous earnings for up to three years.
The ability to generate a supply of capital losses is another advantage of diversification. In concentrated portfolios, few capital losses may be available for harvesting. This can make the tax costs of portfolio adjustments prohibitive and cause an investor to remain locked into a few stocks with large unrealized gains.
Realized losses within an account can be used to offset realized gains outside the account. Tax efficiency increases when Dimensional coordinates management of the account with any gains and losses outside the account.
Tax-lot accounting.
Tax-lot accounting manages capital-gains taxes. When a particular stock is purchased in multiple lots at different prices, each lot has its own cost basis. Whenever holdings are sold, the shares with the highest cost basis are sold first. This minimizes gains and maximizes losses, so tax liabilities are reduced.
Trading costs erode returns and hinder the accumulation of wealth. Once a managed portfolio is in place, discretionary trades are carefully made only to rebalance and harvest capital losses.
1 A thirty-one-day interval is used to avoid "wash sales" that nullify realized losses for tax purposes. On occasion, when large price changes occur within a thirty-one-day cycle, a separate account will be rebalanced immediately.