Robust Asset Allocation in a Tax-Managed UMA
Rebalancing decisions in a tax-managed1 UMA that address the tradeoffs between asset allocation and tax efficiency—instead of putting a myopic emphasis on one or the other—can lead to better outcomes for investors.
How does Dimensional seek to balance these tradeoffs?
- First, we view the asset allocation holistically, including both direct equities and funds.
- Second, we apply a thoughtful approach to tolerance bands around each target position.
- Third, we continually review accounts for opportunities to rebalance, understanding that some opportunities are fleeting and may only be captured with a daily process.
Some of the benefits of these approaches are outlined below.
Holistic View of Asset Allocation
Holistic asset allocation across the UMA, including a direct equity sleeve and ETFs, means we can use proceeds from tax loss harvesting in one sleeve to rebalance the overall portfolio, rather than being limited to keeping the proceeds in the same sleeve. For instance, when we harvest losses in a given sleeve, we might not buy back in the same sleeve all the way up to the target weight. Instead, we will buy back up to the band below target (an allocation floor) and examine the overall portfolio to decide how to optimally allocate any remaining proceeds. This can move the portfolio’s allocation closer to target than if we solely reinvested in the same sleeve.
Efficient Use of Tolerance Bands
Traditionally, the application of tolerance bands (allocation minimums and maximums) means that when a position drifts outside of the band, we may rebalance back to the band, rather than back to target, to avoid unnecessary trading costs and potential realized gains. However, if there is an opportunity to trade back to target in a tax-efficient manner, we will take advantage of that, as these opportunities can disappear quickly. Whether trading back to either target or band, we generally seek to avoid realizing net capital gains.
Flexible Implementation
A flexible approach to portfolio implementation incorporates rebalancing even if allocations are within tolerance bands. We review each UMA every day for opportunities to bring the portfolio closer to its target asset allocation without realizing net gains.
Thoughtful Use of Alternate Positions
A process that integrates robust asset allocation and tax efficiency means we may use alternate positions not only for tax loss harvesting, but also for other tax-efficient trades. For example, suppose we recently harvested losses in a primary ETF, and then the investor deposits more cash into their portfolio. If we repurchased the primary ETF, we could trigger a wash sale and be unable to realize the loss. Instead, we can use the cash to buy the alternate ETF so that the cash is invested right away in an acceptable substitute. This can bring the portfolio closer to its desired asset allocation and avoid triggering a wash sale.
A thoughtful approach to asset allocation can improve after-tax outcomes within a tax-managed UMA. Incorporating target asset class exposures and tax considerations into a flexible, daily process that avoids unnecessary trading costs is key.
Footnotes
- 1. Certain UMA account types such as IRAs, solo 401(k)s, and other non-ERISA tax-advantaged accounts may only select no tax management when choosing a tax management approach.
Disclosures
This information is provided for registered investment advisors and institutional investors and is not intended for public use. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at dimensional.com. Dimensional funds are distributed by DFA Securities LLC.
Risks include loss of principal and fluctuating value. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Dimensional Fund Advisors does not provide tax services or tax advice. We recommend investors consult with their tax professionals regarding their individual circumstances.
ETFs trade like stocks, fluctuate in market value, and may trade either at a premium or discount to their net asset value. ETF shares trade at market price and are not individually redeemable with the issuing fund, other than in large share amounts called creation units. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Brokerage commissions and expenses will reduce returns.
Tax Management Disclosure
Dimensional may be directed to manage separate accounts in a predetermined tax sensitive manner by utilizing certain measures including, but not limited to, tax loss harvesting, seeking to minimize short-term capital gains, maximizing the qualified portion of dividend income, applying a tax-efficient lot selection methodology, and considering tradeoffs among premiums, costs, diversification, wash-sale rules, and capital gains in daily portfolio management. Additionally, certain events (including, but not limited to, client requests to update custodians, strategies, or client-directed restrictions; ongoing client activities like contributions, redemptions, and gifts; incorrect custodian account settings; and advisor direction) may limit Dimensional’s ability to engage in tax loss harvesting and to evaluate the tradeoffs outlined above. While Dimensional will regularly monitor accounts for tax loss harvesting opportunities, Dimensional might not engage in daily tax loss harvesting. For accounts that select light tax management, Dimensional will seek to reduce highly overweight positions if there are losses available to offset any potential gains. If losses are not available, Dimensional may not sell down the overweight positions unless directed.
Dimensional will generally seek to limit potential wash sales in all accounts. “Wash sales” relate to a tax regulation that seeks to prevent investors from selling securities at a loss and then repurchasing the same or a substantially identical security in a span of 30 days before or after the sale. Dimensional may be unable to avoid wash sales or other tax consequences, particularly around client cash flows, corporate actions, or when clients hold substantially identical securities in accounts that are not managed by Dimensional or in accounts that are not linked to the separate accounts Dimensional manages (external accounts). Certain UMA account types such as IRAs, solo 401(k)s, and other non-ERISA tax-advantaged accounts may only select no tax management when choosing a tax management approach.
Dimensional is solely reliant on accurate, thorough, and timely tax lot reporting from custodians. Should custodians fail to provide accurate, thorough, and timely tax lot data, Dimensional may be unable to transact in those accounts. The tax consequences of tax loss harvesting, including wash-sale rules, are complex and uncertain and subject to rulings by tax authorities. Dimensional does not provide tax advice, and each client should consult their own tax advisor or accountant. As such, Dimensional will not be responsible for any tax consequences of such transactions. Dimensional does not guarantee any particular tax outcome.