Less is more: It was the guiding principle of minimalist architect Ludwig Mies van der Rohe, whose iconic glass-and-steel buildings remain jewels in the skylines of New York, Chicago, and other cities. Does his maxim apply to portfolio management too? That is, does centralized portfolio management (CPM) deliver stronger after-tax excess returns than a multiple-manager model?
We drew up a blueprint to find out.
In the spring 2018 edition of the Journal of Portfolio Management, we published a paper that simulated both standard and tax-managed historical CPM portfolios and compared them with portfolios over the same time period under simulated active managers. Our research took a variety of things into account, including tax efficiency, turnover, manager skill level, and level of portfolio diversification. The results were clear. But before we get to them, a bit of definition.
What is Centralized Portfolio Management?
CPM is an implementation strategy that combines multiple managers into a single account in an efficient manner. In the CPM framework, managers aggregate model portfolios into a multi-manager target composite. The central manager trades the client account against this target and customizes the portfolio based on client guidelines. Security restrictions, ESG screens, and tax-management objectives are examples of client-level guidelines the CPM portfolio can manage.
What are the Benefits of Centralized Portfolio Management?
First, clients can access specialist managers at lower account minimums and lower custodial costs. Second, they can reduce turnover and trading costs because the CPM portfolio can net out redundant (and avoid de minimis) trades. And third, the CPM strategy can opportunistically realize capital losses and defer capital gains to help reduce tax liability.
Of course, there are trade-offs: For example, managers must give up the trading control normally associated with an investment mandate. Also, performance differences can arise to the extent the central manager deviates from the underlying managers’ recommendations.
What Did our Research Show?
We focused on quantifying the cost and tax-efficiency benefits of CPM using historical US stock data over the 10-year period from 2006 to 2015. We related these benefits to manager skill as well as other characteristics of the target composite.
We found that a tax-managed CPM portfolio created an annual tax benefit ranging from 30 to 110 basis points, depending on the skill level of the manager. Investors with lower tax rates will get less benefit; if the underlying managers have trading processes that incur significant tax drag, then there’s more opportunity for the central manager to add value. The results hold even when the sample is divided into two separate five-year subperiods, one of which included a major financial and stock market crisis in 2008.