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With inflation on the minds of consumers and the Fed reacting with a sharp turn towards tightening, 2022 may be a year for investors to focus on incorporating tax-efficient strategies into their portfolios. Morgan Stanley Wealth Management’s Chief Investment Officer Lisa Shalett and Chief Cross-Asset Strategist Andrew Sheets discuss.

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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.

Lisa Shalett And I'm Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.

Andrew Sheets And today on the podcast, we'll be discussing the importance of tax efficiency as a pillar of portfolio construction. It's Tuesday, January 25th at three p.m. in London.

Lisa Shalett And it's 10:00 a.m. here in New York.

Andrew Sheets Lisa, welcome back to the podcast! Now, as members of Morgan Stanley Wealth Management's Global Investment Committee, we both agree that the current portfolio construction backdrop is increasingly complicated and constrained. But tax considerations are also important, and this is something you and your team have written a lot on recently. So I'd really like to talk to you about both of these issues, both the challenges of portfolio construction and some of the unique considerations around tax that can really make a difference to the bottom line of investment returns. So Lisa, let's start with that current environment. Can you highlight why we believe that standard stock bond portfolios face a number of challenges going forward?

Lisa Shalett We've been through an extraordinary period over the last 13 years where both stocks and bonds have benefited profoundly from Federal Reserve policy, just to put it bluntly, and, you know, the direction of overall interest rates. And so, our observation has been that, you know, over the last 13 years, U.S. stocks have compounded at close to 15% per year, U.S. bonds have compounded at 9% per year. Both of those are well above long run averages. And so we're now at a point where both stocks and bonds are quite expensive. They are both correlated to each other, and they are both correlated to a large extent with Federal Reserve policy. And as we know, Federal Reserve policy by dint of what appears to be inflation that is not as transitory as the Fed originally thought is causing the Fed to have to accelerate their shift in policy. And I think, as we noted over the last three to six weeks, you know, the Fed's position has gone from, you know, we're going to taper and have three hikes to we're going to taper be done by March. We may have as many as four or five hikes and we're going to consider a balance sheet runoff. That's an awful lot for both stocks and bonds to digest at the same time, especially when they're correlated with one another.

Andrew Sheets And Lisa, you know, if I can just dive into this a little bit more, how do you think about portfolio diversification in that environment you just described, where both stocks and bonds seem increasingly linked to a single common factor, this this direction of Federal Reserve policy?

Lisa Shalett One of the things that we've been emphasizing is to take a step back and to recognize that diversification can happen beyond the simple passive betas of stocks and bonds, which we would, you know, typically represent by, you know, exposures to things like the S&P 500 or a Barclays aggregate. And so what we're saying is, within stocks, you've got to really make an effort to move away from the indexes to higher active managers who tend to take a diversified approach by sector, by style, by market cap. And within fixed income, you know, we're encouraging, clients to hire what we've described as non-core managers. These are managers who may have the ability to navigate the yield curve and navigate the credit environment by using, perhaps what are nontraditional type products. They may employ strategies that include things like preferred shares or covered call strategies, or own asset backed securities. These are all more esoteric instruments that that hiring a manager can give our clients sources of income. And last, you know, we're obviously thinking about generating income and diversification using real assets and alternatives as well.

Andrew Sheets And so, Lisa, one other thing you know, related to that portfolio construction challenge, I also just want to ask you about was how you think about inflation protection. I mean, obviously, I think a lot of investors are trying to achieve the highest return relative to the overall level of prices relative to inflation. You know, how do you think from a portfolio context, investors can try to add some inflation protection here in a smart, you know, intelligent way?

Lisa Shalett So you know what we've tried to say is let's take a step back and think about, you know, our forecast for, you know, whether inflation is going to accelerate from here or decelerate. And you know, I think our position has broadly been that that we do think we're probably at a rate of change turning point for inflation, that we're not headed for a 1970s style level of inflation and that, you know, current readings are probably, you know, closer to peak than not and that we're probably going to mean revert to something closer to the, you know, two and a half to three and a half percent range sooner rather than later. And so in the short term, you know, we've tried to take an approach that says, not only do you want to think about real assets, these are things like real estate, like commodities like gold, like energy infrastructure linked assets that have historically provided some protection to inflation but really go back to those tried and true quality oriented stocks where there is pricing power. Because, you know, 2.5-3.5% Inflation is the type of inflation environment where companies who do have very strong brands who do have very moored competitive positions tend to be able to navigate, you know, better than others and pass some of that the cost increases on to consumers.

Andrew Sheets So, Lisa, that takes me to the next thing I want to talk to you about. You know, investors also care about their return after the effects of tax, and the effects of tax can be quite complex and quite varied. So, you know, as you think about that challenge from a portfolio construction standpoint, why do you think it's critical that investors incorporate tax efficient investing strategies into their portfolios?

Lisa Shalett Well, look, you know, managing, tax and what we call tax drag is always important. And the reason is it's that invisible levy, if you will, on performance. Most of our clients are savvy enough to suss out, you know, the fees that they're paying and understand how the returns are, you know, gross returns are diluted by high fees. But what is less obvious is that some of the investment structures that clients routinely use-- things like mutual funds, things like limited partnership stakes-- very often in both public and private settings, are highly tax inefficient where, you know, taxable gain pass throughs are highly unpredictable, and clients tend to get hit with them. And so that's, you know, part of what we try to do year in, year out is be attentive to making sure that the clients are in tax efficient strategies. That having been said, what we also want to do is minimize tax drag over time. But in a year like 2022, where you know, we're potentially looking at low single digit or even negative returns for some of these asset classes, saving money in taxes can make the difference between, you know, an account that that is at a loss for the full year or at a gain. So there's work to be done. There's this unique window of opportunity right now in the beginning of 2022 to do it. And happily, we have, you know, some of these tools to speed the implementation of that type of an approach.

Andrew Sheets So Lisa, let's wrap this up with how investors can implement this advice with their investments. You know, what strategies could they consider? And I'm also just wondering, you know, if there's any way to just kind of put some numbers around, you know, what are kind of the upper limits of how much these kind of tax drags, you know, can have on performance?

Lisa Shalett Yeah. So that's a great question. So over time, through the studies that we've done, we believe that tax optimization in any given year can add, you know, somewhere between 200 and 300 full basis points to portfolio performance, literally by reducing that tax bill through intelligent tax loss harvesting, intelligent product selection, you know, choosing products that are more tax efficient, et cetera.

Andrew Sheets Well, Lisa, I think that's a great place to end it. Thanks for taking the time to talk. We hope to have you back soon.

Lisa Shalett Absolutely, Andrew. Happy New Year!

Andrew Sheets As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.