What do the human body and investment portfolios have in common?
The timeliness of the current market loss
Opportunities for change
Investors looking to change their portfolios must consider which methods suit their goals and what potential challenges may arise. Below are three of the most common types of changes investors make to their portfolios—along with their associated risks and benefits.
Active to passive. A common challenge is moving from an existing actively managed, appreciated portfolio to a passive portfolio. The appreciation in the portfolio presents a tax cost for an immediate transition. A gradual transition from active to passive helps spread out the tax cost. SMA managers can provide a preliminary analysis to help investors decide on an initial gain budget that balances tax costs and the extent of a transition. SMA managers can then gradually transition portfolios closer to the client’s chosen benchmark. This is done by using tax losses to offset the gains required to make trades that trim overweight positions. Investors that have sustained losses from other investments during this pandemic may look to accelerate the transition of their portfolio.
ETF to SMA. Investors with ETFs in their portfolios may consider transitioning their holdings to tax-managed SMAs. Tax-managed SMAs have numerous advantages over ETFs. The first is the opportunity for tax-loss harvesting, which can reduce an investor’s tax bill. The second is a multitude of customizations that can be implemented in the SMA, including responsible investing and factor themes. The challenge with transitioning from an appreciated ETF position to an SMA is the tax cost of liquidation, which is low for ETF positions at a loss or a slight gain realization. Current market drawdowns reduce the appreciation level of ETFs and provide a great opportunity for transitioning to SMAs.
US to international or international to US. For investors looking to increase exposure to international markets, there may be allocation changes that have been postponed due to tax costs. These include investors looking to trim US exposure and increase international exposure—or vice versa. The current environment results in reduced tax costs that make it a great opportunity for investors to revisit allocation decisions that may have previously been restricted by high tax costs.
The bottom line
Investors that view their portfolios amid an economic downturn may not be surprised to find steep losses. While incurring huge losses can be discouraging, many investors can take solace in having opportunities to make constructive changes to their portfolios at reduced tax costs. In a market full of uncertainty, these opportunities may present the best chance for investors to increase diversification, implement postponed ideas, and improve overall portfolio health. Think of the tax losses as the lemons that create the lemonade.