What do the human body and investment portfolios have in common? They both thrive on healthy balance. The body operates more effectively when given a balanced diet, regular exercise, and a sufficient amount of sleep. Portfolios tend to perform better when assets are diversified and emphasis is placed on risk management and rebalancing. While a number of things can prevent investors from optimizing the performance of their portfolio, tax costs are among the most ubiquitous.
The best investment ideas are often hamstrung by taxes. The long-term goals of investors may be to reduce concentration risk in their portfolios, to shift a portion of their portfolio from active to passive, or to enhance tax efficiency or customization by shifting from ETFs to SMAs. Implementing investment strategies often requires the sale of securities that can trigger realized capital gains and their resulting tax costs. With many investors saddled with losses from the recent market downturn, it’s become an opportune time for tuning up portfolios at lower costs.
Let’s explore why the current environment of market loss has become an opportunity for investors looking to change their portfolios and the methods that may offer the healthiest results.
The timeliness of the current market loss
Coronavirus-related market losses give investors the opportunity to make some strategic shifts in their portfolios at much lower tax costs. Investors that harvested losses during the early months of the crisis can use those losses to offset the gains they often incur when transitioning their portfolios. Other investors may have unrealized losses or muted gains in their existing portfolios that can soften the transition costs.
At this point in the market downturn, we’ve seen huge losses hit many sectors. However, equity markets have begun to restabilize—with the exception of oil—making it a favorable time for investors to step back and scan their portfolios for opportunities to accelerate changes that were previously blocked by high tax costs.
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.
Rey Santodomingo, CFA, Managing Director of Investment Strategy
Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.