In barely more than a month, another tax day will roll around—another chance for investors to take (sometimes painful) stock of the decisions they made in 2018 that had tax implications and another chance to figure out what, if anything, to do differently in 2019.
Tax-advantaged investment vehicles
Unlike actively managed funds, ETFs are passive, with low turnover. This makes them inherently tax efficient, and so ETF investors likely received no capital gains distributions for them in 2018. But ETFs are also a single, unified investment product, preventing investors from accessing the individual underlying securities that make up the fund. So if a stock lost significant value during one of the periods of volatility we saw in 2018—and 75% of the stocks in the S&P 500® had a maximum drawdown of more than 20% at some point during the year—there was no way to sell that stock without liquidating one’s holdings in the entire ETF.
Investors in separately managed accounts (SMAs), on the other hand, do have access to the individual underlying securities in their portfolio. This enables stock-level tax-loss harvesting—something SMA asset managers can do for their clients throughout the year, whenever opportunities present themselves. This is helpful not just when the market falls but also when it’s broadly up yet individual stocks or sectors fall. The chart below illustrates a few examples from last year.
Key loss-harvesting opportunities in 2018
Source: Parametric, 2019. For informational purposes only. Not a recommendation to buy, sell, or hold any security. It is not possible to invest directly in an index. All investments are subject to risk of loss.
The upshot? Not only did SMA holders avoid the 3–4% tax drag experienced by investors in actively managed funds, but they would likely have been able to generate anywhere from 1% to 5% in additional tax benefits from tax-loss harvesting the individual stocks in their portfolio. The variation in the tax benefit depends on how highly appreciated one’s holdings are, but the impact is undeniable.
The bottom line
It’s neat and easy to think of investment tax as the tail of the dog. But we think that metaphor is barking up the wrong tree. Instead we think it’s more accurate to describe tax as the tail of the crocodile. Sure, it’s still a tail, but on that ancient beast the tail represents 40% or more of its total body. And when the tail moves, the entire animal moves. In investing, as in nature, we ignore the tail at our peril.