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.
There are many in the financial community who believe taxes shouldn’t drive investment choices. Fund managers pursuing active strategies, for example. For many of them, the primary objective is to generate pretax alpha, giving less thought to the after-tax consequences. Maybe this works for them. After all, there are trillions of dollars invested in actively managed funds, so clearly people are buying what they’re selling. “We never let the tax tail wag the investment dog,” one of those managers told Barron’s in February.
We have nothing against actively managed funds, of course, or any other vehicle that delivers value to its investors. But many managers and investors could improve their returns by paying more attention to taxes. As we’ve shown in our research and in our work with advisors and their clients for over 25 years, investment taxes do matter. In fact, they matter a lot. And 2018 proved it once again.
Market volatility in 2018: Insult meets injury
Not that you need reminding, but 2018 saw some periods of extended market volatility—perhaps most notably in the fourth quarter, when the S&P 500® Index lost more than 13.5% of its value. That swoon helped the index close the year down nearly 4.4%.
So on the performance front, not great news. But wait—for many fund investors there was some insult to go along with that injury. As the Wall Street Journal reported in November, funds’ capital gains distributions were putting 2018 on track to be the costliest year ever in terms of investor tax exposure. Sure enough, data from Morningstar confirmed this, with US equity funds distributing an average of 10.6% of their net asset value in gains in 2018, mostly the result of funds’ being forced to sell off highly appreciated assets to make up for redemptions as investors continued to switch from actively managed funds to index funds.
As a result, even though US large-cap equity funds lost 6.3% on average last year, according to Morningstar, investors got stuck paying an additional 3–4% in taxes as a result of the distributions (depending, of course, on the investor’s tax rate). This will no doubt be an unpleasant surprise to many investors as they file their tax returns in the coming weeks. What could they have done differently?
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. It is not possible to invest directly in an index.
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, as the chart below shows, the impact is undeniable.
Tax alpha generated in Parametric's Custom Core® SMAs in 2018
Source: Parametric, 2019. Data aggregated from 9,093 taxable accounts benchmarked against the S&P 500 Index. Tax Alpha is hypothetical and is defined as the simulated, net after-tax excess return minus any gross pretax excess return: αtax = (RATport,net – RATBench) – (RPTport – RPTBench).
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.
Potential Parametric Solution
One of the primary drivers of tax efficiency in a tax-managed Custom Core® account comes from tax-loss harvesting. Parametric portfolio managers will sell a basket of securities at a loss and simultaneously replace it with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio.
Rey Santodomingo, CFA - Managing Director of Investment Strategy
Mr. Santodomingo 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 advisers to design, develop and implement custom portfolio solutions.
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.