Bear markets are stressful for investors, but tax-loss harvesting is something positive advisors can do for the long-term health of SMAs.
Returns in negative territory can be unsettling for investors, especially double-digit returns like we’re experiencing year to date. That feeling isn’t without merit. Only the consumer discretionary and energy sectors in the US were positive for the third quarter of 2022, and energy was the lone positive sector this year. Investors may open their quarterly statements with trepidation, not wanting to see how much they may have lost.
Long-term index returns are the goal
Equity markets are expected to deliver a meaningful excess return over less risky investments, such as Treasury bonds, over the long term. Investors can expect some downturns and some volatility in the short term. A separately managed account (SMA) can take advantage of this short-term volatility by harvesting tax losses when available and reinvesting the proceeds of these sales to support the objective of long-term equity returns. It’s worth also keeping in mind that the loss harvesting done now in an SMA resets cost basis and sets up the portfolio for more potential tax losses in the future.
This strategy doesn’t change in this environment
Volatility has increased, prices are dropping, and losses are plentiful in many investors’ portfolios. That doesn’t mean the strategy should change. Market downturns are an opportunity to collect additional tax losses, harvest, and reinvest the proceeds to maintain market exposure. The fundamentals still apply. Since no one can time the market, it’s important to maintain full market exposure.
Don’t worry about missing out on losses
After an initial loss-harvesting trade, the market may fall further, and investors may notice additional losses in their portfolio. Or they may believe that if a loss isn’t harvested immediately, they’ll miss the opportunity. Portfolio losses could reduce or continue to deepen on any given day. A method to avoid trading too soon is using a trigger-based approach to harvest losses when they become meaningful.
Watch for wash sales
Under its wash-sale rules, the IRS disallows a tax loss if the investor purchases the same or equivalent security within 30 days before or after the sale date. As a result, it’s typically most efficient to trade accounts when there are no outstanding wash-sale restrictions. This is one reason SMA investors may see unharvested losses in their portfolios. It usually means the SMA manager is trying to navigate the wash-sale trade restrictions and avoid the risk of nullifying the loss-harvesting benefit. It is a balancing act between risk, taxes, and costs. Trading within a wash sale period may be necessary during periods of heightened volatility to bring the portfolio closer to risk targets and realize deep losses.
The bottom line
Loss-harvesting opportunities during this downturn have been plentiful. In the S&P 500® Index in the third quarter of 2022, around half the stocks in the index showed losses of greater than 5%, with 79 showing losses of greater than 15%. In international markets, as measured by the MSCI EAFE Index, the story was even more pronounced, with nearly 70% of the 801 stocks at a loss of greater than 5% and 215 names showing losses of greater than 15%. Since January, 99% of US and international developed stocks had a loss of greater than 10% at some point during this year.
While bear markets like the one we’re experiencing are stressful for investors, there’s still something positive they can do for the long-term health of their SMAs. Loss harvesting investor portfolios while maintaining their diversified market exposure allows them to reap valuable tax benefits for when markets turn around again.
There is no assurance that a separately managed account (SMA) will achieve its investment objective. SMAs are subject to market risk, which is the possibility that the market values of the securities in an account will decline and that the value of the securities may therefore be less than what you paid for them. Market values can change daily due to economic and other events (for example, natural disasters, health crises, terrorism, conflicts, and social unrest) that affect markets, countries, companies, or governments. It is difficult to predict the timing, duration, and potential adverse effects (for example, portfolio liquidity) of events. Accordingly, you can lose money investing in an SMA. Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision.