Reversal exposures in S&P 500® quintiles, March 2009
Sources: MSCI Barra and Parametric, March 2009. For illustrative purposes only. Not a recommendation to buy or sell any security. Equally weighted performance quintiles are based on the previous 12 months of individual stocks’ returns (March 2008–February 2009). Performance quintiles for short-term reversal exposures are based on the previous month’s individual stock total returns.
Importance of our research
Parametric has always been cognizant of the reversal risk following stock market crashes. Historically, our approach to managing this risk has been to intervene, tightening risk controls across the board during periods of extreme market volatility, then resuming a standard posture once volatility subsides. The main challenges with interventions are that broad-based tightening of risk management reduces portfolio manager latitude to capture available tax alpha, along with the uncertainty of market timing during the volatility of a crisis.
We can best address these challenges by tightly managing exposure to beta, momentum, and short-term reversal. First, this more targeted approach puts fewer constraints on portfolio managers wanting to harvest losses than a broad-based tightening of risk controls. Second, we can apply reversal-risk factor controls to loss-harvesting trades regardless of the level of market volatility, which removes the need to time a risk-control intervention.
Through extensive testing using our after-tax simulation tool, we’ve performed side-by-side comparisons of post-crash performance of accounts managed with and without targeting the three key reversal risk factors. The accounts managed using the targeted approach have better post-crash performance. Moreover, they do so without sacrificing tax alpha, without higher tracking error, and without greater turnover.
The bottom line
In Parametric’s 30-year history with tax-managed SMAs, we’ve seen many stock market crashes. Our focus has always been on the balance between delivering tax alpha and maintaining market exposure that aligns with the benchmark. In periods of extreme volatility, this balancing act becomes even more important given the reversal risk. The implementation of the short-term reversal factor, along with tightened constraints around momentum and beta, should allow our portfolio managers to more effectively manage this risk.
Test your knowledge of tax-loss harvesting with our interactive quiz. Some of the answers might surprise you, and that’s OK; they might surprise many in the industry who are new to tax-loss harvesting or aren’t fully sure how it works. We believe that, armed with more knowledge, we can all make the right decisions for clients—decisions based not on lore but on good, sound investment science.
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