Tax-loss harvesting in a low return world
written by David Lebovitz, Dennis Follmer
Our Long-term Capital Market Assumptions suggest interest rates will remain low and expected returns will be under pressure going forward
In order to generate sufficient rates of return, investors will likely need to embrace a broader set of asset classes and investment strategies
Active tax management (tax alpha) is one way that investors can take advantage of volatility in taxable accounts and enhance overall rates of return
Death and taxes
In a note written almost fifteen years after the U.S. Constitution was signed, Benjamin Franklin remarked that “in this world nothing can be said to be certain, except death and taxes.” While at the time he was referring to the permanency of the new U.S. government, the same idea can be applied to investing – at some point we will likely need to access the money that we have saved, and along the way, most of us can expect to pay taxes on realized gains.
Looking ahead, interest rates look set to remain low, and asset returns more broadly will likely be muted relative to what has been observed in recent years. The reality of this situation is that many investors will fail to generate required rates of return, and as a result have begun to look for ways of addressing these prospective shortcomings. Some investors have gone to less liquid, private markets, in search of uncorrelated sources of income and more robust returns. Others have chosen to embrace riskier public market strategies, some of which use leverage. Relatively few, however, have looked at active tax management as a way of addressing this return challenge; that said, this may begin to change, as tools are now available that allow investors to look for tax-loss harvesting opportunities throughout the year.
Expected returns are under pressure
Expected annualized return over next 10-15 years, USD
Sources: J.P. Morgan 2021 Long Term Capital Market Assumptions. Data are as of April 7, 2021.
With tax rates likely headed higher, this option may become increasingly attractive, especially for investors in the higher tax brackets. In the simplest sense, active tax management monitors portfolios year-round for opportunities to take advantage of market-based declines to add value for an investor – contrary to popular belief, this isn’t just something that happens in December. While it can be challenging to get clients comfortable with the idea of realizing a loss on one of their investments, the proper management of these losses can keep portfolios aligned with target allocations and simultaneously improve after-tax outcomes.
How to take advantage of stock market volatility
At the end of the day, active tax management is a way to take advantage of volatility. Volatility is a hallmark of the capital markets, but it also tends to derail investors and undermine their ability to reach their long-term retirement goals. While a diversified approach to investing is a good first step towards mitigating some of this volatility, plain vanilla portfolios may fail to generate sufficient rates of return going forward.
So how can investors take advantage of volatility to help boost overall rates of return? Suppose that you have a $10,000 investment in a given security, and the price of that security falls by 20%. Your $10,000 investment is now worth $8,000. Many investors would tell you to stay the course and hold the security; this isn’t wrong, as markets trend higher over time, but is there a better approach?
If this security is in a taxable account, there may be - imagine selling the remaining $8,000 investment to realize the capital loss, and then reinvesting the proceeds into a security with similar characteristics. Not only would you have generated a capital loss deduction that may lower the current year’s tax bill, but you would have done so without simply transitioning to cash. This is valuable in a world where short-term interest rates look set to remain low, as it allows investors to maintain exposure to assets with greater return potential.
Harvesting a loss for tax savings
For illustrative purposes only. Actual results may vary. Past performance is not an indicator of future results.
* Assumed 23.8% capital gains tax rate. Short-term capital gains tax rates correspond to ordinary income tax brackets and range from 10% to 37%. Long-term capital gains tax rates range from 0% to 20%. A 3.8% investment income tax is applied as both long and short-term gains as well.
Diversified portfolios naturally cater to active tax management. As we show in the chart below, global equities tend to move in cycles – often times, periods of U.S. outperformance are followed by periods of non-U.S. equity outperformance. So simply put, some assets will “work” when others do not; this is the most basic definition of diversification. In this example, imagine that non-U.S. equities rise 10% while U.S. equities fall by 5%. An investor could potentially take advantage of harvestable losses in their U.S. portfolio to offset some of the realized capital gains from their non-U.S. portfolio, thereby enhancing the overall after-tax rate of return generated while continuing to maintain a balanced allocation. Furthermore, an active approach to tax management can help keep portfolios in line with target allocations.
MSCI EAFE and MSCI USA relative performance
U.S. dollar, total return, cumulative outperformance*
Source: FactSet, MSCI, J.P. Morgan Asset Management.
*Cycles of outperformance include a qualitative component to determine turning points in leadership.
Guide to the Markets – U.S. Data are as of April 6, 2021.
At the end of the day, the benefits of an active approach to tax management are clear, and it is particularly relevant that such an approach is applicable at both the asset class and portfolio level. The final point to consider has to do with the direction of taxes going forward; the Biden administration campaigned on the back of higher taxes, and we would not be surprised to see tax rates increase in the next 12-18 months. Capital gains taxes in particular seem to be in the crosshairs, suggesting that the value an active approach to tax management can provide will likely increase.
Enjoying the bounty of active tax management
A single harvest may feed a family for the winter, but tax loss harvesting on its own will not solve the return challenges that face investors. The bottom line is that there is no silver bullet in the current environment. That said, investors can take a variety of different actions to address these challenges, one of which is a more active approach to investing, and specifically, tax management.
In general, alpha generation is a function of volatility. Looking ahead, there are plenty of uncertainties and challenges that the economy will face, which suggests that volatility will remain elevated. Even as we begin to have more clarity about what the future holds, however, it is important to remember that volatility is normal and should be expected. In fact, as illustrated in the chart below, the S&P 500 has seen an average, intra-year decline of 14.3% since 1980.
S&P 500 intra-year declines vs. calendar year returns
Despite average intra-year drops of 14.3%, annual returns positive in 31 of 41 years
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management.
Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2020, over which time period the average annual return was 9.0%.
Guide to the Markets – U.S. Data are as of April 6, 2021.
This environment may allow stock pickers to add alpha as winners are differentiated from losers, and investors who take a more active approach to tax management to generate alpha from a different source. Up until this point, many advisors have thought of tax management as simply a year-end exercise searching for losses to offset realized gains; going forward, an ongoing, systematic, technology-enabled approach may result in an additional source of return.