With the S&P 500 hovering near all-time highs for now, not all equity sectors, styles and market caps have bounced back from the late-March lows. This provides investors with the opportunity to sell investments in taxable accounts that have lost value to offset capital gains and help to reduce taxes. With tax-loss harvesting, if your losses exceed your gains at year-end (or if there are no gains), losses can offset up to $3,000 in noninvestment income, even though that is often taxed at a higher tax rate than capital gains are. Losses greater than $3,000 carry forward to offset capital gains and ordinary income over your lifetime.
Many investors begin tax-loss harvesting by identifying which asset classes have experienced losses. However, other factors also can impact the tax efficiency of nonqualified accounts. For instance, Which fund structure is most tax efficient? is an often-overlooked question.
ETFs are generally more tax efficient than mutual funds are because of how the funds handle investor outflows (and inflows). When mutual funds experience redemptions, the portfolio manager must sell off enough securities so that the cash levels of the fund can cover the redemptions. When the securities are sold, that triggers a potential capital event, as any taxable gains would be passed onto the shareholder. ETFs handle redemptions quite differently, as those transactions are centered on the underlying fund securities — not cash — thereby dramatically reducing the chance of a capital event. To meet ETF redemptions, an intermediary called an authorized participant (AP) returns the ETF shares to the sponsor in exchange for a basket of the funds’ underlying securities. The AP then liquidates the basket of securities and transfers the sale proceeds to the original ETF shareholder. Known as creation and redemption, this process sets ETFs apart from mutual funds.
As a result of these differences, due to their reliance on cash to meet redemptions, mutual funds — in general — have a higher probability of distributing capital gains to shareholders than ETFs do.
Another tax-efficiency consideration is whether a mutual fund you own has experienced extreme outflows. As redemptions accelerate, not only does the likelihood of a capital event increase, but there is also a smaller base of shareholders to shoulder the burden of annual capital gains — thus potentially further exacerbating the mutual fund’s inherent tax inefficiency.
Take US large-cap value, for example. It has been widely reported that value-style strategies have been under pressure over the past few years. Active managers in this segment have seen the lion’s share of redemptions, as investors have pulled in nearly $40 billion, representing a 14% drop in total assets.1 Passive large-value mutual funds, on the other hand, raked in more than $2 billion during the same period.2
Active large-value funds also have a historically high probability of paying capital gains. We looked at all funds in this size and style segment that have distributed a capital gain in the past 10 years. We found that, on average, 62.2% of large-value funds distributed a capital gain to shareholders. However, as equity markets have reached new all-time highs over the past five years, this average jumps to over 80%, as capital events have become more abundant.3
Recently, the magnitude of value’s underperformance has intensified, as the Russell 1000 Value Index has lagged the Russell 1000 Growth Index by 40% on the year.4 Our data shows that in this market cap and style segment, active managers have proven to be ineffective at consistently beating their benchmarks. After analyzing 10 years of returns in rolling one-year windows, we found that active managers outperformed their benchmarks in just 36.2% of the almost 35,000 observations.5 The average annualized excess return was an eye-popping -1.5%.6
Putting it altogether, active large-value funds have done an especially poor job at providing investors with above-benchmark returns and have demonstrated a propensity to pay capital gains in those years in which they have experienced extreme outflows. If you currently own an active large-value fund, now might be a good time to reassess your conviction in the mutual fund structure, investment style, and/or the fund manager, as the evidence clearly points toward this investment strategy as a viable candidate for tax-loss harvesting. When you sell a losing position, you could consider using sale proceeds to seek to bring down management fees, improve portfolio exposures, and/or shift toward a potentially more tax-efficient fund structure, such as an ETF.
Outside of fund structure, there are asset classes with year-to-date losses greater than that of large value, and depending on the performance of strategies within these categories, the magnitude of losses may be even greater. The losing asset classes on the equity side are listed below with average YTD fund return and the percent of funds with negative returns:7
Mid-Cap Value: down 15.5%, with 98.6% of funds in price losses.
Small-Cap Blend: down 13.3%, with 94.5% of funds in price losses.
US Real Estate: down -13.4%, with 91.2% of funds in price losses.
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1 Morningstar, 12/31/2019 to 09/30/2020. 2 Morningstar, 12/31/2019 to 09/30/2020. 3 Morningstar, as of 12/31/2019. Calculations by SPDR Americas Research. 4 Bloomberg Finance L.P., 12/31/2019 to 10/13/2020. 5 Morningstar, 1/1/2010 to 12/31/2019. Calculations by SPDR Americas Research. One-year rolling windows. One-month moving step. Analyzed all US mutual funds in the Large Value Morningstar Category (oldest share class). Includes obsolete funds. Excess return measured relative to each fund’s primary prospectus benchmark. 6 Morningstar, 1/1/2010 to 12/31/2019. Calculations by SPDR Americas Research. One-year rolling windows. One-month moving step. Analyzed all US mutual funds in the Large Value Morningstar Category (oldest share class). Includes obsolete funds. Excess return measured relative to each fund’s primary prospectus benchmark. 7 Morningstar, as of 09/11/2020. Calculations by SPDR Americas Research. US-Listed ETFs and oldest share class mutual funds were analyzed in the respective Morningstar Categories; 139 funds ranked in Mid-Cap Value; 255 funds ranked in Small Blend; 91 funds ranked in US Real Estate.
Basis Point (bp) A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of one percent, or 0.01%.
Russell 1000® Growth Index A benchmark measuring performance of the portion of the large-cap segment of the US equity universe that exhibits strong growth characteristics.
Russell 1000® Value Index A benchmark measuring performance of the portion of the large-cap segment of the US equity universe that exhibits strong value characteristics.
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