Volatility Underscores the Importance of Rebalancing and Tax-Loss Harvesting
A double-digit selloff is hard to stomach, particularly when it coincides with a global pandemic that upends society. However, it does create opportunity.
Right now, rebalancing and tax-loss harvesting are two topics that should be at the forefront of every portfolio construction conversation.
A double-digit selloff is hard to stomach, particularly when it coincides with a global pandemic that upends society. However, it does create an opportunity to examine best practices for portfolio construction, especially since volatility remains high, given that the S&P® 500 Index has registered the most sessions since 1933 with a plus-or-minus 1% daily return over a 30-day period.1
Rebalancing and tax-loss harvesting are two topics, therefore, that should be at the forefront of every portfolio construction conversation.
Rebalancing matters, more than ever
The timing of portfolio rebalancing can have a dramatic impact on a portfolio’s period-based and cumulative return figures. Those return differences result from “timing luck,”2 something that’s very much on display right now, as volatility has spiked and asset class dispersion has become idiosyncratically elevated.
To illustrate this point, I calculated returns for a standard 60/40 portfolio rebalanced monthly and quarterly – but with different intervals, resulting in four different quarterly periods3 – as well as the returns for a naively constructed equal-weighted sector portfolio with the same rebalancing frameworks. The chart below plots the dispersion between the five portfolios that were rebalanced differently, but similarly constructed in terms of asset mix, for March, year-to-date and over the past one-year period.
As shown, in a basic 60/40 portfolio, the aspect of “when” you rebalanced over the past year led to very different results during this volatile period. The difference in March for the 60/40 portfolio was more than 40 basis points. Remember, these portfolios consist of all the same assets. This return differential will be compounded in future periods, based on performance trends (e.g., portfolio A is overweight US relative to portfolio B, and the US rallies) along with further deviations between associated rebalancing programs.
Tax-loss harvesting is the practice of selling an investment that has lost value in order to offset capital gains. Investing the proceeds from a harvested loss into another fund, called a "tax swap," offers investors the opportunity to tax efficiently reposition portfolios while still maintaining their investment strategy and asset allocation framework.
Typically, the bell for tax-loss harvesting rings loudest toward year-end, before the tax books are closed. However, that bell should ring all year long, as losses can occur at any point – creating opportunities that could disappear in a market rebound.
The opportunity to harvest losses in sector portfolios can be quite large. My recent analysis found that in 249 of 347 months, at least one sector had a negative trailing one-year return—that’s 72% of the time.4 And today, on a trailing-year basis, every sector except one (Technology) has a negative return. Therefore, harvesting sector positions today seems ideal — as it’s a rebalancing action that would seek to improve a portfolio’s after-tax alpha.5
To illustrate the after-tax alpha improvements as a result of year-round harvesting, I took a naïvely equal-weighted sector portfolio that started at the end of 2018 (12/31/2018). While naïve, equal weighting actually creates negative tax effects, as the portfolio is constantly selling winners and buying losers, leading to a high probability of taxable gains. As a result, it would likely benefit from year-round tax-loss harvesting.
A few caveats to this example:
This portfolio was rebalanced quarterly. I’m acknowledging the timing luck introduced here, but in order to keep this example simple, I went with quarterly. After all, this is an example meant to show the impact of tax-loss harvesting, not path-dependent return generation from different rebalancing frequencies.
Transaction and holding costs were not applied, as indices were used to produce returns
Price returns were used, and no dividend reinvestment took place, as I sought to isolate capital gains from purchase/sales
Last-In, First-Out tax accounting method was applied6
For any harvested position, it is assumed that an equivalent sector exposure could be purchased
Analysis of whether a position was at a loss took place only at month-end, although this could occur daily
Initial portfolio investment was $1,100,000, or $100,000 per sector
Quantifying the impact of all-season tax-loss harvesting
Everything went up in 2019, with no sector falling below its original purchase price at the end of 2018. The lone exception was Energy, which in May 2019 fell below its December 31, 2018 level. As a result, the selling-winners, buying-losers aspect of the equal-weighted strategy led to $12,927 of capital gains. Harvesting the loss in Energy reduced the capital gains bill by $400.7
The benefit of tax-loss harvesting is more apparent when analyzing 2020, as eight sectors are below their December 31, 2018 purchase price. Only Technology, Health Care, Utilities, and Consumer Staples are not, a trend that speaks to their current market appeal based on growth and business cycle tendencies. The chart below shows the taxable gains/losses so far in 2020 from an equal-weighted sector portfolio that has conducted tax-loss harvesting, versus no tax-loss harvesting.
As shown, by tax-loss harvesting at the end of March, the portfolio realized $95,000 of losses (9% of portfolio value), as opposed to the portfolio generating a gain due to the continued selling of winning sectors (i.e., Tech). These realized losses could offset gains in the broader portfolio or potential future gains in the same equal-weighted portfolio strategy.
Now, consider the potential to offset future gains in this scenario:
Each sector rallies back to the year-end 2019 levels by the end of 2020
The client becomes frustrated with the overall performance of equal-weighting sectors (this type of sector strategy has underperformed the broader market, as it has been structurally overweight Energy and underweight Technology)
All positions are broadly liquidated
The chart below depicts the taxable profile for this example of an equal-weighted sector portfolio that consistently employs tax-loss harvesting versus one that doesn’t. As shown, the harvested equal-weight sector portfolio has 32% lower taxable gains in the broad market rally scenario.
Managing market volatility
When volatility strikes, investors are often tempted to do something. Revisiting rebalancing strategies and looking for tax-loss harvesting opportunities can channel that energy in a way that can benefit portfolios. In a highly volatile environment like today’s, focusing on how and when you rebalance can help to manage risk and identify opportunities. And harvesting losses throughout the year can help to improve portfolio returns on an after-tax basis.
1Source Bloomberg Finance L.P., as of 04/07/2020 per Calculations by SPDR Americas Research using a rolling 30-day period. In 21 out of the last 22 trading sessions the S&P 500 Index has moved up or down by 1% as of 04/07/2020. In 1933, there were periods where it was 22 out of 22. 2“Rebalance Timing Luck: The Difference between Hired and Fired,” Hoffstein, Sibears, Faber, Journal of Index Investing January 2019. 3January- April- July- October; February- May- August- November; March- June- September- December. 4Based on S&P 500 sector returns from 1991-2019 based on data from Bloomberg Finance L.P. Calculations per SPDR Americas Research. 5Tax Alpha = Excess After-Tax Return – Excess Pre-Tax Return. 6Last In, First Out (LIFO) Definition: An accounting method for inventory and cost of sales in which the last items produced or purchased are assumed to be sold first; allows business owner to value inventory at the less expensive cost of the older inventory. 7Source Bloomberg Finance L.P., as of 04/07/2020 per Calculations by SPDR Americas Research
Basis Point (bps)
A unit of measure forinterest rates, investment performance, pricingof investment services and other percentages in finance. One basis point is equal to onehundredth of 1 percent, or 0.01%.
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