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.
As my colleague Dan Farley discussed in a recent post, understanding how a rebalancing strategy impacts returns is crucial in a normal, functioning market, but especially so in one marked by volatility. Options to counterbalance, though not solve, the randomness of rebalancing include constructing overlapping portfolios or using asset-level tolerance rebalancing. Factoring this decision into strategy due diligence, as well as performance attribution, is important.
Tax-loss harvesting, an all-season event
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.