Get the most out of Tax-Smart Separately Managed Accounts (SMAs)
Harvesting stock losses has gone from a manual year-end process to a best practice made possible all year round thanks to intelligent automation. Now, simpler, more consistent, and more effective tax management via separately managed accounts (“SMAs”) has allowed more investors to put this type of technology to work in their portfolios than ever before.
Tax-managed SMAs give investors the ability to actively generate losses that can then be used to reduce their tax bills at the end of the year. Effectively, these strategies allow investors to use market volatility to their advantage by employing technology to pinpoint losses across the portfolio and harvest them, all while keeping the risk attributes of the portfolio intact.
As more investors adopt these strategies and experience their significant benefits, expectations for the long term are important to address. Keeping a few key points in mind for maintenance and monitoring may help keep those benefits coming for longer.
Understanding “tax alpha”
Of course, no matter what the market conditions, there are likely to be stocks in an investor’s portfolio that fall below their purchase price. Taking those losses and using them to offset gains from other parts of an investor’s portfolio can generate after-tax performance gains, known as “tax alpha.”
Tax-managed SMAs achieve this by systematically applying two steps:
- Actively monitor all positions within a portfolio and sell positions where losses can be harvested and claimed against their tax bill—either that year or any year to come. Unused losses never expire; they can be rolled forward until you use them.
- Simultaneously, replace the position that was sold with a similar security (or set of securities). This step preserves the portfolio’s asset allocation and helps keep the risk profile of the portfolio consistent.
This tax reduction creates two spillover effects. First, a lower overall tax bill can diminish the need to liquidate assets to pay taxes, keeping more funds in an investor’s portfolio. Second, by keeping more dollars invested, a compounding effect takes place which can have a meaningful impact on overall portfolio value over the long term.
These enhanced after-tax returns are what make tax managed SMAs so appealing to many investors, and by taking proactive steps, you can help ensure that those portfolios keep capturing losses over time.
What is “tax alpha decay”?
Over time, the tax alpha potential of any tax-managed SMA —if left unchecked -- is likely to erode due to two forces:
- Markets historically go up. Hold on to any stock long enough and historical market data shows its value is likely to increase over time. This dynamic means that a client’s potential for tax harvesting is typically highest when first funded and that embedded losses tend to diminish over the long haul.
To illustrate this point, the following exhibit looks at more than 20 years of S&P 500 holdings at the start of each calendar year and shows the percentage of stocks with negative returns by time frame. Over a 3-month, or even 3-year period, there are chances of having a majority of stocks at gains or losses – hence, the unpredictability of the market in the short term. But as you extend that window forward, a higher percentage of stocks that you started with tend to be at gains making the process of finding losses all the more challenging.
- If you keep harvesting losses, a portfolio’s cost basis will decrease over time–Indeed, by harvesting losses, an investor is, in effect, “averaging down,” which is akin to dollar cost averaging (dripping into investments over time, regardless of price), but only buying after a loss. If the stocks do well after an investor’s purchase, that increases the spread between their cost basis (the price at which they bought a stock) and the stock’s current value. This only serves to exacerbate the first point above.
There are more potential harvesting opportunities early on
Percentage of stocks in the S&P500 with negative returns by time frame (%)
Source: Bloomberg, data as of 12/31/2021. Past performance is no guarantee of future results..
To maximize tax savings, minimize “tax decay”
Fortunately, there are steps that investors can take to mitigate tax alpha decay and optimize their after-tax returns over the long run:
- Add dollars to create new cost basis
The tax decay scenario we described above assumes that no new dollars are coming into the investor's portfolio. New dollars invested create new (many times higher) cost basis, so any ensuing volatility after a contribution may create additional opportunities for harvesting those "fresh" tax lots. By educating investors about the benefit on ongoing contributions, tax savings can be maximized over time.
- Take advantage of high volatility, lower return environments
After a long bull market, J.P. Morgan anticipates the returns for equity markets to be more limited for the next 10-15 years. We also believe that these lower returns will be accompanied by more volatility. While not an attractive environment for most investors, it does create more harvesting opportunities and an extended time frame to realize large, embedded gains across most stocks, delaying potential tax decay.
- Rebalance to create fresh tax lots
Regular monitoring and rebalancing of the portfolio can create "fresh" tax lots and new opportunities to harvest losses. Monitoring portfolios daily for losses can help increase turnover thoughtfully, thereby creating fresh lots that may be easier to harvest later. A systematic, ongoing, active tax management approach doesn’t just help increase harvesting potential in the early years, but it can also help to extend these benefits over the life of the investment.
Ongoing tax management is a powerful tool in the fight to keep more dollars invested and enhance after-tax returns. A combination of the right client actions, market volatility, and thoughtful rebalancing can make a significant difference in maximizing the benefits of a tax managed SMA. Thoughtful planning and execution can help ensure that clients get the most from their tax-managed investments, both now and for years to come.
Important information: Separately Managed Accounts (SMAs) are not mutual funds. SMAs are discretionary accounts managed by J.P. Morgan Investment Management Inc. (JPMIM), a federally registered investment adviser.
Professional money management may not be suitable for all investors. It should not be assumed that investments made in the future will be profitable.
55ip is the marketing name used by 55 Institutional Partners, LLC, an investment technology developer, and for investment advisory services provided by 55I, LLC, an SEC-registered investment advisor. 55ip is part of J.P. Morgan Asset Management.