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.
David M. Lebovitz
Global Market Strategist
Listen to On the Minds of Investors
Uncertainty around the trajectory of inflation, monetary policy, and the situation in Eastern Europe has unsettled markets in 2022. However, one thing that remains clear is that asset returns will likely be challenged going forward. Against this backdrop, 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, while others have chosen to embrace riskier public market strategies. Relatively few, however, have looked at active tax management as a way of addressing this return challenge.
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.
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.
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.
Elevated volatility creates an opportunity to generate "tax alpha"
S&P 500 annual returns & intra-year declines, price return
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 2021, over which time period the average annual return was 9.4%.
Guide to the Markets - U.S. Data are as of May 3, 2022.