One of our investment leaders’ key takeaways from the 2020 election was the durability of populism, and related appetite for spending on relief and social programs that, over time, will likely lead to pressure to raise revenue through taxes regardless of who occupies key positions of power in Washington, DC. As practitioners of tax-efficient investing, this has reinforced for us the value of investing not just for topline return numbers, but for actual take-home returns—what you’ll have after the government takes its piece of the pie.
For individuals, “tax efficiency” often takes the form of portfolio location—the effective use of retirement accounts to grow assets on a tax-deferred basis in the case of traditional IRAs and 401(k)s, and tax-free in the case of Roth accounts. This may involve not only maximizing contributions to the accounts, but choosing appropriate assets for them—for example, higher-turnover or dividend-oriented investments that typically generate significant ordinary income in the context of a taxable account. Traditionally, investors have also benefited from the tax advantages of municipal bonds, which can offer tax-free interest at the federal and sometimes local levels, while serving to ballast portfolios through more volatile market environments.
Tax Deferral and Loss Harvesting: Pillars of a Tax-Aware Portfolio
Beyond these ideas, we believe two pillars of tax-efficient investing may get less attention today than they deserve: deferring gains within ordinary accounts and the effective use of loss harvesting to minimize current tax liability.
The idea of gain deferral is fairly straightforward—that an investor will tend to hold assets for as long as possible, consistent with their investment strategy, in order to avoid having to pay taxes that might cut into assets available for compounding. Tax deferral is closely associated with many revered investors, including our founder Roy Neuberger and Berkshire Hathaway’s Charlie Munger, who lamented that a “very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes.” As shown in the display below, postponing tax payment in a hypothetical portfolio over a multiyear period could greatly enhance one’s ultimate potential for return on investment.
Hypothetical Portfolio: The Impact of Deferring Gains
Hypothetical $1 Million 30-Year Investment at 10% Annual Return1
Source: Neuberger Berman, based on example from Munger, Charlie, The Art of Stock Picking. Hypothetical results shown are for illustrative purposes only. They are not intended to represent, and should not be construed to represent, a prediction of future rates of return. The illustration does not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
The strategic use of tax-loss harvesting can also be highly effective to delay tax payment and enhance potential returns over time. This is familiar territory for our private clients, whose portfolio managers will generally engage with clients to execute, when available, individual tax-loss sales inside their separate accounts to offset realized capital gains in a process that usually takes place toward the end of the year. Although the landscape for tax-loss harvesting is typically most compelling during a down year for the markets, there are often losses available during bull environments as well. For example, in 2020, when the S&P 500 was up 18%, some 181 stocks were in the red, and despite 2019’s 31% advance, 45 stocks in the index suffered from negative results. For those who are more broadly invested, and able to own individual securities in other asset classes, opportunities for loss harvesting may be substantially greater.
Tax-Loss Harvesting Opportunities Are Available Even in Up Markets
% of S&P 500 Stocks With Negative Returns Each Year (in Blue)
Source: Bloomberg. Data through 2019. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
Systematizing Tax-Loss Harvesting
Despite the potential benefits of tax-loss harvesting, limitations in the current investment landscape can make it challenging to access them. Although a core equity manager may execute transactions on behalf of a client at year-end, this greatly depends on close communication to ascertain the gains/losses picture in other areas of the client’s overarching portfolio. Moreover, it may be that some of the client’s assets are in mutual funds or ETFs, which don’t lend themselves to tax-loss harvesting at the individual security level or with any meaningful frequency. So-called robo-advisors often offer harvesting, but typically in passive investment vehicles exclusively, leaving fans of active investing in a bit of a lurch. All this has suggested to us a particular opportunity to apply loss harvesting in a systematic way, across asset classes, while capitalizing on return potential from active management and maintaining diversification within a separate account structure.
How effective could such an approach to tax-loss harvesting be?
We conducted a study of a hypothetical portfolio made up of 500 stocks, assuming three different market return scenarios (an average of 0%, 6% and 10%, annualized) and two different volatility levels (a fairly moderate 25% and more significant 35% for each security) over a 10-year period. We also set their correlation to each other (or tendency to move together) at 0.3 (roughly equal to the S&P 500’s constituents). The tax rates we applied were equivalent to top federal levies of 40.8% on short-term gains (on stocks held a year or less) and 23.8% on long-term gains (on stocks held more than a year). Finally, we chose to harvest losses every month, if any security dipped by more than 5%, and buy back a similar security right away, applying the realized losses to offset an equivalent amount of realized gains in the portfolio. With these assumptions in place, we then ran 1,000 Monte Carlo simulations to project a range of hypothetical performance scenarios around the return and correlation combinations noted above, over the full 10-year period.2
The results, in our view, lay out the opportunities for a systematic approach to loss harvesting in generating what we call Tax Alpha—or the difference between pre-tax and after-tax annual returns on a given portfolio.3
Hypothetical Back tested Portfolio Illustration: Loss Harvesting Generated Outperformance Over Non-Tax-Aware Investing
Hypothetical Annual Tax Alpha by Return Regime (10 Years)
Source: Neuberger Berman. Hypothetical results shown are for illustrative purposes only. They are not intended to represent, and should not be construed to represent, a prediction of future rates of return. Tax Alpha figures assume an investment that is taxed at 50% short-term and 50% long-term rates (40.8% and 23.8%, respectively). The correlation to the S&P 500 is assumed to be 0.3 with 500 stocks in the portfolio and a dividend yield of 2%. Fees are assumed to be 0.35% over a typical passive portfolio, with no transaction costs and monthly rebalancing. A loss of 5% is the assumed threshold for harvesting. The illustration does not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. PLEASE SEE IMPORTANT “HYPOTHETICAL BACKTESTED PERFORMANCE DISCLOSURES” AT THE END OF THIS ARTICLE.
As we expected, our hypothetical portfolio analysis demonstrated that a 10-year period of generally flat average portfolio returns provided more opportunity for tax-driven sales, given the increased proportion of stocks with negative returns, and thus produced higher Tax Alpha. Also of interest is that periods of higher volatility proved beneficial, because even where stocks might ultimately finish in the black, there was increased likelihood that many would temporarily dip below the -5% return bogey and trigger sales at some point during a given year. Importantly, the return advantage came not just from generating immediate tax savings, but also from the ability to compound those savings over time, adding to the overall growth of the portfolio.
It’s important to note that we are talking about tax-deferral here. Unless assets are held until death (when they receive a step-up [or step-down] in cost basis to current market value), the capital gains in a portfolio will eventually be realized. Moreover, a tax-driven approach has a tendency to distort an investor’s asset allocation, further concentrating exposure to winning stocks, sectors and asset classes. As such, investors may wish to set ongoing parameters around the extent of tax sales or the level of concentration, and then revisit their asset allocation on a regular basis to ensure that it still matches their personal requirements. The separate account structure provides an ideal setting for such customization, built around individual risk profile, objectives, environmental, social and governance considerations and more.
Overall, the beauty of systematic tax-loss harvesting is that it can mimic the tax deferral of traditional retirement assets within a taxable account framework, setting investors up to minimize the drag created by regular tax payments on capital gains. In an environment where pressures for higher tax rates are likely to increase, the benefits of postponing taxes could be substantial.
1 Source: Bloomberg.
2 See footnote beneath “Hypothetical Backtested Portfolio Illustration” display for relevant disclosures.
3 Technically, the difference in the study is between the pre- and after-tax “excess returns,” or the amount that the portfolio returns above Treasury rates, but the difference would be the same if the full total returns of the portfolio were used.
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IMPORTANT: The projections and other information generated by a Monte Carlo analysis tool regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
A Monte Carlo analysis runs multiple simulations of your wealth analysis against future market conditions. The result of introducing random investment volatility to the analysis produces a range of values that demonstrates how changing investment markets may impact your wealth. Tools such as the Monte Carlo analysis will yield different results depending on the variables input, and the assumptions underlying the calculation.
Hypothetical Annual Tax Alpha by Return Regime
The returns presented reflect hypothetical performance an investor would have obtained had it invested in the manner shown and does not represents returns that any investor actually attained. Neuberger Berman calculated the hypothetical results by running a model portfolio on a backtested basis using the methodology described below. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented.
The investment process represented in the NB BH Tax Alpha Model: The model is based on assumption that the annualized return is 0%, 6% and 10% while the annualized volatility is 25% and 35%. Tax alpha figures assume an investment that is taxed at 50% short-term and 50% long-term rates (40.8% and 23.8%, respectively). The correlation to the S&P 500 is assumed to be 0.3 with 500 stocks in the portfolio and a dividend yield of 2%. Fees are assumed to be 0.35% over a typical passive portfolio, with no transaction costs and monthly rebalancing. A loss of 5% is the assumed threshold for harvesting.
When calculating after-tax returns, the model applies the highest U.S. federal tax rates. For short-term gains, the highest U.S. federal marginal income tax rate is 43%. For long-term gains, the highest U.S. capital gains tax rate is 23%. These assumed tax rates are applied to both net realized gains and losses in the portfolio. Applying the highest rate may cause the after-tax performance shown to be different from an investor’s actual experience. Investor’s actual tax rates, the presence of current or future capital loss carry forwards, and other investor tax circumstances will cause an investor’s actual after-tax performance to be over or under model estimates presented here. In periods when net realized losses exceed net realized gains, applying the highest tax rates to our calculations illustrates the highest after-tax return that could be expected of the portfolio, and assumes the maximum potential tax benefit was derived. Actual after-tax returns will vary. As with all after-tax performance, the after-tax performance reported here is an estimate. In particular, it has been assumed that the investor has, or will have, sufficient capital gains from sources outside of this portfolio to fully offset any net capital losses realized, and any resulting tax benefit has been included in the model’s computation of after-tax performance.
The investment process represented in the Russell 1000 (Simulated) model portfolio has multiple steps: Benchmark after-tax returns are simulated for the portfolio using a hypothetical, after-tax benchmark portfolio with the same inception date, cash flows, cost basis, and tax rates as the client portfolio. The after-tax benchmark’s capital gain realization rate is based on the average turnover rate of the pre-tax benchmark and ending gain or loss of the after-tax benchmark for each period. After-tax benchmark returns are hypothetical, do not reflect actual trading, and may not be relied upon for investment decisions.
Hypothetical backtested returns have many inherent limitations. Unlike actual performance, it does not represent actual trading. Since trades have not been actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity, and may not reflect the impact that certain economic or market factors may have had on the decision-making process. Hypothetical backtested performance also is developed with the benefit of hindsight. Other periods selected may have different results, including losses. There can be no assurance that the Neuberger Berman will achieve profits or avoid incurring substantial losses. Neuberger Berman managed accounts in the manner reflected in the models during a portion of the backtested time periods shown.
Unless otherwise indicated, results shown reflect reinvestment of any dividends and distributions. Unless otherwise indicated, the hypothetical performance figures are shown gross of fees, which do not reflect the deduction of investment advisory fees, transaction costs and other expenses. If such fees and expense were reflected, returns referenced would be lower. Please note that there is no comparable reduction from the indices for the fees. Indexes are unmanaged and are not available for direct investment. The use of tools cannot guarantee performance. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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