Why You Should Go Beyond Tax Loss Harvesting in SMAs
- Dimensional’s multifaceted tax management approach goes beyond loss harvesting and considers tax implications at every step of the SMA investment process.
- Broadly diversified, low-turnover, tax-aware portfolio design results in greater ability to harvest losses, avoid short-term gains, and minimize long-term gains.
- A flexible rebalancing process seeks to balance the tradeoffs among expected returns, costs, taxes, and diversification, with meaningful and long-lasting benefits.
Unlike mutual funds and exchange-traded funds, separately managed accounts (SMAs) can pass through capital losses from the sale of individual securities to the investor. As a result, tax loss harvesting is often promoted as the key benefit of SMAs. But, as our research shows, the power of tax management in SMAs can go beyond tax loss harvesting.
By considering taxes throughout the investment process and effectively balancing the tradeoffs among premiums, costs, and diversification, a multifaceted tax management approach can help investors minimize tax costs and capture equity premiums (size, value, and profitability) when they appear. Moreover, the benefits of tax management approaches solely focused on loss harvesting tend to decline a few years after portfolio inception. Since stocks have positive expected returns, the average position tends to appreciate over time, minimizing the opportunities for tax loss harvesting. However, our study finds that the tax benefits of a multifaceted tax management approach can last over long investment horizons.
What Is Dimensional’s Multifaceted Tax Management Approach?
Our approach considers the tax implications of capital gains, capital losses, and dividends throughout the investment process. First, we design our SMA strategies with an eye toward tax efficiency. For example, we exclude REITs because they pay nonqualified dividend income, which is taxed at the same rate as short-term capital gains. Our SMA strategies are also broadly diversified because more names mean more opportunities to harvest capital losses, avoid short-term gains, and minimize long-term gains while pursuing the desired portfolio characteristics. Our thoughtful weighting approach enables us to target the premiums with low turnover, which helps improve after-tax returns.
We also apply multiple tax considerations in the portfolio rebalancing process. For instance, we systematically evaluate a portfolio for meaningful loss harvesting opportunities that effectively balance taxes and expected returns. We can sell completely out of a name to realize a large loss, provided this trade does not affect the overall portfolio characteristics. Similarly, we can decide to step away from tax loss harvesting trades if they will force the portfolio to deviate dramatically from its focus on higher expected returns.
We also use loss harvesting as an opportunity to incrementally rebalance the portfolio towards its desired size, value, and profitability characteristics. The broadly diversified nature of our SMA strategies provides ample opportunities to replace a security sold at a loss with another one that has similar or higher expected returns without violating the wash-sale rule across linked accounts. Even if there are no meaningful opportunities to harvest losses, we still review the portfolio for trades that can move the portfolio closer to its desired characteristics while minimizing capital gains.
Dimensional offers three levels of multifaceted tax management in our SMA program: Targeted, Moderate, and Aggressive.1 The Targeted approach seeks to minimize net short-term and overall capital gains and places a mild emphasis on capital gains considerations in the evaluation of tradeoffs among premiums, costs, and diversification during rebalancing. It also seeks to deconcentrate highly overweight positions in a tax-efficient manner. Moderate and Aggressive tax management both seek to minimize net short-term and overall capital gains and systematically harvest losses to offset external gains. Compared to Targeted, Moderate and Aggressive place greater emphasis on capital gains considerations in the evaluation of tradeoffs among premiums, costs, and diversification, with Aggressive applying the strongest focus.2
What Can Multifaceted Tax Management Do for Investors?
To answer this question, we simulated applying each level of multifaceted tax management to three equity strategies (US All Cap Market, US All Cap Core 1, and US All Cap Core 2) in three different decades: the 1990s, 2000s, and 2010s.3
For each strategy, we assumed an investor started with $1 million in cash and rebalanced the portfolio at the end of each month. The monthly rebalancing incorporates key aspects of real-world investing, including realistic trading costs for each buy and sell order. We also applied today’s highest federal capital gains tax rates each year. Rather than focusing on a set of unrealistic assumptions that can boost tax efficiency (e.g., that an investor will add cash every year, has unlimited short-term gains to offset, or will donate the entire portfolio), we examined multiple scenarios to provide a more realistic view of tax benefits. Here we share a few of our key findings.
1. Delivers Meaningful After-Tax Outperformance
The difference in after-tax returns between a strategy that applies active tax management and a strategy that does not apply tax management is known as “tax alpha.” Exhibit 1 shows the tax alpha for each of the three levels of tax management– Targeted, Moderate, and Aggressive–averaged across the three decades examined, under three different tax scenarios: at each year-end the investor uses any available losses to offset unlimited short-term capital gains generated outside the SMA; at each year-end the investor uses any available losses to offset unlimited long-term capital gains outside the SMA; or the investor has no external capital gains to offset. The positive tax alphas generated across the board show that all three levels of multifaceted active tax management on average outperformed the No tax management approach.
The tax alpha of Targeted demonstrates that thoughtful tax management can improve after-tax returns even without systematic loss harvesting to offset external gains. Averaged across the three decades and the three investment strategies studied, the Targeted tax management approach delivered tax alpha ranging from 30 to 90 basis points, depending on available external capital gains to offset.
Moderate and Aggressive tax management delivered tax alpha of 1 to 2 percentage points for an investor with external gains who plans to donate her portfolio. To put these tax alphas in perspective, consider an investor who plans to donate their assets and who has unlimited long-term gains outside the portfolio to offset. For such an investor, $1 million would have grown to about $2.7 million in 10 years under the No tax management approach. However, with Aggressive, it would have grown to about $3 million, for an overall difference of about $290,000 in ending wealth.
The outperformance of Aggressive and Moderate for investors with external gains is in line with the results reported in other studies, even though many of those studies assume frequent cash contributions, which can provide more tax loss harvesting opportunities. Our study does not make that assumption and yet arrives at similar estimates, which speaks to the power of tax management that goes beyond tax loss harvesting.
Tax Alphas, Averaged Across Three Decades and Three Investment Strategies
Past performance, including simulated performance, is no guarantee of future results, and there is always the risk that a client may lose money.
2. Pursues Both Higher Returns and Lower Tax Costs
We believe it’s important to use a tax management approach that can both minimize tax costs and deliver the premiums. After all, after-tax returns are a function of both pretax returns and tax costs.
Since Dimensional’s multifaceted tax management approach seeks to balance the tradeoffs among premiums, costs, and taxes every time it rebalances, the all cap core equity portfolios in our study are able to remain focused on the drivers of higher expected returns while also minimizing tax costs. Exhibit 2 shows that in periods when size, value, and profitability premiums were strong, such as during 2001-2010, the All Cap Core 1 and Core 2 portfolios outperformed the All Cap Market strategy under both Moderate and Aggressive tax management on an after-tax basis. In other words, they managed to both deliver the premiums and minimize tax costs.
After-Tax Returns Across Investment Strategies
Past performance, including simulated performance, is no guarantee of future results, and there is always the risk that a client may lose money.
3. Seeks Longer-Lasting Tax Alpha
The benefits of tax alpha can last many years. Exhibit 3 plots the difference in annual after-tax returns between each active tax management approach and No tax management for Year 1 to Year 10, averaged across the three decades and the three investment strategies. We report the results for the same three tax scenarios described above. Our study found that all three levels of multifaceted tax management generated tax alpha throughout the 10-year investment periods examined. Broad diversification across securities and a thoughtful focus on the tradeoffs among taxes, premiums, and costs in rebalancing enabled that.
Annual Tax Alphas, Averaged Across Decades and Investment Strategies
Past performance, including simulated performance, is no guarantee of future results, and there is always the risk that a client may lose money.
The Power of Going Beyond
A systematic investment approach that goes beyond indexing can add value. Our study shows that a multifaceted tax management approach that goes beyond tax loss harvesting can add value, too. Is it possible to go beyond in both dimensions? Dimensional’s SMAs do exactly that.
Footnotes
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1. Certain UMA account types, such as IRAs, solo 401(k)s, and other non-ERISA tax-advantaged accounts, may only select no tax management when choosing a tax management approach.
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2. For more information, see Savina Rizova and Ashish Bhagwanjee, “Dimensional’s Multifaceted Tax Management of SMAs” (research paper, Dimensional Fund Advisors, July 2022).
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3. In our study, the simulated version of the Targeted tax management approach does not incorporate the deconcentration feature. This feature is an additional benefit of the approach on top of the results of our study.
Glossary
Expected return: The percentage increase in value a person may anticipate from an investment based on the level of risk associated with the investment, calculated as the mean value of the probability distribution of possible returns.
Nonqualified dividend income: Income that doesn’t meet IRS requirements to qualify for a lower tax rate, also known as ordinary income.
Profitability: A company’s operating income before depreciation and amortization minus interest expense scaled by book equity.
Qualified dividend income: Ordinary dividends that meet specific criteria to be taxed at the lower long-term capital gains tax rate rather than at the higher tax rate for an individual’s ordinary income. The rates on qualified dividends range from 0 to 23.8%.
Separately managed account: An investment vehicle in which investors directly own the securities held in individual custody accounts.
Wash sale rule: A tax rule stating that, if an investment is sold at a loss and then the same security or a substantially identical security is purchased within 30 days before or after the sale, the initial loss cannot be claimed for tax purposes.
Methodology: We run historical simulations of three equity strategies: US All Cap Market (“Market”), US All Cap Core 1 (“Core 1”), and US All Cap Core 2 (“Core 2”). The simulations are run over three nonoverlapping 10-year periods (December 31, 1990–December 31, 2000, December 31, 2000–December 31, 2010, and December 31, 2010–December 31, 2020) using stock data from CRSP and Compustat.
For each strategy, we construct a “target” portfolio at every month-end. For the US All Cap Market strategy, this portfolio consists of all US common stocks (excluding REITs and ADRs) that have a total market capitalization of at least $100 million and a share price greater than $2 at month-end. The stocks in the eligible set are weighted by market cap. The “target” portfolios for US All Cap Core 1 and Core 2 differ from the Market strategy portfolio in two ways. First, the eligible universes for Core 1 and Core 2 exclude small cap stocks with lower expected returns: small growth low profitability stocks and small high investment stocks. We define small cap stocks as stocks in the bottom 8% of the aggregate market capitalization of common stocks. Within small caps, small growth low profitability stocks are either in the bottom half on profitability and the top quarter on relative price, or in the bottom quarter on profitability and the top half on relative price. Profitability is defined as operating income before depreciation and amortization minus interest expense scaled by book equity. Relative price is defined as market capitalization scaled by book equity. Small high investment stocks are defined as companies whose asset growth for the latest fiscal year exceeds the higher of the 95th percentile across all small cap stocks and 75%. As in prior academic studies, we require a minimum six-month lag for financial data from Compustat.
The “target” portfolios for Core 1 and Core 2 also differ from the “target” portfolio for the Market in the weights they apply to eligible stocks. Both Core 1 and Core 2 overweight groups of stocks with higher expected returns (which have lower market capitalization, lower relative price, and higher profitability) and underweight groups with lower expected returns. Core 2 applies stronger over- and underweights than Core 1.
Disclosures
Simulated strategy returns are based on model/backtested performance. The performance was achieved with the retroactive application of a model designed with the benefit of hindsight; it does not represent actual investment performance. Backtested model performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes only. The securities in the model may differ significantly from those in client accounts. Model performance may not reflect the impact that economic and market factors might have had on the advisor’s decision-making if the advisor had been actually managing client money. Actual investor results will be impacted by account cash flows, changing tax rates, the tax lot relief methodology used by the advisor, and the investor’s individual circumstances.
The simulated performance is “net of fee,” which includes the reinvestment of dividends and other earnings and reflects the deduction of advisory fees (0.29%) and transaction costs (0.10%). A client’s investment returns will be reduced by the advisory fees and other expenses that may be incurred in the management of the advisory account.
This information is not meant to constitute investment advice, a recommendation of any securities product or investment strategy (including account type), or an offer of any services or products for sale, nor is it intended to provide a sufficient basis on which to make an investment decision. Investors should consult with a financial professional regarding their individual circumstances before making investment decisions.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
Dimensional does not provide any investment, tax, or financial advice. Investors should consult with their financial advisors and tax professionals about their individual circumstances. Dimensional is not a tax advisor and does not know the effective tax position of any individual client. Tax management in Dimensional SMAs is limited to managing the account’s investment approach in a tax-sensitive manner.
Diversification neither assures a profit nor guarantees against loss in a declining market.
This information is provided for registered investment advisors and institutional investors and is not intended for public use. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.