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Point of View · 12.16.23
What the U.S. Equity Rally Means for Tax Planning
We analyze how investors can harvest losses in a robust stock market
- Portfolio Construction
- Equity Insights
- Tax Advantaged Equity Strategy
Head of Tax-Advantaged Equity
What the U.S. Equity Rally Means for Tax Planning
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Key Points
What it is
We explore how investors can potentially cut taxes using tax-reduction tactics, even during market booms.
Why it matters
Tax expenses, such as those on capital gains, can erode a significant portion of investment returns, especially over a long period.
Where it's going
Strategic tax harvesting aims to mitigate the impact of capital gains, a major barrier to wealth accumulation over time.
When markets are soaring, investors may think that tax-loss harvesting is not an effective tax strategy. Fortunately, our research shows it’s possible in most any market and can be used in short- and long-term investments. We explore how tax loss harvesting can be a key tool for enhancing after-tax returns, even amidst market highs.
Not Every Stock Climbs in a Market Upswing
Historically, the stock market has gone up over time but, even when the market is soaring, some equities will still underperform (often more than you would think).
For example, since the start of 2023:
- The S&P 500 Index has risen approximately 20% year-to-date, with seven technology companies making up the lion’s share of the gains.
- Of the remainder, nearly half of the stocks in the index are sitting in the red, with more than 60 companies down greater than 20%.
- Four of the eleven sectors have fallen, including a 9% drop for utilities and a 3% slide in health care.
It’s important to point out however, that the opportunities to harvest losses amid a rally this year isn’t unique. If we look back to 2021, when the S&P 500 rose 28%, nearly a third of the stocks fell more than 10% at some point throughout the year and more than half fell by greater than 5%.
In fact, Exhibit 1 shows that, whichever way the broad equity market moved over the last 10 calendar years, there have been stocks with losses. So historically, even when investors are enjoying positive returns, there has been opportunity to to offset gains. This creates consistent opportunities for diligent tax-aware separate account managers who can take advantage of any temporary dips in price to harvest losses at the stock level.
EXHIBIT 1: S&P 500 INDEX BREAKDOWN OF ANNUAL UP/DOWN STOCKS
Even in up markets like 2013 and 2019, more than 50% of S&P 500 stocks had a decline.
Source: Northern Trust Asset Management, Bloomberg. Data as of November 30, 2023.
Periodic Loss Harvesting: A Year-Round Strategy for Taxable Investors
If you haven’t purposely realized losses to reduce the tax burden this year, we think now would be a good time to do so. But a good resolution for your investment plans in 2024 may be to harvest losses more frequently. Investment managers with specialized skills in tax efficient portfolios, in particular with separately managed accounts, employ techniques such as selling the most advantageous at least monthly and monitoring of portfolios daily in an effort to optimize tax savings.
Exhibit 2 shows the price chart of a hypothetical stock over a 12-month period. Note that a manager purchasing shares of the stock near the beginning of the period would have had numerous opportunities to realize a loss over the course of the year despite the overall positive return.
Tax Lots
Tax lots are records of securities purchased in a transaction, to track the date of purchase, cost and transaction size. They provide the cost information of a transaction in order to determine the amount of loss or gain when securities are sold.
EXHIBIT 2: HYPOTHETICAL STOCK: TAX OPPORTUNITIES IN A VOLATILE YEAR
This hypothetical stock moved quite a bit during a 12-month period, providing a number of opportunities for tax-loss harvesting.
Source: Northern Trust Asset Management, Bloomberg. This graph does not show actual performance result. For illustrative purposes only.
We have found it best to trade around the Internal Revenue Service wash sale rule, which states that a security or a substantially identical security cannot be repurchased in the 30 days before or after a sale for a loss. This means we are typically trading in our client’s portfolios every 31-45 days. Trading this frequently helps to manage risk in the portfolio, invest cash received from dividends and corporate actions before it becomes a drag on performance, and take advantage of any market volatility.
Why Tax Management Matters
Tax expenses, such as those on capital gains, can erode a significant portion of investment returns, especially over a long period. In contrast, the impact of investment fees (like management fees or advisory fees) and trading costs (like brokerage fees and transaction fees) have historically had a less significant impact on the after-tax accumulation of investor wealth than tax expenses. Understanding this dynamic underlines the value of investing with a tax-aware separate account manager as a key strategy in taxable portfolios, even in up markets.
Source of data: FactSet and Bloomberg
Main Point
Enhancing After-Tax Returns Through Tax Harvesting, Even in Up Markets
Tax-loss harvesting has the potential to be an effective tax strategy, even in bullish markets. While the S&P 500 may rise, individual stocks often underperform at the same time, which offers opportunities for tax optimization.
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