Tax loss harvesting involves selling securities to generate a loss that can be used to offset capital gains in other parts of a portfolio, with the proceeds reinvested to maintain the desired market exposure. Given this year’s high levels of stock market volatility and the performance dispersion among active managers, 2020 may turn out to be a banner year for the strategy.
We have seen several years of market volatility packed into 2020, first on the downside with the advent of the coronavirus earlier in the year and then to the upside as stocks rallied to new highs in November. This has produced uneven returns. A story in The Financial Times (11/11/20) flagged the issue: in what should have been a good year, many active managers have struggled to outperform. Across all U.S. equity funds, fewer than 40% of managers beat their indexes for the twelve months ended in June, according to the FT. For the five-year period, that number fell to about one in five.
Of course some did very well while others fared poorly. HFR, the hedge fund data provider, reported that the top decile of its index constituents gained 41.4% in 2Q 2020, while the bottom decile fell -9.3%. Total top/down dispersion was 50.7% This was actually an improvement from the prior quarter, when top/down dispersion came in at 56.2%.
Given the level of volatility, the recent rotation in asset classes, and the underperformance of some asset managers, many investors may be sitting on losses that can be harvested to enable asset allocation repositioning. Matching those losses with gains – while maintaining the desired portfolio allocations – is the key to successful tax loss harvesting. Consider, for example, liquid alternatives in light of the HFR data. In the course of the year we have seen some limited partnerships and traditional open-end mutual funds offering these strategies underperform relative to ETFs like our IQ Hedge Multi-Strategy Tracker ETF (QAI) and the IQ Merger Arbitrage ETF (MNA). This divergence provides investors with the opportunity to sell some shares in investments where they have losses and move to what is usually a more efficient fund structure, i.e. exchange-traded funds (ETFs), all while maintaining a general allocation to liquid alts.
Other areas where investors may have experienced losses include international and small capitalization stocks, both of which have underperformed so far this year compared to the S&P 500 (up about 12%). EAFE (Europe, Australasia, Far East), which focuses on developed nations outside the U.S. and Canada, is up 2.3% through November 18th, while the Russell 2000, a broad index of small cap stocks, has returned a little over 7.0% in the same period. These asset classes have now turned positive, but they spent much of the year in the red and individual experience is again likely to vary based on both manager dispersion and holding periods, among other factors.
International investors looking to reposition some assets may want to consider moving to a currency hedged fund, like the IQ 50 Percent Hedged FTSE International ETF (HFXI) which provides broad exposure to international markets ex-U.S. while also incorporating a hedge against currency moves. With a new administration assuming power in Washington, and an uneven global economic recovery, we believe currencies are likely to remain volatile through the end of the year and into 2021. The hedging strategy can help dampen the effect of currency dislocations on the portfolio.
Small cap stocks are another place to look as a possible source for tax loss harvesting. While the broader indexes are now up modestly, investors may have realized losses from earlier in the year, or have negative returns in their portfolios based on individual holding periods. The IQ Chaikin U.S. Small Cap ETF (CSML), which uses a multi-factor model to provide exposure to a broad universe of U.S. small cap stocks, is a way to maintain exposure to the asset class and can act as a core component in a portfolio.
In sum, tax loss harvesting can offer multiple benefits, offsetting capital gains while allowing an investor to maintain consistent exposure to the markets. There is one catch, however: to take advantage of the strategy, most will need to take action before year end.
As always, individuals should consult their tax advisors to determine their best course.
Diversification cannot assure a profit or protect against loss in a declining market.
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This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
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The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.
The MSCI EAFE® Index consists of international stocks representing the developed world outside of North America.
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.