Special thanks go to Jianing Zhai, who helped with the research for this paper during her internship with Neuberger Berman.
Actively using tax-efficient strategies can be a powerful tool to enhance after-tax investment returns. During the lifetime of a portfolio, the two most important aspects of tax management are tax loss harvesting (realizing a loss by selling a security, which can then offset other taxable gains) and tax deferral (delaying taxation so that money remains invested and continues to generate returns).
In this paper we focus on tax loss harvesting. We show that even a naïve tax loss harvesting strategy can add value (“tax alpha”), but also that the available level of tax alpha depends upon the market environment—specifically, its availability is higher when market returns are lower and stock volatility is higher.
Executive Summary
- Actively using tax-efficient strategies can be a powerful tool to enhance after-tax investment returns.
- In this paper we focus on tax loss harvesting.
- We define “tax alpha” as the difference between excess after-tax return and excess pre-tax return relative to a benchmark.
- We describe our methodology for assessing the potential availability of tax alpha.
- We find that the available level of tax alpha depends upon the market environment—specifically, its availability is higher when market returns are lower and stock volatility is higher.
- While the availability of tax loss harvesting opportunities diminishes over time, the immediate savings it generates continue to compound for as long as taxation on those gains is deferred.
- We compare our results to a historical backtest on S&P 500 stocks, as well as results reported by a peer group from eVestment.
- While acknowledging some potential upward biases in our results, as well as the cumulative effect that tax loss harvesting has on portfolio concentration, we believe that the overall benefit of tax-efficient strategies is clear.
The impact of taxes on the overall performance of a portfolio can be meaningful. Therefore, actively using tax-efficient strategies can be a powerful tool to enhance after-tax investment returns. During the lifetime of a portfolio, the two most important aspects of tax management are tax loss harvesting (realizing a loss by selling a security, which can then offset a taxable gain from another security) and tax deferral (delaying taxation so that money remains invested and continues to generate returns).
While no investor has portfolio losses as their objective, they occur with regularity and they can be exploited throughout the year with a tax loss harvesting strategy. As figure 1 shows, the opportunity set can be substantial even during bull markets.
Tax Loss Harvesting Opportunities Can Be Substantial Even During Bull Markets
Positive vs. negative return dispersion in the S&P 500 Index, 2001 – 2019
Source: Neuberger Berman, Bloomberg.