Let’s face it. If you have any level of exposure to traditional assets, such as stocks or bonds, 2022 has been unpleasant. Equities closed at all-time highs in 2021, then steadily declined in 2022. Bond investors have arguably had it worse, certainly on a risk-adjusted basis.
Just when you think it can’t get much worse, unless you are in tax-managed strategies, another round of pain could be on the horizon. Taxes.
We hate to be the bearers of bad news, but investors—particularly those in active or semi-active mutual funds—could be in for trouble.
Tax Double-Whammy
Coming on the heels of a long bull market in both stocks and bonds, many asset managers, advisors, and/or clients rotated portfolios while searching for new areas of opportunity or safe havens. This almost necessarily resulted in capital gains.
At the same time, declining asset prices have caused outflows from a variety of mutual funds, requiring their managers to free up cash. In so doing, they potentially sold positions with gains.
This double-whammy sets the stage for an investing nightmare: significant negative returns and higher taxes from capital gains.
Tax Management is Often Ignored When Times are Good
In our view, taxes are often overlooked during roaring markets. If portfolios are increasing and fund flows remain stable, you probably won’t question how asset managers are dealing with future tax issues.
Risk management is often treated the same way. When volatility is low, after a while it’s as if asset managers are allowed to act as though risk has simply disappeared. As a firm focused on systematic investing, we often comment on our belief that risk management should be—and for us is indeed—“baked in the cake.” In other words, our emphasis on risk and return never changes; it is ever-present.
The same can be said of how we approach before- and after-tax returns. The rules and timeframes built into our systematic investing strategies are, in our opinion, conducive to a tax-managed investment approach. We believe they help us with continual tax-loss harvesting because we can sell losses quickly and stay in winners for as long as possible, but not so long as to be held hostage by capital gains.
Systematic Investing Can Balance Risk, Return, & Taxes
We don’t let the tail (taxes) wag the dog (after-tax return). Said another way: risk management comes first; we don’t let concerns about taxes get in the way of preserving compounding when market conditions warrant downside protection. A close second is upside capture; we seek maximum return when market conditions are strong. A byproduct of focusing on these two principles is that it can naturally smooth out the tax profile.
Our strategies may not be best for risk, return, or taxes individually—but they are an optimal combination of all three, in our opinion. Our goal is not to have a great strategy for specific moments in time, but for all times.
Recent history provides an illustration of how systematic investing can balance the sometimes—competing influences of risk, return, and taxes. Risk management remained our focus as conditions changed in 2022, which allowed us to have less downside thus far while being tax neutral.
All strategies meant to benefit from the growth of traditional assets, like stocks and bonds, will suffer to some degree in years like 2022. However, years like this create great opportunities to see which of your asset managers are best positioned for not only manage risk but also capital gains.
When evaluated on these measures, we believe systematic processes stand apart. For example, in 2021 most of our strategies offered compelling returns and no capital gain distribution. In 2022, most of our strategies are again shaping up to be tax neutral. To help identify estimated capital gains distributions, use the Tax Evaluator tool from BlackRock.
Contact Us
Please fill out our contact form if you have questions or need assistance with mutual fund capital gains and taxes. We look forward to speaking with you soon.