SMAs vs. ETFs: there’s got to be a better way
Increase Investment Wins Through Losses Even in bull markets, there are gains to be had through tax loss harvesting
2017 was another record breaking year for the stock market, with the S&P 500 up 19.4%, its best year since 2013. But even when the market is setting record highs, there’s still more money to be made—if you know where to look.
Lee Ainslie's Maverick Capital had a difficult third quarter, although many hedge funds did. The quarter ended with the S&P 500's worst month since the beginning of the COVID pandemic. Q3 2021 hedge fund letters, conferences and more Maverick fund returns Maverick USA was down 11.6% for the third quarter, bringing its year-to-date return to Read More
Investors seeking more return can do one of three things:
Be more aggressive by taking on more risk,
Pay less for what they own with a move from active to passive, or
Get more out of what they own through tax loss harvesting.
Let’s see how 2017 would have worked out with these three strategies.
More investment, switch to passive still reign supreme
The stock market is an indication that many investors are choosing to be more aggressive. The fundamentals of the economy remained solid, but it wasn’t until the tax cut at the end of the year that there was a new catalyst for growth. Investors continued to buy more and more stock and the Dow set more than 80 new record closing highs last year.
Investor preference to pay less for equity returns continued, as the shift from active to passive accelerated. In fact, 2017 marked the largest money shift from active to passive investments ever, with Credit Suisse estimating passive investment flows could make up half of all U.S. equity retail moves in the next two years.
That third option, getting more from what you own, is an often overlooked option for investors.
Get more out of what you own
ETFs have been the primary way that investors have shifted from active to passive. ETFs had more than $1.4T inflows in the decade after the financial crisis. The primary reason is the convenience of buying one security to own an entire sector or index.
Advances in technology have now made it just as convenient to own an index in a separate account at the individual security level commonly known as direct indexing of the many benefits of direct index in the ability to tax loss harvest your passive investments is high on the list (not to mention the added transparency, greater control and risk management it allows).
Direct indexing means you can sell the stocks in the index that are down for the year, and then rebalance 31 days later to lock in the losses and reduce your tax burden. Historically, this works best during times of market volatility and bear markets (when there are more losses to harvest). But what about in a bull market?
Tax loss harvesting works in bear, bull markets
As mentioned before, 2017 saw record stock market highs with little volatility and very few negative weeks, much less real sell-offs. The VIX, a measure of investor fear, was at or near lows all year. The benefits of tax loss harvesting in a strong market, though, are still quite impressive.
For instance, a lot of energy-based companies and big retailers were down big last year. If you tax loss harvested the 28 stocks from the S&P 500 down more than 20%, on an equal weight basis you could potentially harvest 1.79% in losses. Not bad in year when the market was up almost 20%.
The Powered by WilshireSM BRI Dynamic Growth & Value Index (BRIDGV), which captures the enhanced factors of large and mid-cap US stocks, was up 20.61% in 2017. Over 81% of the roughly 400 stocks in the index were positive. Yet, tax loss harvesting on the 19% of stocks, whose losses averaged 13.8%, meant that over 2.62% losses were available to be harvested.
Depending on your tax bracket and realized capital gains. That is a lot of extra performance available to harvested - or to leave on the table if you’re investing through ETFs rather than direct indexing.
Does it seem too good to be true to maximize tax savings and increase return without increasing risk? Not if you’re direct indexing, it’s not.