When an investor has held a portfolio for a period of time and it is embedded with unrealized long-term gains, the investor may wish to liquidate part of the portfolio. By choosing to liquidate part of the portfolio, the investor may be able to raise cash and reinvest the proceeds in other strategies for diversification, or for tactical purposes such as rebalancing out of equities to maintain a fixed income allocation. However, it could be that certain underlying portfolio positions sit on capital gains, thus creating potential tax expense when liquidation occurs. NB Custom Direct Investing (NB CDI)™ strategies can offer a tax-neutral liquidation solution that aims to raise cash with no tax-cost budget, allowing for reinvestment according to investor preferences.
Tax-neutral liquidation is a tax objective that investors can select with any NB CDI™ strategy. The goal of this objective is to explicitly avoid the recognition of net gains and generate cash efficiently over time. To illustrate the benefit of tax-neutral liquidation, we have analyzed how much cash could have been raised for a hypothetical model CDI™ US Large Cap Core strategy where an investor has selected tax-neutral liquidation as a tax objective in different historical market environments over a five-year period without experiencing a taxable event. Let’s assume the model portfolio holds securities worth $2 million with a 35% unrealized gain and a tracking error of 50 basis points (0.50%) to the S&P 500 Index and with rebalancing taking place every 2 weeks. We will start with three bear market scenarios because a bear market provides more opportunities to harvest losses.
Historical Bear Scenarios
| Scenario | Bear 1 | Bear 2 | Bear 3 |
|---|---|---|---|
| Start Date | 12/31/2007 | 7/31/2008 | 7/31/2007 |
| Following 1Y S&P 500 Total Return | -37.00% | -20.02% | -9.93% |
| End Date | 12/31/2012 | 7/31/2013 | 7/31/2012 |
Chart 1: Hypothetical Model CDI™ US Large Cap Core Strategy - Tax Neutral Liquidation - Cash Raised in various bear market scenarios1
“Chart 1” above shows how much cash could have been raised under the three different bear markets laid out in the “Historical Bear Scenarios” chart above. For all three bear market scenarios, we found it would have been possible to liquidate around 70% of the hypothetical model portfolio in five years. It is important to note that by liquidating the portfolio, tracking error may increase overtime depending on the starting positions in the portfolio.
Now, let’s also look at how the model portfolio performs in other market environments: flat, bull and reversal (where the market declines and rebounds rapidly).
Other Market Scenarios
| Scenario | Flat | Bull | Reversal |
|---|---|---|---|
| Start Date | 12/31/2014 | 2/28/2009 | 12/31/2019 |
| Following 1Y S&P 500 Total Return | 1.38% | 53.62% | 18.40% |
| Back-Test End Date | 12/31/2019 | 2/28/2014 | 1/31/2022 |
Chart 2: Hypothetical Model CDI™ US Large Cap Core Strategy - Tax Neutral Liquidation - Cash Raised in various market environments1
“Chart 2” above shows our ability to liquidate a model portfolio during three non-bear market scenarios without triggering a tax event. When the market is flat, we have the potential to liquidate about 40% of the model portfolio. Where the market is up 53.62% (Bull), we have the potential to liquidate 10% of the portfolio over five years. We also analyzed how the model portfolio would have performed in recent COVID 19-related turbulence, which is the market reversal scenario. In this case, the model portfolio would have been able to take advantage of special market conditions to liquidate almost 70% of the initial portfolio.
Given investors’ unique portfolios and objectives, assessing tax situations can be highly individualized. Across many investor cohorts, applying the tax neutral liquidation tax objective to NB CDI™ strategies can provide a solution to liquidate portfolios in a manner that does not incur tax liability. With the NB CDI™ platform’s customization capability, we can tailor portfolios based on investment, liability, and risk objectives.
