Volatile and downward sloping markets offered an uneasy ride for investors
It was a difficult past year for investors as geopolitical turmoil, surging inflation and rising interest rates prompted a sell-off in equity and bond markets with no place for investors to hide. Since 2020 there have been many adjustments in daily life, and while a global pandemic was the most notable, investors have also faced the return of market volatility after a relatively tame decade. In the past three years, investors have experienced 97 days of the S&P 500 Index moving more than +/- 2%, compared to 62 days total from 2012 – 2019.
Source: FactSet and Neuberger Berman.
It wasn’t only US Large Cap stocks that experienced volatile and downward trending returns in calendar year 2022: markets across segments and regions saw drastic moves day-to-day and month-to-month, largely moving in unison as shown below.
Source: FactSet.
Volatility persisted across indexes, stocks, sectors, and countries throughout 2022
While broad market returns tell us the overall client investment experience, when tax-managing portfolios we look further into market dispersion happening day-to-day on the way to that year-end return. Whether the market return is up, down or flat, markets may see that some names increase in value, representing a potential tax liability to investors in the form of an unrealized gain, and some stocks may decrease in value that, if sold, represent a potential tax savings. This dispersion between individual stocks occurs throughout the year, providing managers an opportunity to tax-manage portfolios to a client’s specification, weighing the risk of deviating from the benchmark with the tax cost (deferring gains) or savings (realizing losses).
In a year where the S&P 500 Index finished down more than 18%, 158 companies had a positive return for the year, and five months throughout the year when more stocks increased in value than decreased.
Source: FactSet.
Clients taking advantage of market dispersion throughout the year were rewarded
Our look back at 2022 clearly shows a difficult experience for investors, most of whom saw their portfolios decrease in value. The silver lining of volatility for taxable investors was the ability to capitalize on realizing losses while continuing to track the market when a rebound occurs.
One metric used to measure the efficacy of tax-management is tax alpha, calculated as net after-tax excess returns minus net pre-tax excess returns. Looking at the composite for NB CDI™ US Large Cap Core in 2022, we saw 8.64% after-tax alpha while tracking the S&P 500 Index within 0.27% on a pre-tax basis.
Looking at two representative client accounts that made an initial cash investment in NB CDI™ US Large Cap Core portfolios in late December 2021, their 2022 experience included realized losses of 22% and 25% respectively.* If a client had hypothetically** invested $1m at the beginning of the year, this would equate to $90k – $104k in tax savings that can stay invested in the market and compound over the next 20 or 30 years.
Looking ahead, what should investors expect in 2023?
Macroeconomic uncertainty and elevated inflation are expected to persist in 2023, leaving investors with more questions than answers heading into the new year. In NB’s Solving for 2023 outlook, Joe Amato, President and Chief Investment Officer—Equities, referenced recent market rallies in July and October 2022, noting that, “we would caution against getting sucked into what we regard as these bear-market rallies. We think there is some meaningful equity market downside still to come because we see earnings estimates for 2023 as too high—not least because the quality of current earnings is quite poor, with the highest use of accruals in at least 30 years of history.”
He went on to state that, “as the direction of inflation turns downward even as the level of inflation remains high, we think the challenges of persistent inflation will start to become clearer and we will see not only lower reported and estimated earnings, on average, but wider dispersion of earnings between companies. The fit and the not so-fit are likely to fare very differently. Those less exposed to labor and commodity costs, less exposed to rising rates through high debt levels and with more pricing power to defend margins are likelier to weather the conditions and find favor with investors, in our view.”
With this in mind, we expect to see more stock dispersion in the years ahead than we have seen in the decade prior, potentially creating a greater opportunity for active tax-loss harvesting across equity portfolios benchmarked both to a passive or an active model.
What is the potential for tax reform in 2023?
One important factor around tax management is the potential for changes to the tax code. A few tax reform proposals were discussed throughout 2022 that would impact capital gains taxes, including these three items in Joe Biden’s 2023 budget:
- Higher top rates for individual income, corporate income and capital gains income
- Ending step-up in basis by making death a taxable event
- Expanding the base of the Net Investment Income Tax (NIIT) to apply to active pass-through income and making the active pass-through business loss limitation permanent
In July, Sam Petrucci, Head of Advice, Planning and Fiduciary Services, and Frank Kelly, Founder and Managing Partner, Fulcrum Macro Advisors, discussed the landscape for tax reform based on the potential outcomes of midterm elections. Regardless of whether Republican would be able to sweep the House and Senate in the November elections, or Democrats were able to salvage a split congress, which they did with the results of the Nevada run-off, Sam at this time saw no path forward for implementing the type of tax reform outlined above, and expected any significant tax reform to be put on hold until after the 2024 Presidential election.
What action can be taken by investors in the new year?
- Just as resolutions are made for a new year, it can be helpful to set or adjust an annual capital gains budget. Within a tax-managed portfolio, this budget can be utilized to reduce portfolio risk and reset cost basis. By doing so early in the calendar year, the fresh cost basis provides increased potential for future loss harvesting.
- Revisit your plan for reducing concentrations. For clients who have concentrated stock positions with low cost basis, selling at once may provide too high of a tax bill. Creating a staged diversification plan, where the sale of the position may be done over multiple years to spread out the tax burden, in conjunction with a tax loss harvesting portfolio, can allow a smoother path to lowering risk.
- Get ahead of gifting plan to optimize the approach. We’ve spoken in the past about the value of gifting appreciated securities in lieu of cash, and while typically charitable giving conversations take place near year-end, the benefit can be realized at any point during the year. Analyzing the potential benefit of giving an optimized list of securities can serve as a helpful conversation starter.
- Systematically harvest losses throughout the year. Research has shown clients can see annualized tax alpha of 1 – 2% versus a passive index by realizing losses and deferring gains over time. If investing in active equity strategies, tax alpha can potentially add 3 – 6% annualized to a client portfolio vs. the active model.
