SMAs at Work: A Smarter Approach to Tax Loss Harvesting


Dimensional separately managed accounts (SMAs) are robust investment solutions that can help investors meet their financial goals while also incorporating customized tax management; personal environmental, social, and governance preferences; and flexibility around individual securities and sectors. For investors who opt for standard or aggressive tax management in their SMAs, Dimensional will harvest capital losses as part of the daily implementation process. However, we do not blindly go for every possible dollar or cent of tax loss harvesting. As with everything we do, we view tax loss harvesting through the prism of expected returns, costs, and risks, with the ultimate goal of improving after-tax returns. Tax loss harvesting focuses on losses where the potential tax benefits are not likely to be outweighed by expected trading costs or a drop in diversification.Tax loss harvesting also seeks to support the systematic pursuit of higher expected returns.

Dimensional has been applying this thoughtful loss harvesting approach to tax-managed separate accounts for over 20 years. To show how this approach works in the real world, let’s examine a live tax-managed separate account in the spring of 2020,2 a volatile period for the stock market. This account holds US large cap equities, overweighting stocks with higher expected returns (stocks with smaller market capitalizations, lower relative prices, and higher profitability). The portfolio is benchmarked against the S&P 500 Index.

At the beginning of 2020, the portfolio had high overlap (86.6%) with the US large cap core equity investment universe, indicating that the portfolio was providing the investor with the desired equity exposure.3 The portfolio also had unrealized gains totaling 15% of the account value. 

In March 2020, the S&P 500 Index declined 33.8% from its high five weeks earlier on February 19, 2020.4 In addition, equities in the US were characterized by above-average market volatility and cross-sectional dispersion in returns, as seen in Exhibit 1.
 

Exhibit 1

Wow Factors

Market volatility and cross-sectional returns dispersion in US, January 1994–December 2020

Past performance, including hypothetical performance, is no guarantee of future results. Actual investment returns may be lower. Monthly cross-sectional dispersion is defined as the cross-sectional standard deviation of stock returns over one month, where each stock is weighted by its relative market capitalization. Daily volatility data is expressed in monthly terms by multiplying the computed daily return volatility each month by the square root of the number of observations in a month. We assume 21 trading days in a month. The US market includes all cap US equities with market cap ≥ $10 million meeting minimum listing and liquidity requirements. The market universe is rebalanced quarterly. Dimensional calculations from data provided by Bloomberg and Thomson Reuters. Filters were applied to data retroactively and with the benefit of hindsight. Groups of stocks and their returns are hypothetical, are not representative of indices, actual investments, or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual investment.



This market turbulence provided an opportunity to harvest losses in the US large cap core equity separate account. Indeed, monthly turnover increased from a normal level of around 0.25% in the first two months of 2020 to a high of 5.7% in April 2020. As turnover increased, so did losses harvested, as shown in Exhibit 2.5 By the end of May 2020, the portfolio had realized capital losses that represented 9% of the assets in the account.
 

exhibit 2

Quick Turn

Monthly realized gains (losses) and portfolio turnover, 2020

Realized gains and losses determined as a percent of beginning of month assets. Monthly turnover computed as lesser of buys and sells over the month, divided by beginning of month assets.



During this period of extremely high market volatility, stocks with low relative prices and smaller market capitalizations underperformed their peers. A naive portfolio management approach may have simply maximized loss harvesting and sold out of these stocks, tilting the portfolio toward large growth stocks that had fewer losses. Dimensional’s approach, however, used proceeds generated from harvesting losses to maintain an emphasis on stocks with higher expected returns. This can be seen in Exhibit 3: Monthly overlap with the US large cap core equity investment universe remained steady over 2020, while the portfolio also realized 9.7% of assets in losses over the year. For a $1 million portfolio, this would equate to $97,000 in realized losses.
 

exhibit 3

Going Steady

Loss harvesting and overlap, 2020

Monthly turnover computed as lesser of buys and sells over the month, divided by beginning of month assets. Overlap computed at the end of each month as the minimum weight of stocks held in common across the account and the US large cap core equity investment universe. Monthly realized gains and losses determined as a percent of beginning of month assets. The US large cap core equity investment universe used for comparison against the portfolio is based on a customized strategy. This customized strategy focuses on eligible US large cap stocks, defined as approximately the top 90% of the eligible universe in the US. Within this universe, the strategy emphasizes stocks with higher expected returns (lower market capitalization, lower relative price and higher profitability). The strategy excludes REITs and PFICs.


The consistent and accurate focus on known drivers of higher expected returns paid off. Following the market downturn in March 2020, the portfolio outperformed its benchmark by 1.8% net of fees from April through December 2020, returning 49.0% vs. 47.3% for the S&P 500 Index.6 The outperformance was primarily driven by the size premium. From April 2020 through December 2020, mid cap stocks in the US handily outpaced their larger peers. For example, the Russell Midcap Index beat out the Russell Top 200 Index by 11.9% over that period.

With the portfolio’s continued emphasis on targeting reliable equity premiums, the value premium also contributed to outperformance in the latter part of 2020. From September to December 2020, for example, both the value premium and the size premium were positive, with large cap value stocks beating large cap growth stocks by 7.2% and mid caps outperforming the largest US stocks by 10.6%.Over this period, the portfolio returned 8.6% net of fees, outperforming its benchmark by 0.7%.8

The goal of Dimensional’s multifaceted tax management approach is to pursue higher after-tax returns, not just harvest losses. As a result, we seek to balance tax loss harvesting opportunities with an emphasis on equity premiums. In contrast, an approach that harvests losses but does not consider the portfolio’s overall investment objective may have left investors disappointed come December 2020.

For more on Dimensional’s approach to multifaceted tax management, see our forthcoming white papers “Beyond Tax Loss Harvesting” and “Multifaceted Tax Management.”



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Footnotes

  1. 1Dimensional’s tax management process applies the highest marginal tax rates in the evaluation of potential tax benefits. Actual tax rates depend on an individual investor’s particular tax situation and may differ from those used in this analysis, sometimes significantly.

  2. 2Please see Methodology appendix for additional information on the analysis shown.

  3. 3Overlap measures the proportion of the starting strategy that ends up in the personalized investment solution. The greater the overlap between the two, the lower the expected deviation in returns. For additional discussion, see Kaitlin Hendrix, “SMAs: Measuring the Impact of Personalization” (white paper, Dimensional Fund Advisors, 2021). The US large cap core equity investment universe used for comparison against the portfolio is based on a customized strategy. This customized strategy focuses on eligible US large cap stocks, defined as approximately the top 90% of the eligible universe in the US. Within this universe, the strategy emphasizes stocks with higher expected returns (lower market capitalization, lower relative price and higher profitability). The strategy excludes REITs and PFICs.

  4. 4S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.

  5. 5In some months, realized losses exceed turnover. This may happen, for example, if the portfolio buys a stock for $10, the stock price declines, and the portfolio then sells the stock for $2. In this case, the portfolio realizes $8 in losses and $2 in turnover.

  6. 6Other separate accounts managed by Dimensional with similar strategies, tenure, and tax objectives experienced similar outcomes. A portfolio with a similar strategy incepted at a different time may have experienced a different outcome. Numbers are rounded.

  7. 7From April through December 2020, the Russell Top 200 Index returned 48.7% and the Russell Midcap Index returned 60.6%. From September through December 2020, the Russell 1000 Value Index returned 13.4% and the Russell 1000 Growth Index returned 6.2%. From September through December 2020, the Russell Midcap Index returned 17.6% and the Russell Top 200 Index returned 6.9%. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

  8. 8From September through December 2020, the portfolio returned 8.6% net of fees and the S&P 500 Index returned 7.9%. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global.

methodology

The sample account used in the case study was incepted prior to Dimensional expanding the SMA offering to accounts with funding minimums of $500,000. The strategies available to the accounts with lower funding minimums were not available when the sample account was incepted. The account was chosen on the basis of it being the most recently incepted tax-managed strategy currently managed by Dimensional that most closely resembles the Dimensional SMA US Large Cap Core Equity Strategy based on eligible investment universe and investment objective and that was incepted and fully funded prior to 2020, to examine the market volatility in first quarter 2020. Account size, investible universe, investment strategy, cost basis, and investor customizations can impact the tax management of an account. The results experienced by this account may not be representative of the results of other accounts. The results are no guarantee of future performance or success. Actual results will vary.

Glossary

Cross-sectional return dispersion: Measure of the distribution of returns of individual stocks over a given period. Higher cross-sectional dispersion indicates a wider distribution of returns.

Expected return: The percentage increase in value a person may anticipate from an investment based on the level of risk associated with the investment, calculated as the mean value of the probability distribution of possible returns.

Market capitalization: The total market value of a company’s outstanding shares, computed as price times shares outstanding.

Overlap: Measures the minimum security weight in common between two investment universes, for example the proportion of a starting strategy that ends up in a personalized investment solution. 

Premium: A return difference between two assets or portfolios.

Profitability: A company’s operating income before depreciation and amortization minus interest expense scaled by book equity.

Relative price: Refers to a company’s price, or the market value of its equity, in relation to another measure of economic value, such as book value.

Separately managed account: An investment vehicle in which investors directly own the securities held in individual custody accounts.

Turnover: Measures the portion of securities in a portfolio that are bought and sold over a period of time.

Disclosures

Dimensional Fund Advisors does not provide tax services or tax advice. We recommend investors consult with their tax professionals regarding their individual circumstances.

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. There is no guarantee strategies will be successful.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.