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, industries, sectors, and countries. 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.1 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.
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.
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.
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%.7 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.”