Speaking about broad market returns for the more popular indexes like the S&P 500 or the Dow Jones Industrial Average often masks what happens within the equity market. Consider last year when the S&P 500 Index was up 18.4%. This very attractive double-digit annual return likely gave investors the impression everything must have been up.
Looking at actual constituent returns reveals a fuller story. Exhibit 1 shows the range of returns across the index for the year. The exhibit is sorted by market capitalization size left to right. For the year, there were just over 300 stocks with positive returns and 191 names with negative returns. It takes all ~500 names and market capitalizations to equal the total return of 18.4%.
An active tax-managed approach provides a process to capitalize on these return disparities. And one cannot assume that a stock that was positive for the full year was positive throughout the full year. An active approach allows for an analytical, systematic framework to understand the costs to include—trading costs, tax costs, tracking error and more. These trades can’t be done just to avoid a tax. Having a 0% return and $0 tax bill is not a path to successful attractive after-tax outcomes. Professionals can perform this analysis on every trade throughout the year.
Helping Investors
Whether tax rates change or not, we know taxable distributions from capital gains and income erode an investor’s return. Many investors are not taking these tax headwinds into account when making their investment-selection and asset-location decisions. Making informed decisions on tax-managed offerings can make a meaningful difference for client investment outcomes.
1. 7% distribution based on Morningstar broad category “U.S. Equity,” which includes mutual funds and ETFs (and multiple share classes). % = Calendar Year Cap Gain Distributions/Yr-End NAV. Includes all share classes. 2. S&P 500 Index.
Frank Pape, CFA, CPA., is the Senior Director of Portfolio Consulting at Russell Investments, which has an extensive tax-managed function that works closely with financial advisors to best manage their portfolios from a tax perspective.