November 2017 What Happens to Loss Harvesting under FIFO? Paul Bouchey Chief Investment Officer One of the tax law changes proposed in the U.S. Senate bill, but not in the House of Representatives bill, would require investors to use a First In, First Out (FIFO) accounting methodology for tax lots when calculating capital gains tax. This would impact the way portfolios are managed with respect to taxes. Specifically, FIFO takes away some flexibility instead of choosing the most favorable tax lot to sell, investors are forced to sell the oldest tax lot first. Assuming the provision makes it into the final tax bill, and that Congress is able to pass the bill in the next month or so, the new rule would become effective January 1, 2018. Tax management becomes more complex under this methodology. While there will still be significant value to tax management, it will be harder to unlock and will require the specific expertise of a tax-aware manager. Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA 98101 T 206 694 5575 F 206 694 5581 parametricportfolio.com 2017 Parametric Portfolio Associates LLC.
We have been following the potential for FIFO legislation for much of 2017. Parametric Research and Strategy teams have been testing systems and processes across various market scenarios. Also, due to restrictions at a particular custodian, Parametric already manages a number of accounts under a FIFO accounting methodology. As a result, we have already built out the required systems to manage portfolios in this fashion, so we are ready should the tax laws change. We have navigated multiple tax-code changes over the past three decades, and we understand the benefit of being instantly prepared to incorporate any changes. Often there is a window of opportunity between when the law is passed and when it goes into effect that allows investors to position their portfolios for the new environment. In this case, the window could be very narrow the few weeks between Thanksgiving and the end of 2017. We are ready to maximize each client s after-tax performance in the final weeks of 2017, if and when tax-code changes become clear. How does FIFO change tax management? Based on our experience managing client portfolios and our recent research, we estimate lower tax alpha under FIFO than when using specific tax-lot identification. 1 Under current law, we expect a range of 0.7% to 2.5% estimated tax alpha, annualized over 10 years 2. If FIFO becomes law, then we would likely reduce our estimates of tax alpha to the 0.5 to 2.0% range. More research needs to be done to quantify the effects of the FIFO rule in different market conditions and for different client situations. The three reasons below help provide some basis for why there will be significant opportunities to add tax alpha under FIFO: 1) When there is only one tax lot for a security, then there is no difference between FIFO and specified tax-lot accounting. When trading baskets of stocks, especially stocks outside of the top-ten mega caps, it is very common to sell completely out of the position to realize a loss. This leaves only one tax lot when the holding is repurchased later. 2) Many of the benefits of tax-loss harvesting come from large price moves. If the loss is significant, there will usually be benefits regardless of the accounting method. 3) Realizing a long-term capital gain (from an old tax lot) to get a short-term capital loss (from a newer tax lot) creates a tax-rate arbitrage that can actually boost tax alpha. These gain realizations also refresh the cost basis, making tax-loss harvesting opportunities more likely in the future. In other words, each trade is more constrained, but across multiple time periods and trades, the opportunity for tax management is not diminished very much. 1 Tax alpha is the after-tax excess return, net of fees and any pre-tax excess returns. 2 See, for example, Tax-Efficient Investing: Tactics and Strategies, in Investments & Wealth Monitor, Jan/Feb 2015. The 0.7% to 2.5% estimated tax alpha assumes an account that starts with cash and faces typical levels of market appreciation and volatility, with after-tax returns calculated on a pre-liquidation basis. It also assumes the investor has a store of short-term capital gains that can be offset by the losses generated by this portfolio. Estimates are net of an assumed 0.35% management fee, reflect the reinvestment of dividends, but do not reflect trading costs. 2017 Parametric Portfolio Associates LLC. 2
Backtest Results As an initial test, we simulated a tax-managed U.S Large Cap account from 2010 to 2015. 3 Figure 1 shows the tax benefit is reduced from 1.25% to 1.13% annualized about 12 basis points. Figure 2 shows the year-by-year results. We are currently expanding this test and looking at different market conditions and client situations. Figure 1: Simulated Pre-tax and After-tax Returns for a Tax-Managed U.S. Large Cap Account, 2010-2015 Cumulative Annualized Specific Tax Lot Pre-tax Return 54.12% 7.48% After-tax Return 65.20 8.73 Tax Benefit/Impact 11.08 1.25 FIFO Pre-tax Return 55.27 7.61 After-tax Return 65.28 8.74 Tax Benefit/Impact 10.01 1.13 Difference (Specific vs FIFO) -1.07-0.12 Figure 2: Simulated Annual Capital Gains Tax Benefit for a Tax-Managed U.S. Large Cap Account 6% 5% 4% 3% 2% FIFO Specific Lot 1% 0% -1% 2010 2011 2012 2013 2014 2015 Source: Parametric, 2017. Simulated performance presented in Figures 1 and 2 is hypothetical and is provided for illustrative purposes only. It does not reflect the experience of any actual investor and is not intended to project or estimate the performance of any parametric strategy. Actual client returns will vary. The simulated performance is presented net of fees, but does not reflect brokerage commissions, cash flows, transaction costs, or the reinvestment of dividends. The deduction of brokerage commissions would reduce the returns presented. All investments are subject to the risk of loss. See disclosure for additional information about hypothetical performance. 3 Results assume monthly rebalancing, ignore the effect of dividends, and are net of a 0.35% management fee. The account was benchmarked against the Russell 1000 Index, with a 1% tracking error target. There were no cash flows and transaction costs or commissions. 2017 Parametric Portfolio Associates LLC. 3
Other Implications There are other implications of FIFO, beyond tax alpha. Turnover will likely be higher in tax-managed accounts. In some cases, long-term gains may need to be realized to unlock short-term capital losses. Adding cash to an appreciated portfolio will tend to increase the number of tax lots, which won t be as beneficial to tax-loss harvesting in the future as it would be under a specified tax-lot rule. Although, recently released possible FIFO tax code language reveals opportunities to maintain these benefits through account structure Another implication is that selecting tax lots for gifting will also be subject to FIFO, making it harder to push tax liability out of the portfolio (although for an account that is aggressively loss harvested, this issue will be minimized). Again, the final ultimate structure of any change may or may not restrict security gifting activities. Transitions from an existing portfolio that is highly appreciated into a tax-managed account becomes more challenging. Figure 3 shows a hypothetical transition. In this case, the portfolio had a 73% cost-basis to marketvalue ratio across 89 stocks, transitioning to a U.S. Large Cap Index. Holding the benchmark-relative risks constant, we show an increase in gain realization under FIFO. The results depend on the initial condition of the account. The high tracking error scenario was able to match gains versus losses in both specific tax-lot and in FIFO methodologies. Some investors may, therefore, consider allowing more benchmark-relative risk (tracking error) into their portfolios to counter the impact of FIFO. These results are highly dependent on the particular situation of the investor. For more highly appreciated accounts, the difference in gain realization could be greater. Figure 3: Hypothetical Transition Analysis, Specific Tax-Lot versus FIFO Low TE Mid TE High TE Specific FIFO Specific FIFO Specific FIFO Tracking Error (TE) 0.30% 0.31% 0.80% 0.80% 1.40% 1.40% Turnover (Sell) 58.00 57.91 35.72 35.42 18.92 18.66 Realized Long-Term Gain (Loss) 12.17 14.07 4.90 5.69 0.05 0.18 Realized Short-Term Gain (Loss) 0.61 0.50-0.17-0.17-0.24-0.22 Realized Net Gain (Loss) 12.79 14.56 4.73 5.51-0.19-0.04 Difference in Realized Net Gain (Loss) 1.77% 0.78% 0.15% Source: Parametric 2017. The scenario presented is hypothetical and is provided for illustration purposes. It does not reflect the experience of any investor and should not be used for investment decisions. Actual client results will vary. The simulated performance is presented net of fees (35 bps) but does not reflect the reinvestment of dividends and the cost of brokerage commissions. The deduction of brokerage commissions would reduce the returns presented. All investments are subject to the risk of loss. See disclosure for additional information about hypothetical performance. 2017 Parametric Portfolio Associates LLC. 4
2017 Year-End Planning Investors often think about charitable giving and tax-loss harvesting at year end. This year, these activities may be especially important because we can still specify tax lots for gifting or loss harvesting. Conclusion As noted earlier, more research needs to be done to quantify the effects of the proposed FIFO rule in different market conditions and for different client situations. Despite the potential pending changes, the basics of tax management still apply: Avoid realizing short-term gains Defer long-term gains as long as possible to earn a compounding benefit Accelerate the realization of tax losses (to offset those realized gains that are unavoidable) Pay attention to your holding period to honor the wash-sale rule and the qualified-dividend rule For portfolios with options and derivatives, pay attention to the straddle rules Congress hasn t shared the actual language in the legislation yet, and changes are being made to the proposals daily. If FIFO is put into place, portfolio managers will need to balance the benefits of harvesting a loss against the potential gains required to get through the older tax lots. While this adds some additional complexity to tax management, paying attention to taxes is still a source of significant value to investors. Disclosures Parametric Portfolio Associates LLC ( Parametric ), headquartered in Seattle, Wash., is registered as an investment adviser with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. Parametric is a leading global asset management firm, providing investment strategies and customized exposure management directly to institutional investors and indirectly to individual investors through financial intermediaries. Parametric offers a variety of rules-based investment strategies including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future results. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax 2017 Parametric Portfolio Associates LLC. 5
and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Charts, graphs and other visual presentations and text information were derived from internal, proprietary, and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including, but not limited to, Bloomberg, MSCI/Barra, FactSet, and/or other systems and programs. Parametric makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party. This material contains hypothetical, back-tested and/or model performance data, which may not be relied upon for investment decisions. Hypothetical, back-tested and/or model performance results have many inherent limitations, some of which are described below. Hypothetical returns are unaudited, are calculated in U.S. dollars using the internal rate of return, may reflect the reinvestment of dividends, income and other distributions, but may exclude transaction costs, advisory fees and do not take individual investor taxes into consideration. The deduction of such fees would reduce the results shown. Model/target portfolio information presented, including, but not limited to, objectives, allocations and portfolio characteristics, is intended to provide a general example of the implementation of the strategy and no representation is being made that any client account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, simulated trading does not involve financial risk, and no simulated trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Because there may be no actual trading results to compare to the hypothetical, back-tested and/or model performance results, clients should be particularly wary of placing undue reliance on these hypothetical results. Perspectives, opinions and testing data may change without notice. Detailed back-tested and/or model portfolio data is available upon request. No security, discipline or process is profitable all of the time. There is always the possibility of loss of investment. When calculating after-tax returns, Parametric applies the client s individual tax rate (which may include federal and state income taxes), if provided by the client. If the individual tax rate is not provided by the client, Parametric applies the highest U.S. federal tax rates. For shortterm gains, the highest U.S. federal marginal income tax rate is 39.6% plus the 3.8% net investment income tax, for a combined rate of 43.4%. For long-term gains, the highest U.S. capital gains tax rate is 20% plus the 3.8% net investment income tax, for a combined rate of 23.8%. These assumed tax rates are applied to both net realized gains and losses in the portfolio. Applying the highest rate may cause the after-tax performance shown to be different than an investor s actual experience. Investors actual tax rates, the presence of current or future capital loss carry forwards, and other investor tax circumstances will cause an investor's actual after-tax performance to be over or under Parametric s estimates presented here. In periods when net realized losses exceed net realized gains, applying the highest tax rates to our calculations illustrates the highest after-tax return that could be expected of the portfolio, and assumes the maximum potential tax benefit was derived. Actual client after-tax returns will vary. As with all after-tax performance, the after-tax performance reported here is an estimate. In particular, it has been assumed that the investor has, or will have sufficient capital gains from sources outside of this portfolio to fully offset any net capital losses realized, and any resulting tax benefit has been included in Parametric s computation of after-tax performance. All contents copyright 2017 Parametric Portfolio Associates LLC. All rights reserved. Parametric Portfolio Associates, PIOS, and Parametric with the iris flower logo are all trademarks registered in the US Patent and Trademark Office. Parametric is located at 1918 8th Avenue, Suite 3100, Seattle, WA 98101. For more information regarding Parametric and its investment strategies, or to request a copy of Parametric s Form ADV, please contact us at 206.694.5575 or visit our website, www.parametricportfolio.com. 2017 Parametric Portfolio Associates LLC. 6