The second quarter of 2022 saw continued volatility as markets wobbled back and forth digesting interest rate moves and recessionary concerns. Both stock and bond markets are well off their highs, a twin performance drag that rarely has this level of intensity. Below is a brief summary of what happened in financial markets between April 1 and June 30, 2022, followed by some perspective on markets in both the present and the future.
First quarter pain continued through the second as the S&P 500 finished Q2 at -16.1% and the Russell 3000 dropped -16.7%. International markets were slightly more resilient but still fell with the MSCI EAFE -14.5% and the MSCI Emerging Market Index -11.5%. Value stocks outperformed growth stocks, and large stocks edged out small stocks.
Year-to-date, equity market performance has been punitive. The S&P 500 fell -20.0% and the Russell 3000 tumbled -21.1%. Internationally, returns have edged out their domestic peers with the MSCI EAFE down -19.6% and Emerging Markets shedding -17.6%. Value stocks continue to beat out growth stocks, and large stocks are outpacing small stocks.
In fixed income markets for the second quarter, the yield curve shifted as both short and long yields rose. Corporate spreads widened. Bond performance still struggled this quarter on the back of rising rates with the core US government and credit market -2.4%, outperforming global bonds and high yield credit.
Year-to-date, fixed income has fallen in historic fashion. The yield curve has shifted up and flattened as short rates rose substantially more than long rates. Corporate spreads have been volatile but widening. So far in 2022, the core US government and credit market has dived -6.8% with global bonds and high yield credit falling even farther.
A clear takeaway from the Market Review section is that the “snapshot” of current asset prices compared to those of late 2021 is not exactly a “rosy” picture. However, selloffs like this give prudent Portfolio Managers a unique opportunity to add value for their clients through tax-loss harvesting.
Tax-Loss Harvesting: The Long and Short of It
The goal of tax-loss harvesting is to take advantage of a negative price move in an investment in order to create a tax-loss capable of reducing capital gains in the current tax year or a future tax year; thereby, reducing what a client pays in taxes. A secondary goal of the process is ensuring that the client’s overall asset allocation and portfolio risk characteristics do not change as a result of the action. This opportunity can present itself during wide-spread market declines as well as during individual stock or bond selloffs.
Given the backdrop of recent market moves, WoodTrust’s Portfolio Managers are taking value-additive action in the tax-loss space. Therefore, it is helpful for investors to know the types of actions being taken and the methodology behind them.
The Mechanics of a Successful Tax-Loss Harvest
As noted, tax-loss harvesting works when two key points are satisfied: 1. a loss is realized and 2. the proceeds from that loss sale are reinvested in a way that maintains a similar level of risk for the client.
For the sake of this exercise, assume a client owns 1,000 shares of ABC Company that he or she bought a few years ago. ABC Company is a nation-wide consumable and durable goods retailer. Since buying shares of ABC, the stock price has been pretty stable. Unfortunately, due to a slow Spring, the company sold less toys than expected for Q2 and the stock price went from $100 (the price at which the client purchased the shares) to $80.
Following the selloff, the client’s Portfolio Manager worked with WoodTrust’s Investment Committee to decide whether or not the Committee still had confidence in the long-term prospects of the company. After substantial due diligence, the Committee affirmed its confidence in owning the stock long-term. The Portfolio Manager then decided this would be a good opportunity to offset some of the $25,000 in capital gains that the client had realized year-to-date by tax-loss harvesting ABC Company’s shares. The Portfolio Manager sold 1,000 shares on behalf of the client for $80,000 in total ($80/sh x 1,000sh = $80,000). This realized a loss of $20,000 ($80,000 sale – $100,000 purchase), taking the yearly capital gains for the client to $5,000 ($25,000 – $20,000); saving the client $4,000 in taxes ($20,000 gain x 20% tax rate).
Since the Investment Committee likes ABC Company long-term, the Portfolio Manager only wants to sell the shares for long enough to realize the loss – the IRS denotes this time period as 30 days. Unfortunately, ABC Company makes up a large portion of the client’s stock allocation, and letting the proceeds of the sale sit in cash for 30 days would impair his or her asset allocation, possibly hindering long-term portfolio growth potential. Consequently, the Portfolio Manager must find somewhere to invest those proceeds for the 30 day “wash sale” period to satisfy the second point in the Mechanics of a Successful Tax-Loss Harvest.
The most important part of this “placeholder” asset is that it has similar risk characteristics and correlation to the asset that the Portfolio Manager is tax-loss harvesting. This means that the Portfolio Manager would not want to buy a bond with the proceeds of the sale because the risk profile associated with a bond is quite different than that of ABC Company’s stock. On the contrary, the Portfolio Manager may look toward buying a low cost, broad stock market ETF (exchange traded fund) to hold for 30 days as it will likely have similar price performance to ABC Company. The Portfolio Manager buys $80,000 of Total Stock Market ETF on behalf of the client and waits 30 days.
Upon the completion of the 30-day period, the Portfolio Manager sells Total Stock Market ETF which has appreciated a bit for $81,000. ABC Company has also appreciated slightly and now trades at $81/sh. The Portfolio Manager uses the $81,000 to buy back 1,000 shares of ABC Company and completes the tax loss harvest.
Now, the client once again owns 1,000 shares of ABC Company which WoodTrust’s Investment Committee believes will perform well in the long-term. Additionally, the client has saved $4,000 in taxes without ever deviating from their target asset allocation. The prudent Portfolio Manager has added value for their client.
Tax-loss harvesting is a clear, quantifiable way that Portfolio Managers can make a difference for their clients. WoodTrust prides itself on not only fulfilling the intangibles of investment and trust advisory but also capitalizing on any chance to create clear, tangible value.
We remind you that even during times of market turmoil, there is often action to be taken and opportunity to be had. Your WoodTrust service team is looking to do just that. As always, we thank you for your trust and look forward to our meetings with you in the near future.