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Highfliers Drive Market Returns. Losers Drive Tax Alpha.

Active Tax Management
February 23, 2021

The S&P 500 Index return was up 18.4% in 2020, even though 95% of its constituents experienced a drawdown of more than 10%. This is not, however, just another crazy thing that happened in 2020. As we show in Figure 1, the pairing of strong US large-cap index performance (blue dots) with large drawdowns to most index constituents (gray bars) has been the norm and not the exception since 1975. The S&P 500 return was positive in 38 of 46 years since 1975, while more than half the S&P 500 constituents had a drawdown larger than 10% in 41 of those years. This suggests that the S&P 500 Index growth of 12% per year since 1975 has been driven, at any given time, by a small number of exceptional performers, while many stocks have languished or suffered catastrophic losses.1

The characteristics of the strongest performers have varied over time. Technology companies dominated the market in 2020, with Facebook, Amazon, Apple, Microsoft, and Google (FAAMG stocks) accounting for 16% of the S&P 500 by capitalization as of December 31, 2020. Excluding FAAMGs from the S&P 500 Index would have diminished the 2020 return from 18.4% to 10.8%.2 Similarly, the energy sector had stellar performance in 1980, with Exxon, Schlumberger, Shell, Mobil, Chevron, Atlantic Richfield, Texaco, and Halliburton accounting for 15.9% of the S&P 500 by capitalization on December 31, 1980. Excluding them from the index would have dropped its 1980 return from 31.4% to 25.1%.

A broad market that exhibits strong growth, even as many constituents undergo declines, may be good for tax-managed investing. The abundant supply of drawdowns helps facilitate harvesting of tax-liability-reducing losses, while the depth and breadth of the market provide the substitutability that allows for tight index tracking. At the same time, reinvestment of the tax savings into US equities compounds in the market updraft.

Figure 1: Annual return at year-end of the S&P 500 Index (blue dots) and the fraction of index constituents with a drawdown exceeding 10% (gray bars). Source: Aperio Group.


At Aperio, we measure the benefits of loss harvesting with tax alpha, the difference between portfolio return and benchmark return after tax. In the absence of management, tax alpha can easily be negative,3 but loss harvesting typically turns that around for an investor with realized gains to offset. As an example, Aperio’s US Large-Cap Composite, which accounted for more than $1.36 billion across 247 accounts benchmarked to the S&P 500 as of December 31, 2020, delivered 3.46% in tax alpha, even as the S&P 500 Index was up 18.4%.

What will tax alpha look like in the future? It is possible, of course, that S&P 500 Index returns will be disappointing relative to recent experience. Severe drawdowns to index constituents may become scarce, making it more difficult to harvest losses. However, if the US market continues to be risky, and if that risk is rewarded even a little, tax-managed index tracking may continue as a cornerstone of wealth generation for a taxable investor.


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1 Hendrik Bessembinder, “Do Stocks Outperform Treasury Bills?”Journal of Financial Economics 129, no. 3 (2018): 440–57. Michael Cembalest, “The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position,” J.P. Morgan Eye on the Market (2014).
2 We excluded Facebook, Amazon, Apple, Microsoft, and Google from the S&P 500 while keeping holdings of other member securities unchanged. We then rescaled the weights so that total weights for the index was 100%.
3 Patrick Geddes, “Adding Insult to Injury: The 2015 Tax Penalty for Active Management,” Aperio Research (2015).

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