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A Guide to ESG Portfolio Construction

In this article, the authors explore six quantitative environmental (E), social (S), and governance (G) strategies to provide insights into best practices for ESG portfolio construction. These strategies offer different approaches to the trade-off between desired ESG attributes and investment performance. They conclude that fully understanding the dynamics of these trade-offs will allow investors to select the strategy that best matches their ethical and financial views.
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Loss Harvesting with Inflation-Adjusted Gains

Taotai Cai
Active Tax Management
by Ben Schneider & Taotao Cai
October 6, 2020

aperio tax economics


In a White House press briefing in August, US President Donald Trump said he is “considering a capital gains tax cut.” While the administration has discussed a straightforward reduction of the long-term capital gains rate, the impact of such a change on the value created from loss harvesting is not particularly blogworthy.1

Furthermore, analysts were quick to observe that reducing the capital gains rate would require support from Congress but that indexing capital gains to inflation2 had the potential to accomplish the same objective and may be achievable via executive order.

The impact of taxing inflation-adjusted gains (IAG) is not as clear as the effect of directly changing the capital gains rate. So, in the same spirit as our previous post on Biden’s proposal, we used our After-Tax Back-Testing Analysis Tool to get a sense of the magnitude of the impact IAG might have had on historical after-tax performance.

Methodology

We ran an index-tracking strategy with the Russell 1000 Index as both the benchmark and the universe from which we purchased securities. By staggering the start date, we generated multiple runs of the strategy under the current and IAG tax regimes started January 31, 1987, and ended August 31, 2020, applying current top marginal federal capital gains rates3 in calculating after-tax active return. We then looked at the performance over the first five, 10, and 20 years of the strategy and averaged the results across those different back-tests. Under the IAG regime, we used the consumer price index (CPI) to adjust the cost basis of the tax lots for inflation before each rebalance.

Observations

The charts below show the annualized average after-tax active return at various investment horizons for both Estate/Donation and Liquidation scenarios. As a reminder, the former scenario assumes no capital gains tax will be owed on unrealized gains at the end of the investment period, while the latter assumes the portfolio is moved to cash, which would realize all gains and losses and trigger capital gains taxes.

The general observation is that the IAG Regime resulted in higher average after-tax performance under both scenarios and across all time horizons, with the effect being more pronounced under the Estate/Donation scenario. This result makes sense: if inflation is generally positive over the investment period, then a portfolio’s cost basis would also increase, which would increase loss-harvesting opportunities. But what if inflation is not positive?

Deflationary environments are closely linked to economic recessions. If we assume the IAG proposal is symmetric in its treatment of the cost basis, then deflation would have the opposite effect: decreased cost basis and decreased loss-harvesting opportunities. Indeed, when we examined our back-tests, we found the IAG portfolio with the worst after-tax performance at a 10-year horizon was the one incepted on June 30, 2008, in the midst of the global financial crisis. Its after-tax performance underperformed the same Current Regime portfolio by 0.13% (annualized).

Conclusion

It is worth restating that tax proposals seldom become law in their original form, and we encourage investors to consider the broader impact of tax law changes beyond their impact on loss harvesting. Indexing capital gains to inflation could accomplish the intended objective of reducing the tax on capital gains, but without additional rules, it could prove to be a double-edged sword.

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Send questions or comments to blog@aperiogroup.com.

1 The expected tax benefit from loss-harvesting strategies is proportional to the capital gains rates. That is, if the capital gains rates were reduced by 25%, the expected tax benefit would also be reduced by 25%.
2 Indexing capital gains to inflation is another idea that has been discussed for some time.
3 Short-term: 40.8%; Long-term: 23.8%. These rates include the 3.8% Medicare surcharge (Net Investment Income Tax).

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock [Aperio] to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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