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Big Returns from the ‘Magnificent 7’ Complicate Year-End Tax Planning

By John Manganaro

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What You Need to Know

  • Though markets have performed better this year than last, excess returns have been concentrated among some big names.
  • Portfolio managers who incorporate tax mitigation into the investment process have had to strike a balance.
  • Managers and advisors are hearing more questions about tracking error and other client concerns.

There is no question that the market conditions enjoyed by investors so far in 2023 have been far superior to those in 2022, even with lingering volatility and big questions still being asked about high inflation and rising interest rates.

The reprieve has been welcomed by investors and financial advisors, says Jeremy Milleson, director of investment strategy at Parametric Portfolio Associates, but that doesn’t mean this year has been without its challenges. Among these, Milleson says, has been the concentrated outperformance among a handful of big-name companies, especially earlier in the year.

As Milleson recently told ThinkAdvisor, positive performance is always welcome in a portfolio, but one must take care to understand where the performance is coming from and what it looks like at a granular, stock-by-stock level — especially if one sees tax mitigation as an important goal in the investment management process.

Milleson says portfolio managers at Parametric are asking just such questions as the end of the year quickly comes into view, and the answers are helping them to understand when, why and how to engage in tax-loss harvesting efforts.

It’s challenging and engaging work, Milleson says, but the results should deliver added value to clients who are expecting their advisors and managers to help them reduce taxes while maintaining access to the market’s full upside.

A Better, if Uneven, Year for Stocks

As Milleson recalls, this year has seen very strong performance from a number of big-name stocks, many (but not all) of them in the technology sector, while the broader market as represented by the S&P 500 has enjoyed more muted gains — including a roughly 3% drop in the third quarter.

So, while performance is up overall, much of that performance has been centered around a relatively limited number of companies, and there are still plenty of positions with negative returns.

“The so-called ‘Magnificent 7,’ for example, saw very strong performance so far for the year,” Milleson explains, referring to the grouping of Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla and Meta. “Their performance has moderated more recently, but they have still posted very solid gains for the year.”

The result of this dynamic, Milleson suggests, is that any investors whose portfolio strategies have seen them underweight these key names have seen their performance lag significantly behind the full market index.

A related result is that investors who are pursuing tax-mitigation techniques in their portfolios, such as tax-loss harvesting, have had to be more strategic about where they are sourcing said losses.

“This year has been a good test case for why harvesting losses throughout the year should be a consideration for investors who are using separately managed accounts and direct indexing,” Milleson says. “This approach gives you the opportunity to own the underlying assets directly, so the whole market doesn’t have to be up or down at a given moment for you to take advantage of potentially short-lived opportunities in different parts of the portfolio.”

By the end of this year, the full market could likely be up, Milleson says, so “grabbing losses along the way” is going to be prudent.

How Concentrated Performance Affects Tax Management

As Milleson explains, these mixed market dynamics add a layer of complexity to the already sizable job of effective tax-loss harvesting in direct indexed portfolios and separately managed accounts.

“Remember, when we are tax-loss harvesting, we are selling out of names that are standing at a loss and thereby effectively trimming those names down so they are underweight to the benchmark,” Milleson notes. “The question then becomes about just how much you want to sell down those names, especially when they are the biggest components of the underlying index and the biggest potential driver of performance looking forward.”

Take Tesla, for example. The mega-cap company has been among the best performers in 2023, far outshining many other constituents in the S&P 500 index. Were a portfolio manager to have reduced their position in Tesla earlier in the year during a period of weaker performance, for example when its price fell between March and April, they would subsequently have seen their performance deteriorate meaningfully relative to the benchmark.

“So, as portfolio managers, we have to think hard about the big names throughout our process,” Milleson explains. “We like to say that we take a belt and suspenders approach, meaning we aren’t just trying to minimize tracking error and maximize tax benefits.”

Instead, the firm is also controlling its exposures at the security level, the sector level and the industry level, and it brings in risk factors as well, which means that ultimately, Parametric’s managers limit their underweight positions to those names that are big and volatile even as they pursue loss-harvesting opportunities.

“That’s been really important for performance this year,” he says. “With the way some of the biggest names have been whipsawing, it has been key from a performance perspective to maintain tight risk bounds around those positions.”

Better Defining Tracking Error

Milleson says another big topic for advisors and managers who leverage direct indexing to address as the fourth quarter unfolds is tracking error — helping clients understand what it is, and perhaps more importantly, what it isn’t. It’s a topic he addressed at length in a recent blog post.

According to Milleson, few terms set off more alarm bells with investors than “taxes” and “tracking error.” Investors in separately managed accounts find themselves hearing these hot-button words from their advisors on a regular basis, he notes, but the relationship between the two is often misunderstood.

“It is vital to help clients manage their taxes while also understanding the role that tracking error plays in potentially lowering their tax burden,” Milleson writes. “Once investors understand how tax management and tracking error work hand in hand, the alarm bells fade away.”

Simply put, by choosing to use a tax-managed SMA, investors will inevitably experience tracking error. This may be an uncomfortable concept for investors who don’t want an “error” showing up in their portfolio, Milleson says, but tracking error in itself isn’t necessarily good or bad.

“It merely measures how closely a portfolio tracks its benchmark,” Milleson explains.

By managing a portfolio to harvest losses, transition assets tax efficiently or realize gains, an SMA inevitably diverges from its stated benchmark, resulting in tracking error. What is key for investors to understand is that this “error” can spell excess performance on an after-tax basis, assuming the manager plays their cards right.

“Again, the key concept to understand is that the tax-managed portfolio naturally underweights those particular securities that have underperformed relative to the benchmark,” Milleson says. “We also see a natural deviation from the benchmark in the opposite case, if an investor decides to hold an appreciated security to defer the realization of a gain. In this case the portfolio may hold those securities at an overweight position relative to the benchmark.”

The bottom line, Milleson writes, is that customizing a portfolio through tax management inevitably leads to tracking error, but advisors can work with clients to strike a comfortable balance between a portfolio’s tax-management techniques and its deviation from the benchmark.

“At the end of the day, while tax-managed portfolios may result in tracking error, they also have the potential to allow investors to keep more of their money invested while seeking to maximize after-tax returns,” he concludes.

Credit: Adobe Stock 

John Manganaro

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