Taxes are one of the certainties in our lives.  Their implications factor into many decisions that investors face when allocating and modifying their portfolio.  Yet, they are not often mentioned when talking about tactical trading strategies.

Three possible ways to reduce the impact that taxes may have on tactical portfolios are:

1. Holding the investments in tax deferred or tax exempt accounts (IRAs, 401(k)s, etc.) – This makes taxes a non-issue until you begin to make withdrawals.

2. Reducing the turnover of the strategy – This is Newfound’s primary method of reducing the tax impact on a portfolio.  Our strategies aim to strike a balance between capitalizing on opportunities for outperformance and turnover/trading frequency.  This also reduces transaction costs and avoids triggering wash sales.

3. Factoring tax impacts into trading decisions – Looking at the cost/benefit of trading now versus waiting until more favorable tax treatment can significantly increase returns.

1 and 2 are fairly self explanatory, but 3 deserves more attention.

With the many nuances of the US tax code, making an optimal trading decision is often difficult.  We will explore some more in depth ways of looking at this issue in a forthcoming whitepaper referenced here, but for now, let’s look at a simple example to see the impact of waiting.  The following chart shows the profit (or loss) realized if you have held SPY for one week shy of a year and wait an extra week to sell it (and hence pay taxes on long-term capital gains) versus selling it immediately (and paying taxes on the short-term capital gain).  For this specific example, we used a 35% short-term capital gains rate and 15% long-term capital gains rate.  The same analysis could be applied to any tax rate pair.

SPY Taxes Waiting

Now we all know that qualifying for a lower tax rate is much better than a higher one on similar gains.  This is where there is value in waiting, value that was as high as 15% in this example and 1.8% on average.  However, when there are losses (2001 to 2003 and 2008 to mid-2009), selling before the lower tax rate kicks in at the one-year holding anniversary is advantageous since it can offset other short-term gains or ordinary income.  These opportunities were worth as much as 15% in this example.

The graph also illustrates how the decision can vary from week to week during periods such as 2005 to 2006 and mid-2011 to mid-2012, indicating that the outcome is very sensitive to specific characteristics of the tax lot under consideration.

So when do we actually execute our trades given by our tactical strategy?  The answer is a resounding: it depends.  We must be aware of our different tax lots and sell them efficiently; we must be cognizant of the wash sale rules (e.g. if you recently purchased VOO in a retirement account, even a spouse’s account, selling SPY at a loss may not qualify as a deduction); and perhaps most importantly, we must understand and be able to quantify the value added by the model’s decision to act immediately.

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.