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Summary

  • When carried through a traditional mean-variance optimization process, J.P. Morgan’s capital market assumptions imply a significant overweight to satellite bonds.
  • Many portfolios have significant capital gains as a result of strong equity and fixed income markets over the last 30+ years.
  • However, be careful before dismissing the possibility of rebalancing a portfolio based upon current asset class outlooks on the basis of tax concerns without thorough investigation. The return outlook for core asset classes, especially U.S. stocks and bonds, suggest that there may be an opportunity to improve client outcomes by incorporating other exposures, even if that means paying a sizable tax bill upfront.

Two weeks ago, (J.P. Morgan Outlook Implies Satellite Bonds Are King), we evaluated the portfolio allocation implications of J.P. Morgan’s current capital market assumptions.

When carried through a portfolio optimization process, J.P. Morgan’s assumptions for major asset class returns, volatilities, and correlations point squarely in one direction: the opportunities for both return enhancement and risk mitigation lie beyond traditional stock and bond portfolios.  In the allocation scheme designed to match the volatility of a traditional 60/40 stock/bond portfolio, U.S. equities received only a 2% allocation, while satellite fixed income received a cumulative 57% recommendation.

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We received several emails about the results of this commentary, all raising points we thought were worth addressing.  To paraphrase the most common two lines of questions:

  1. “How can I account for the fact that my clients benchmark to U.S. equities when the 60/40 portfolio only recommends a 2% weight?”
  2. “How should I think about moving my non-qualified accounts towards this optimal portfolio given they have significant embedded capital gains from the last 7 years?”

We addressed the first question in last week’s commentary (Optimizing for Anxiety).  We’ll tackle the tax management issue this week.

Taxes are always difficult to discuss quantitatively since they are so situation specific.  However, we will use some very simple assumptions to ballpark how an investor might start to evaluate the pros and cons of rebalancing towards an optimal portfolio consistent with current capital market expectations.

Compliance note: Nothing in this document should be considered investment or tax advice or advice for any specific client or individual. 

What is my capital gain exposure?

The first step to incorporating taxes in your asset allocation decisions is to determine your exposure to capital gains.  This is obviously going to depend on a number of factors, such as:

  1. When was I invested?
  2. What have I invested in?
  3. When did I rebalance?
  4. What have I done with my dividends and interest?

For this commentary, we will just consider four hypothetical investors, each with a different target outcome / risk profile (Income, Conservative, Moderate, and Aggressive).

The Income investor will buy the Vanguard LifeStrategy Income Fund (ticker: VASIX).  The Conservative investor will buy the Vanguard LifeStrategy Conservative Growth Fund (ticker: VSCGX).  The Moderate investor will buy the Vanguard LifeStrategy Moderate Growth Fund (ticker: VSMGX).  The Aggressive investor will buy the Vanguard LifeStrategy Growth Fund (ticker: VASGX).

We range the initial investment date from December 1994 to December 2014 and assume that the investor holds the fund corresponding to their risk profile through August 2016.

In the following two charts, we plot the percentage of the August 2016 portfolio that consists of capital gains for each risk profile, depending on the date the investor first started investing.  The first chart assumes that dividends are reinvested.  The second chart assumes they are not.

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Data from Yahoo! Finance.  Calculation by Newfound Research.  Assumes dividend reinvestment.  Does not include any fees except underlying Vanguard fund expenses. 

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Data from Yahoo! Finance.  Calculation by Newfound Research.  Does not assume dividend reinvestment.  Does not include any fees except underlying Vanguard fund expenses. 

As an example of how to read these charts, we can see that for the Income investor that began investing in 2008 and reinvests their dividends, approximately 20% of the portfolio value consists of capital gains.

Accounting for reinvestment versus withdrawal is important, as in a positive return environment, dividend reinvestment will general raise the cost basis as dividends are reinvested at higher and higher prices.  As a result, the hypothetical investors that reinvested dividends have less of their current portfolio tied up in capital gains.

On average, investors with more aggressive risk profiles and longer holding periods have more of their current portfolio tied up in capital gains.  On the other hand, investors with more conservative risk profiles and shorter holding periods have less of their current portfolio tied up in capital gains.

As an example, consider an aggressive investor that invests $1.0mm in 1994 and reinvests dividends.  In August 2016, this investor’s portfolio would be worth $5.2mm.  $2.5mm, or 48.5%, consists of capital gains that would be taxed in the event of a sale.  The remaining $2.7mm can be sold without any tax impact.

For the sake of simplicity, we assumed a single investment.  In reality, most people invest gradually over time.  The next chart shows capital gain exposure assuming that investor puts an equal (inflation-adjusted) amount of capital to work each year from 1994 to 2014.

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Data from Yahoo! Finance.  Calculation by Newfound Research.   Does not include any fees except underlying Vanguard fund expenses. 

What is my capital gain tax rate?

The way our example was constructed, all gains would be taxed at the long-term rate.  The long-term capital gains rate is 0%, 15%, or 20%, depending on income level and filing status.  We assume 20% to be as conservative as possible.

What are the risk/return assumptions on my existing portfolio vs. the “optimal” portfolio that we would potentially rebalance towards?

For this analysis, we continue to use the J.P. Morgan Capital Market Assumptions as well as the analysis we conducted two weeks ago.  We compute the expected return and volatility of each of the Vanguard funds using the most recently disclosed holdings.

We assume that each of our investors wants to maintain their risk profile, so assume that would move to an optimized portfolio with the same estimated volatility as their current Vanguard fund.

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Data from Yahoo! Finance, Vanguard, and J.P. Morgan.  Calculations by Newfound Research.   Does not include any fees or expenses.  Optimization performed by Newfound Research using a simulation-based process to account for parameter uncertainty.  Certain asset classes listed in J.P. Morgan’s capital market assumptions were not considered because they were either (i) redundant due to other asset classes that were included or (ii) difficult to access outside of private or non-liquid investment vehicles. There is no guarantee that any of the Funds or portfolios will actually realize the return and/or risk metrics listed in the table.

Putting the Pieces Together

Of course, the numbers in the table above are only estimates.  Perhaps a better way to frame the discussion is: what is the breakeven amount by which the “new” portfolio would need to outperform the “old” portfolio each year to make up for the tax hit from rebalancing?

Fortunately, we can derive a simple formula for this:

screen-shot-2016-09-18-at-12-48-47-pm

where:

  • CG is the portion of the current portfolio that consists of capital gains
  • T is the capital gains tax rate
  • N is the holding period for the new portfolio
  • R is the estimated return on the “old” portfolio (i.e. the Vanguard funds)

Note: the breakeven spread in our formula is annualized.  So if the breakeven spread is 1.00% for a 10-year holding period, then we would need the “new” portfolio to outperform the “old” portfolio by an average of 1.00% per year to justify a rebalance.

The tables below show these breakeven spreads for the scenarios we explored above.  The breakeven spreads are highlighted in green (red) if they are below (above) the actual amount of outperformance we expect by the optimized portfolios relative to the Vanguard funds.

Green means that given the J.P. Morgan capital market assumptions, we would expect a rebalance to the optimized portfolio to add value for the investor.   Red means that we would expect a rebalance to make the investor worse off than just sticking with the current portfolio.

We assume a 10-year holding period to be consistent with the horizon of the J.P. Morgan capital market assumptions. Shorter holding periods would call into question the validity of the optimized portfolio in the first place.

Breakeven Spreads Between Optimized and Vanguard Portfolios

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Data from Yahoo! Finance, Vanguard, and J.P. Morgan.  Calculations by Newfound Research.   Does not include any fees or expenses.  Optimization performed by Newfound Research using a simulation-based process to account for parameter uncertainty.  Certain asset classes listed in J.P. Morgan’s capital market assumptions were not considered because they were either (i) redundant due to other asset classes that were included or (ii) difficult to access outside of private or non-liquid investment vehicles. There is no guarantee that any of the Funds or portfolios will actually realize the return and/or risk metrics listed in the table.

We see that except for more aggressive investors that invested nearly two decades ago and did not reinvest dividends, the potential value from rebalancing to a currently optimal portfolio exceeds the tax cost.

That being said, we have to recognize that expected returns are just that: expected.  Even if J.P. Morgan’s capital market assumptions 100% accurately described the asset class return distributions, the actual spread between the performance of the optimized and “old” portfolios can vary, even over a 10-year holding period.

To capture this uncertainty, we can redo the tables above, but replace the breakeven spread with the probability of the actual spread exceeding the breakeven spread (i.e. the probability that rebalancing adds value).

Probability of Rebalancing to Optimized Portfolio Adding Value

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Data from Yahoo! Finance, Vanguard, and J.P. Morgan.  Calculations by Newfound Research.   Does not include any fees or expenses.  Optimization performed by Newfound Research using a simulation-based process to account for parameter uncertainty.  Certain asset classes listed in J.P. Morgan’s capital market assumptions were not considered because they were either (i) redundant due to other asset classes that were included or (ii) difficult to access outside of private or non-liquid investment vehicles. There is no guarantee that any of the Funds or portfolios will actually realize the return and/or risk metrics listed in the table.

With this type of framework, an investor can determine how confident they need to be that a rebalance will add value and then decide based on that whether a rebalance is prudent in their situation.  The level of confidence required may depend on factors like:

  • Personal risk aversion
  • Attitudes towards taxes
  • Confidence in capital market assumptions

For this exercise, we assume that an investor would rebalance to the optimized portfolio with expected volatility equal to their current income fund.  There is no reason that the rebalance couldn’t be executed from the opposite perspective by moving to the lowest volatility optimized portfolio with the same expected return as the current Vanguard portfolio.  In this approach, the investor is using the rebalance in an attempt to take risk off the table.

Client Talking Points

  • Based on J.P. Morgan’s outlook, investors looking to maximize success over the next decade must look beyond core stocks and bonds.
  • Many portfolios have significant capital gains as a result of strong equity and fixed income markets over the last 30+ years.
  • Investment decisions, especially those involving taxes, should always take into account an individual's or family’s specific circumstances.
  • However, be careful before dismissing the possibility of rebalancing a portfolio based upon current asset class outlooks on the basis of tax concerns without thorough analysis.
  • The return outlook for core asset classes, especially U.S. stocks and bonds, suggest that there may be opportunity to improve client outcomes by incorporating other exposures, even if that means paying a sizable tax bill upfront.

Justin is a Managing Director and Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Justin is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Justin is a frequent speaker on industry panels and is a contributor to ETF Trends.

Prior to Newfound, Justin worked for J.P. Morgan and Deutsche Bank. At J.P. Morgan, he structured and syndicated ABS transactions while also managing risk on a proprietary ABS portfolio. At Deutsche Bank, Justin spent time on the event‐driven, high‐yield debt, and mortgage derivative trading desks.

Justin holds a Master of Science in Computational Finance and a Master of Business Administration from Carnegie Mellon University as a well as a BBA in Mathematics and Finance from the University of Notre Dame.