The Tax Trade - Fact or Fiction?
Year-end is invariably a time of increased buzz around tax-loss harvesting as investors across all corners of the market look to minimize tax liabilities. Traditional tax-loss harvesting strategies typically include selling losers to offset gains and lower the overall capital gains tax liability. These strategies can also extend to selling winners to lock in gains offset by the losses incurred from selling the losing stocks.
Given the widespread nature of tax-loss harvesting, the price action that occurs at year-end, as a result, could create substantial crowding effects, of which investors should be aware. So, in this week’s Factor Spotlight, we set out to answer the question of whether or not a “tax trade” effect exists. And, if so, what does the “tax trade” look like from the eyes of the factor models?
Does the Tax Trade Exist?
To further study the tax trade, we chose to study stocks defined as “losers” or “winners” based on the security return from Jan 1-Nov 30 for the years 2007-2020. To build the portfolio of losers and winners, we started with the Russell 3000 universe and filtered for only stocks with a market cap greater than $500 million and average daily trading volume greater than $5 million. Then, on Nov 30 of each year, we created two equal-weighted portfolios of the bottom 1% of stocks (“Losers Portfolio”) and the top 1% of stocks (“Winners Portfolio”) based on the Jan 1 to Nov 30 return.
Once we created each portfolio, we looked at the portfolio performance from Dec 1 to Dec 31 of each year to understand how the tax trade behaves in the year's final weeks. The chart below shows the 1-month performance of each portfolio, relative to the Russell 3000, for every December from 2007 to 2020.
The Losers portfolio outperformed the Russell 3000 almost two-thirds of the time and had a median December relative performance of 2.6%. Interestingly, the Winners portfolio had an opposite overall trend and underperformed the Russell 3000 two-thirds of the time, with a median relative performance of -1.3%.
The performance profile of our portfolios has several implications. First, there appears to be a rebound effect for YTD losers sold off to generate tax offsets. These names may present a buying opportunity for investors who believe in the company for fundamental reasons, contributing to the December upswing.
Second, the YTD winners tend to see a December downturn. Selling off these names at year-end to lock in gains could be one contributing factor, especially if investors start to view these high-flying stocks as becoming overvalued and poised for a fundamental downturn.
These results illustrate the end-of-year opportunity that exists in names that are sold off due to tax purposes and highlight a potential opportunity in tax trade that includes both YTD losers and winners. We further investigated the profile of a market-neutral Tax Trade basket that goes long the Losers portfolio and short the Winners portfolio.
This tax trade theme has a median December return of 1.3% and has positive returns almost 65% of the time. This further highlights the likely tax-related dynamics at year-end that one can exploit as an investment theme.
The DNA of the Tax Trade for 2021
So, how does a 2021 tax trade look? We used the factor models and the Tax Trade basket as of Dec 1, 2021, to help us dive deeper into the DNA of this theme.
To start, let’s use a sector lens on the tax trade theme. The table below shows the GICS Industry Group breakdown for the Tax Trade basket.
GICS Industry Group Weights - Tax Trade Basket
The tax trade theme looks to have some significant sector influences, with large underweights to Energy and Retailing and overweights to Software, Insurance, and Consumer Durables & Apparel. These results make intuitive sense given these groups' performance in 2021 in the wake of the economy reopening after the initial waves of COVID.
Using the Axioma US 4 Medium-Horizon ("Axioma US") risk model, we can see that the tax trade currently looks to be:
- Long - Value and Volatility.
- Short - Market Sensitivity, Momentum (both Medium- & Short-Term), and Profitability.
Axioma US Style Exposures - Tax Trade Basket
However, factors are not the entire story for this theme. For example, the Axioma US risk model only explains about 42% of the predicted risk of the Tax Trade basket, with the remaining 58% of the risk attributable to idiosyncratic effects. This makes sense, given that this basket is intended to capture a tax loss harvesting theme that does not exist as a factor in the risk model.
Axioma US Risk Decomposition - Tax Trade Portfolio
To better understand how our Tax Trade basket interacts with some of the non-traditional crowding and macro factors that have plagued markets this year, we incorporated the Wolfe Research QES US Broad (“Wolfe US”) risk model into the analysis.
Wolfe US Style Exposures - Tax Trade Portfolio
Here, we see that the tax trade theme has heavy overexposures to HF Crowding and Short Interest. This overexposure tells us that the names driving the tax trade theme may be highly crowded across both institutional long and short books. We also see a notable underexposure to the Interest Rate Beta factor, which could pose some danger if the theme is held for too long, given the threat of inflation and pressure on the Fed to raise interest rates.
Beware (or Take Advantage) of the Tax Trade in Your Portfolio
As the results above illustrate, this time of year can expose portfolios to unwanted dynamics created by end-of-year trades related to tax-loss harvesting. Investors who hold names in YTD losers could see upwards price pressure as investors buy the dip and/or these names start to rebound for fundamental reasons. Conversely, those who hold names in YTD winners could see downward price pressure as these names get sold off, presumably to lock in gains. A tax trade basket could provide an attractive end-of-year boost to portfolio returns for investors looking to exploit these themes. No matter which side of the fence you're on, it's key to ensure that you're aware of the potential impact of tax-related market themes on your portfolio.
US & Global Market Summary
US Market: 12/03/21 - 12/10/21
- The Dow Jones Industrial Average rose 4%, snapping a 4-week losing streak and its best weekly performance since March. The S&P 500 and Nasdaq Composite rose 3.8% and 3.6%, respectively, — the best week since February for both indexes.
- The Bureau of Labor Statistics said prices for U.S. consumers jumped 6.8% in November compared with a year earlier, its highest rate in almost 40 years, but inline with analyst expectations.
- Investors' worries over omicron eased this week amid encouraging signs that the variant may be less dangerous than delta.
- The price of U.S. crude oil rose 1% providing a modest boost to energy sector stocks.
- Business software maker Oracle surged 15.6% for the biggest gain in the S&P 500 after reporting strong quarterly results.
Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)
- Value reversed its recent slide and finishes the week atop the U.S. factor leaderboard.
- Earnings Yield moved upward for the 10th consecutive week but shows signs of running out of steam as it approaches extremely overbought status.
- Volatility fell for the 9th straight week.
- Medium-Term Momentum slid after a 6-week climb to land at +0.27 SD above the mean.
- Growth dipped following a recent run in the + column to end the week at +0.26 SD above the mean.
- Market Sensitivity continues to show weakness following two weeks of last-place finishes to barely avoid an ingnomious three-peat.
- Profitability took a nose-dive after a recent positive run to finish last in this week’s leaderboard.
- US Total Risk rose by 0.54% this week.
Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)
- Similar to the U.S., Global Value shot upwards to finish the week atop the global factor leaderboard.
- Growth saw a different trajectory than its U.S. counterpart with another upward move and now within sight of the mean.
- Size continued its recent swing upward and now sits in overbought territory at +1.34 SD above the mean.
- Profitability fell for the first time in 7 weeks to move further away from extremely overbought terrain.
- Exchange Rate Sensitivity moved deeper into oversold territory and once again finishes at the bottom of the global factor leaderboard.
- Global Total Risk rose by 0.45% this week.