It’s that time of the year again. Of course I’m talking about tax loss selling season.
Q3 hedge fund letters, conference, scoops etc
As a fund manager, I attempted to avoid allowing capital gains or losses interfere with my investment decision making process. For example, if I incurred an above average amount of capital gains YTD and had a stock trading over fair value, I’d sell the stock regardless of the tax implications.
My rational was simple. First, I had a healthy mixture of taxable and non-taxable clients. While delaying the sale of an overvalued security would lower the tax bill for taxable clients, it would also increase the valuation risk assumed for non-taxable clients. And valuation risk was and remains the key, in my opinion. In effect, I believe the risk of holding an overvalued asset outweighs the tax implications of assuming capital gains.
While my process places more emphasis on valuation risk than capital gain management, I understand why portfolio managers prefer avoiding sending clients a large and possibly unexpected tax bill. It’s bad for business and in some instances it’s just plain rude.
This year’s capital gain setup is becoming increasingly uncomfortable and possibly awkward for many managers. For most of the year, the equity market was decidedly positive and ripe for assuming capital gains. And after a ten year bull market, there were plenty of gains to take! However, as the current market cycle’s legs have begun to wobble, large YTD gains have disappeared and in many cases have turned to losses (50% of the stocks in the S&P 500 are down -20% from their highs).
Imagine for a moment you’re a fund manager invested in many of this cycle’s leading stocks, such as those in the Nasdaq 100 (QQQ). Now imagine it’s September 30, 2018 and your fund is up 20% and you’ve taken considerable realized gains throughout the year. Although you’re aware of the large tax bill you’ve been racking up, given the fund’s large YTD gains, you’re not concerned. Client meetings have been going great — filled with smiles and applause.
Now fast forward to today. The realized taxable gains you incurred earlier in the year are still there, but your YTD gains have disappeared. In fact, your fund is currently showing a loss YTD!!! What do you do? I know one thing you probably don’t want to do — send your clients a large tax bill after losing their money! The definition of adding insult to injury.
The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill. As such, and assuming the current decline in stocks continues, I expect this year’s tax loss selling season could add additional pressure to many of the market’s laggards.
For patient absolute return investors, this could turn into an interesting opportunity. I have several stocks on my possible buy list that are down considerably YTD that I’m closely monitoring. While I believe the average small cap stock remains expensive, I’m hopeful an amplified tax loss selling season could allow opportunistic investors to pick up a few discounts heading into year-end.
