Nov 1, 2016 - There are always stocks that are trading at a loss, regardless of how the ... Exchange-traded funds (ETFs) are generally considered to be.
CIO REPORTS
The Weekly Letter NOVEMBER 1, 2016 GWIM Chief Investment Office
Don’t let taxes be such a drag: We believe investment returns will be lower going forward and that taxes on them will remain high or move higher. As such, it will be important for investors to focus on constructing tax-efficient portfolios that can reduce the drag from higher taxes. We encourage investors to pursue proactive tax planning strategies such as tax-loss harvesting as well as tax-advantaged asset classes, tax-efficient investment vehicles and asset location.
Emmanuel D. Hatzakis
Markets in Review: Last week equities were down, with the S&P 500 declining 0.7% and international equities as represented by the MSCI EAFE Index falling 0.4%. Bonds also fell on the week, with the 10-year Treasury yield finishing at 1.85%, up from 1.73% on Friday of the week prior. Commodities overall, as measured by the Bloomberg Commodity Index, fell 0.2% with WTI crude dropping 4.3% to $48.70 per barrel. Gold rose by 0.7% to $1,275.00 per ounce.
Recent Publications
Looking Ahead: In the U.S., economic data is headlined by the Bureau of Labor Statistics’ nonfarm payrolls for October. In the Eurozone, Markit will report its Manufacturing PMI for the region for October. (See page 3.)
Don’t let taxes be such a drag We believe investment returns will be lower going forward and that taxes on them will remain high or move higher. As such, it will be important for investors to focus on constructing tax-efficient portfolios that can reduce the drag from higher taxes. Tax-aware wealth management thus becomes crucial in helping them pursue their goals. Exhibit 1: Tax drag on investment returns (1926 to 2015) Average Annual Returns (%)
12 10
Director
John Veit Vice President
Weekly Letter The New Geopolitical Normal Election clouds earnings outlook A Balanced Approach to Risk in the Fourth Quarter Valuation is in the Eyes of the Beholder Monthly Letter A Bridge to the Other Side CIO Outlook The Forces Shaping Our World
U.S. stocks and bonds have delivered positive returns in the midto-high single digits year-to-date. Taxes can substantially diminish such returns when realized (see Exhibit 1). The starting point for efficient investment and wealth planning has to be an appropriate goals-based asset allocation and wealth structuring. From there, we encourage investors to incorporate into their portfolio management proactive tax planning strategies such as tax-loss harvesting as well as tax-advantaged asset classes, tax-efficient investment vehicles and asset location.
Tax-loss Harvesting Tax-loss harvesting entails selling and taking capital losses on assets that have dropped in price relative to their cost of purchase, which can offset some or all of the capital gains realized on the sale of assets that have appreciated, and a limited amount of ordinary income, currently up to $3,000 per year.
10.0%
8
7.1%
6
5.3%
4
3.0%
2
Note: 75% of the stocks’ return is assumed to be taxed at the long-term capital gains rate of 23.8% and 25% at the short-term rate of 43.4%. Bonds are assumed to be taxed at the short term rate. These tax rates include the 3.8% health care surtax. Stocks are represented by the S&P 500, bonds by the 10-year Treasury. Source: Bloomberg, Robert Shiller and GWIM Chief Investment Office. Annual data as of December 31, 2015. Past performance is no guarantee of future results.
While the strategy cannot fully compensate investors for losses taken, it can reduce their overall tax liability, both now and in the future. Short-term capital gains — those on assets held a year or less — are taxed at an investor’s highest marginal ordinary income tax rate and therefore offsetting them can be especially valuable to investors in high tax brackets. According to a recent study, tax-loss harvesting can be worth as much as 1.0% to 1.9% of a portfolio’s value annually.1
As we enter the final quarter of the year amid economic uncertainty and the looming presidential election, we encourage investors to consider 2016 Year-End Tax Planning strategies.
Tax-loss harvesting can be employed in any market environment. There are always stocks that are trading at a loss, regardless of how the overall market is doing (see Exhibit 2). It can be used
0
Stocks
Stocks after taxes
Bonds
Bonds after tax
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May Lose Value
with both stocks and bonds. For fixed income, opportunities lie within and across sectors and credit ratings, from investment grade to high yield. Stocks also provide tax loss harvesting opportunities across sectors, geographies and levels of quality, as well as securities within these groupings. Exhibit 2: There are stocks trading at a loss even in up markets Russell 3000 Return
Stocks in R3000 with Positive Returns
Stocks in R3000 with Negative Returns
19
98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15
% of Stocks with Gains/Losses
100 80 60 40 20 0 -20 -40 -60 -80 -100
Source: MSCI Barra, Aperio Group LLC, Bloomberg and GWIM Chief Investment Office. Annual data as of 2015. Past performance is no guarantee of future results.
Considering tax lots or the method of cost basis to calculate gains and losses recognized on investments can have a significant impact on the amount of taxes paid. This is particularly true when investors have built a large position in a stock over time.
Tax-advantaged Assets Municipal bonds are an example of a tax-advantaged asset class. Municipal bond interest income is exempt from federal taxes and most state and local taxes, making these bonds attractive for investors in high tax brackets. In this area we believe investors can benefit from engaging active managers with a strong credit research team and the experience to determine whether municipal bonds may be an appropriate part of their portfolios. Pass-through entities such as master limited partnerships (MLPs) are another example of an asset class that has gained traction in recent years for its tax advantages. The net income earned by an MLP is usually exempt from corporate taxes and instead is subject to tax only at the individual unit-holder level. Furthermore, an MLP generally pays cash distributions out of operating cash flows, and taxes can be deferred on a portion of these payouts because of tax deductions taken by the MLP that
flow through to the individual unit-holder’s tax return. However, owning an equity interest in an MLP may require filing of state income tax returns and paying state income tax in at least some of the states in which the MLP conducts business.
Tax-efficient Investment Vehicles Separately Managed Accounts (SMAs) and exchange-traded funds (ETFs) tend to be more tax-efficient investment vehicles than mutual funds. SMAs may be used for securityspecific tax loss harvesting. This strategy, which we call tax selling, may reduce the investor’s total tax bill. Exchange-traded funds (ETFs) are generally considered to be more tax-efficient than mutual funds due to the use of in-kind redemptions and lower portfolio turnover. In-kind redemptions are the exchange of ETF shares for a basket of securities rather than cash. Since the trade is conducted in-kind, other non-redeeming investors are not liable for capital gains that would otherwise be recognized. Mutual fund investors may receive distributions of capital gains resulting from positive performance by fund holdings. The amount of the gains can vary greatly depending on how actively the fund is managed. Moreover, mutual funds often face redemption requests that they meet by liquidating portfolio holdings and distributing proceeds, which may give rise to capital gains allocated to investors still holding shares in the fund even if they haven’t realized a gain on them.
Tax-efficient Asset Location Investors might also improve their after-tax returns by deciding whether to hold specific assets in a taxable account or a taxadvantaged one like an IRA or a 401(k) — a distinction known as asset location. It is typically advantageous to place less tax-efficient assets such as bonds or stocks with high yields in tax-advantaged accounts, and to put in taxable accounts more tax-efficient ones such as municipal bonds, MLPs or lowyielding stocks held for long periods. Studies have found that asset location can generate 0.7% to 1.0% of a portfolio’s value annually.2 Factors that complicate asset location decisions include an investor’s tax bracket and the fact that assets may shift from efficient to inefficient from a tax perspective due to changes in interest rates and yields as well as tax laws
Portfolio Strategy: As we are in a regime of lower investment returns and potentially higher taxes, investors should continue to focus on tax-efficient financial planning. After appropriate asset allocation and wealth structuring, simply using the approaches we’ve described can help investors achieve tax-efficient portfolios. Tax planning is individual in nature and should be tailor-made. Thus, we recommend that investors discuss their options for tax management with their financial advisor or private wealth advisor as well as with their tax professional.
For more guidance on tax planning please see 2016 Year-End Tax Planning 1 2
Geddes, P., L.R. Goldberg, and S.W. Bianchi. 2015. “What Would Yale Do If It Were Taxable?” Financial Analysts Journal, 71(4):10-23, July/August. The range is bracketed by a low estimate of 0.7% in a study by Vanguard and a high one of 1.0% in an Envestnet report.
CIO REPORTS • The Weekly Letter
2
Markets in Review Trailing Economic Releases
Equities
On
Tuesday, S&P/Case-Shiller released its August U.S. home price index in line with the BofA Merrill Lynch (BofAML) Global Research estimate of 5.1% year-over-year (YoY) growth. Rising home prices have served as a supporting factor for consumer psychology.
On
Wednesday, Markit reported its preliminary U.S. service sector snapshot for October with a reading of 54.8, above consensus estimates. A reading above 50 signals expansion. Services is an important component of the U.S. economy.
In
the Eurozone on Friday, the European Commission released its region-wide economic confidence indicator for October with a reading of 106.3, above the BofAML Global Research projection of 104.3. Investors have been keen on detecting whether Brexit may reduce confidence in the Eurozone and slow growth.
S&P 500 Sector Returns (as of last Friday’s market close) S&P 500 Sector Total Returns (week-to-date) Consumer Staples Utilities Financials Industrials Information Technology Telecom Materials Energy Consumer Discretionary Health Care -2.8%
0.2%
1.0% 0.9% 0.6%
-0.2% -0.6% -0.8% -1.1% -2.0%
-3%
-2%
-1%
0%
1%
DJIA NASDAQ S&P 500 S&P 400 Mid Cap Russell 2000 MSCI World MSCI EAFE MSCI Emerging Mkts
Level 18,161.2 5,190.1 2,126.4 1,499.7 1,187.6 1,691.0 1,665.6 903.5
Total Return in USD (%) WTD MTD YTD 0.1 -0.7 6.5 -1.3 -2.3 4.7 -0.7 -1.8 5.9 -1.7 -3.3 8.7 -2.5 -5.1 5.8 -0.6 -1.9 3.5 -0.4 -2.1 -0.4 -0.8 0.1 16.1
Fixed Income Yield (%) ML US Broad Market ML 10-Year US Treasury ML US Muni Master ML US IG Corp Master ML US HY Corp Master
2.05 1.85 2.04 2.96 6.19
Total Return in USD (%) WTD MTD YTD -0.5 -0.9 4.9 -0.7 -1.5 5.3 -0.1 -1.0 3.1 -0.8 -0.9 8.1 -0.5 0.6 16.0
Commodities & Currencies
Bloomberg Commodity WTI Crude $/Barrel1 Gold Spot $/Ounce1
Level 173.6 48.7 1,275.5
Level EUR/USD USD/JPY
Current 1.10 104.74
Total Return in USD (%) WTD MTD YTD -0.2 0.7 9.6 -4.2 1.0 31.5 0.7 -3.1 20.2 Prior Prior 2015 Week End Month End Year End 1.09 1.12 1.09 103.80 101.35 120.22
Source: Bloomberg.1 Spot price returns. All data as of last Friday’s close. Past performance is no guarantee of future results.
Looking Ahead Upcoming Economic Releases On
Thursday, the U.S. Department of Labor is set to report seasonally adjusted initial jobless claims for October. BofAML Global Research estimates there were 260,000 claims. Jobless claims have flirted with lows last seen in the early 1970s, implying little firing among firms.
On
Friday, the U.S. Bureau of Labor Statistics is set to report on its seasonally adjusted nonfarm payrolls for October. BofAML Global Research estimates a net gain of 170,000 month-over-month. While job growth this year has shifted lower from last, it still suggests continued healing in the labor market.
On
Wednesday, Markit is set to report its final seasonally adjusted Eurozone Manufacturing PMI for October. Consensus estimates are for a reading of 53.3. Manufacturing may be accelerating, given that the preliminary reading was the highest since April 2014.
BofA Merrill Lynch Global Research Key Year-End Forecasts S&P 500 Outlook Target
2016 E 2,000
EPS
$117.00
Real Gross Domestic Product
2016 E
Global
3.0%
U.S.
1.5%
Euro Area
1.5%
Emerging Markets
4.1%
U.S. Interest Rates
2016 E
Fed Funds (eop)
0.63%
10-Year T-Note (eop)
1.50%
Commodities
2016 E
Gold ($/oz-period average)
$1,301
WTI Crude Oil ($/bbl-eop)
$54.00
All data as of last Friday’s close. CIO REPORTS • The Weekly Letter
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CHIEF INVESTMENT OFFICE Christopher Hyzy
Chief Investment Officer Bank of America Global Wealth and Investment Management
Mary Ann Bartels
Karin Kimbrough
Niladri Mukherjee
Head of Merrill Lynch Wealth Management Portfolio Strategy
Head of Investment Strategy Merrill Lynch Wealth Management
Managing Director Chief Investment Office
Emmanuel D. Hatzakis
Rodrigo C. Serrano
John Veit
Director
Vice President
Vice President
The opinions expressed are those of the Global Wealth & Investment Management (GWIM) Chief Investment Office only and are subject to change. While some of the information included draws upon research published by BofA Merrill Lynch Global Research, this information is neither reviewed nor approved by BofA Merrill Lynch Global Research. This information and any discussion should not be construed as a personalized and individual recommendation, which should be based on your investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases. Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). Investments in MLPs in the energy sector will be subject to more risks than if the investment were broadly diversified over numerous sectors of the economy. A downturn in the energy sector of the economy could have a larger impact than on an investment that does not concentrate in the sector. At times, the performance of securities of companies in the sector may lag the performance of other sectors or the broader market as a whole. In addition, there are several specific risks associated with investments in the energy sector, including the commodity price risk, depletion risk, supply and demand risk, and catastrophic event risk, among others. Past performance is no guarantee of future results. © 2016 Bank of America Corporation. All rights reserved.
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