Value Library

The following is an excerpt from the ABC Perspective - January 2002 - Pg. 3

The Angst of Tax Loss Selling

An important secondary objective of most mutual funds is tax efficiency. But this is not to say that the primary objective of earning a top notch rate of return is to be sacrificed. Portfolio managers walk a fine line trying to satisfy their investors' demand for superior investment performance while trying to minimize the tax effect of the investment return.

Now this two-pronged objective is easier said than done. For instance if a portfolio manager has excellent performance in a particular year it stands to reason that he will take significant realized profits. But these profits unfortunately will precipitate meaningful realized taxable income to the mutual fund unitholder. In fact, over the years I have witnessed instances of fund returns of say 25% crystallizing fully taxable capital gains of the same amount. Taxable unitholders (other than RSP., RRIFs ,etc.) become upset as the net effect of a 50% capital gains tax rate reduces a 25% pre-tax return to 12.5%. I have also observed an investment quirk whereby a fund may lose 5 or 10% in a particular year and yet have realizable taxable gains of 10 or 15%. The net effect is that a perplexed investor will have to pay capital gains taxes on a losing year.

To compensate for calendar-year capital gains a portfolio manager will attempt to scour through his investment portfolio and realize capital losses to offset earlier year taxable gains. The major risk is that a portfolio manager may tax loss sell a common stock just before it embarks on the road back to price recovery. Ultimately this whole process of tax planning becomes "the angst of tax loss selling".

Tax loss selling in my experience can become very stressful. Firstly, if a manager selects a stock to become a tax loss selling candidate he must rationalize that the share price isn't coming back soon. It is one thing to sell a stock for $2 that cost $8 in order to realize a tax loss of $6. However, if that same stock subsequently climbs from $2 back to $5, an opportunity to recoup the loss is missed. Secondly, in transacting a tax loss a manager must get over the psychological hang-up of admitting defeat. That is, "I made a mistake, the stock was a loser and I am taking a loss." This is easier said than done since few managers like to admit an investment mistake. Furthermore, in psychological terms "hope springs eternal". We all hope and pray that a losing stock will come back. The tax loss sale of a losing position bears finality to a bad investment. This admission and eventual sale is formidable, perhaps the toughest decision for any portfolio manager.

From my experiences of the angst of tax loss selling, I have found that if I can take a tax loss in a company that I have legitimately lost confidence in and can reinvest the proceeds in another investment with excellent capital appreciation potential then I am willing to make that very hard decision. In effect, if I can materially improve our investment portfolio by liquidating a money losing disappointment and reinvest in a fresh, undervalued security, I will grit my teeth and just do it.

Irwin A. Michael, CFA