Tax cost of rebalancing portfolio

The decision on whether to invest in an active fund or a passive fund is never easy, if you were to analyse from a technical standpoint. Most investors base their decision on their view of how efficient the market is.

If you believe that the market consistently mis-prices securities, then investing in active funds is meaningful. If not, buying passive funds is optimal. But whether you buy passive or active funds, you must re-balance your portfolio. In this article, we discuss the need for portfolio re-balancing and the tax implication of such re-balancing.

Re-balancing process

A portfolio manager of an active fund is expected to generate positive alpha — excess returns the fund generates over its appropriate benchmark index. That requires continual buying and selling stocks in the portfolio. But the portfolio manager’s decision to actively manage the fund does not result in a tax liability for you. That is because you must pay capital gains only on realised gains — when you redeem your units in the fund.

Now, suppose an active fund has gained 32% over the last three years; these gains are determined by the increase in net asset value (NAV) over the three-year period. But your gain from the investment is still unrealised unless you redeem the units. What if the stock market dives after climbing up sharply? You would have lost a significant part, if not all, of your unrealised gains in the mutual fund. To moderate this issue, you must re-balance your portfolio, preferably annually. This requires you to sell some units and invest the sale proceeds in bonds. Redemption of fund units will attract capital gains tax. The argument is more important for passive funds. Such funds simply buy and hold securities inside the portfolio. So, re-balancing portfolio is the only way you can realise gains on your investments in the fund.

Conclusion

Capital gains tax is a cost to moderate the asymmetric returns effect (ARE) on your equity investments, whether you invest in active funds or passive funds. ARE refers to the phenomenon that it takes little effort to give-up unrealised gains than it takes to recover unrealised losses of the same magnitude; 25% unrealised gains requires a 20% decline to wipe out the gains but 25% unrealised loss requires 33% gain to recover the losses.

You are exposed to asymmetric returns effect on all investments that earn capital appreciation.

(The author offers training programmes for individuals to manage their personal investments)