The chance that US capital gains tax could rise sharply might mean that investors planning to rotate portfolios are going to press the button faster than they might have done, a wealth management firm says.

Investors may choose to rebalance their equity portfolios “sooner rather than later” if a threatened near-doubling in US capital gains tax to almost 40 per cent goes through, according to a Californian wealth manager.

As the economy re-opens from the COVID-19 lockdowns, business sectors that have suffered may recover while beneficiaries might lose ground, prompting investors to recalibrate their holdings, Bel Air Investment Advisors, which oversees more than $8 billion of client money, said in a note this week. 

“Our base case remains constructive on the equity market broadly with effective vaccines, accommodative monetary policy and fiscal stimulus supporting risk assets. However, the factor tilts within equity allocations should be balanced to manage the risk of underperformance as the economy re-opens. At the same time, we can better hedge the risk of our equity exposure with a mix of Treasuries and high-quality municipals,” it said. 

“Finally, we recognize the potential tax impediment to portfolio rebalancing after a long bull market, particularly in growth stocks. However, it is important to note that the Biden tax plan includes an increase in long-term capital gains to 39.6 per cent for those with income exceeding $1 million which, if it gains traction on Capitol Hill, may create an incentive to rebalance sooner than later.”

Whether CGT rises from its current level is open to debate, although wealth managers have told this news service that they expect the tax to rise, if not double the current level of 20 per cent. At the same time, other taxes - such as estate taxes - are also expected to rise (with thresholds falling). Wealth managers typically advise clients not to let asset allocation be driven by tax, but post-tax returns are inevitably important particularly when the general level is likely to rise. (See here for another commentary about the outcome of last November's elections and the January 2021 Georgia senatorial run-offs.)

“We are coming out of a tremendously traumatic year that exposed us to a global health crisis, an economic threat rivaling the Great Depression, a political environment where either side felt the end was near, and unfathomable changes to our daily social interactions,” Kevin Philip, managing director at Bel Air Investment Advisors, said. 

“There is no doubt the ramifications of all of this are yet to be understood; we are quite reasonably suffering from collective PTSD. But I believe that the darkness will recede further and further as winter gives way to spring, and by summer, we may find ourselves taking a communal (yes – in person) sigh of relief as we realize a shared confidence in renewed health and economic security. And then, at some point in the future, we will find something new to be concerned about, and I hope it pales in comparison to this past year,” he said. 

Philip’s colleague, Carl Ludwigson, director of manager research, noted that most investors are overweight growth stocks because these equities outperformed over the last decade. However, as or if interest rates rise to where they were before the pandemic, investors should consider balancing growth and value exposure in equities.

“We recognize that buying cyclical value stocks exposes portfolios to more economic risk, which is a reason to maintain some duration on the fixed income side. We see an advantage in adding 10-year Treasuries to portfolios given they are more liquid, effectively free of default risk, and provide similar yield on a tax adjusted basis to high-quality municipal bonds,” Ludwigson said. “Complementing municipal portfolios with 10-year Treasuries reduces economic risk by adding to our duration exposure. Remember, duration is a risk in the fixed income bucket, but duration is defensive in the context of the overall portfolio because it works to offset economic risk in the equity bucket.”