Both the trending value and consumer staples strategies I’ve introduced work well with annual rebalancing, which is great because gains you make on stocks that were held for more than a year are subject to a lower capital gains tax rate. Gains from stocks that were held for less than a year are subject to your ordinary income tax rate.
There are real tax benefits to holding stocks for more than a year, but there are also benefits to trading more frequently:
To help determine if the increased return from trading more frequently is worth the higher tax rate, let’s review an example:
Long-term: I invest $1,000 in the trending value strategy on Day 1. I sell on day 366, my capital gain for the year being $1,000 * 16.1% = $161. Because I’m in the 25% tax bracket, I have to pay 15% of that gain in taxes, $161 * 15% = $24.15, so my end balance after tax is $1,000 + $161 – $24.15 = $1,136.85.
Short-term: I invest $1,000 in the trending value strategy on Day 1 and rebalance monthly. By day 366, my capital gain is $1,000 * 20.9% = $209. Because I’m in the 25% tax bracket and I traded more frequently, my capital gains are subject to my ordinary income tax rate, $209 * 25% = $52.25, so my end balance after tax is $1,000 + $209 – $52.25 = $1,156.75.
After taxes, the monthly version of the trending value finishes ahead of the annual version by $19.90. Trading these two strategies more frequently returns more before taxes, but after taxes it’s close to even. (It looks like the trending value strategy does not benefit beyond monthly, which makes sense since the ranking system uses 6 month % return).
There are, however, many strategies that benefit tremendously with more frequent trading because they are able to react more quickly to opportunities as they arise. Increased trading frequency also ensures that you aren’t stuck in a poor position because of a poor entry point (What Works on Wall Street demonstrates that the return of an annual strategy can vary widely depending on which month you enter, partly due to the ever-shifting January effect).
To help make this decision whether to trade once a year or more frequently without having to go through an example every time, I’ve created a table. It shows the nominal gain required if trading long-term or short term.
Comparing the two columns within each tax bracket indicates the additional return required to offset the tax implication.
One caveat to the table is that if your ordinary income is right below the next highest tax bracket, and adding short term capital gains on top of that pushes the total into the higher bracket, the portion of short term capital gains that fit into the higher tax bracket will be taxed at that higher tax rate (read more here). If this is the case, you can compare an LT column to the ST column in the next highest bracket.
Assuming $10 a trade and a 25 stock portfolio (to make the numbers more even), the trading costs (as a percentage of your portfolio) for different rebalance schedules and portfolio sizes are summarized below:
I’ve highlighted in green 2% and lower, which is about the most you would expect to be charged for an actively managed fund.