More On Tax Planningfrom The Advisor's Professional Library
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
Financial planning, tax management, and investment management. At Brinton Eaton Wealth Advisors, a fee-only firm in Morristown, New Jersey, says Jerry Miccolis, a senior financial advisor with the firm, "We feel strongly--and we're organized this way--that you can't do an adequate job in any one of those three areas without your arms around the other two." The firm's investment philosophy involves building portfolios on a foundation of ETFs, partly because they constitute a more efficient way of performing asset allocation, partly because they're a more efficient way of rebalancing a portfolio, and partly because they're a more efficient way to tax loss harvest.
Miccolis, who in addition to being a CFA and CFP is a Fellow of the Casualty Actuarial Society (FCAS) and a Member of the American Academy of Actuaries (MAAA), spoke to editor Jamie Green in late August about the benefits of tax loss harvesting in general, why ETFs are particularly helpful when doing so, and why tax loss harvesting is something that ideally should be done year-round, not just in the fourth quarter.
To put our conversation into context, tell me how your firm is set up.
Everthing is done on a team basis; there's a dozen of us in total [at Brinton Eaton], nine of us are professionals. We tend to work pretty closely together, so it's not like one of us does financial planning, another does taxes, another does investment management--we all are experienced in all three, though we have varied strengths--mine are more in the investment side.
Talk about your actuarial experience.
It's a great background to have. Much of investment is really risk management, and my prior career was 25 years with Towers Perrin, the consulting firm, where I ran their risk management practice, so a lot of those techniques are pretty transportable into the investment world. We've got a lot of scientific improvements in the way we approach investments for our clients that I was able to bring with me from the risk management side--modeling.
This is a good year for harvesting, because of the way the markets have behaved?
It's gone violently sideways, which is an ideal situation for tax loss harvesting. It's not a situation we'd desire or ask for at the beginning of the year, but now that we find ourselves in it, we need to make what we can out of it.
It presents opportunities for tax loss harvesting, at least the way we do it.
What about tax loss harvesting in the traditional sense?
It's typically done near the end of a year, when you have a position in a certain stock and it's at a loss--you take the loss and then try to find something comparable, either another stock or an index fund or a sector fund, and/or wait 31 days and then buy back into that stock and hope it hasn't had a runup since.
What we do is more throughout the year, and it's primarily through ETFs, in fact, almost exclusively through ETFs (see "About That Floor" sidebar at end of this article).
Let's back up and tell you why we have ETFs in the portfolio. Regardless of the portfolio's size, we will start each portfolio out with a floor or working layer of ETFs across all our major asset classes and sectors. So if you look at fixed income, you look at different maturities. If you look at equities, you look at small cap, mid cap, and then within large cap, the different industry sectors. We also have a third category which we call alternatives, in which we have real estate and commodities. So if you look at all those asset classes/sectors, there may be 20 of them.
We want a floor, a working layer, across all 20 of those categories, that we fill with ETFs. If an ETF doesn't yet exist, then we'll use a mutual fund. Then we'll top off each of those sectors with individual securities, portfolio size permitting.
So we find ourselves with a working layer of ETFs and a market that's violently sideways, where the ETF is at a loss. One thing about ETFs is that there's a lot of competition, so there's more than one ETF in a subsector. So let's take the finance sector: there's an iShare and a SPDR, among others. If you happen to be in the iShare finance sector ETF, and it's at a tax loss for the year, it could be February. There's nothing to prevent you from selling it and buying the SPDR finance sector ETF the same day, because technically they don't follow the same index: the iShare follows the Dow Jones finance sector, and the SPDR follows the S&P finance sector. It's not the same security, and it's not tracking the same index. There's nothing to prevent you from replacing one with the other on the same day. It's not like selling Bank of America and buying it back the same day; you have to wait 31 days.
But in our modeling, we've modeled both indexes, and for portfolio diversification purposes, one's as good as the other. They're both correlated with the other indexes in the portfolio--the other industry sectors, the commodities, the real estate, the bonds, in the same way. So for portfolio construction purposes they're virtually interchangeable, even though for tax purposes they're as distinct as can be.
Any time that the ETF you may be holding in that sector shows a tax loss of a given size--there's a materiality threshold here, if the threshold's too low, you'll be doing so many of these swaps during the year that you'll give away the benefit in trading costs, so we set a materiality threshold before we'll even look at a tax loss harvesting trade. The rough rule is that there has to be a $2,000 loss. The theoretical threshold is lower than that, but as a practical matter we set it at that, because by the time you make the trade, prices move, so we set it at $2,000 to give ourselves a little margin of error. Even if it's as low as $1,000 by the time the trade is consummated, it still pays for itself.
The cost of trading the ETF will be the same as a stock, but you won't be left with an odd lot. We try to keep our clients' stock in even lots of stock, because we want everything to be instantly marketable. But odd lots of ETFs are so liquid, it's just more efficient the way we operate to use them. These are rebalancing trades. In tax loss harvesting, it makes more sense to do them with ETFs because of the different families of ETFs like I said earlier, for portfolio construction purposes they're virtually identical. For stocks, there's no virtually identical replacement for Bank of America, or PNC, or MetLife. But two ETFs are sisters, almost identical twins.
You've done no damage to the portfolio, you've left it exactly as you intended for an asset allocation point of view, you've stockpiled the tax loss, and you don't have to sit on the sidelines for 30 days hoping it doesn't move up.
Why not use an index mutual fund for tax loss harvesting?
Mutual funds will work, but there are other advantages to using an ETF. One, it trades throughout the day, so you're not subject to the abuses that made all the headlines a few years ago. They're more tax efficient because they don't throw off capital gains distributions during the year because other people happen to sell their shares. You can control when you take the gain or loss with the ETF, and they're generally less expensive. Most mutual funds that are sector specific are actually managed, so you're paying higher expense ratios. An ETF generally just tracks the index; it doesn't try to outsmart the index.
We know how we want the portfolio to behave, we know what indexes we want to follow, so what we want is something that will faithfully follow that index and not try to beat it and miss half the time.
Editor-In-Chief James J. Green can be reached at firstname.lastname@example.org.
About That Floor
At Brinton Eaton, portfolios of any size are built on a "floor" of ETFs, topped off by individual stocks, bonds, or alternatives like real estate and commodities. Jerry Miccolis explains the reasoning:
"One is that we spend much time and modeling to get the asset allocation right to begin with. So we know what classes and what sections we want to be in, and in what proportion given that client's risk tolerance.
The most efficient way to get there, to get the diversification we want inside each of those 20 classes/sectors, is to get there all at once through an ETF. So if we want a certain percentage of the portfolio to be in healthcare or biotech, and we want a good representation of that sector, the most efficient way to do that is through an ETF.
The second reason is that because of the modeling we do, we have pretty rigorous rebalancing standards. If the portfolio drifts outside its desired allocation by more than a certain tolerance, we rebalance back to it. Those rebalancing trades are relatively small fine-tuning trades, and it's more efficient to do that with an ETF than an odd lot of stock.
The third reason is tax loss harvesting. If there were no tax loss harvesting, we'd still have a layer of these ETFs for those other reasons."