The presence of taxes should affect the way an investment portfolio is managed, but most portfolio managers are not sensitive to tax issues. Indeed, investment performance traditionally has been measured on a pre-tax basis only. This should not come as a surprise given the origins of money management. First, the bulk of professionally managed assets were for tax-exempt investors such as pension plans, endowments, and personal retirement accounts. Second, active managers are typically unwilling to compromise security selection for tax considerations.
Fortunately, the tax management technique known as tax-loss harvesting is increasing in popularity. According to a recent survey conducted by The Money Management Institute, more than 70% of money management firms have seen an increase in loss harvesting during the last three years. This is significant because taxable separate accounts traditionally have not been managed with an eye toward taxes, even though this is a key benefit to having a separate account. A 2002 Cerulli Associates report concluded that less than one third of taxable separate accounts benefit from special tax treatment.
The MMI study also showed that the increase in loss harvesting is a result of client requests instead of coming from advisors, programs, or proactive money management strategies. Among accounts using loss harvesting strategies, clients were responsible for 77% of the requests. The survey also found that loss harvesting is used often in both bear and bull markets, with 43% of MMI respondents reporting no significant difference in their use of loss harvesting in positive months versus negative months.
Taxable investors should cheer this study. If clients are asking for loss harvesting, the managers and separate account platforms will eventually offer it as a standard and systematic feature. In fact, wrap programs are pointing to tax management as a key feature in the new, rapidly growing category in managed accounts–multistyle portfolios or unified managed accounts (UMA) with tax overlay management.
Not every manager who claims to be tax sensitive achieves it the same way or at the same level, however. It is critical to evaluate the manager’s tax management skills based on a keen understanding of the manager’s process, just as an investor would evaluate the stock picking acumen of an active manager. To understand what loss harvesting offers, it is important to know how market conditions set the expectation of the potential benefits delivered.
Simply defined, loss harvesting is a process that realizes capital losses within the portfolio. When pursued properly, whether by active stock pickers or passive managers, it will allow for similar pre-tax performance (versus non-tax managed accounts) while delivering a significantly better after-tax result. Loss harvesting enhances after-tax returns by creating losses in order to mitigate gains. To the extent there are excess realized losses from one portfolio, those losses can be used to offset any other capital gains that the investor may incur that year. Under current law, unused losses can be carried forward indefinitely.
Some loss harvesting approaches can add from 0.50% to 1.50% of after-tax performance (average annualized over 10 years) versus their benchmarks.
In practice, loss harvesting is a relatively straightforward technique as long as the portfolio manager takes into account several key considerations with respect to portfolio structure and trading. For example, risk management considerations have the potential to reduce loss harvesting because of constraints such as sector and industry alignment that may be applied in order to maintain a portfolio that tracks its respective benchmark.
Transaction costs must also be considered when evaluating the benefit of the losses versus the cost of the trade. Harvesting too frequently may not enhance after-tax returns significantly, but could lead instead to higher levels of turnover and transaction costs.
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