The Case for Loss Harvesting

Much of loss harvesting’s benefit is derived from the optionality of realizing gains. A thoughtful investor has the option to pay a capital gains tax either at the pres-ent time or at some point in the future. Although the tax has to be paid eventually, the value of deferral can be significant, especially when compounding over a long horizon. Loss harvesting is also valuable in lower return environments since the tax rates apply regardless of gross returns. One does not need to be an expert in financial analysis to understand that paying taxes on a 6% return is more painful than taking the hit on a 20% return.

Deferring the gain is not the only benefit. There is significant benefit to what is, in effect, a tax rate swap. Imagine realizing short-term losses to offset short-term gains and avoiding the 35% Federal tax rate for such gains in the current year. When realizing the loss, the basis of the portfolio is reduced. Later, when some or all of the holdings are sold, the investor triggers the gain that had been deferred. If the securities were held for longer than one year, the gain is long-term in nature and taxed at the favorable 15% rate. The rate spread provides a permanent difference, effectively reducing the tax rate by nearly 60%.

Some sophisticated managers employ strategies that involve the early realization of long-term capital gains at the favorable 15% tax rate. In doing so, they reset a portion of the portfolio’s basis and replenish the portfolio with short-term holdings. This is done to take advantage of the opportunity to harvest valuable short-term losses in order to shelter the higher-rate short-term gains (35%) that many investors are receiving from alternative investments such as hedge funds. Much of the performance from hedge funds comes from realized gains, an estimated 60% or more of which may be characterized as short-term gain. This can be an effective approach for investors with significant allocations to alternate investments where the investor expects a continuing stream of short-term gains.

When evaluating managers for tax management or loss harvesting prowess, financial planners should look for managers who have made it a central part of their process. These managers realize that the tax and performance balancing act needs to occur throughout the year. By calibrating the tax impact of all buys and sells, not just those at year end, they provide the greatest chance of maximizing after-tax returns. The CFA Institute has provided after-tax performance standards to the industry for a number of years, and a strong indicator of a manager’s focus on these issues is whether he furnishes after-tax performance reports. After all, the bottom line for the taxable investor is the after-tax performance that he can spend!

Not Just Loss Harvest Engines

Whether active or passive as to security selection, a manager who employs loss harvesting is not buying securities in hopes that they will go down. He is merely dealing with the reality that there may be losses at any given time in the portfolio. It is essential to evaluate whether the loss harvesting process will help meet the portfolio’s performance objective and reduce the tax bite.

Generally, the benefit of loss harvesting increases with the level of volatility in the market. Markets combine varying levels of direction, strength, and volatility, so clients will have different experiences depending on when they fund their account. For example, investors funding in 1998 enjoyed strong equity returns, but because of high volatility they had ample loss harvesting opportunities. In 2005, we have seen relatively low volatility providing few windows for loss harvesting. That said, the talented tax manager can still add more value than a tax-oblivious competitor even in low loss harvesting environments. These managers have ways to capture tax savings from this more episodic volatility, thus providing benefit to justify the cost of the trade. Managers who look to take losses only in the fourth quarter will typically capture a fraction of the losses available.

For many active managers, loss harvesting is a distraction to their core focus on securities selection. These managers should be selected for the right reasons since loss harvesting may materially compromise their performance. For the right passive managers, tax loss harvesting should come more easily as they are tracking a benchmark instead of trying to beat it, and they should find it easy to identify suitable replacement securities for their loss harvest trades. It is critical to remember that the primary objective for these managers is capturing the return of a benchmark. Asking them to deviate from that benchmark to garner tax savings will compromise the pre-tax objective without guaranteeing successful tax loss harvesting.

Since after-tax returns are the only returns that really matter to an investor, and because taxes are the single highest investor cost, loss harvesting is a technique that investors cannot afford to ignore. Yet despite its advantages, it traditionally has not received the attention it deserves. Today, however, taxable investors and their advisors have a renewed appreciation for the role that loss harvesting can play, which is resulting in an increase in its popularity. In addition, the growth of personal assets, increased investment education, and heightened investor participation are contributing to the awareness of loss harvesting. Importantly, managers and program sponsors are stepping up their efforts through improved processes and technology to make tax management available as a regular feature. Investors can find the right fit for them by finding managers or separate account programs that have tax management embedded in their approach, applied systematically throughout the year, and by regularly monitoring the pretax versus after-tax tradeoff.

Robert Breshock is director, private client services, for Parametric Portfolio Associates in Seattle, a $16 billion firm that helps advisors and their clients improve after-tax performance with the goal of creating and preserving wealth. He can be reached at [email protected].