Tax loss harvesting used to be an end of year tradition – with advisors and individuals poring over account statements to identify stocks that could be sold at a loss in December to reduce taxes paid the following April.
The intersection of academic research and technology has turned tax loss harvesting into a year-round activity for some clients, popularized first for larger investors by a few innovative asset managers and private banks and more recently for the mass market by online advice providers.
Tax Loss Harvesting
Tax loss harvesting strategies are most effective when funded with cash, though in many cases we see strategies funded with the combination of cash and a legacy stock portfolio. Clients often turn to tax loss harvesting strategies after an active relationship has “gone wrong,”seeking a lower-cost and more tax-sensitive alternative to active management.
The most common approach to harvesting involves equities (though it can also be used with less effectiveness for portfolios of ETFs or mutual funds), with the portfolio manager building a portfolio that attempts to track an index before taxes while generating enough tax losses to beat the portfolio after-tax.
The strategy takes advantage of the natural movement of stock prices, identifying losses among portfolio holdings and selling those positions to capture the loss. As stocks are sold, replacement securities are purchased so as to maintain the portfolio’s risk positioning relative to the benchmark.
For example, it’s common to replace similar securities for one another, such as Coke for Pepsi, Exxon for Chevron or Bank of America for Wells Fargo. Risk models help to identify less obvious substitutions, but these intuitive examples provide a good example of the risk management approach inherent in the strategy. Realized losses generated by the strategy are intended to be used to offset gains, thereby reducing or deferring tax pain.
Concentration Stock Positions
An increasing number of investors hold a significant portion of their net worth in company stock and options. Although they are passionate believers in their company, many are all too aware of the risk associated with concentrating their net worth in a single company. Memories of the demise of companies such as Enron, AIG and Bear Stearns are all too fresh, and clients realize that events beyond their control could cause them to lose their nest egg and career at the same time.
One common method used to “un-lock” concentrated potions is a tax loss harvesting portfolio. Tax loss harvesting is a way to reduce the tax impact of selling a portion of the concentrated holding, and facilitates the creation of a more diversified portfolio.
There are a few key assumptions that inform our thinking about tax loss harvesting, and have meaningful implications for the success of the strategy.
- Portfolio tax status:Harvesting strategies only work in taxable portfolios!
- Offsetting capital gains: A critical assumption is that the client will have realized gains to offset; realized capital losses can only offset a small amount of ordinary income each year.
- Capital losses only delay the tax bill: Harvesting strategies may delay taxes, but eventually most clients will pay taxes on their appreciated securities, unless they gift the securities to charity or leave them to beneficiaries who receive a step-up in basis at death.
- Tax planning is critical: Clients who expect to be in higher tax brackets in the future may want to accelerate rather than delay gain realization!
- Loss harvesting results typically decline over time: Unless cash is regularly added to a portfolio, a strategy of selling “losers” while holding on to “winners” often leads to a portfolio filled with stocks held at gains, limiting the opportunity to take losses. The best results in a tax loss harvesting strategy are often found in the first five years.
Beware of Inflated Claims
We’ve noted with a mix of amusement and consternation lofty claims about the effectiveness of tax loss harvesting from some online advisors (also known as robo-advisors). Although we are proponents for harvesting strategies, some of the claims we’ve seen are unrealistic given our more than a decade of experience managing tax loss harvesting portfolios and results we’ve seen from competitors we respect.
The claims made by online advisors arguably represent the triumph of favorably simulated back-tested results over actual experience. Although we believe that back-testing simulations serve an important role in portfolio management, we are skeptical of investment managers who use back-tested results too prominently in their marketing campaigns.
Investor and media attention typically is devoted to high-profile managers that have eye-catching returns. This is an understandable fact of life in a headline-driven world, but in our view performance tends to be hard to predict and few managers deliver market-beating performance over extended periods of time. Taxes are often a “silent killer,”eroding investor returns while getting insufficient attention other than in the days leading up to year end or April 15.
The good news for investors is that they can take steps to manage their tax bill, with a tax loss harvesting strategy being an easy-to-implement, low cost and transparent way to do so.