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.