A down market means more tax-loss harvesting opportunities. We explore why you shouldn’t jump at all of them.
Is tax-loss harvesting (TLH) a valuable activity? Of course it is. No one’s a bigger proponent of this powerful way to increase net returns than we are—in fact, Parametric pioneered the practice of after-tax reporting for separately managed accounts (SMAs), and we’ve been harvesting losses systematically for our clients since 1992.
Partly thanks to our success in this practice, tax-loss harvesting has penetrated the mindset of many advisors and their high-net-worth clients. Investors understand that there’s a real benefit and are keen to take advantage of it. This is unquestionably a good thing. But we’ve observed some behavior around loss harvesting that’s disconcerting—and potentially damaging to the long-term health of investors’ portfolios.
When should advisors harvest tax losses?
During periods of market distress, many advisors see TLH as something good they can do for their anxious clients—immediately—and overemphasize this practice. Some seek to sell every name in their clients’ SMAs that currently shows a loss, sometimes week by week as the markets tumble further. Leaving aside the very real issue of wash-sale constraints, harvesting all the losses in a portfolio creates risk—risk that can cost far more than the transaction will benefit the client.
Other advisors simply request to sell out of the entire SMA, not realizing that, in addition to the losses, there are embedded gains that offset the net realized losses. Selling out of an SMA, and purchasing an ETF in its place with similar exposure, also discards any customizations the client may have made, such as factor tilts or responsible investing screens.
Another risk is making the mistake of trading when losses are too shallow. Some losses could be so minimal that the transaction cost of the trade wouldn’t make realizing the loss worthwhile. There’s also an opportunity cost to shallow losses: Investors could miss out on the potentially greater tax benefits that accrue by waiting to see deeper losses. We avoid harvesting losses daily, or at any other calendar-based frequency, for precisely this reason. Instead we use a trigger-based approach, in which we trade only when there’s sufficient opportunity to add value that justifies the inherent costs of trading. Under the trigger-based approach, we monitor portfolios daily and trade accounts more often during periods of elevated market volatility, as is often the case during bear markets, when there are increased opportunities to harvest losses.
Loss harvesting is a marathon, not a sprint. It benefits clients over the long term as realized losses offset realized gains. This may happen this tax year or in the future, and market returns compound on the tax dollars that are deferred—ideally over many years. It’s not a strategy that necessarily brings immediate benefits, when the loss is realized, or that should be done in tactical portfolios that have short time horizons and expect to liquidate.
Make taxes less taxing
Short-term loss harvesting can introduce long-term risk
It’s important to remember that diversified equity portfolios that harvest losses are equity portfolios first and foremost. They’re designed to provide predictable performance relative to a broad-based benchmark. We’ve seen advisors willing to distort or unbalance their clients’ equity portfolios by selling all securities at a loss or self-selecting securities to harvest. This is risking potentially severe underperformance going forward.
Why severe? The benefits of loss harvesting are significant, but they’re relatively small compared with the cost of missing the greater movement of the market, or significant sections of the market, in these volatile times. Staying systematically invested in the broader market means investors can capture the next rally—and remain on track to harvest future losses and capture future tax alpha.
What are the risks of harvesting tax losses too often?
All bear markets eventually end, but Parametric manages portfolios for the full market cycle. The most severely beaten-down stocks tend to be the most attractive TLH candidates during a bear market downturn. However, these names also tend to bounce back the most aggressively when markets recover. Overemphasizing TLH for these beaten-down names creates the risk of underperforming the portfolio’s benchmark during the recovery period.
Parametric has developed an innovative reversal-risk model that provides extra protection, reducing the chances of underperforming during a market recovery. Standard commercially available risk models fail to fully capture the inherent reversal risk associated with the bottom of a market crash. The usual approach to TLH, risk-managed based on these models, is more vulnerable to reversals and underperformance when stocks bounce back.
The bottom line
Parametric has more than 30 years of experience managing SMAs for advisors and their clients throughout full market cycles. TLH has always been a core focus of our strategies, and our trigger-based approach to trade timing allows us to take advantage of market downturns while minimizing the mistake of harvesting shallow losses. Our innovative risk-management process helps further by reducing the chances of underperforming when markets recover. Through our decades of building tax-managed portfolios, we’ve built a well-informed and thoroughly vetted methodology that works through all market environments.
