Springtime naturally has me thinking about taxes and tax returns. Tax Day may be behind us, and you might be sick of hearing about it, but it’s not too early to begin thinking about how you can best position your clients’ portfolios for Tax Year 2018.
There are many different strategies for managing taxes in an investment portfolio, but none so popular as tax loss harvesting. When a security is trading at a loss, selling it creates a realized tax loss that can be used to offset a capital gain realized in the same year. Yet there are three common misunderstandings about tax loss harvesting that are worth examining to help set the record straight.
Myth 1: The time to think about tax loss harvesting is at year-end
A common practice is to review the portfolio at year-end to find losses for harvesting. In our experience, continuously monitoring for tax opportunities is much better than focusing on it only at year-end. For example, in the first few months of 2018, we’ve seen significant volatility in the stock market, which has created opportunities for loss harvesting. If stock prices recover, those investors that wait for year-end to look for losses will miss out.
Myth 2: Tax loss harvesting requires finding good substitutes
To claim a tax loss, US taxpayers can’t buy back the security during the wash-sale period. Instead of holding cash and potentially missing out on price appreciation, many investors will look for substitute securities with similar risk and return characteristics. However, it’s not always easy to find a good substitute, and if the replacement security appreciates during the wash sale period, reverting back to the primary security creates a capital gain and wipes out any tax benefit from the original trade.
At Parametric we take a holistic, portfolio-based approach to tax loss harvesting. We think replacing “exposures” is more efficient than trying to find pair-wise substitutes. In other words, instead of searching for pairs of stocks to trade, we use a risk model to quantify benchmark-relative risk at the portfolio level. For example, if there are several stocks in the portfolio at a loss, it may be possible to sell and replace them with a handful of different stocks that in aggregate leave the portfolio with similar sector, industry, country, and risk-factor exposures.
Myth 3: If you double the benchmark-relative risk, the tax benefit doubles
In an index-based portfolio that uses portfolio-level risk management and continuous loss harvesting throughout the year, we expect a 1–2% tax “alpha” given a 1% tracking error risk budget. This often provokes the question, “Can I get 2–4% tax alpha at a 2% tracking error?” Unfortunately, no. The marginal benefit decreases with the level of active risk. The chart below shows that at a more aggressive 2% tracking error, expectations are only about 0.5% higher than the 1% tracking error. Higher than 2% tracking error, there’s really no additional expected tax benefit.
Source: Parametric. For illustrative purposes only. Graph is theoretical and not derived from actual client results. It should not be relied on to make investment decisions. All investments are subject to the risk of loss. See disclosures for additional information.
This is why, over the 20 years we’ve managed portfolios in this manner, we’ve recommended 1% tracking error as our standard and default recommendation for tax-managed clients.
Of course, overall portfolio tax management involves much more than just tax loss harvesting. A continuous tax management process optimizes for tax efficiency and risk-related improvements. And helps make Tax Day a little less taxing.
The Value of Tax Alpha
Parametric’s Custom Core strategies are designed to provide flexible, tax-efficient equity index exposure. “Tax alpha” is how we quantify the value of active tax-management. Here, we explore the two key drivers of tax alpha - the overall market return and cross-sectional stock volatility.
Wash Sales: How to Keep Your Tax Losses from Shrinking
Want to use your investment losses for tax purposes? Running afoul of the IRS’s wash-sale rule is like accidentally laundering your favorite wool sweater in the hot-water cycle. Here's what you need to know to avoid being hung out to dry.
Potential Parametric solution
One of the primary drivers of tax efficiency in a tax-managed Custom Core® account comes from tax-loss harvesting. Parametric portfolio managers will sell the majority of a basket of securities at a loss and simultaneously replace it with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio, such as hedge funds.
Paul Bouchey, CFA, Chief Investment Officer
Paul leads Parametric’s research and development activities across all strategies. He has authored numerous academic and practitioner articles in publications such as the Journal of Portfolio Management, the Journal of Wealth Management, and the Journal of Index Investing. Paul earned a BA in mathematics and physics from Whitman College and an MS in computational finance and risk management from the University of Washington. A CFA charterholder, he is a member of the CFA Society of Seattle.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.