Is tax-loss harvesting 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 lately, during the market downturn triggered by the coronavirus outbreak, we’ve observed some new behavior around loss harvesting, and it’s disconcerting—and potentially damaging to the long-term health of investors’ portfolios.
When should you harvest tax losses?
During periods of market distress, such as the one we’re experiencing now, many advisors see tax-loss harvesting 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 have tumbled 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. (More on this below.)
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. Or that many of the losses are so minimal that the transaction costs of the trade wouldn’t make realizing the loss worthwhile. (Selling out of an SMA also discards any customizations the client may have made, such as factor tilts or responsible investing screens.)
But most of all, what these advisors misunderstand is that 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 (portfolios that have short time horizons and expect to liquidate).
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. Lately 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—and 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.
The bottom line
Parametric has decades of experience building customized SMAs for advisors and their clients. And while we’ve always been—and remain—big fans of tax-loss harvesting, our approach has always been to first get the equity beta exposure right for the client, then be very careful about risk control, and finally systematically harvest losses over time. It’s an approach that’s worked through all market environments, and it’s one we think advisors should keep in mind as we work together through the current one.