More Investors Should Have Access To “Tax Alpha”
Sell low. It’s the opposite of conventional wisdom that tells us to always “buy low, sell high.” But for some investors, selling low — even at a loss — can be a powerful tool to generate what investment professionals call “tax alpha.”
Done strategically, selling a portfolio’s losers enables the investor to book a capital loss, which can be used to balance out capital gains elsewhere. And those gains don’t necessarily have to be gains on securities. You can use capital losses from stocks to reduce your liability for capital gains in your business, for example, or on hard assets like property.
This process, called tax-loss harvesting, has many uses and potential benefits. But investors planning to take advantage of this strategy should be aware of a few key issues.
The first is that many advisors and financial planners, even some of the biggest advisory firms in the business, don’t offer this service. They don’t because they can’t.
Why? Because harvesting capital losses requires that you own individual stocks. But many RIAs, both large and small, rely solely on mutual funds, ETFs, and other fund vehicles to build client portfolios. They don’t use individual stocks in client portfolios, for reasons of internal costs, efficiency, and scale. Technology and automation make it easier for money management firms to lower their costs and increase their capacity, building out cookie-cutter, commoditized products that may have a veneer of something custom, when they really aren’t.
That observation is certainly true in the area of customized tax-loss harvesting. Think about how fund vehicles work in practice, particularly actively managed mutual funds. Inside the fund, the manager may be selling losers and harvesting losses. But those sales/losses are balanced against the winners inside the fund. As an investor, you only get to see the total performance that comes out at the end. If it’s a decent-performing fund, there will be more winners than losers in that basket of stocks, and the fund’s share price will go up.
That’s good news, as long as you’re not trying to employ a tax harvesting strategy. With fund investing, selling individual stocks to harvest capital losses is done at the sole discretion of the fund manager. And all the tax loss benefits accrue to the fund, not to you personally.
So, if your adviser only uses mutual fund and ETF vehicles in client portfolios—rather than individual stocks—then you’re out of luck when it comes to implementing a “tax alpha” strategy.
Second, it requires hard work, expertise, and advanced systems to create and implement a tax-loss harvesting strategy. At Concord Asset Management, the first thing we do is work with the financial planner to determine how much of the portfolio should be dedicated to this strategy — generally 40% to 60% of a client’s total portfolio assets. In our program, we have created sleeves that directly invest in two distinct asset classes, U.S. value, and U.S. growth stocks. Thus, we also assess the client’s existing holdings to determine if any current positions fit into one of these two sleeves to avoid unnecessary turnover when implementing the tax-loss harvesting strategy.
Then we use state-of-the-art technology, and a process called optimization, to a create portfolio of individual stocks that are expected to mirror the performance our internal U.S. value or U.S. growth benchmarks.
And here’s the exciting part: now that the client owns individual stocks, we can decide how, when, and why we want to harvest any losses that show up in the portfolio. We can embed tax-loss harvesting into the portfolio’s regular rebalancing approach, when appropriate. Or maybe there is a need to reduce a concentrated position, which we can do systematically over a period of time. We can also optimize the portfolio according to any criteria the client has in mind such as socially responsible investing. In fact, we have the capabilities of including individual values that a client feels are important enough for us to include in our proprietary screening process for their individualized portfolio. Eliminating fund holdings problematically reduces the impact of year-end fund distributions, which can be significant.
Finally, we believe that there is a no more important element in tax-loss harvesting than the strategic planning that goes into it. To be truly effective, tax-loss harvesting needs to be a collaborative effort, including the client, financial planner, tax advisor, and investment manager.
Some examples of this are, how do we best time the losses to be most useful from a tax perspective? Is the capital loss part of a business planning exercise? Is the loss being used to offset gains in the value of a hard asset? Or, to offset gains in a highly concentrated asset that requires diversification (e.g., for corporate executives who receive large grants of stock or stock options; or investors with decades-long holding periods whose portfolio may be over-allocated to a small number of names).
The key takeaway is this: tax-loss harvesting is a powerful tool based on a simple premise. Sell low when that capital loss serves a strategic purpose. But this takes work, discipline, sophisticated systems, and a deep understanding of the individual client to do it right.
Author
Mitch York, CFA®
CIO
Concord Asset Management
———————————-
Disclaimer: Concord Asset Management (“CAM”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CAM and its representatives are properly licensed or exempt from licensure.
The information provided in this commentary is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All data is as of the end of April 2021 unless otherwise noted. Data sources include www.morningstar.com. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Concord Wealth Partners, LLC (“IA Firm”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from IA Firm. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. IA Firm is neither a law firm, nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of IA Firm’s current written disclosure Brochure discussing our advisory services and fees is available upon request or at https://concordassetmgmt.com/. Please Note: If you are an IA Firm client, please remember to contact IA Firm, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. IA Firm shall continue to rely on the accuracy of the information that you have provided. Please Note: IF you are an IA Firm client, Please advise us if you have not been receiving account statements (at least quarterly) from the account custodian.
Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. You cannot invest directly in an index. Stock markets, and many individual equities, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
The price of bitcoin and other digital currencies has fluctuated unpredictably and drastically. You could experience significant and rapid losses. Profits or losses from investing in bitcoin are virtually impossible to predict. Platforms that buy and sell bitcoins may be unregulated, can be hacked, may stop operating, and some have failed. Unlike banking institutions that can provide FDIC insurance, there are no such safeguards provided to digital wallets. Bitcoin payments are irreversible. Once you complete a transaction, it cannot be reversed. Reversing a transaction depends solely on the willingness of the recipient to do so.
