Tax-Loss Harvesting

Jon Weatherly

Jon Weatherly June 22nd, 2021

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 of 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 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.

Read More By Jon Weatherly

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Investment advisory services are offered through Concord Wealth Partners, an SEC Registered Investment Advisor.

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