Tax Harvest Myths: I can do tax-loss harvesting myself

Avatar photo by Hiren B. Patel, Head of Advisor Solutions

Key Takeaways

Tax-loss harvesting was once a largely qualitatively-driven, ad-hoc and time-consuming process. The costs – and opportunity costs – were significant. For some advisors they still are.

Tax-tech has simultaneously expanded opportunity and created a new model of sophistication, automation and usability for tax-loss harvesting.

The potential for delivering enhanced and differentiated outcomes – beyond those possible with manual processes – is here.

Evolving Processes Beyond the Spreadsheet

As proponents of ongoing, automated tax-loss harvesting we see considerable value in the process and its outcomes. From our vantage point, the technology (what we refer to as tax-tech) has fundamentally amplified the opportunity set and the scale of the potential benefit. But an oft-cited criticism of tax-tech is that it’s unnecessary – harvesting opportunities can be identified manually and trades made easily, as they always have been.

We would (and indeed do) argue that continual monitoring of opportunities that ebb and flow rapidly – and the cumulative benefit of harvesting transactions on overall portfolio performance – are all but impossible to replicate manually, especially at scale. The need to customize portfolios adds an additional dimension of complication. If, for example, a portfolio’s exposure to particular sectors is constrained or tailored in some way, then manual management gets exponentially more complex, time consuming and potentially error prone.

Nevertheless skepticism, perhaps healthy skepticism, remains. Let’s look closer at the benefits of sophisticated tax optimization and why manual tax-loss harvesting can – and we believe should – go the way of the 8-track, video tape and the ipod.

The Equity Conundrum: Dispersion is Constant Yet Often Fleeting

Let’s begin with a common, but incomplete, use case – the stock level dispersion story. Markets ebb and flow, and these fluctuations are of course fairly easy to monitor. But the aggregate market data obfuscates what’s happening within. From FAANGs to the Magnificent Seven to… whatever acronym, pseudonym or whatever name comes next, investment performance is far from uniform.

Markets are often driven by clusters of strength and simultaneous swaths of decline and mediocrity.  And because each new investment resets the dispersion clock, harvesting opportunities have to be monitored and evaluated at the tax lot and not just at the portfolio level. And time is always of the essence. In April of 2023 for example, the regional banking crisis arose and then faded with surprising speed. This provided real-time harvesting opportunities for the nimble (and the automated) even though the S&P ended the month slightly in the black.

Continually taking advantage of this stream of fluctuating opportunity manually requires an awful lot of our most valuable resource – time. Time that could have been used to check in with that client you meant to call. Time that could have been used to learn that new software. Time that could have been spent on your short game or helping your kid with her homework.

And Stocks are Far from the Whole Story

Harvestable losses – and therefore the opportunity to add value – occur across and within asset classes. The 2022 bond market was historical for all the wrong reasons. A more than 16% drop in the Bloomberg US Aggregate (the agg) through October generated investor consternation and the opportunity for tax-tech savvy advisors to mitigate some losses, just when it was needed most.

But for investors it’s the portfolio that matters.  Identifying a harvestable opportunity is an essential signal, but that signal is just a first step in successfully managing a tax-optimized portfolio. The optimal loss threshold by which an opportunity should be realized must also be determined. Answering the main question “Do I harvest this position now or wait till there is a larger loss?” is not an intuition-based response but one of mathematical calculation.

Here again, the decision must account for a broad and dynamic set of issues – including client and manager tolerances for the security/asset class sale and protecting against wash sales.  It’s also essential that the degree to which each individual trade might have a larger, cumulative impact on the portfolio be measured and monitored.

It’s a multi-dimensional challenge to be sure. Today though it’s one that tax-tech solves with aplomb.

We’ve written in some detail about how tracking error can be effectively balanced against tax benefits. The sophisticated ongoing analysis needed was once the bastion of institutional investors but has now been democratized.

At 55ip, our ActiveTax platform dynamically selects proxy securities and baskets of securities.  “Best fit” proxies are identified not simply by industry sector, but by analysis of:

  • Qualitative factors
  • Relative and absolute volatility
  • Correlations relative to other portfolio components

Importantly, this analysis cannot be static. Past performance being no guarantee of future results, proxy analysis is continual. The net impact is designed to avoid wash sales and reduce the impact of substitutions and therefore tracking error.

The Growing Tax-Tech Opportunity

When I was young, I remember my father lifting the hood on the family’s Toyota on the weekends. With the manual, a few tools and a bit of time, he’d service our car and repair most of what went wrong. Today, automotive performance, whether measured by reliability, mileage and/or safety (risk mitigation!), are all much improved. But that improved performance requires a level of automotive sophistication far above my father’s abilities and the time he had to spend – my siblings and my mother made sure of that.

Even with the best intentions and resources, the opportunity costs of manual tax optimization are significant. Automated, sophisticated tax-advantaged trading enhances the opportunity set, delivers scalable efficiency, meaningfully differentiated services, and the potential for enhanced outcomes. Tax-tech has changed what’s possible and what’s scalable. The benefits to your business (and perhaps your short game) tangible. And there’s more to come.

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