What’s Next for Fintech? Tax-Tech

Avatar photo by Swati Bairathi, Chief Product Officer

Financial technology is delivering a better standard of tax-efficient asset management in the form of tax-tech.

This piece was originally published in the March/April 2024 issue of Investments & Wealth Monitor.

From machine-learning augmented stock picking to real-time risk analysis of weather patterns, “what’s next for our industry” headlines are fascinating and futuristic. But technology is solving specific problems and improving investor outcomes today, not just at some undefined point in the future.

Sophisticated trading technology and fractional share ownership have reduced fees and made direct indexing accessible for most investors. With the ascension of tax-tech, direct indexing also provides a foundation for the delivery of automated, tax-smart investing in ways that are broader, more sophisticated, and more impactful than would have been practical for even the largest portfolios just a few years ago.

In an industry that’s simultaneously homogenized and yet rife with complexity, opportunities for advisors—freed from operational tasks all but impossible to scale—to differentiate their service capabilities and deliver demonstrably better client outcomes are within reach. Our firm is at the forefront of the technology-driven progress of automated, personalized, tax-smart investing. From customized models and separately managed accounts (SMAs) to direct indexed portfolios, we’ve seen this progress firsthand, and we expect to see a lot more.

Tech-Forward, Tax-Smart, Process-Wise

In combination with direct indexing, automated tax-smart trading has removed the manual labor involved in harvesting losses from taxable portfolios. It’s also changed the size of the harvesting opportunity itself and the ease and scale at which it can be accessed. It’s doing away with a year-end-only, labor-intensive process practical only for very large portfolios.

Multiple tax lots and significant variance of security-level returns typically have generated an abundance of small short-lived opportunities and a dearth of worthwhile, actionable trades. That’s because, until now, acting on them required constant security-level analysis and consistent, diligent monitoring of a portfolio’s overall exposure. If an investor’s portfolio was designed to replicate or track the S&P 500, continual harvesting trades had the potential to create sizable differences over time.

Technology Has Changed the Rules

By continually seeking, evaluating, and identifying security-level opportunities throughout the year, tax-smart automation ensures a larger universe of harvesting opportunities, the sum of which could significantly exceed the year-end-only event (see figure 1). For each individual security and tax lot in a portfolio, intra-year market volatility and security- and sector-level dispersion become tailwinds in bad years and good.

Figure 2 illustrates how, even during a year that ends in a gain, intra-year volatility may still generate harvesting opportunities. Intelligent, automated tax-loss harvesting throughout the year can improve processes and results while reducing time spent on operational tasks.

Tax-Managed Investing: It’s Not Just for Equities

The 16.1-percent drop in the Bloomberg U.S. Aggregate Bond Index during January–October 2022 threw investors for a loop. The 60/40 portfolio’s reputation as “set it and forget it” took a kick in the pants. Granted, the resulting higher yields, a moderating outlook for inflation, and the end of U.S. Federal Reserve tightening have all improved the performance and outlook for bonds. But investors seeking safety and diversification from fixed income in 2022 were zero for two.

There was, however, a silver lining—an opportunity for tax-loss harvesting. As with equities, if you took an automated approach, there were worthwhile opportunities within the opportunity. No one wants a repeat of 2022, but advisors with the ability to partially offset fixed income losses when—not if—they occur again are well positioned to differentiate their services to their clients and add value when it’s most needed.

Figure 3 is a simplified illustration of automated tax-loss harvesting at the fund or portfolio level only. In this example, one tax lot is purchased at the beginning of the year and the market peaks and troughs are identified with the benefit of hindsight—but the thesis still holds. That is, the easier it is to tax-loss harvest, the more often it can be done; and the more often it’s done, the larger the opportunity.

Tax advantages beyond accumulation. The same technological advances that can add value during accumulation can continue to add value through decumulation by managing the tax impact of selling securities. It can prioritize the sale of investments with the lowest gains and delay the sale of those with the largest. Let’s not forget the intersection of the two certainties in life: Some investors may never sell a security and inheritors of appreciated stock receive a step up in basis at death. Passing on stocks with the highest gains to heirs optimizes this benefit—reducing the investor’s decumulation tax bill without raising that of the inheritors.

Measuring the impact. It’s imperative that we don’t accept the benefits of automated tax-loss harvesting at face value. Advisors must consistently deliver these benefits, with the cumulative impact measured and continually validated.

Tax-Tech at Scale

Implementing tax-loss harvesting at scale is predicated on the integrated delivery of operational excellence, efficiency, and usability. Complex trading algorithms, scalable platforms, intuitive user interfaces that spur engagement, and the delivery of sophisticated technological advancement require a holistic approach. When delivered well, it can create significant downstream benefits.

Tax-Smart Transitions: The Tech Solution that Empowers the Investment Solution

When an advisor proposes enhancements to a portfolio, the tax consequences of getting from portfolio A to portfolio B create an innate problem. The same automated security-level analysis that helps investors build portfolios designed to help them keep more of what they earn also facilitates tax-efficient transition into those portfolios. This intelligent compromise between perfect alignment with the new portfolio and the tax impact of that alignment can now be managed based on investor preference and enhanced over time.

Automated Tax-Loss Harvesting has its Critics

From the Sinclair C51 to the Microsoft Zune2 and Google Glass,3 history has given us many examples of viable technology that is far from optimal. Direct indexing and automated tax-loss harvesting have their detractors, and their arguments are worth analyzing.

Harvesting Opportunities are More Persistent than Some Believe

Skeptics argue that if the market keeps going up and we wait long enough, nearly every stock in an index will rise. Granted, time in the market is an investor’s best friend—only 10.1 percent of rolling five-year periods are negative for the S&P 500, and over 10 years it’s 2.9 percent.4 But direct indexing and automated tax-smart investing give advisors the ability to look—and act—at the security level where the story (or more accurately, stories, plural) can be very different. The dispersion of stock returns within the index is the key determinant of the opportunity and can differ greatly from the returns of the index itself.

Past performance is, of course, no guarantee of future results. But even across long periods, just as some outperformers persist, so too can index laggards. By May 2023, the S&P 500 was up 8 percent but most stocks in the index were down—the median return for the year at that point was –0.2 percent.5

In 2023, dispersion for the S&P 500 climbed to 31 percent at the end of March, up from 23 percent in February and above the 75th percentile historically. 6 In July 2023 alone the S&P 500 rose 3.1 percent, but the gap between the top- and bottom-performing stocks in the index was more than 55 percent.7 It’s the same story at the sector level. By the end of 2023, information technology was up 56.4 percent and utilities had fallen 10.4 percent.8

Not every underperformer is WorldCom and not every dip is a crisis. If you’re looking closely and constantly, harvesting opportunities always are ebbing and flowing, usually without headlines. Annual and annualized numbers by definition obscure intra-year volatility. In 2020, the gap between the year’s bottom (down 34 percent) and end-of-year return (up 16 percent) was 50 percent. In 2023—a relatively calm year—the swing was 34 percent (a 24-percent gain and 10-percent loss intra-year).9 Granted, this volatility also can be a benefit to harvesters owning the index at the single fund or exchange-traded fund level, but it can exacerbate dispersion at stock and sector levels.

How Reasonable is ‘Extreme Buy and Hold’?

The premise of eroding opportunity is largely based on a narrow application of “buy and hold.” That is, if a lump sum is invested on a specific date, even the laggards eventually generate a positive return or leave the index (see figure 4). But in practice that’s a very limited use case. Whether through dollar-cost averaging, ad-hoc investments, or automatically reinvesting dividends, many investors continue to add to their portfolios during lengthy accumulation phases and beyond.

Each new purchase represents a new entry point into each of the stocks in the index—with a resetting of the dispersion clock for that reinvestment (see figure 5). Should the previous period’s laggards reverse course, new laggards emerge and the opportunities for harvesting continue even if the names change.

Solving the Tracking Error Conundrum

A primary benefit of direct indexing is the ability to change, fundamentally or tactically, portfolios at the security level while replicating an underlying index. But whether we’re tailoring around other positions, screening for impact or fundamental criteria, or trading to realize tax losses, the degree of change, by definition, introduces differences in composition from the index. Thus, the potential for differences in risk and return, and therefore tracking error, also are introduced. Investors seeking index-like returns should expect index-like returns—and risk. The concern that frequent automated tax-loss harvesting can create large differences in holdings and therefore large differences in performance is theoretically valid, but it was more valid in the past, before the emergence of tax-tech.

The solution, though, can’t simply measure security-level losses and dispersion. It must constantly measure and effectively balance the total impact of differences from the index versus the cumulative benefits of tax-loss harvesting (see figure 6). The sophisticated ongoing analysis needed was once the bastion of only the largest institutional investors. It’s now been democratized.

Delivering the Best Fit: Effective Guardrails Between Tracking Error and Tax Benefit

Index replication for tax-smart portfolios that use the S&P 500 as their benchmark typically involves about 350 stocks, not 500. This is essential because the portfolio’s risk profile must be established and maintained. A simple model could keep similar overall sector weights to the index despite not owning every security, but a more sophisticated factor risk model can more closely and effectively optimize the portfolio’s profile against that of its index.

Using fewer stocks to replicate an index provides an important advantage for automated tax-loss trading. Losses can be harvested by replacing positions with other stocks (or baskets of other stocks) in the same industry sector or with similar risk characteristics. As a result, the portfolio can maintain a similar risk–return profile.

And when it comes to tracking error, the name itself is a misnomer in our tax-loss harvesting use case—we’re tracking the expected impact of deliberate portfolio differences and not errors. This enables us to tax-loss harvest without undue impact on the portfolio itself. The tracking guardrails defined by the portfolio’s manager can be continually monitored and easily adhered to.

Operational Excellence Delivered with Operational Simplicity

A new standard for automated, personalized tax-smart investing has emerged: a highly sophisticated tax-smart optimization engine integrated with a simple user experience and operational efficiency. Free from the restrictions and labor of a manual, year-end process, advisors can differentiate services, manage risks, and scale practices—while helping clients keep more of what their portfolios earn. Tax-tech is already here and delivering value for investors and their advisors—often when it’s needed most.


1. The Sinclair C5 is a small one-person battery electric recumbent tricycle, technically an “electrically assisted pedal cycle.” See https://en.wikipedia.org/wiki/Sinclair_C5.

2. Zune was a brand of discontinued portable media players sold by Microsoft. See https://en.wikipedia.org/wiki/Zune.

3. Google Glass is a brand of smart glasses developed and sold by Google. See https://en.wikipedia.org/wiki/Google_Glass.

4. S&P; “US Stocks Portfolio: Rolling Returns,” https://www.lazyportfolioetf.com/allocation/us-stocks-rolling-returns/.

5. CNBC. https://www.cnbc.com/2023/05/24/chart-s-and-p-500-is-up-this-year-but-most-stocks-are-down.html.

6. ETF Trends/S&P Global. Dispersion is the annualized, index-weighted standard deviation of the index constituents’ full-month total returns. https://www.etftrends.com/managed-futures-channel/mind-gap-equity-dispersion-remains-pronounced/.

7. ETF Trends/S&P Global.

8. ETF Trends/S&P Global.

9. J.P. Morgan Asset Management Guide to the Markets, page 14. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/.

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