Active Tax Management

What is tax-loss harvesting?

Tax-loss harvesting is the process of selling securities at a loss and using those losses to offset taxable capital gains, thus reducing the investor’s tax bill and improving after-tax returns. At Aperio, we use separately managed accounts (SMAs) which allow us to manage portfolios of individual equities. Taking advantage of the natural price movements in stocks, we continuously rebalance a portfolio to recognize tax losses from securities that have declined. Recognized tax losses can offset taxable capital gains from other assets such as hedge funds, active mutual funds, private equity, company stock, or the sale of private businesses. This reduction in taxes paid gives rise to an improvement in after-tax returns.

What is “tax alpha”?

Traditionally “alpha” is the measure of the outperformance, relative to the benchmark, attributed to stock picking. As indexers employing tax-loss harvesting, we are seeking to match pre-tax benchmark performance (no alpha sought) and to outperform on an after-tax basis. “Tax alpha” is the term we use to describe the improvement to after-tax returns that can be attributed to the use of tax-loss harvesting.

Why do I need “tax alpha” or tax-loss harvesting?

Not everyone does. All taxable investors benefit from investing in tax-efficient strategies. For retail investors, indexed mutual fund and ETFs offer investors good, low-fee options. For investors who have Schedule D gains, tax-loss harvesting strategies are valuable tools for reducing the overall tax bill and improving portfolio after-tax returns. The losses are only valuable if you have gains now or anticipate needing to offset gains in the future.

What if I don’t have any gains?

If you don’t have any gains and don’t anticipate any in the future, then you should stick with a very low-cost, tax-efficient index fund or ETF. There is no reason to pay slightly more for tax losses you can’t use.

Can’t I just do this with index funds?

You can do some tax-loss harvesting using index funds or ETFs. There are a few things to keep in mind. When the fund is up, there is no tax-loss harvesting available. However, in an SMA you own all of the underlying securities, so even if the market is up, some of the securities in the account will be trading at a loss, thus allowing for tax-loss harvesting, regardless of market performance. For investors, especially those with a heavy allocation in tax-inefficient hedge funds, a more systematic and consistent approach to tax-loss harvesting may prove to be valuable.

After a certain amount of time, is my portfolio going to be concentrated?

We have not experienced a significant decrease in stocks nor a significant increase in tracking error. This is mainly because we are trading the portfolio over time to have a balance between loss harvesting and tracking error. So while there might be a slight increase in tracking error, it is not significant. Our simulations, and the simulations of others, bear out the negligible effect that time has on tracking error.

Doesn’t the benefit of loss harvesting run out after a few years?

In normal markets, tax-loss harvesting occurs mostly in the first few years of managing a portfolio. As losses are taken and gains are deferred, fewer losses become available in future years. This benefit does not completely run out as we are reinvesting dividends along the way. However, the value of loss harvesting portfolios does not deteriorate because of the compounding of the tax savings. By deferring paying those taxes now, the money stays invested and “grows” at the rate of investment. It is the compounding of these tax-savings dollars that maintains of the value of loss harvesting portfolios.

When do the tax benefits of working with Aperio run out?

The tax benefit of loss harvesting portfolios versus holding just a mutual fund can continue to add value every year for periods as long as 20 or 30 years for an account with no new cash added, but the time value of the deferral of tax liability continues to compound so that longer horizons like 20 years can offer similar benefits to shorter holding periods like 10 years.

Can you help me understand why AMT is important?

The alternative minimum tax is effectively a separate tax regime. Taxpayers are required to calculate their income under the standard rules and then again under AMT. Which tax rules apply to an investor can make a big difference in how to implement tax-efficient strategies. Good tax economics require using the actual rates people or trusts pay rather than just assuming some simple blanket rule. Similarly, state taxes vary widely and need to be incorporated in any good portfolio strategy based on after-tax returns. While it’s a pain to have to think about both AMT and conventional taxes, it pays for an investor to incorporate the nuanced differences between the two systems.

Why can’t I get tax alpha in my mutual fund?

Tax alpha can accrue only in a separately managed account (SMA) because commingled funds such as exchange-traded funds and mutual funds are prohibited by law from distributing losses to investors.

All investments involve risk, including loss of principal invested. Past performance does not guarantee future performance. Individual client accounts may vary. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Please refer to the "Disclosure" link below for additional information.