Advisory Blog
Three myths of tax loss harvesting

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

  • All Posts
  • More
      The article below is presented as a single post. Click here to view all posts.

      By Paul Bouchey, CFA, Chief Investment Officer, Parametric

      Seattle - Springtime naturally has me thinking about taxes and tax returns. You might be sick of hearing about taxes, but it's not too early to begin thinking about how you can best position your clients' portfolios for Tax Year 2019.

      There are many different strategies for managing taxes in an investment portfolio, but none so popular as tax loss harvesting. When a security is trading at a loss, selling it creates a realized tax loss that can be used to offset a capital gain realized in the same year. Yet there are three common misunderstandings about tax loss harvesting that are worth examining to help set the record straight.

      Myth 1: The time to think about tax loss harvesting is at year-end

      A common practice is to review the portfolio at year-end to find losses for harvesting. In our experience, continuously monitoring for tax opportunities is much better than focusing on it only at year-end. For example, market weakness early in a calendar year may create opportunities for loss harvesting. If stock prices recover, those investors that wait for year-end to look for losses will miss out.

      Myth 2: Tax loss harvesting requires finding good substitutes

      To claim a tax loss, U.S. taxpayers can't buy back the security during the wash-sale period. Instead of holding cash and potentially missing out on price appreciation, many investors will look for substitute securities with similar risk and return characteristics. However, it's not always easy to find a good substitute, and if the replacement security appreciates during the wash sale period, reverting back to the primary security creates a capital gain and wipes out any tax benefit from the original trade.

      At Parametric we take a holistic, portfolio-based approach to tax loss harvesting. We think replacing "exposures" is more efficient than trying to find pair-wise substitutes. In other words, instead of searching for pairs of stocks to trade, we use a risk model to quantify benchmark-relative risk at the portfolio level. For example, if there are several stocks in the portfolio at a loss, it may be possible to sell and replace them with a handful of different stocks that in aggregate leave the portfolio with similar sector, industry, country, and risk-factor exposures.

      Myth 3: If you double the benchmark-relative risk, the tax benefit doubles

      In an index-based portfolio that uses portfolio-level risk management and continuous loss harvesting throughout the year, we expect a 1-2% tax "alpha" given a 1% tracking error risk budget.

      This often provokes the question, "Can I get 2-4% tax alpha at a 2% tracking error?" Unfortunately, no. The marginal benefit decreases with the level of active risk. The chart below shows that at a more aggressive 2% tracking error, expectations are only about 0.5% higher than the 1% tracking error. Higher than 2% tracking error, there's really no additional expected tax benefit.

      Blog Image Tax Alpha Error April 1

      Source: Parametric. For illustrative purposes only. Graph is theoretical and not derived from actual client results. It should not be relied on to make investment decisions. All investments are subject to the risk of loss.

      This is why, over the 20 years we've managed portfolios in this manner, we've recommended 1% tracking error as our standard and default recommendation for tax-managed clients.

      Of course, overall portfolio tax management involves much more than just tax loss harvesting. A continuous tax management process optimizes for tax efficiency and risk-related improvements.

      And helps make Tax Day a little less taxing.

      Bottom line: One of the primary drivers of tax efficiency in a tax-managed portfolio comes from tax-loss harvesting. At Parametric, we continuously look for opportunities throughout the year for harvesting. The trades can result in a net tax loss for the client, which can offset capital gains realized by other parts of the portfolio, such as active mutual funds or hedge funds.