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By Brian Langstraat, CFAChief Executive Officer, Parametric

Seattle - Back in the early 1990s, Parametric helped pioneer tax-loss harvesting — selling a basket of securities at a loss and simultaneously replacing it with a different basket of securities — to help clients reduce their tax risk while maintaining their market exposure. That strategy has migrated from the realm of specialty practice to the broader world of investment advisory.

Tax-loss harvesting isn't for every investor

More and more financial advisors are touting the benefits of tax-loss harvesting to more and more clients. After all, if the strategy is good for some investors, it must be good for all investors, right? As with everything else in the finance universe, however, tax-managed investing isn't a free lunch. At heart, tax-loss harvesting is a trade-off between risk and return. In this respect it's no different from any other investment decision, and investors must evaluate tax-loss harvesting accordingly.

For example, will you be comfortable vacating a position to harvest a loss, or is there risk in being out of a position that potentially exceeds the tax benefit? If so, how might you mitigate that risk? If you sell out of multiple positions to harvest losses, are you comfortable with the effect that might have on the portfolio's overall tracking error?1

The responses may be different for every investor, and in our experience the risk-return trade-off ends up favoring certain types of investors. So to the extent that the average investor is being told to harvest losses in knee-jerk fashion, we think they're being done a disservice. Advisors may have some clients who would benefit greatly from tax-loss harvesting, other clients who would see more modest benefits and still others who would see no benefit at all. Overpromising what tax-loss harvesting offers doesn't do those clients any favors.

Advancing the understanding of tax-loss harvesting

Parametric spends a good deal of time helping advisors and their clients with loss harvesting, so it may be useful to devote some energy to lore harvesting — gathering some of the things we hear from advisors and investors from time to time and testing them against what we know to be true.

Here are six true-or-false questions to help you advance your knowledge:

  1. It doesn't matter when you harvest losses in a portfolio as long as you do it before the end of the year.

False: Harvesting losses effectively means doing it continuously — all year round and not just at the end of the year, by which time key opportunities may have already been missed.

  1. Tax-loss harvesting opportunities shrink over time.

True: Over time, especially under bull-market conditions, a portfolio can be expected to appreciate and there could be fewer losses to harvest. The value of tax losses comes from their ability to offset short-term capital gains and defer those taxes into the future. When the gain is eventually realized, it should qualify for the lower long-term tax rate.

  1. You can't harvest losses and maintain similar market exposure at the same time without violating the IRS's wash-sale rules.2

False: You can sell a security at a loss, then immediately purchase a set of similar securities that, from a risk perspective, match the security you sold. You just have to make sure you don't buy back the same security within 30 days.

  1. Harvesting losses works the same way in a separately managed account (SMA) as it does with an ETF or a mutual fund.

False: You can harvest a loss in an ETF or mutual fund only if the entire fund's value falls below its cost basis. And due to the fund structure, excess losses harvested by the fund manager can't be passed through to the investor and must be used to offset gains within the fund. Whereas with an SMA, the investor owns the individual underlying securities, unlocking the loss-harvesting potential of each individual stock.

  1. You can harvest losses in your equity portfolio to offset gains in other holdings, such as real estate.

True: If investors have capital gains elsewhere — in hedge-fund investments, real estate and other holdings — those gains can, with some restrictions, be offset by the losses harvested in their equity portfolios. Under certain circumstances they can even offset ordinary income.

  1. You can harvest losses even when the market is rising.

True: Even when the market is broadly up, certain stocks may be down. For example, in 2017, while the S&P 500® Index saw a total gain of close to 22%, 122 names in the index showed a loss for the year. An investor with direct access to the individual underlying stocks, through an SMA for instance, could harvest those losses to offset gains elsewhere in the portfolio.

Bottom line: Tax-loss harvesting can be a powerful tool that helps advisors provide more value to their clients, but it's not a one-size-fits-all solution. It's not even a many-sizes-fit-all solution. Instead it's more accurate to think of it as a many-sizes-fit-most approach. If any answers to my six questions surprised you, that's OK — they may surprise others who are new to tax-loss harvesting or aren't fully sure how it works. My hope is that, armed with more knowledge, we can all make decisions based not on lore but on good, sound investment principles.

1 Tracking error is formally defined as the standard deviation of the difference between the returns of the portfolio and its benchmark. That is, tracking error measures the dispersion of the excess returns of a strategy versus its stated benchmark.

2 For more information about wash sales, read IRS Publication 550.

S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.

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