Issue 30: 2015

Insights

Harvesting Losses for
Tax-Advantaged Investing

A thoughtful approach aims to enhance after-tax returns.

Photograph by Andy Ryan

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As the saying goes, it’s not what you earn; it’s what you keep.

Pretax investment returns are great, but the only returns we get to keep are after-tax returns. And while we know that taxes can take a bite out of gains, many people are less aware of how big that bite can actually be. In fact, taxes can be one of the largest detractors of performance of actively managed portfolios. Lipper mutual fund return data shows that taxable investors historically gave up an average of 0.98% to 2.5% in annual return to taxes.1 And erosion of wealth because of taxes compounded over time can have an even greater negative impact on wealth accumulation.

For example, assume an equity market price return of 6% and no dividend distribution, and a short term capital gains tax of 40%. Compounding a $1 million investment for 10 years, a taxable investor can lose over $320,000 compared to a portfolio with no tax frictions. This scenario assumes the portfolio’s taxable turnover is 50%. The loss grows if the taxable turnover is higher.

Clearly, considering the tax efficiency of your investments is important — especially now that the higher returns after the financial crisis have been realized. For the rest of the market cycle, we’re expecting lower returns from almost all asset classes, and deeper and more frequent bouts of volatility as central banks around the world return to more normal monetary policies. At the same time, taxes are likely to be more burdensome on a federal level and, for many, on a state level.

Loss harvesting
Can work reliably
regardless of prevailing market conditions.

In a challenging, lower-return environment, preserving as much as possible of your investment returns after taxes is crucial.

Maximizing after-tax wealth

U.S. Trust’s recently launched Tax Advantaged Strategies (TAS) is designed to enhance after-tax returns. The key to this is what is called loss harvesting.

Erosion of wealth by capital gain taxes can be managed or potentially eliminated through loss harvesting. Systematic loss harvesting — selling a portfolio’s losing stocks — can help offset gains realized from other investments, which improves the after-tax return of the total portfolio.

Various academic studies have shown that loss harvesting can improve a portfolio’s after-tax returns by as much as 1.9% a year. That’s a meaningful improvement, especially when pretax portfolio returns are lower. Over longer periods, the compound benefit can add substantially to wealth.

In addition, loss harvesting can work reliably regardless of prevailing market conditions. Although the stock market generally rises over time, it really never does so in a straight line — volatility always exists. Even in rising markets, some stocks have negative returns over periods of time. U.S. Trust’s Tax Advantaged Strategies take advantage of volatility to systematically harvest losses while maintaining exposure to the market. The goal is to track an index — whichever one the client and portfolio manager determine is most appropriate — on a pretax basis, but outperform the index on an after-tax
and after-fees basis.

To be more specific, TAS portfolio managers don’t invest in every single security in an index; they choose a representative set of securities with the goal of closely mirroring the performance of the index over time. In investment jargon, they try to reduce tracking error. Since there are bound to be short periods when some of the portfolio’s individual securities will decline below their purchase price, TAS managers will sell some, or all, of those holdings, book a short-term loss, and then replace them with securities that have similar characteristics. By doing so, the portfolio should continue to behave like the index, seeking to achieve the index return on a pretax basis. But the real benefit is to use those short-term capital losses to offset short-term capital gains in other parts of the portfolio, including, for example, hedge funds or active trading strategies, both of which are generally considered to be much less tax efficient.  

It’s not the same as owning an exchange-traded fund (ETF) or an index fund. As with an ETF or an index fund, a TAS portfolio tries to replicate the performance characteristics of an index. With TAS, you own the individual stocks in the portfolio, rather than shares of an ETF or mutual fund. This allows the TAS managers greater control when it comes to managing a client’s tax situation. When the client’s situation, or the market, changes, they are able to sell and buy individual securities as needed, as opposed to having to sell everything outright. This leads to booking tax losses that offset taxable gains elsewhere, allowing clients to keep more of their return.

Is TAS appropriate for you?

If you prefer passive management, U.S. Trust’s Tax Advantaged Strategies may be an effective approach for an entire equity portfolio, providing exposure to a broad index and the additional benefits of potential tax-loss harvesting.  

Taxable investors
could benefit from
tax-loss harvesting
and the TAS approach.

On the other hand, if you prefer active management, the TAS approach could be particularly effective as a core portfolio component because it would allow for the use of loss harvesting to offset gains from other — non-TAS — investments.

TAS and tax-loss harvesting can also be helpful if you need to diversify out of a large position in a single stock with a very low cost basis, replace an underperforming active manager or if you have a large amount of short-term gains in your portfolio. The fact is that taxable investors could benefit from tax-loss harvesting and the TAS approach. And because it is a separately managed account, it can be tailored to fit the needs of each individual investor.  

Your U.S. Trust team can work with you and your personal tax advisor to review and identify potential tax challenges in your strategy and help determine whether the TAS strategy is appropriate for you.

1 Thomson Reuters Lipper, 2017.

Photograph of hedges by Bartholomew Cooke/Trunk Archive

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Mutual Funds and Exchange-Traded Funds are offered pursuant to a prospectus, which contains the investment objectives, risks, charges and expenses and other important information about the fund. Investors should read the prospectus and carefully consider this information before investing. Prospectuses can be obtained from your investment professional.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

International International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

As the saying goes, it’s not what you earn; it’s what you keep.

Pretax investment returns are great, but the only returns we get to keep are after-tax returns. And while we know that taxes can take a bite out of gains, many people are less aware of how big that bite can actually be. In fact, taxes can be one of the largest detractors of performance of actively managed portfolios. Lipper mutual fund return data shows that taxable investors historically gave up an average of 0.98% to 2.5% in annual return to taxes.1 And erosion of wealth because of taxes compounded over time can have an even greater negative impact on wealth accumulation.

For example, assume an equity market price return of 6% and no dividend distribution, and a short term capital gains tax of 40%. Compounding a $1 million investment for 10 years, a taxable investor can lose over $320,000 compared to a portfolio with no tax frictions. This scenario assumes the portfolio’s taxable turnover is 50%. The loss grows if the taxable turnover is higher.

Clearly, considering the tax efficiency of your investments is important — especially now that the higher returns after the financial crisis have been realized. For the rest of the market cycle, we’re expecting lower returns from almost all asset classes, and deeper and more frequent bouts of volatility as central banks around the world return to more normal monetary policies. At the same time, taxes are likely to be more burdensome on a federal level and, for many, on a state level.

Loss harvesting
Can work reliably
regardless of prevailing market conditions.

In a challenging, lower-return environment, preserving as much as possible of your investment returns after taxes is crucial.

Maximizing after-tax wealth

U.S. Trust’s recently launched Tax Advantaged Strategies (TAS) is designed to enhance after-tax returns. The key to this is what is called loss harvesting.

Erosion of wealth by capital gain taxes can be managed or potentially eliminated through loss harvesting. Systematic loss harvesting — selling a portfolio’s losing stocks — can help offset gains realized from other investments, which improves the after-tax return of the total portfolio.

Various academic studies have shown that loss harvesting can improve a portfolio’s after-tax returns by as much as 1.9% a year. That’s a meaningful improvement, especially when pretax portfolio returns are lower. Over longer periods, the compound benefit can add substantially to wealth.

In addition, loss harvesting can work reliably regardless of prevailing market conditions. Although the stock market generally rises over time, it really never does so in a straight line — volatility always exists. Even in rising markets, some stocks have negative returns over periods of time. U.S. Trust’s Tax Advantaged Strategies take advantage of volatility to systematically harvest losses while maintaining exposure to the market. The goal is to track an index — whichever one the client and portfolio manager determine is most appropriate — on a pretax basis, but outperform the index on an after-tax
and after-fees basis.

To be more specific, TAS portfolio managers don’t invest in every single security in an index; they choose a representative set of securities with the goal of closely mirroring the performance of the index over time. In investment jargon, they try to reduce tracking error. Since there are bound to be short periods when some of the portfolio’s individual securities will decline below their purchase price, TAS managers will sell some, or all, of those holdings, book a short-term loss, and then replace them with securities that have similar characteristics. By doing so, the portfolio should continue to behave like the index, seeking to achieve the index return on a pretax basis. But the real benefit is to use those short-term capital losses to offset short-term capital gains in other parts of the portfolio, including, for example, hedge funds or active trading strategies, both of which are generally considered to be much less tax efficient.  

It’s not the same as owning an exchange-traded fund (ETF) or an index fund. As with an ETF or an index fund, a TAS portfolio tries to replicate the performance characteristics of an index. With TAS, you own the individual stocks in the portfolio, rather than shares of an ETF or mutual fund. This allows the TAS managers greater control when it comes to managing a client’s tax situation. When the client’s situation, or the market, changes, they are able to sell and buy individual securities as needed, as opposed to having to sell everything outright. This leads to booking tax losses that offset taxable gains elsewhere, allowing clients to keep more of their return.

Is TAS appropriate for you?

If you prefer passive management, U.S. Trust’s Tax Advantaged Strategies may be an effective approach for an entire equity portfolio, providing exposure to a broad index and the additional benefits of potential tax-loss harvesting.  

Taxable investors
could benefit from
tax-loss harvesting
and the TAS approach.

On the other hand, if you prefer active management, the TAS approach could be particularly effective as a core portfolio component because it would allow for the use of loss harvesting to offset gains from other — non-TAS — investments.

TAS and tax-loss harvesting can also be helpful if you need to diversify out of a large position in a single stock with a very low cost basis, replace an underperforming active manager or if you have a large amount of short-term gains in your portfolio. The fact is that taxable investors could benefit from tax-loss harvesting and the TAS approach. And because it is a separately managed account, it can be tailored to fit the needs of each individual investor.  

Your U.S. Trust team can work with you and your personal tax advisor to review and identify potential tax challenges in your strategy and help determine whether the TAS strategy is appropriate for you.

Thomson Reuters Lipper, 2017.

Photograph of hedges by Bartholomew Cooke/Trunk Archive

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Mutual Funds and Exchange-Traded Funds are offered pursuant to a prospectus, which contains the investment objectives, risks, charges and expenses and other important information about the fund. Investors should read the prospectus and carefully consider this information before investing. Prospectuses can be obtained from your investment professional.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

International International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.