Spring Harvesting

The year 2022 has been challenging across financial markets, to say the least. While it is best to stay disciplined during times of uncertainty to achieve long-term goals, that does not mean we avoid making changes. Tax-loss harvesting is a strategy that we consistently use for clients regardless of economic conditions. Given the challenging market environment today, where stocks and bonds have sold off simultaneously, we believe the time is ripe to harvest.

Tax-loss harvesting allows you to sell investments that are below their cost basis, immediately replace them with reasonably similar investments, and then offset realized capital gains with capital losses. The end result is that less of your money goes to taxes and more will stay in your pocket. If there was a year where you did not have any realized capital gains, losses can then be used to offset $3,000 of ordinary income for a joint tax return. Unused capital losses can also be carried forward indefinitely, allowing investors to build a reserve of losses today to be used against any future gains. The end result does not show up on an investment performance report but on your tax return through lower income taxes.

With market volatility that feels like a roller coaster, it doesn’t mean that the only thing you can do is close your eyes and hang on until the ride is over. Volatility can actually provide additional opportunities for agile trading strategies that can use market movements to their advantage.

We offer a personalized strategy to clients that want to take advantage of capturing stock market index returns while also accumulating capital losses to be used to offset future capital gains. The strategy, known as direct indexing with a tax alpha overlay, works by first purchasing a large subset of the individual securities that make up a particular index that we want to match. For example, instead of purchasing a mutual fund or exchange-traded fund to invest in the S&P 1500, clients of this particular strategy directly own many of the individual stocks that make up the index. Since our clients own the individual securities, it allows us to actively trade on a position level rather than buying or selling entire funds. If our strategy held a position in Coca-Cola shares and they were trading at a loss in any particular month, we could sell the shares and immediately purchase a similar stock like Pepsi. This would allow our client to remain fully invested and ride the following recovery, while also accumulating a capital loss to be used to offset future capital gains. We do this across a large portion of the individual stocks that make up an index and the strategy is perpetually searching for trading opportunities. This approach creates “tax alpha” or an extra rate of return that is earned beyond the index. Historical results have demonstrated that this strategy can add 1-2% of tax alpha outperformance beyond the rate of return for the index.

We have included a hypothetical example of how the tax loss harvesting process generates capital losses while continuing to keep a portfolio invested. Remaining invested is essential because a pillar of our investment philosophy is that maintaining discipline throughout all market cycles will lead to improved investment outcomes. The tax benefit generated by this strategy provides a reward for your discipline.

Tax-loss harvesting opportunities are substantially greater when the underlying investments in a portfolio have higher volatility. Market corrections in December 2018 and March 2020 are terrific examples of the added benefit that our tax alpha strategy has created for clients. During each of these corrections, markets suffered quick drops and followed with a rapid recovery. Investors that were not utilizing a nimble, active, tax-loss harvesting approach likely missed out on capturing losses with the pace of the recovery.

We believe this strategy can be effective and is well suited for clients of all different backgrounds. If you own a business and are contemplating a sale in the future, this can be an ideal strategy to build losses today in order to avoid future taxes on the sale. Our clients that own real estate and are therefore subject to capital gains on the future sale of property have benefitted tremendously from accumulating losses today. The tax alpha strategy has demonstrated that we can produce capital losses equal to about 33% of the initial portfolio value within the first five years, while still capturing the full return of the index.

To determine if this strategy makes sense in your particular circumstance, please reach out to a member of your client centric team.