An Unexpected Opportunity amid Volatility: Tax-Loss Harvesting

“Market volatility” isn’t just a euphemism for “a market that’s more often down than up.” It can actually be an opportunity for advisers to support their clients by applying tax-loss harvesting, selling holdings at a loss to offset gains. In an interview with InvestmentNews Creates, Natalie Miller, director of investment strategy at Parametric , explained why tax-loss harvesting matters so much in a volatile market, and how it can be even more efficient when it’s part of a direct indexing strategy.

InvestmentNews Create: What is tax loss harvesting and why is it so important for advisors to understand?

Natalie Miller: At its most basic, tax-loss harvesting involves selling a security whose price has dropped below its purchase price. It’s about realizing that loss effectively and then reinvesting the proceeds to maintain the market exposure in the portfolio. The realized loss can be used to offset realized gains elsewhere in that account or the client's portfolio, or can be banked to offset any future gains. Ideally, this is all done at the tax-lot level.

It's an important concept because loss harvesting leads to improved after tax result for investors. It's not what investors earn, it's what they keep that really matters. And tax loss harvesting is one way to help investors keep more of their investment earnings.

InvestmentNews Create: Is this a situation where an advisor would need to partner with a client's accountant, or do most advisors on their own have a strong enough understanding of how to manage this process without involving part of a client's full advisory team?

Natalie Miller: Advisors who have all of the clients assets can certainly look across that client's portfolio and do it on their own. They may have to involve accountants or other members of their investment advisor team to get a full view of the portfolio. And don’t forget that harvesting tax losses across tax lots can can be resource intensive, which is just one reason that having access to the scale and expertise of an asset manager is important.

Often advisors save tax-loss harvesting for year-end but that means they miss out on volatility earlier in the year. Especially this year, if you had waited till now to harvest losses, you might have missed losses that occurred in January or the summer. It's important to consider timing.

InvestmentNews Create: What does tax-loss harvesting have to do with direct indexing?

Natalie Miller: Tax-loss harvesting is most effective when it's done at the tax-lot level. So you must also own the securities in the account, preferably with lots of them to choose from. And direct indexing provides that ownership of individual securities.

Direct indexing at its core is a customized, separately managed account that provides investors direct ownership of securities in an index-like solution. That index can be very broad or very customized, depending upon client preferences. And the goals of direct indexing include providing benchmark-like returns on a pretax basis, and potentially improving on the benchmark after tax. One of the key strategies to the latter goal is tax-loss harvesting.

InvestmentNews Create: Why is tax-loss harvesting such an important consideration in volatile markets?

Natalie Miller: Because they can provide an abundance of losses to harvest. Volatile markets can be very stressful for clients. Tax-loss harvesting is a positive that can be generated from all of that volatility, and that can help alleviate the stress that comes with volatile markets.

InvestmentNews Create: How can you gauge when and how often to harvest losses? Is there a rule of thumb to follow?

Natalie Miller: If you wait till year-end, you may miss out. Any kind of scheduled, calendar-based loss harvesting, whether that’s annual, quarterly or monthly, could miss out on loss harvesting opportunities.

A portfolio should be monitored daily in order to take advantage of tax-loss harvesting opportunities as they arise. But trades should be reserved only for when there's sufficient opportunity to add value that justifies the inherent cost of trading.

We call this trigger-based loss harvesting. The actual frequency of that trading depends on the securities’ cost basis and market volatility. In periods of high volatility, trading is naturally more frequent due to that increased opportunity set.

It's on the asset manager to monitor that account on a daily basis, and the trigger is a function of balancing costs, volatility and tax benefit opportunity with the risks inherent in the portfolio. You don't want to trade too often if the costs outweigh the benefit that you get. But you also want to make sure that the portfolio stays true to the benchmark-like or index-like exposure that the client wanted. It's a balancing act.

You also have to balance the tax-loss harvesting with market exposure. So often, the securities that fall the most in a volatile market are the most attractive from a tax-loss harvesting perspective. Those are also the names that tend to bounce back the quickest when the markets recover. If you overemphasize tax-loss harvesting for those beaten-down names, it creates the risk of underperforming when the market bounces back.

IRS wash-sale rules are another factor. The IRS will disallow a tax loss if the investor purchases the same or equivalent security 30 days before or after the sale date. So that needs to be to be factored into the balancing act, too.

All of those risks highlight the need for a well-informed tax-loss harvesting procedure that maintains investors’ market exposure for when the markets do turn around again.