Journal of Financial Planning: October 2022
Eduarda Gaige is a junior analyst at Schoeppler Wealth Group, a private wealth advisory practice of Ameriprise Financial Services, LLC. She earned her bachelor’s degree in international business and finance from the University of South Florida. Eduarda is an accredited portfolio management advisor (APMA) professional, and currently a candidate for Level II of the CAIA program.
Brandon Schoeppler is a private wealth adviser with Schoeppler Wealth Group. He operates as the director of advanced advice for his team and develops interdisciplinary strategies for high-net-worth clients. Brandon cofounded two estate planning council chapters in the Tampa Bay Area and was recently named a Forbes Best-in-State Advisor for 2022.
Mitchell Meurlott is a financial adviser with Schoeppler Wealth Group and operates as the director of financial planning within his team. Mitchell has worked as a financial planning consultant for financial advisers across Florida and was a founding member of the Young Professionals Estate Planning Council of Tampa Bay.
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The primary goal of the financial planner is to provide value in all market and economic environments. During bear markets, it is especially important to provide actionable and insightful recommendations. In times of market sell-offs, people sometimes ignore their long-term financial goals due to short-term risk factors and make fear-based decisions that conflict with their financial plan. A shift to “direct indexing” with a focus on tax loss harvesting may provide value to clients looking for a silver lining during bear market sell-offs.
Over the last decade, exchange-traded funds (ETFs) have replaced mutual funds as the preferred investment vehicle for retail investors. Financial planners should not ignore the change in investor preferences that the ETF revolution signifies. Clients have become more fee conscious, and technological capabilities have provided a significantly larger number of investment options with greater transparency. As a result, investors are relying less on active management and more on ETFs with rules-based algorithms to create funds ranging from dynamic asset allocation to purely passive index funds. Additionally, the structure of ETFs usually allows them to be more tax efficient than their mutual fund counterparts, which has also contributed to their meteoric success. Cognizant planners who were early adopters of active selection within ETFs benefited from the shift away from active management by taking a more hands-on approach to portfolio construction. These planners understood the need to adapt, which we believe is crucial at this time as new investment options are rolled out to investors.
Currently, ETFs account for over one quarter of global equity AUM. These funds were originally constructed to duplicate stock market indices, such as the S&P 500 and the NASDAQ-100, at a cheap cost. Firms eventually developed ETFs with active strategies and smart beta algorithms to meet financial planner and investor demand. Unfortunately, this has led to an oversaturation in the market with over 8,500 ETFs available as of 2021 (Statista 2022). Given the number of funds available, financial planners are now required to implement an even more rigorous active selection process even if a passive investment is desired, especially when dealing with taxable accounts. Even though exchange-traded funds may be more tax efficient by way of capital gain distributions, they fail to recognize some complex tax situations encountered by specific investors. Some funds claim to be tax-advantaged or tax-aware, but client-specific needs can require truly customized portfolios that are not available in fund format.
With direct indexing, the investor owns the actual basket of stocks that comprise the chosen index (there are over 5,000 of them to choose from). This strategy was once considered impractical for the retail investor but has gained traction with advances in trading software resulting in lower transaction costs. Direct indexing gives planners the ability to exercise greater tax control, improve exposure customization, and include client specific preferences. Implementing direct indexing allows the investor to harvest losses in a single position to be used against current or future capital gains on their federal tax returns. A more active approach is preferred so the portfolio manager can select the losing stocks over the top gainers. In addition, asset location in account types can assist in improving the original strategy at the household level.
Chauduri, Burham, and Lo (2020) revisited the potential benefits of tax loss harvesting in theoretical terms. The study assumed that wash sale rules did not exist while also assuming transaction costs had no impact on returns. If an investor did sideline dollars from sales for the required 30 days to avoid a wash sale, annualized tax alpha was reduced by 26 basis points from 1995 to 2018.
While it is nice to test things in theory, the practical application is important to the financial planner. Because there is little guidance on how to build a customized direct index, the goal of this article is to provide a framework on implementation of tax loss harvesting with a secondary focus on asset location enhancement. The strategies outlined summarize two common account-level approaches, as well as an additional household-level approach. The household strategy has not been explored in prior publications and could provide the theoretical results achieved in the publication.
Constructing a Direct Index
The first step in creating a tax loss harvesting portfolio is identifying the desired benchmark fund to be used to track error and quantify tax alpha over time. The same holdings of the benchmark fund will be directly owned by the investor with the same starting weights. Many studies have concluded that 12 to 30 stocks are sufficient to eliminate unsystematic risk through diversification. To maximize harvesting opportunities, a larger number of individual stocks is recommended. However, buying all companies in the S&P 500 and weighting by market cap is excessive and may be very time consuming. A 60- to 100-stock portfolio would provide plenty of opportunities to harvest losses over the course of several years. No matter how the broader market performs, there will always be stocks that are up and some that are down. Even funds and indices during bull markets have losing positions when looking under the hood.
Pure Direct Index Loss Harvesting
The first loss harvesting approach assumes that investors do not want to deviate from the holdings found in the benchmark fund. To avoid a wash sale, cash proceeds from stocks sold at a loss are left in the account to repurchase 30 days later. The biggest risk with this strategy is that single stock price swings can be unpredictable, and a rapid recovery in a stock could cause an investor to miss out on returns while holding cash. Conversely, a decline in stock price will allow the investor to buy back the stock at an even lower price, missing out on the losses in between. Based on prior studies, this approach provides positive tax alpha over decade-long timeframes. This strategy does provide 82 basis points in tax alpha going back to 1995, but has two major potential drawbacks:
- Significant underperformance can occur during periods of holding cash while waiting to repurchase stocks to avoid wash sales.
- Temporary periods of lower diversification across the portfolio depending on how many stocks were sold simultaneously to harvest periodic losses.
Rules-Based Direct Indexing
Rules-based direct indexing is most easily implemented using separately managed accounts (SMAs) that attempt to harvest losses through security swaps within a taxable account. Planners who would like to take a more active approach by building their portfolios need an extra step to apply a security swap strategy. After the benchmark fund is selected and the subsequent positions are purchased, “best-fit” stock replacements need to be identified.
It is true that securities in certain industries provide relatively homogenous returns over the long term, but returns can deviate substantially over the short term. This potentially results in lower performance and may lead to a worse outcome even after accounting for tax alpha. JPMorgan and Bank of America provide a good example for how quickly a short-term dislocation can occur: from August 21, 2017, to October 4, 2021, these companies’ returns were only 70 basis points apart, but from October 4, 2021, to August 5, 2022, a 16.89 percent divergence in returns occurred.
Despite this potential shortcoming, the strategy is superior to the pure direct index loss harvesting approach since there is no idle cash. The rapid sell-offs and recoveries currently seen across the market can have a tremendous impact in the long run. Implementing the rules-based strategy would be ideal in a high-volatility environment to capitalize on opportunities that may come up after a sell-off.
The most common approach to finding a best-fit replacement is to analyze the correlation between two stocks. However, it is preferred to take a more qualitative, active approach in finding replacement peers for the initial 60 to 100 stocks. After accounting for correlation, stocks are screened for similar exposures such as industry competitors or company life cycle. This also assists in ensuring specific tilts and preferences desired by client and planner are considered.
It is recommended to run a backtest for the portfolio allocation to ensure factor, size, and sector exposures remain aligned with the chosen benchmark. Additionally, risk and return metrics such as standard deviation, beta, Sharpe ratio, Sortino ratio, Treynor ratio, etc. should be reviewed prior to making any security swap with the prescreened replacement stocks. This ensures they are within the specific rules and tolerance bands being used during the initial portfolio construction process.
A Household-Level Approach
This is the preferred method for investors with both taxable and nontaxable accounts. Using this approach, tax loss harvesting is implemented with significantly lower tracking error, while simultaneously reducing tax drag through improved asset location. Asset location is the placement of an investment in a taxable (nonqualified) account or nontaxable (qualified) account to optimize tax efficiency. The asset location decision can have a major impact in after-tax returns.
Adding complexity to strategy implementation, portfolios are managed considering all accounts in the household instead of looking at each account individually. After choosing the benchmark fund for the direct indexing, stocks are not purchased evenly across different account types (IRA, Roth, taxable). Instead, high dividend payers are purchased in qualified accounts while lower yielding stocks are bought in taxable accounts. A simple rule can be used where stocks with dividend yields under 2 percent are held in nonqualified accounts, and those above 2 percent are in nontaxable accounts, resulting in an almost 50/50 split.
Following the household-level approach to direct indexing may alleviate risks associated with wash sale rules, loss of stock exposure, etc. Stocks can be swapped across account types, improving asset location and reducing tax drag. When a security is sold in a taxable account at a loss, it is immediately repurchased in a tax-deferred (401(k), IRA) or a tax-free (Roth IRA) account. There is a problem of available cash in the qualified account needed to repurchase the same stock sold in the taxable account. To maintain asset location optimization, the stock with the lowest current dividend yield in the qualified account should be sold and repurchased in the taxable account. The cash proceeds from the sales in each account will be used in the simultaneous security swap.
The union of tax loss harvesting with strategic asset location may potentially remove a high-dividend-paying stock from a taxable account and place it in an account where the dividend is not taxed annually. This strategy could reduce costs associated with purchasing the same investments across multiple accounts and provide clients with a more tax-efficient portfolio. Every investor has specific needs and preferences, but the goal is to increase after-tax rates of return. Many firms and planners can institute a direct indexing strategy but often forget the ability to move assets across account types. Alas, they are blindsided by the concept of managing accounts on the individual level.
From Practical Idea to Practical Application
Financial planning is an ongoing process that requires analyzing client circumstances and goals, determining current plan trajectory, recommending potential alternatives, and plan implementation with frequent monitoring. The household-level approach for direct indexing and tax loss harvesting involves tax planning and investment planning in conjunction with the process of recommending alternate strategies and implementation.
This investment strategy provides greater control during the implementation stage by ensuring that projected values match real world application and results. It also allows planners to create value by building portfolios that are personalized to a client’s specific constraints and preferences. This in turn makes investors feel more involved in the process and directly fulfills the financial planner’s obligation to provide actionable investment advice.
Direct indexing allows planners to customize recommendations according to the client’s tax, income, and risk profile. This strategy can be implemented without causing large deviations from the asset allocation found within the financial plan while simultaneously reducing tax drag through improved asset location across multiple account types. For clients with little or no capital gains liabilities, tax loss harvesting can provide annual benefits in the form of reduced income taxation. However, this benefit becomes even more pronounced for clients with large unrealized capital gains liabilities.
Generally, planners can include these tax liabilities in plan projections but often lack the means to directly address the issue. Building a direct index potentially allows for a reduction in future tax liabilities through a systematic, rules-based process that can be modeled within the financial plan. During the review stage, planners can update assumptions to reflect the realization of loss harvesting leading to value justification and a quantifiable reason to engage a financial planner.
In Conclusion
Various investment constraints exist deterring financial planners and investors from fully utilizing advanced asset management strategies. Transaction costs, wash sale rules, trade execution timing, and ongoing management are common issues that need to be evaluated prior to taking a more active approach to asset and tax management.
Most of these constraints can be easily overcome using some of the recommendations and processes outlined. Investors will continue to seek advanced advice and management from their financial professionals; they expect more than just a salesperson. Implementing new and creative strategies during difficult and stressful times can provide a silver lining for investors while adding value to the financial planning process.
As with any investment decision for a client, you should consider that the strategies mentioned above are in line with your client’s specific goals, risk tolerance, liquidity needs, tax considerations, and any other factors relevant to their unique situation.
References
Chauduri, Shomesh, Terence Burnham, and Andrew Lo. 2020. “An Empirical Evaluation of Tax-Loss-Harvesting Alpha.” Financial Analysts Journal 76 (3): 1. DOI:10.1080/0015198X.2020.1760064.
Statista. 2022, January. “Number of Exchange-Traded Funds (ETFs) Worldwide from 2003 to 2021.” www.statista.com/statistics/278249/global-number-of-etfs/.
