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Does your financial advisor really tax loss harvest?

The Uniqueness and Importance of ETFs in Tax Loss Harvesting

While almost all performance reporting focuses on pretax returns, it is after tax returns that truly help investors grow their wealth.

o For example, an investor earning 10% annualized pretax with no recognized capital gains and thus no annual taxes, will see their money double in a little over 7 years.

o The very same investor earning 10% annualized where each year’s income is fully taxed (at 40% in this example), will need more than 12 years to double their money!

So buy and hold can be a very powerful investing strategy when returns are consistently positive. However, most investors don’t hold their entire portfolio unchanged for that long for a variety of reasons including the need to thoughtfully rebalance exposures across asset classes, geographies and factor exposures among others.

One of the key issues that investors often muddle together is the separation of their investment strategy from their tax strategy. This issue often rears its head after certain positions have such large gains that investors become allergic to ever crystallizing them and paying the associated taxes. While tax deferral is desirable, it is also desirable to constantly evaluate the merit of the underlying investment. At Astoria, we would suggest that your investment strategy is paramount and should not become a slave to your tax deferral dreams.

So the best way to keep some reallocation flexibility in your portfolio is to build up a buffer of losses that can be used to offset gains. While the current frothy market of the last few years has offered relatively minor tax loss harvesting opportunities, that can always change quickly.

ETFs offer investors a very efficient and effective product structure for harvesting losses. The key element of this is the full transparency of the holdings within them.

o With ETFs, you can harvest losses where available and replace your sold positions with highly correlated ETF substitutes. This is because there are so many ETFs that have significant overlap in their holdings.

o When making such trades, investors can bypass the wash sale rule that disallows certain losses. Wash sales exist when investors sell and rebuy the same security. However, tax loss harvesting strategies would purchase a different though highly correlated security.

o With knowledge of the substitute ETF trades that keep your investment allocations and exposures virtually intact, investors can harvest losses with much greater frequency than they otherwise might.

o Such a strategy is much harder to implement with mutual funds (where you NEVER know what they hold in real time) or individual securities that really don’t have close substitutes in most cases.

Armed with these tools, tax loss harvesting should be something that is done constantly. Any financial advisor telling you that they do tax loss harvesting because they look for tax trades at the end of the year is overselling their efforts. For example, the biggest harvesting opportunity in 2016 came in January when markets were spooked over oil prices and Chinese growth. U.S. Equities sold off 8-9% but rebounded within a month. Savvy tax loss harvesters pocketed valuable realized losses while those that did not got few other chances throughout the year.

So how do you quantify the value of deferring taxes by loss harvesting? The unsurprising answer is that it depends. It could be 50 basis points in one year and 500 bps in another. In fact, the benefits are radically path dependent. Volatile and rotating markets provide significant opportunities for harvesting while consistently upward trending markets like we have seen lately in equities provide fewer such moments. Multi asset class portfolios will likely have more opportunities over time than single asset class portfolios. To conclude, doing tax loss harvesting systematically and with the required precision as we do at Astoria is one of the soundest ways to improve after tax returns.

Best, Bruce Lavine

Senior Strategy Advisor of Astoria

The information above is not tax advice and should not be considered tax advice. Investors should consult with a tax professional when considering tax implications from changes to their portfolios.

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