Tax-Managed Indexing
Our first quantitative layer is a tax-managed indexing strategy. By decomposing what otherwise might be held as an index-tracking mutual fund or ETF into a portfolio of individual equity holdings, we can control tax liabilities and turnover with greater precision (than with a passive index fund), customizing transactions to an individual investor’s tax situation. Here, we use tax-loss harvesting—the process of selling securities in an investor’s portfolio at a loss and simultaneously replacing the sold securities with new holdings with similar risk-and-return characteristics to the ones sold. Example: an investor holds a portfolio of 150 securities which aims to replicate an index of 1,000 securities. If 10 of those 150 stocks have unrealized losses, an active tax loss-harvester could sell those 10 securities and simultaneously buy 10 others with similar risk exposures.
Here are a few examples of the ways in which active tax-loss harvesting can add value to an investment portfolio:
• Capital-gains tax reduction: Realized losses can be deployed to offset gains in the same portfolio to avoid paying capital gains taxes, or used to offset other capital gains outside the portfolio (such as on the sale of an investment property).
• Taking advantage of inevitable losses: Volatile markets such as this year’s create abundant opportunities for tax-loss harvesting; even in the bull market of 2017, more than a quarter of stocks in the S&P 500 Index suffered losses.
• Ordinary income tax reduction: If an investor has no realized capital gains in a tax year, the IRS permits taxpayers to offset up to $3,000 of ordinary income per year with net capital losses and to carry forward unused losses.
With the second quantitative layer, we add systematic style tilts to the portfolio. Instead of holding individual securities in proportion to their market capitalizations (the approach in most passive index funds), we adjust their weights to “tilt” the portfolio toward security characteristics, or “factors” (such as momentum, value, and profitability), that academic and our own research has shown to reward long-term investors in the form of enhanced returns over the market. In a tax-managed portfolio, for example, we would tend to tilt away from tax-inefficient securities such as high dividend-yielding shares (and REITS, with their non-qualified dividends in particular) and towards the more-efficient value factor (for more detail on dividend-yield vs. value investing, see our paper, “Dividend Investing: A Value Tilt in Disguise?”
Conclusion
As I’ve demonstrated above, taxes can be an insidious drag on a portfolio’s long-term investment returns. In many cases, the difference between a pre- and post-tax investment return is even greater than the costs associated with the investment’s management fees. I realize that tax managed-investing can be rather complicated and even intimidating, but it is also an extremely important discipline. To learn more, I encourage you to read an extensive research paper on the subject that we recently produced: “Managing One of the Greatest Costs Investors Face: Taxes”.
Gregg S. Fisher, CFA, is the founder, head of research and portfolio strategy at Gerstein Fisher and the portfolio manager for the Gerstein Fisher Funds.