Springtime naturally has me thinking about taxes and tax returns. Tax Day may be behind us, and you might be sick of hearing about it, but it’s not too early to begin thinking about how you can best position your clients’ portfolios for Tax Year 2018.

There are many different strategies for managing taxes in an investment portfolio, but none so popular as tax loss harvesting. When a security is trading at a loss, selling it creates a realized tax loss that can be used to offset a capital gain realized in the same year. Yet there are three common misunderstandings about tax loss harvesting that are worth examining to help set the record straight.

Myth 1: The time to think about tax loss harvesting is at year-end
A common practice is to review the portfolio at year-end to find losses for harvesting. In our experience, continuously monitoring for tax opportunities is much better than focusing on it only at year-end. For example, in the first few months of 2018, we’ve seen significant volatility in the stock market, which has created opportunities for loss harvesting. If stock prices recover, those investors that wait for year-end to look for losses will miss out.

Myth 2: Tax loss harvesting requires finding good substitutes
To claim a tax loss, US taxpayers can’t buy back the security during the wash-sale period. Instead of holding cash and potentially missing out on price appreciation, many investors will look for substitute securities with similar risk and return characteristics. However, it’s not always easy to find a good substitute, and if the replacement security appreciates during the wash sale period, reverting back to the primary security creates a capital gain and wipes out any tax benefit from the original trade.
 
Myth 3: If you double the benchmark-relative risk, the tax benefit doubles
In an index-based portfolio that uses portfolio-level risk management and continuous loss harvesting throughout the year, we expect a 1–2% tax “alpha” given a 1% tracking error risk budget. This often provokes the question, “Can I get 2–4% tax alpha at a 2% tracking error?” Unfortunately, no. The marginal benefit decreases with the level of active risk. The chart below shows that at a more aggressive 2% tracking error, expectations are only about 0.5% higher than the 1% tracking error. Higher than 2% tracking error, there’s really no additional expected tax benefit.

This is why, over the 20 years we’ve managed portfolios in this manner, we’ve recommended 1% tracking error as our standard and default recommendation for tax-managed clients.

Of course, overall portfolio tax management involves much more than just tax loss harvesting. A continuous tax management process optimizes for tax efficiency and risk-related improvements. And helps make Tax Day a little less taxing.

Paul Bouchey is chief investment officer at Parametric, a global asset management company with roughly $230 billion in total assets as of December 31, 2017. Parametric is a majority-owned subsidiary of Eaton Vance Corp.