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Many advisors prefer to use separately managed accounts (SMAs) over mutual funds in their clients' portfolios for their greater tax efficiency. Within an SMA, a client owns the underlying securities, has their own tax lots and cost basis, and the ability to make client-specific tax decisions that can result in improved after-tax returns as compared to mutual funds. SMAs are also cost effective and have increased fee transparency as compared to mutual funds, often making them a preferred vehicle for high-net-worth clients.
Today many of those clients have unrealized losses in their SMA portfolios. It's become an accepted industry theory that "banking" these losses-selling portfolio losses in anticipation of future gains-makes sense. In its simplest form, this is accomplished by selling securities and repurchasing the same securities after the period required (31 days) to avoid wash sale rules.
Harvesting losses to offset gains already realized in the same tax year can add value in clients' portfolios. If the client anticipates realizing gains within the same tax period, loss harvesting can also be prudent.
However, realizing losses simply to offset possible gains in future tax years is a questionable strategy, especially when investing in actively managed accounts.
In determining the benefit of such a strategy, an advisor should weigh the likelihood of gains in future periods versus three potential costs: 1) transaction costs 2) tracking error risk/cost and 3) the increased likelihood of short-term gains.
To explain why harvested losses by themselves-that is, in the absence of known or expected gains-have no value, we'll use an overly simplified example of a single security. Say a security costs $100, and then depreciates by 50%, and then appreciates by 140%. By simply holding the security, the client ends up with a $20 taxable gain.
Now let's assume that instead, we harvested that loss at its low point, repurchased the security after the holding period with no price change during that time, experienced the same market movement thereafter, and subsequently sold the stock.
In both scenarios, the investor is left with the same taxable gain of $20 and assuming a 20% tax rate, the same tax of $4.
As this example shows, lacking same-tax-year gains, a harvested loss has no value by itself. Harvesting has the same effect as simply leaving the loss embedded in the security and allowing it to appreciate to a gain. Moreover, using such a strategy within actively managed accounts typically will introduce costs and unfavorable deviations in performance to the active strategy.
Potential Costs
This example excluded the effect of transaction costs, but these costs are real and take multiple forms. If the investor pays commissions, a portion of that cost is explicit. But even if these trades are within a managed account or other vehicle where trading costs are included as a flat fee, there are other forms of "trading costs" that can adversely affect a client's account.
First, depending on the liquidity of the security being sold, the transaction can add a performance drag to portfolio returns. While an investor's actual experience will vary based upon a number of factors, it is reasonable to expect at least five basis points of performance drag for any loss harvested, and this cost could easily exceed 100 bps for less liquid securities.
Second, within an actively managed account, investors will want to repurchase the harvested security as soon as practical (probably right after the 31-day wash sale holding period) to avoid a potential performance deviation from the money manager's model portfolio. But, what should happen with the proceeds for those 31 days? A very few sophisticated loss harvesting techniques use replacement securities meant to replicate the market movement of the harvested issue, while others use an exchange-traded fund or other liquid securities to maintain market exposure during the wash sale period. Each of these transactions can cause performance differences as compared to the unharvested portfolio. And transaction costs are doubled as the manager must trade in and out of these securities.
