As the end of the year approaches, investors are trying to make lemonade (tax loss harvesting) out of lemons (capital losses on investments). Investors ought to keep in mind: when managing a separately managed account, tax loss harvesting is a year-long process, not a year-end event
At City Different Investments, we engage in proactive tax planning and risk management for our clients. Using quarterly reports showing tax profit and loss, we’re able to work with clients and advisors to harvest losses throughout the year.
We approach tax loss harvesting as a multi-factor problem requiring deft management of various risk factors. Our portfolio managers are primarily focused on three risk factors when it comes to tax loss harvesting:
- Maintenance of market exposure
- Year-end illiquidity
- Future performance management
Maintenance of market exposure
Tax loss harvesting should be done in tandem with maintaining the portfolio’s risk profile. Suppose, for example, that an investor spent the last 10 days harvesting losses in their portfolio without replacing the duration of the bonds they sold. In that scenario, the duration of their portfolio would be reduced. If the market then rallies and the bonds are not replaced, however, the ‘new’ portfolio will underperform the old. This shows why it’s important to replace the duration of the sold bonds carefully.
If an investor waits until the last month of the year to begin managing their tax losses, they most likely will run into year-end illiquidity issues. The investor would accomplish their goal of harvesting tax losses, but the prices they receive on those sales would probably reflect a much wider bid/ask spread and prove suboptimal in the long run.
Future Performance Implications
At what cost is a tax loss worth harvesting? Just because a bond price drops below its amortized cost does not necessarily mean it’s worth selling the bond to capture the tax loss. To wit, the future return potential of a given security might not be worth the immediate satisfaction of booking a tax loss because wash sale rules preclude an investor from re-buying the sold security for 30 days.
Tax loss harvesting is a decision that involves a host of risk characteristics for a separately managed account. These risks should be addressed throughout the year by the manager and the advisor in tandem. City Different Investments prides itself on making our managers fully accessible to our clients. Our detailed, strategic reports can help you assess tax loss harvesting implications for your clients throughout the year.
If you have questions about your tax loss harvesting plan, schedule a meeting today!
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