The Tax Harvesting Mirage
As passive investments have gained at a rapid pace in recent years over active investment management, many investment advisors are turning toward other sources of alpha (market-beating performance) to justify their fees. One of these sources is the “rebalancing bonus”, which I have previously shown to be a phantom. More recently, some advisors have been competing to show that their tax loss harvesting strategies produce a substantial “tax alpha.”
While this source of alpha is not wholly mythical, its benefits are vastly overstated.
Indeed, they may be negligible.
I will first discuss the appropriate framework to measure the potential benefit of tax-loss harvesting. I will then explain the simulations I did to measure those benefits, and then compare my results to those of Wealthfront and Betterment, two so-called robo-advisors.
The basics of tax-loss harvesting
A specific strategy being advertised is that an advisor will monitor the portfolio daily for losses in the values of securities and determine whether it may be advantageous to sell them in order to take a tax write-off. If the value of a security such as a passively managed exchange-traded fund (ETF) falls well below its original purchase price – its cost – then a tax loss can be realized by selling it.
One challenge with this strategy is that it needs to navigate the “wash rule.” The rule states that losses from a sale of a security cannot be deducted if a substantially identical security is purchased with the proceeds within 30 days. The Internal Revenue Service (IRS) established this rule in an attempt to prevent investors from taking artificial losses solely for the purpose of tax avoidance. I will come back to the intent of the rule later.
To avoid the wash-sale penalty while still adhering closely to an investment strategy, the investor needs to use the proceeds from the loss to purchase a security that the IRS would not construe to be “substantially identical,” but which is nonetheless close enough to identical for the investor’s purposes. This “not quite substantially identical” security can then be sold 31 days later and replaced with the security that was originally held.
Advisor-practitioners of the daily tax-loss harvesting approach profess to have determined which passively-managed ETFs are “not quite substantially identical” in the eyes of the IRS and can therefore be legitimately substituted temporarily for one another in the process of harvesting a tax loss and avoiding the wash-rule penalty.
The specifics of the strategy
When a tax loss is harvested and a substitute security is purchased, the new security will have a lower cost basis than the security sold. Hence, in the future, the eventual capital gains will be increased by the exact same amount as the amount harvested as a loss. Therefore, the tax write-off on the loss that was realized is only temporary (except in the event that the security is held until the investor’s death, when the security’s cost basis will receive a “step up” to its current value).
Because the substitute security will — at least according to the strategy used by some advisors — be sold 31 days after its purchase, in order to restore the “integrity” of the intended mix of assets, that sale could produce a short-term gain. The tax cost of that short-term gain needs to be weighed against the benefit of the tax loss that was harvested. Hence, some practitioners of the daily tax-loss harvesting strategy establish a loss threshold below which losses will not be harvested. Only when the loss passes that threshold will the security be sold and a substitute security purchased in its place, to be sold in 31 days and the original security repurchased and placed back in the portfolio.
It is a complex but accomplishable task to evaluate how much the savings from this form of tax-loss harvesting can add to after-tax investment returns. Some practitioners have referred to this positive increment to an investor’s after-tax return as “tax alpha.” Unfortunately, as we shall see, their definitions of tax alpha leave much to be desired. They can overestimate the tax alpha by a factor of 5 to 10 times.