The Gimmick of Tax Loss Harvesting

Karen White Uncategorized 0 Comments

Over the last few years, several robo-advisors (automated investment services), such as Betterment and Wealthfront, have been promoting the tax loss harvesting feature of their product as a value-add to their investors. Tax loss harvesting at face value seems like a great idea, but implemented for the wrong reasons only detracts from returns. As an investment adviser who has managed money for almost twenty years, spanning three bull markets and two bear markets including the credit crisis, I find the promotion of tax loss harvesting to be a gimmick.

Taxes are a Secondary Consideration

One of the principles of long term investing is that taxes are a secondary consideration relative to the quality and long-term prospect of an investment. In other words, if you owned a quality investment and its price was down, you wouldn’t sell it simply because it was down and you wanted to capture a loss for your taxes. Doing so would deprive you of an opportunity to buy more of that position at a cheaper price and lower your cost basis on that security.

In fact, selling a quality position because it was down is tantamount to short-term trading and not long-term investing. The practice of buying down or lowering your cost basis is a strategy many investors fail to apply due to their short-term focus and lack of understanding of the securities they own. As a result, investors miss out on enhancing the potential return on their investments.

Questioning “Highly Correlated Alternate Investments”

To make the tax loss harvesting qualify under the 30-day wash sale rule, robo-advisors purchase “a highly correlated alternate investment”. The problem with this strategy is that the “highly correlated alternate investment” may not have declined in price to the same degree as the position that was sold. As a result, they would not be buying the alternate position at the same discounted price as the one sold, which ultimately would translate to a lower potential return.

In fact, the use of an alternate investment has its own set of problems from a due diligence standpoint of selecting quality investments. Because the original position was sold for purposes of capturing a tax loss, there doesn’t seem to be any consideration as to whether the alternate investment is a quality position to own at the time the original position was sold, especially if the robo-advisors already have a pre-set list of alternate investments in the queue.

In addition, the alternate investment has to use a different index than the one tracked by the original position. Wealthfront’s white paper states “we will sell one of your ETFs that is trading at a loss and replace it with an alternative ETF that represents a different but highly correlated index to maintain the risk and return characteristics of your portfolio”. If the underlying index or benchmark of the alternate security is different from the one sold, it is essentially an entirely different security with a different objective. Now the composition of the investor’s portfolio has completely changed. All this for the purpose of capturing a loss and not for generating a gain or making the investor money, which is the primary objective of investing.

One aspect of tax loss harvesting that is noted by robo-advisors is that they can quantify the “tax savings” captured. However, in making their case, the robo-advisors assume that the investor would invest the tax savings amount into their account. It is highly questionable as to what percentage of their individual investors actually “reinvest” the tax savings amount.

In my experience as an advisor, investors do not invest the “tax savings” amount because it’s money that is not actually generated, rather it’s money that they didn’t have to pay in taxes. After all, there is a significant time delay from the day the tax loss harvesting was employed and when the investor files their taxes. Furthermore, I highly doubt that the robo-advisors remind their investors at tax filing time of the “tax savings” amount and has them invest that amount into their robo-account.

The Value of Buying Down

So what is the value of not selling a position at a loss and buying down? An example of the value of buying down can be seen with Boeing’s stock in the last ten years. I will disclose that the example I am using is an actual investment I made as an adviser on behalf of clients through my previous firm.

In February 2008, I began buying shares of Boeing at roughly $85 per share. At the time, I had a target price of $150 per share four years out. My thesis for buying shares of Boeing was that air travel around the world, particularly in developing countries was expected to increase over the next 20 years as more countries develop a sustainable middle class. In addition, I liked the new carbon fiber technology Boeing was using on its new aircraft, the 787 Dreamliner, and the savings it will provide on fuel costs. Lastly, the company had as much as four years in back log orders at the time, enabling me to better forecast Boeing’s earnings four years into the future.

When the credit crisis began to unravel in late 2008 and into 2009, Boeing’s shares fell to as low as $29 per share in March 2009. In that time, Boeing’s business held up well despite the worsening global economy and a machinist strike in September 2008. In fact, by the end of 2009, the company delivered record revenues and maintained its total backlog at more than four times annual revenue.

By buying down, we were able to lower our cost basis from $85 per share to approximately $55 per share. With a target price still at $150 per share, lowering the cost basis essentially enhanced the potential return on Boeing from roughly doubling it to tripling the return on investment. This is the value of buying down. While writing this article, Boeing closed at $148.32 per share. If I had sold Boeing in 2008 to capture a tax loss, I would never have had the opportunity to achieve a 169% return.

Buying down is a critical part of investing, knowing that we never really get the right or best price the first time we buy a position. Thus, buying down enables us to improve on that initial purchase price. I realize that most robo-advisors utilize ETFs in their portfolios and not individual stocks, but the strategy of buying down applies to ETFs and mutual funds as well.

Are these Portfolios “Intelligent”?

With the continuous practice and promotion of tax loss harvesting to millennials, robo-advisors are influencing a whole generation of investors that may never know the importance and value of buying down to lower their cost basis. This would not only be a tragic result, but these so called “intelligent portfolios” are essentially creating a whole generation of dumb investors.

The fact that a majority, if not all, robo-advisors came into the marketplace after 2009 shows that none of them have managed money through a sustained down market or bear market. How their algorithms or their investment philosophies will hold up during a down turn is yet to be seen. Since the tax loss harvesting feature sells positions as they fluctuate down in price, it wouldn’t be far fetched to imagine an extensive selling of positions within these portfolios when a broad bear market occurs.

When Tax Loss Harvesting is Appropriate

So when should tax loss harvesting be employed? The strategy of selling a position within a taxable account when it is down to capture a tax loss is not entirely bad when used appropriately. It is appropriate for positions within a portfolio that are deemed of low quality. An investment may not have been low quality when it was first purchased for the portfolio, but over a period of time as markets and economies change, some positions and their underlying businesses may be negatively impacted, and is reflected in the price of the security. At that point, it makes sense to sell the position, especially if it can capture a tax loss to be applied to future gains. But selling a quality position because it has fluctuated down in price is not conducive to generating positive investment returns.

Since more and more robo-advisors are being launched in the marketplace, individual investors should be aware that the practice of tax loss harvesting by robo-advisors is not necessarily a good investment strategy that helps investors grow their investments. Furthermore, when selecting an investment adviser, investors should not only understand the investment strategies employed by the advisor, but also take into account their track record of managing money over the long term.

By Tom F. White, Founder and CEO

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