This is a summary of “Tax-Loss Harvesting: An Individual Investor’s Perspective,” by Kevin Khang, Thomas Paradise, and Joel Dickson, published in the Fourth Quarter 2021 issue of the Financial Analysts Journal.
Tax-loss harvesting produces diverse outcomes depending on the profile of the individual investor and the return environment.
What’s the Investment Issue?
Tax-loss harvesting (TLH) has been explored from the perspectives of portfolio managers and investors in aggregate, but what about from the viewpoint of an individual investor?
Many individual investors have small and irregular capital gains, which means that widely held assumptions of unlimited gains through TLH programs rarely apply to them.
This article shows the more realistic potential of TLH benefits to individual investors and how these benefits vary widely depending on the investor type. It also examines the extent to which the market environment and individual investor characteristics (such as applicable tax rates and the amount of taxable income that can be offset) drive returns from TLH strategies.
How Do the Authors Tackle the Issue?
The authors employ a two-pronged approach. First, they examine balance sheet information across a diverse range of investors and estimate TLH alpha for archetypal individual investors. The tax rates and capital gains profiles of these archetypal investors are then applied to estimate the available TLH alpha.
Second, to understand and compare how investor profile and the return environment drive TLH alpha, the authors create a framework to quantify the contribution of several variables. To compare individual investors, the chosen variables are tax rates, loss-offsetting income to taxable equity (LOI/EQ), investors’ cash contributions to their taxable equity accounts, and how investors liquidate their taxable accounts. The variables for the return environment are average returns, volatility of cash flows, and cash flow returns.
This framework uses so-called “boosted regression trees” (BRTs) and maps 150,000 individual TLH alphas to the relevant investor profile and return environment combinations. Since BRTs are good at uncovering nonlinearities, the outputs of the framework are customizable across a wide range of individual investors.
What Are the Findings?
The dispersion of tax alpha from TLH across the individual investor spectrum is around 300 bps. That is chiefly because many investors do not enjoy the high levels of capital gains that previous studies of TLH have assumed. Since fewer gains can be offset with losses, these losses simply accumulate and are carried forward year after year, meaning TLH schemes may not be useful.
The opportunity to conduct TLH in all return environments through direct indexing adds the most value to investors with LOI/EQ above 5%, meaningful tax spread, and a high harvest tax rate. Systematic TLH through commingled investment vehicles, on the other hand, tends to suit investors with irregular and modest LOI/EQ and a small tax spread.
In terms of the drivers of TLH, 60% of the variation in returns is driven by investor characteristics—their tax rate, the tax rate spread of their current and future rates, and the amount of income an investor could offset with losses. The remaining 40% is driven by the return environment, which is largely outside the control of investors. “Generational luck” and the timing of the launch of a TLH strategy are both important in determining whether significant alpha is created. In addition, there is wider dispersion of alpha in high-volatility and low-return environments.
What Are the Implications for Investors and Investment Managers?
The article demonstrates that even relatively wealthy investors may not be able to access the sizable TLH alpha estimated in previous studies. Therefore, individual investors (and their investment advisers) should take a more idiosyncratic approach toward their TLH investments. This approach should be tailored to their tax and income profiles in the same way they would set a strategic asset allocation to match their investment objectives and horizons.
TLH programs may constitute a misallocation of risk capital for some investors. As a consequence, investors with low levels of expected TLH alpha will likely prefer to harvest losses as and when they arise, rather than pay fees for a full TLH program that incorporates transaction costs, commission costs, and regulatory compliance costs.