Core Concepts

Tax Strategy Optimization

Tax Strategy Optimization

Understanding Tax Liabilities

Potential tax liabilities are an important consideration for any sophisticated investment adviser. Our model looks at the time value of deferring taxes paid for 20 years as part of analyzing expected returns of existing holdings versus replacement candidates. Yes, if a change is compelling enough, losses will be recognized. However, the key to tax efficient investing is not being hesitant to recognize gains if disciplined analysis dictates such action. Tax alpha can’t be analyzed in a vacuum; it’s an input to optimal portfolio construction that maximizes risk controlled expected return.

Tax Strategy Optimization

Potential tax liabilities

Advisors may employ rudimentary tax loss harvesting strategies where securities with unrecognized losses are sold and replaced with new securities. This simple approach is rooted in common sense but has several shortfalls. An investor incurs substantial amounts of transaction costs as the manager aggressively sells losers and buys replacements. Secondarily, the strategy runs out of steam after a few years as all losses are recognized. Investors are left with a dilemma of holding static portfolios containing large unrealized gains simply because they don’t want to pay capital gains tax; not a bad problem, but one that may introduce a variety of new portfolio risks:

  • Lumpy concentrations with poor diversification
  • Low return holdings that are nowhere near the efficient frontier curve
  • Exposure to declining industries

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