Tax Management, Loss Harvesting, and HIFO Accounting

Abstract

Virtually all companies and individuals are faced with the management of taxable assets. To manage these assets efficiently, investors need to be aware of the impact of taxes on investment returns. In the study we report in this article, we quantified the benefits of loss harvesting and highest in, first out (HIFO) accounting by using Monte Carlo simulations and investigated the robustness of these strategies in various markets and with various cash flows and tax rates. We concluded that a market with high stock-specific risk, low average return, and high dividend yield provides more opportunities to harvest losses. In addition, a steady stream of contributions refreshes a portfolio and allows the benefits of loss harvesting to remain strong over time. Conversely, withdrawals reduce the advantages of realizing losses. Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner gives substantially better after-tax performance than a simple index fund, both before and after liquidation of the portfolio.

Virtually all companies and individuals are faced with the management of taxable assets. To manage such assets efficiently, investors need to be aware of the impact of taxes on investment returns. Most investment managers serving the taxable investing market are happy to trade off known tax costs in the quest for stock-selection added value, or alpha, which is highly uncertain. But the alpha for a taxable portfolio consists not only of this unknown pretax alpha but also a tax alpha—the tax consequences of active management—which can be managed with precision. The largest source of negative tax alpha is capital gains taxes, which are incurred on any profitable sale; the largest source of positive tax alpha is tax savings from realizing losses. The strategy of realizing losses has become known as “loss harvesting” in the tax management arena.

In the study reported here, we quantified the benefits of loss harvesting and highest in, first out (HIFO) accounting. We previously used Monte Carlo simulations to study the benefits of these two techniques only under standard market conditions. We review those results and report our findings from quantifying the separate effects of loss harvesting and HIFO accounting. We conclude that under normal market conditions, investors should harvest losses to generate tax credits and should use HIFO accounting whenever a security holding is sold. Next, we report our findings from expanding Monte Carlo simulations in several significant ways.

First, we systematically varied the market conditions to observe the effects on the rewards from loss harvesting. In so doing, we determined the robustness of tax-efficient methods to changes in market environments. We found greater opportunity to harvest losses when individual stock prices are more volatile, but a high level of market volatility does not necessarily increase the value added from tax management. Not surprisingly, a depressed market creates more losses to be harvested and, therefore, better tax alpha than does a roaring bull market, although the increased tax alpha will compound at a lower rate. Increased dividends create more loss-harvesting opportunities from reinvestment, but the immediate tax hit creates a drag.

Second, we addressed issues that tax-aware investors and managers can affect. Increased turnover in the index does not have a significant impact; the tax benefit is slightly less when the index turns over more frequently, but investors/managers can often moderate the effect. We also studied the issue of cash flow—the impact of contributions, withdrawals, and a mixture of the two. We found that a steady stream of contributions refreshes the portfolio and allows the benefits of loss harvesting to remain strong over time. Conversely, withdrawals reduce the advantages of realizing losses by accelerating the problem of locking in stocks with low cost basis. As for tax bracket, we found that the before-liquidation tax advantage associated with our tax-efficient portfolios is roughly linearly related to tax rates. On an after-liquidation basis, however, the marginal benefit of our strategies increases at a slower rate.

Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner will provide substantially better after-tax performance than will a simple index fund, both before and after liquidation of the portfolio. The tax alpha that results from a combined loss-harvesting/HIFO accounting strategy is both significant and persistent; it stabilizes at about 40 bps annually. Active management would need to deliver a startlingly large alpha, and without triggering capital gains taxes, to merely match a simple loss-harvesting strategy. Taxes matter—a lot. But at least they are the one aspect of asset management known with certainty in advance and hence can be managed effectively to minimize their impact.