An Introduction to Tax-Smart Indexing™

Volatile market environments, like the conditions we recently experienced, remind us just how valuable a tax-aware investment approach can be. Though down moves in the market can be unsettling, they can also provide opportunities for tax-loss harvesting — the “silver lining” of a market decline, which can provide tax benefits at a time when asset values are going down.

As a CPA-based financial advisory firm, we have always taken a tax-sensitive approach to investing. We deploy a range of tax-management techniques on behalf of our clients — from using low-turnover funds, to the strategic placement of assets in accounts that make the most tax sense, to the ongoing harvesting of losses to offset gains.

Gain from losses

We have a robust, ongoing process for harvesting losses in mutual funds when the opportunities present themselves, as they have over the past few weeks. Advisors have traditionally focused on taking losses for their clients at year-end, thereby missing out on opportunities during intra-year declines like this. We tax-loss harvest year-round to capitalize on market volatility.

Taking that to the next level, we are now pleased to offer clients tax-managed separate accounts — Tax-Smart Indexing™, or TSI 500. By incorporating TSI 500 into their overall portfolios, clients can benefit from tax-loss harvesting at both the individual stock level and the fund level, which can multiply the opportunities for tax savings.  In the past, these types of separate accounts were generally available to large clients at higher asset levels. Through TSI 500, we are now able to offer the solution for smaller account sizes.1

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What is tax-loss harvesting?

At a basic level, tax-loss harvesting involves selling funds that have declined in value to realize a loss that can be used to offset gains in your portfolio, which can reduce your tax liability. With the proceeds of the sale, an appropriate replacement fund is then purchased to serve the same place in the portfolio as the original fund.

This helps ensure that your overall portfolio exposures remain similar.

How Tax-Loss Harvesting Works

TSI Chart_generic_fund1-2_1000x550Hypothetical and for illustrative purposes only. All investments are subject to ongoing risk of loss and may have materially different levels of volatility. There is no guarantee that a replacement investment in any tax-loss harvesting scenario will perform better or equally to the original investment.

In order for the loss to be allowed, wash sale rules dictate that we cannot buy back the original fund for at least 30 days. If the replacement fund has declined or has been relatively flat over that period, typically we will sell it and buy back the original fund.

If there is a sizeable gain in the replacement fund, we will consider holding it to avoid negating the original loss with a new, short-term capital gain. In this way, our tax and investment strategies go hand in hand. Replacement funds are thoroughly vetted by our Investment Committee to allow for the eventuality that we hold them more permanently for tax purposes.

With tax-loss harvesting of mutual funds, we can take advantage of what has happened at the overall fund level. TSI 500 takes that practice a step further, allowing us to take losses at the individual security level. Beyond greater flexibility, a separate account also provides the opportunity for tax-efficient charitable giving. In the accounts we offer through TSI 500, highly appreciated stock positions can be “donated” and optimized for charitable gifts, which can allow investors to reduce their current (or future) tax liability, while achieving their philanthropic goals.2

When volatility is your friend

The opportunities to harvest losses in a portfolio increase with a separate account of equities designed to replicate the performance of the S&P 500 index, which is composed of large-cap U.S. stocks. Even when the index or the market as a whole is going up or sideways, a subset of stocks within it may be going down or have declines.

Index Fund vs. Tax-Smart Indexing
Maximum Flexibility

Separate Flexible Account
For illustrative purposes only.

Sophisticated optimization techniques allow us to take advantage of that volatility, while maintaining index exposure to large-cap stocks within a range of tracking error.

Your bottom line

Many investment managers disregard the impact of taxes on their clients’ bottom line; some are more interested in their “alpha” versus a benchmark than the after-tax return to their clients. But high turnover, frequent trading and short holding periods can turn even good results into mediocre ones after the taxman takes his cut. A recent study from the Financial Analysts Journal estimates that tax-loss harvesting of equities in separate accounts can add as much as 1.9 percent to annual, after-tax returns.3

Our approach is to focus on the things we can control. We can’t control what the market does, but we can control what we do in response to it. Sticking with an investment plan over rough patches in the market, rebalancing to target allocation and using tax strategies that take advantage of volatility are all things we can do to help improve long-term outcomes.

 

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
Martha Post
Martha Post

CFA | Principal, Chief Operating Officer

Martha Post, CFA, is a Principal and the Chief Operating Officer for Hewins Financial Advisors, based in Redwood City, CA. Martha oversees Hewins' operations and client service activities and also serves as a member of its Investment Committee, with nearly 30 years of experience in investment management, research and analysis.

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An Introduction to Tax-Smart Indexing™

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