Just How Valuable Is Tax-Loss Harvesting?


Investors looking to improve their overall portfolio returns often turn to tax-loss harvesting at the end of the year. This amounts to selling some stocks or assets that have fallen in value and using the losses to help offset capital-gains tax liability, reducing one’s overall tax bill.

But how much can you actually add to your returns by tax-loss harvesting?

My research assistant Kanwal Ahmad and I decided to tackle this question by running simulations over different tax regimens, portfolio sizes and holding periods. We found that on average an investor facing a capital-gains tax rate of 25% can juice an equity portfolio’s annual return by 1.10 percentage points to 1.42 percentage points with tax-loss harvesting.

The value that can be added is even greater when markets are more volatile, thus producing a bigger number of loser stocks, or when capital-gains tax rates are high, either because the federal government raised rates or an investor is selling short-term holdings.

To explore this issue, we pulled data on all publicly traded stocks on the New York Stock Exchange, Nasdaq and the old American Stock Exchange (which was acquired by the NYSE) going back to 1930. We then created value-weighted portfolios to mimic how most people invest, and ran extensive simulations of each portfolio on how to best tax-loss-harvest. 

Each simulation we ran sold off particular positions that had incurred losses according to various cutoffs. If a losing position was harvested, we added a similar asset to maintain the portfolio’s asset-allocation mix and risk level — though any position that was tax-loss-harvested wasn’t allowed to re-enter the portfolio until a month later in line with the IRS’s wash-sale rule, which says if an investment is sold at a loss and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes.

We then calculated the value of tax-loss harvesting to an investor on a yearly basis as the capital-gains tax rate multiplied by the return of the stock that was cut from the portfolio, adding this up over all stocks that were harvested that year. Averaging this over all simulations and over all years, we were able to come to a maximum estimate for the value of tax-loss harvesting.

To make it a bit more realistic, we put in a condition that no more than half the portfolio could be harvested in a particular year — this we defined as our “conservative” estimate of tax-loss harvesting benefits.

Our first interesting finding is that conservatively, investors can juice their returns 1.10 percentage points a year on average, assuming a 25% tax rate. If investors are pushing it in terms of taking advantage of every tax-loss harvesting opportunity, they can add as much as 1.42 percentage points a year to their portfolio’s return.

Fund investors often debate: Should I entrust my money to an experienced fund manager with a record over many different market cycles, or should I go with an upstart manager who might have fresh ideas on how to generate gains?

My research suggests that if you want a fund that will track an index better and provide superior posttax returns, the more-seasoned fund manager is likely your best bet. If, on the other hand, you are looking for outsize bets and potential home runs, a short-tenure manager may be the way to go.

To examine the relationship between fund-manager tenure and performance, my research assistant, Ioana Baranga, and I collected data on all actively managed mutual funds between 2010 and 2020. We then partitioned all fund managers by their tenure at the fund, using a range of zero to three years to define “short tenure” managers, and six years and greater to define the “long tenure” managers. If there were multiple fund managers within the same fund, we opted to use the oldest fund manager’s tenure to define our partition.genesis3-2-1-1-1-1-1-2-1-1-2-2-1-1

Next, we explored how these fund managers differ in their returns and investment decisions. The results associated with managers in the large-cap U.S.-stock category highlight the results well. On a pretax basis, the average long-tenure manager underperforms the average short-tenure manager by 0.03 percentage point a year (12.39% average annual return for long-tenure managers versus 12.42% average annual return for short-tenure managers).

Yet this result flips when we examine posttax returns — it is actually long-tenure managers outperforming short-tenure managers by 0.14 percentage point a year, on average (9.15% average posttax annual return for long-tenure managers versus 9.01% average posttax annual return for short tenure managers).

Research Shorts

By: Derek Horstmeyer

Read more : https://www.wsj.com/


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