The benefits of the strategy on after-tax returns may be overstated
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Investment professionals often expect better after-tax returns from the use of tax-loss harvesting strategies. But according to one blog post published by the CFA Institute, advisors may want to think twice about these assumptions.
“The value added by such strategies depends on future market environments and an investor’s circumstances,” noted David Allison, CFA, CIPM, and founding partner at Allison Investment Management.
Citing a paper titled Tax Management, Loss Harvesting, and HIFO Accounting, Allison said that tax-loss harvesting strategies are most lucrative in markets with higher stock-specific risks and lower average returns. A steady stream of contributions helps maintain the benefits of the strategies over time, he added.
“On the flip side, large withdrawals are counterproductive to such strategies, while the advantages tend to be related to an investor’s tax rate on a roughly linear basis,” he continued.
While harvesting a loss could generate tax savings in the present, it reduces the cost basis of the investment and potentially increases future liability. An increase in an investor’s tax rate would also blunt the tax-deferral benefit of the harvested loss, while a reduced tax rate would amplify the benefit.
Another factor to consider is the stability of an investor’s tax rate, which many proponents of tax-loss harvesting take for granted. “Rates can change drastically based on shifts in policy or life events,” Allison said. He went on to cite a Wall Street Journal column that points to tax-loss strategies possibly backfiring in case tax rates go up. One analysis by Morningstar expert Christine Benz, he wrote, even suggests that those temporarily on lower tax brackets might be better off harvesting gains.
Models for tax-loss harvesting strategies may disregard the realities of trading, he added. A new security may underperform the one that was sold at a loss, offsetting the trade’s expected economic benefit. Advertisements for such strategies may also refer to hypothetical backtests with specific, cherry-picked scenarios that assume heavy allocations to volatile assets, investors with few liquidity needs, or exposure to a large bear market at the start of the measurement period.
“There is nothing inherently wrong with illustrations containing backtested performance data,” Allison stressed. “If they meet certain standards, they can help investors understand how a recommended strategy might perform under certain conditions. But advisers should always consider the number of disclosures required — and the audience’s sophistication.”
