At Smartleaf we believe in passive portfolio management. There is one area, however, where we think it pays to take an active approach: tax management.
Through our direct indexing program, we are able to generate significant tax alpha, a measure of the impact of rigorous tax management. Based on our own research, we believe that sound tax management strategies can generate tax alpha of approximately 1.5% per year.
Previously, rigorous tax management strategies have been reserved for high-net-worth investors. Because Smartleaf automates these tax management practices, we are able to offer it to clients in separately managed accounts at a much lower minimum—just $50,000.
When index funds first came along in the 1970s, they quickly proved to be more tax efficient than actively managed mutual funds. By holding stocks for longer, managers reduced portfolio turnover and the capital gains they passed on to shareholders. Exchange-traded funds (ETFs) improved upon that tax efficiency further because they didn’t need to sell securities to meet redemptions.
However, even ETFs are limited in how tax efficient they can be. Smartleaf’s tax optimization strategies take tax management to the next level. We use the following strategies to increase tax alpha:
Lot-level tax loss harvesting. Our technology automatically seeks out opportunities to take losses in individual stocks that have declined in price, even if the portfolio’s total value is higher. With ETFs, investors can only harvest losses when the underlying index as a whole has fallen below its purchase price.
Year-round tax loss harvesting. We identify and realize investment losses throughout the year, not just at year-end to beat the Dec. 31 deadline. This gives us greater flexibility about which losses to take and allows us to take advantage of price declines no matter when in the year they occur.
Under current law, investors who can’t use all of their losses to offset gains in one year can offset up to $3,000 in ordinary income, such as wages. The remainder can be held on as a “tax loss carry forward” to offset gains in future years.
Pass-through losses. While ETFs can realize losses and carry excess losses forward on their own books, they are legally prevented from passing on excess losses to shareholders. With direct indexing, investors do not have these legal constraints.
Gains deferral. Normally, taxes are owed on any gains when securities are sold. You can defer the gains on ETF shares by holding them, but that means maintaining your exposure to the entire asset class or sector the ETF represents. Our program lets us defer the biggest gains when rebalancing between asset classes or sectors, while using risk-based tradeoffs to keep asset class and sector exposure on target.
Avoiding short-term gains. Our technology aggressively avoids realizing short-term gains, which are taxed at an investor’s ordinary income tax level. Again, by owning individual stocks, our portfolios help you avoid short-term gains while also maintaining target asset class exposure.
Lot-level logic. In large portfolios when there are several lots of the same security, we make sure to select the one with the smallest gains when selling.
Smart cash withdrawals. When we need to raise cash, we selectively sell securities and lots with low gains or losses as long as we are able to maintain the portfolio’s risk and return characteristics. When you sell ETFs, on the other hand, you're effectively selling all the underlying securities pro rata. That increases the tax consequences for investors since some of the underlying securities may have gains.
Wash sale rule avoidance. The Internal Revenue Service limits investors’ ability to sell securities to realize a tax loss and buy them back immediately. We must therefore wait 31 days before repurchasing the same security. As aggressive as we are on tax alpha strategies, our technology ensures that we comply with this rule.
Learn more about Smartleaf Core Portfolios here.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS
THE EFFECT OF TAX MANAGEMENT ON A PORTFOLIO’S RETURN WILL VARY GREATLY, DEPENDING ON THE PORTFOLIO’S SIZE AND HOLDINGS, CLIENT PREFERENCES AND RESTRICTIONS, MARKET CONDITIONS, CHANGES IN THE TAX LAWS AND OTHER FACTORS.