In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location. In Part II we discussed Overweighting towards small/value equities and Whole portfolio, tax-sensitive rebalancing. Here in Part III, we continue by evaluating the final two techniques, and draw our conclusions.
Technique #4: Tax loss harvesting
Value: up to .46% per year
Tax loss harvesting means selling assets that have incurred a capital loss. The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income.
After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss. Under current tax law, buying the same or similar asset 31 days before or after the sale, in any of your accounts, triggers the wash sale rule. After 31 days, if desired, the proxy asset can be sold and the original asset can be repurchased.
Let’s say your S&P-500 fund is down $20,000. You sell it, capturing the loss, and immediately buy a ‘proxy’ asset, for example an ETF (or mutual fund) based on the Russell-1000. After 31 days, you sell the Russell-1000 and buy back the S&P-500. Alternatively, you might stick with the new asset, in this case the Russell-1000.
Harvesting Capital Gains and Losses (Smith and Smith, Financial Services Review, 2008) compared the effect of various tax loss harvesting approaches on a hypothetical portfolio with the following assumptions:
- 20 asset classes
- Long term capital gain rate 15%, short term capital gain rate 36%
- 6% gross return
Examining a large number of possible outcomes with a Monte-Carlo simulation, it found that tax loss harvesting increased the portfolio by 11% over 20 years, which, annualized, equates to 0.52% growth. Thus for the study’s 6% gross return, tax loss harvesting added 8.72%
(0.52%/6%). To be conservative, we assumed tax loss harvesting opportunities only occurred on the equity portion (60%) of our model 60/40 portfolio. After normalizing for our theoretical maximum return of 8.76% of our period 1990-2009, an improvement of 0.46% is calculated (0.46% = 8.72% x 8.76% x 60%).
Technique #5: Enhanced index funds
Value: up to .48% per year
Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.
While DFA funds have real and quantifiable benefits, many advisors overstate them. A Duke University
Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.
Conclusion
As always, past performance doesn’t predict future performance. In which case, was this whole exercise a waste of time? It’s a fair question, but we think the analysis has some merit. First, most investors don’t implement all five techniques; for them, this analysis provides a rough idea of what they are missing. Second, while your mileage will vary, the analysis provides at least a stake in the ground regarding their relative value.
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