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Jeremy Poulin
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Tax Loss Harvesting

Nov 19, 2013 Marc Odo

One of the toughest questions an investor faces is, “When should I cut my losses and sell out of a position?” Numerous behavioral finance studies explore the idea that investors are loath to realize a loss and will wait years in order to get back to the break-even point. Obviously such a mindset ignores the opportunity cost of a forgone investment in a more attractive alternative. Another opportunity cost that should be considered is the value of the losses of the underwater positions to offset capital gains of the winners, assuming they are held in a taxable account.

IRS rules prevent a “wash sale”- the idea of selling out of an underwater position for tax purposes and then buying back in to the same position within 30 days. While the rules prohibit re-establishing a position in an identical investment, a wash sale can’t prohibit the idea of investing in a similar investment. So how might one go about identifying a similar investment?

In StyleADVISOR one typically uses the search feature to find attractive managers that outperform a passive index. The user will load all the candidate investments, specify the appropriate passive index as a benchmark, and whittle down the list based upon the most attractive risk-reward characteristics.

However, there is no restriction in StyleADVISOR that says one must use a passive index at the benchmark. One could just as easily select an active manager as the benchmark- e.g. a manager currently held in a portfolio that has losses that might be used to offset gains. In the scenario below all of the candidate investments are loaded into a search like usual, but the benchmark is the active manager to be sold.

The results of the search will show the dozens of statistics typically calculated by StyleADVISOR. For this case study we want to focus on three in particular, namely:

  • R2 to market benchmark
  • Correlation to market benchmark
  • Tracking error to market benchmark

All three of these metrics are ways of determining how closely one return series tracks another. Because we specified Fund X as the benchmark, the results below indicate how similar its returns are to all the other candidate investments. A R2 close to 100%, and correlation close to 1.00, and a tracking error close to 0.0% all indicate very similar returns.

Obviously a fund is going to have its highest score to itself, and buying and selling in to the same position violates wash sale rules. Moving down the list, different share classes of the same fund will also have very high numbers, and are probably too similar to be considered a viable replacement. But as we go further down the list we start to see other, entirely different funds that have performance quite similar to the fund we are thinking of replacing.

Note: this blog post in not intended to be tax advice for any specific situation. Rather, it is intended to be an illustration of how StyleADVISOR can be used in different ways.

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