What are the best practices for rebalancing client portfolios and tax-loss harvesting? A survey of the advisor community shows that the issue is more complicated than it might first appear.
The research on so-called “advisor alpha”—excess return gleaned activities other than investment selection—is mixed. But two persistent components are tax-loss harvesting and some kind of disciplined rebalancing strategy—either time-based (monthly, quarterly, annually) or opportunistic as asset classes or underlying investments move out of tolerance by a percentage set by the advisory firm.
As I’m sure you noticed, March of this year provided a remarkable opportunity to harvest losses and rebalance back into equities at lower price points. The subsequent recovery offered some advisors, with some clients, another chance to rebalance.
It’s hard to know how much advisor alpha you can pick up with these strategies. The research (Here are some examples: https://www.researchaffiliates.com/en_us/publications/articles/681-rebalance-or-rush-hour.html; https://www.morningstar.com/content/dam/marketing/shared/research/foundational/831611-GammaEfficientPortfolio.pdf; https://www.hodlbot.io/blog/does-portfolio-rebalancing-actually-improve-returns; and https://www.wsj.com/articles/portfolio-rebalancing-might-be-overrated-1483931101) suggests that rebalancing actually reduces average annual return during most market periods. When the market is going up, like we’ve experienced for the ten years before March of this year, and you rebalance back to your tolerances, you’re reducing your clients’ exposure to the asset classes that deliver the subsequent highest performance. There might be a mitigating pickup in terminal wealth, though, due to the smoothing of returns. (Smoother return patterns deliver more terminal wealth even if the average return is the same.)
It’s possible that you make up some or all of this ground during periods of high volatility like we just experienced—and we may have other such “opportunities” before the year i8s out. Unfortunately, those downturns are exactly the time when many clients—and not a few advisors—lose their nerve. This can lead to a lose/lose situation.
Tax-loss harvesting is somewhat less controversial, but there are mixed reports there as well. (This is one study: https://www.advisorperspectives.com/articles/2014/08/12/the-tax-harvesting-mirage.) “It really comes down to the client circumstance,” says Jacob Wolkowitz, Managing Director of Investment Management at Accredited Investors in Edina, MN. “If the client is spending down the portfolio to zero, the tax loss isn’t particularly valuable, since the basis resets on a new position and they’ll eventually have to sell and pay tax on it. The value of those losses is just the value of deferring taxes out a few years.
“But,” Wolkowitz adds, “for a client who has an enormous tax gain and has significant estate plans, the value of losses can be close to 30%. Every dollar of losses can be written off against a tax that they will never have to pay, and at death the strategy doesn’t generate any future tax liability.”
Earlier this month, I polled the Inside Information community, asking for best practices and real-world challenges associated with portfolio rebalancing and tax-loss harvesting. More than 200 advisors responded, and 20 consented to interviews, helping me understand how they handle rebalancing, when and how they harvest losses, and what software they use to make the process easier. Their responses helped to clarify a number of issues that I haven’t seen reported anywhere else in our professional literature.
Issue: For many client portfolios the need for a full, formal rebalance is unnecessary even during extreme market events.
When she checked client portfolios back in March, Kailie Abascal, a financial planner/co-owner with Middleton & Co. in Vancouver, WA, discovered that for most of her firm’s clients, the rebalancing ‘opportunity’ was not an opportunity at all. “People who were contributing to their portfolios, or dollar-cost-averaging in, or taking recurring withdrawals, were constantly being restored to balance,” she says.
Dave O’Brien, of EVO Advisors in Midlothian, VA, reports that, due to constant inflows or outflows, only about a third of his clients qualified for rebalancing back to tolerance.
There were other mitigating factors, however. One was the unusual fact that many asset classes moved in lockstep in March. “When the market did that waterfall, everything went down,” says O’Brien. “As a result, most asset classes didn’t fall outside their range.” Another factor was the run-up in stock prices in 2019 and the first two months of 2020, which caused many portfolios to be stock-heavy before the downturn. The portfolios self-corrected from stock-heavy within tolerance to stock-light within tolerance.
Some advisors set tolerance bands around the inflows themselves. Sam Muse, at Fi3 Financial Advisors in Indianapolis, IN, says that his firm only reinvest cash back into whatever is underweight the cash holding reaches 150% of a client’s targeted amount.
O’Brien believes that the normal process of using money flows to bring portfolios constantly back to rebalance achieves the same or perhaps greater advisor alpha than the quarterly rebalance process. “We gain opportunities just as a matter of routine,” he says.
Issue: Some portfolio designs offer better ‘rebalancing alpha’ than others.
Mike Dubis, of Dubis Financial Planning in Middleton, WI, has given presentations to NAPFA audiences on rebalancing issues. One of the first points he makes is that rebalancing is more or less valuable depending on the way the portfolio is constructed. The ideal rebalancing mix will have components that have low correlations with each other and which display high volatility. “Correlations, volatility and the subsequent drift are very big drivers of the benefits of rebalancing,” he says. Yet most advisors choose the former but tend to shy away from the latter.
Dubis also found that very conservative or very aggressive portfolios tend to benefit less from rebalancing than moderate portfolios—for obvious reasons. The portfolios at the far ends of the spectrum offer a narrower range of diversification, and therefore less variance among the underlying investments.
Issue: The best way to rebalance is to have a set policy. But the profession has yet to come up with a universally-recognized ‘best practice.’
My unofficial survey uncovered several schools of thought about how to decide when to rebalance. Some advisors rebalance at set time periods that can range from quarterly to semi-annually to annually—or longer. Others set tolerance bands, and the tolerance bands could be at the macro asset class level or the individual investment level. For those who set tolerance bands, the ‘look’ interval varies considerably across the profession.
Dubis’s research suggests that threshold rebalancing outperforms calendar, and that large thresholds (20% of the percentage allocation vs. 5%, for instance) produce better results than lower ones. This is consistent with Gobind Daryanani’s research that was conducted as he was creating the iRebal software; he found that opportunistic rebalancing with a 20% tolerance band was optimal, and if followed rigorously, he concluded that it would produce an average of 30-40 basis points of additional return per year. (To be clear, the tolerance band means a percentage of the percentage; if a position has an original allocation of 10%, then the rebalance is triggered if it falls below 8% or above 12% of the portfolio.)
Norm Boone, of Private Ocean in San Francisco, CA, says that a 20% band has the advantage of not triggering a lot of trades, and when it does (when the market has fallen significantly), you have the opportunity to show clients a real impact. Moreover, such a wide tolerance band reduces the chance that you will be rebalancing into equities while the markets continue to fall—an experience not favored by clients, no matter how well-trained they are.
But do you set the band at the global asset class level or the individual positions? O’Brien was one of many who feel that the 20% band across the major asset classes is now the accepted norm in the marketplace, and he looks for a rebalancing opportunity more frequently than most: several times a week. Tim Admire, Director of Operations for Willow Creek Wealth Management in Sebastopol, CA, uses the same 20% tolerance across all asset classes, but the firm uses Orion’s Eclipse software to look less frequently: once a month. Tim Hatton, of Hatton Consulting in Phoenix, AZ, uses a 25% tolerance across the major asset classes.
Roberto Rivera, of Freedom Advisory, LLC in San Juan, PR and Ft. Lauderdale, FL, does it differently: he sets a three percentage point tolerance band between the broad stock and bond allocations. “There is no scientific reason why we picked that threshold,” he admits. “We believe what’s important is to actually have the threshold established and flexibly execute when reached regardless of market outlooks.” Meanwhile, Kelly McNerney at FJY Financial in Reston, VA uses 10% tolerance bands for the broad stock and bond allocations. The firm looks at the client portfolios weekly.
Niko Finnigan, Delta Wealth Advisors in Hinsdale, IL has an interesting logic behind his tolerance bands. “We set an 8% tolerance for stocks, because in a typical year you will see an 8% pullback three different times,” he says. “We’re hoping to catch two or three of those.” Similarly, the tolerance for bonds is 4%, to catch downturns which will occur less frequently.
Muse, at Fi3 Financial Advisors, does it a bit differently; he uses a client’s bond allocation to set the trigger. “If we target 50% fixed income in the portfolio,” he explains, “we’ll rebalance the entire portfolio if fixed income goes above 53% or below 47%.”
The firm actually uses five model portfolios, ranging from 80/20 to 20/80, and the tolerances in each case are set at the same three percentage points. Muse reasons that stocks are much more volatile than bonds, so letting the bond allocation determine when to rebalance will save a lot of trading activity.
But the firm also combines opportunistic with annual rebalancing—which, in turn, is combined with a dynamic asset allocation strategy. “Every year, we update our capital market assumptions,” says Muse. “That drives changes to our recommended model portfolios. So every February, we are going to rebalance every client, and at the same time move them to the new models.
Aspiriant does something similar. “We utilize dynamic asset allocation, where our clients give us discretion to move the allocation around within certain ranges,” says Sandi Bragar, Wealth Manager at Aspiriant’s San Francisco office.
The driver is valuations. “As equities got more expensive, we pulled away and started loading up more on bonds and lower-volatility asset classes,” Bragar explains. The rebalance in March shifted the allocations of client portfolios, but interestingly, the result was to take a bit more out of equity and add to fixed income, creating a more defensive posture as the pandemic continues. “Our expectations” says Bragar, “were telling us that even with the dramatic decrease in equity prices, equities were still pretty expensive.”
McNerney at FJY has put a slightly different twist on client rebalancing. Instead of rebalancing back to the original asset mix, the firm is raising the cash allocation for retired clients, from one year of expenses to 18 months or two years. “Who knows when the volatility will ease up?” she says.
A few advisors reported setting tolerances around individual positions, rather than the broad asset allocations. Mike Garry, of Yardley Wealth Management in Newtown, PA, sets tolerance bands of 20% around positions as small as 5% of the client portfolio, rebalancing if they go below 4% or above 6%. Accredited Investors sets the equity to bond tolerance at 10%, but sets larger tolerances for international vs. domestic, small cap vs. large cap, etc. “That incentivizes the trading program to do the most impactful trades,” Wolkowitz explains. “Trading small cap to midcap isn’t going to change your expected return every much,” he adds, “because those asset classes tend to be highly correlated.”
Aspiriant, also varies its tolerance bands by asset class. “For fixed income, it’s 15%, for equities it’s 20%,” says Bragar. “For real estate, somewhere in the middle of the two.” The firm looks at rebalance opportunities at least monthly.
Mark Wilson, of MILE Wealth Management in Irvine, CA uses the standard 20% band for the larger positions in client portfolios, but he puts much wider bands around their smaller positions. “Otherwise,” he says, “you’re going to create all kinds of trading. You’ll be rebalancing that little position every three weeks.”
Others are not so sure that opportunistic rebalancing is the best approach. “We aim to do a firm-wide rebalance once a year,” says Joe Jedziniak, VP of Operations at Simon Quick Advisors in Long Valley, NJ. Even so, under extraordinary circumstances, the firm will take advantage of big market shifts. “April was the second time in three months that we were doing a rebalance.” Says Jedziniak. “I think at the end of it, we pumped out 4,000 trades across three custodians.”
Oliver Gooden, Director of Advisor Solutions, Wealth Advisory Group in Charlotte, NC, says that his firm rebalances quarterly based on the anniversary date in which the account was set up. If a client portfolio was initiated on, say, February 15, then the 45th day of the quarter would be the rebalance date for that portfolio, and any positions that have driven more than 20% beyond their target allocation will be returned to target. The logic? “It alleviates the liquidity size concerns,” says Gooden. “The trades are broken up throughout the quarter at the account level.”
Yes, this did produce some interesting results. “There is a real probability,” says Gooden, “that some clients rebalanced on February 1, experienced a 35% drop, then rebounded back, and they have no change in their allocation.”
Issue: The trading aspect of rebalancing becomes very tricky during extremely volatile markets like what we just experienced.
The March downturn reminded everybody that the best rebalancing opportunities come at precisely the time when you’re most likely to run into a pricing whipsaw.
“When we rebalanced in March,” says Wolkowitz, “we were trying to make sure that we were not out of the market for any period of time. If we sell an ETF at 1:30 during a time of extreme volatility, and buy a mutual fund at 3:00, the market could do something crazy to you.”
On some of the most volatile days, he encountered “outrageous” price discrepancies from net asset value in small cap ETFs. “You’d look at the S&P 600 ETF, and it should be down 3%, but it was showing you down 6%,” says Wolkowitz. “If you were buying the mutual fund version, it would be down just 3%. So you could do a lot of damage to yourself by selling an ETF and tax-swapping into a mutual fund on the same day.”
“The obvious asset classes—equity and real estate—were the two with the most volatility,” says Mark Jimenez of Kahler Financial Group in Rapid City, SD. “We didn’t want our clients out of the market with those ten percent daily moves going on.”
Aspiriant actually stopped its rebalancing process altogether at the height of the volatility. “The markets were moving many percent a day, and we felt like it would impair trading,” says Bragar. The firm portfolios are mutual funds, rather than ETFs, but Bragar found “too much of a mishmash between the values of what we were buying and selling. That,” she says, “can create trade errors and all kinds of unintended consequences.”
David Schneider, of Schneider Wealth Strategies in New York City, reports that his AdvisorPeak software has a feature where, if you’re trading ETFs or individual securities, you can press a button and see the updated price of all your securities and whatever it is that you plan to buy, up to the moment. “It helps to know what the current price is during a time of great intraday volatility,”he says. “It can be hard to know exactly what you’ll be getting when you go into the market where the Dow is going up or down a thousand points.”
Not all rebalancing products will let you see the granular detail needed to minimize taxes when you rebalance. Using AdvisorPeak, Abascal and her team were able to identify the asset classes that were out of tolerance, and then, when the market shot back up again, the software recommended the lowest basis individual tax lots within the overweight assets to sell.
Schneider also uses AdvisorPeak to drill down to the lot level. “The problem with some of these tools is that it is very hard to do an efficient tax assessment,” he says. “When you look at a client’s taxable account, you see positions that were purchased on several occasions, and maybe there were dividends reinvested. With the right software,” he adds, “you can spot different tax lots that have losses, and take advantage of that.”
Issue: Ideally, rebalancing should be done at the household level.
Like most advisory firms, Willow Creek practices an asset location strategy, with taxable bonds generally in the clients’ traditional and Roth IRAs, equities generally in the taxable account. But Admire says he has found that it reduces complications if this is not strictly adhered to. “We try to make sure there’s a little bit of everything in all the accounts, which makes it easier to do a household rebalance,” he says. “It also keeps the performance dispersion from being too drastic between accounts, which can lead to client conversations.”
“I use household rebalancing and try to incorporate good asset location as much as possible,” says Brandon Grundy of Ridgeview Financial Planning in Santa Rosa, CA. “Each portfolio is added to the household group, and each group is reviewed as a whole in iRebal once a month.
Wilson uses Morningstar’s tax cost ratios to rank holdings by tax efficiency to determine asset location, and uses Total Rebalance Expert to rebalance across the household rather than the individual positions.
Issue: Software is the key to implementing the various rebalancing strategies.
More than a few advisors who responded to my original message asked me what rebalancer I recommend. So I asked the people I interviewed what they use and whether they like it.
Some compared their previous experience using spreadsheets with how long it takes using specialized software. “Before we had AdvisorPeak, I think our firm had 50 accounts,” says Jedzinski. “And I remember my first firm-wide rebalance; it took a good three or four hours to enter all the trades, and another three or four hours for the allocation.”
Now? “In the last rebalance, I went into the system, selected all the accounts, hit ‘proposed trades,’ and the program produced the trades across 350 portfolios,” Jedzinski says. “The client advisor teams reviewed all the trades, and once we got the go-ahead, we executed the trades. All in, it took maybe 35 minutes.”
Admire says that before using Eclipse, his firm would run spreadsheets that outlined the current portfolio mix, and then he and his staff would hand-key every client trade. Now the evaluation process and identifying proposed trades takes roughly an hour, and the trades can be sent out of Eclipse to the custodian.
Muse uses the Orion platform to manage client portfolios across three custodians, but he tried Eclipse and found it too complicated and too prone to recommending trades when he didn’t feel they were necessary.
I also heard good reports about the speed and efficiency of Total Rebalance Expert, which is also, along with AdvisorPeak, one of the thriftier options. “I use Total Rebalance Expert, which was the first truly affordable rebalancer that came out,” says Pat Jennerjohn of Focused Finances in Oakland, CA. “I once sat in a presentation by Tamarac, and they said, oh, it’s just $35,000 a year. I said, I’m out of the room,” she says, laughing. “That’s not affordable for a firm my size.”
The reviews of iRebal were mixed at best. Wolkowitz says that Accredited Investors was one of the early users of the standalone iRebal version, but eventually they switched to Tamarac rebalancer. “Today, Tamarac is a far better product than iRebal,” says Wolkowitz.
Other advisors, who were reluctant to go on the record with negative mentions, said that the iRebal product was groundbreaking when it first came out, but that it hasn’t been updated much since. (One advisor called it “a prettier version of what you can do in Excel.”) Other advisors using the free version of iRebal compare it favorably with their old method of using spreadsheets, but seem unaware of the advanced features built into the independent software products.
Issue: Rebalancing can be viewed as a market timing activity. (In retrospect, did we rebalance at the bottom?)
A surprising number of advisors I talked with looked back on the March downturn and subsequent recovery with a certain amount of regret. They either rebalanced early and missed the steepest part of the drop (and the opportunities to buy back in at lower prices) or they delayed the rebalance and found to their dismay that the markets had made a substantial recovery.
Abascal’s firm didn’t experience that dilemma because the firm abandoned its “look quarterly” approach and was continuously rebalancing clients from February through April. Shaun Erickson, of Single Point Partners in Boston, MA, took a similar approach and incrementally caught the market bottom. “When we rebalance,” he says, “we tend to move the money back up to the target allocation in stages, so as to reduce the market timing impact of picking the “right” day to push the button. It’s more of a dollar-cost averaging process to rebalance than a one-time event.”
“I would love to say that I clicked the button when the markets were down 35%,” Wilson adds. “But I listened to the software. There were some clients,” he adds, “where I rebalanced at 20% down, and they didn’t need an additional rebalance at the bottom. All of my clients were rebalanced,” he says. “But it was somewhat all over the place.”
Issue: Rebalancing during a market downturn requires client courage and a strong advisor/client relationship.
As you can imagine, various advisors reported a certain amount of pushback from some clients, who were alarmed that the their portfolio would be buying into equities when the markets seemed to be going to hell in a handbasket. “We set a threshold at 5% deviation from the target allocation between stocks and bonds in Tamarac Rebalancer,” says Linda Chao, President of Silver Oak Wealth Advisors Services in Los Angeles, CA. “But full-rebalancing trades are not done automatically,” she adds. “When the market started falling and our portfolios reached that threshold very quickly, we were busy calling and reassuring clients, and for two weeks there was hardly any mental space to discuss and execute rebalancing.”
Ironically, this worked to the clients’ advantage. “By the time the markets hit bottom in late March, we decided to do a rebalance immediately by 50% and wait till May/June for the second tranche, to hedge the risk of timing,” says Chao. Most clients, she says, trusted the firm, while a few teetered on the edge of bailing out. “For those,” she says, “instead of doing the rebalance, we asked how they felt about it, and followed their instruction.”
Simon Quick’s advisory team notified all of their clients of their intentions a couple of days before Jedziniak pushed the button, giving them a chance to opt out of the process. “There were some clients who told us they didn’t feel comfortable rebalancing right now,” says Jedziniak. “So we said: let’s revisit it when you feel comfortable. But,” he adds, “the majority of our clients trusted the process.”
The opposite happened when Joe Kilner, of Kilner Capital Advisors, sent out a negative consent communication informing clients that, if they didn’t object, he was planning to do a full rebalance during the market panic. “I thought it would be a very effective communication,” he says ruefully. “And it was not. It resulted in me spending the next week on the phone all day long talking to people.” As it turns out, that delayed the rebalance from the second week of March to the following week—near the bottom of the waterfall. “The timing happened to work out pretty well,” says Kilner, “but it was pure luck.”
Interestingly, Willow Creek rebalanced some client portfolios that were not outside the tolerances, as a way to placate anxious clients. “When the markets became really choppy, we had clients who asked us what we were doing about it,” says Admire. “In uncertain times, clients want to see that you’re taking some kind of action. So,” he says, “instead of doing something crazy like going to cash, which might be what they had in the backs of their minds, we did a full rebalance. Looking at accounts now that things have come back a little bit,” he adds, “you can really see how that has paid off for a lot of clients.”
Of course, advisors aren’t immune to the herd instincts that market downturns trigger in our brains. “In March, I almost felt nauseous buying so much small cap value, as it had gotten hammered much worse than large cap,” says Garry.
Wilson had a similar experience. “I’m a big believer that I set these parameters for a reason,” he says. “The more there is a pit in my stomach when I press the ‘rebalance’ button, probably the better will be the results.”
Issue: The rebalancing discussion also illustrates some behavioral issues about putting large sums of cash to work in the markets.
During the downturn, O’Brien had clients who happened to be investing large amounts of cash, due to liquidity events, when the markets were extremely volatile. In one case, a client agreed to invest $3,000 a week; another is investing a million dollars in dollar-cost-averaging increments over the next 12 months. Of course, they felt some regret when the money went in right before the downturn, but they felt good about their investments at the bottom.
For Casey Bear, CEO of Cranbrook Wealth Management in Troy, MI, the rapid downturn and then updraft confirmed something that he had previously been recommending by instinct. “We have a lot of dollar-cost averagers,” he says. “People who sold their business, or they’re taking down options and restricted shares, or quarterly bonuses or had a big liquidity event, many millions of dollars in more than a few cases. So we generally agree to move the money in systematically.” One client, he says, is moving $100,000 into the market every day. Others are monthly, or every 90 days.
“I would tell my clients: dollar-cost averaging is an emotional decision over a financial decision. We might even lose a little bit this way, because the math doesn’t support it. But,” Bear adds, “if the client has $20 million of stock options, and we happened to put it all in in February right before the market went down 35%, that client is scarred for life. That is something he will remember forever. That client will never want to be in the market again. I’m willing to give up maybe a percent over rolling ten year periods,” he says, “to prevent that $20 million from turning into $11 million in the first four months after he moved into the market.”
Issue: Like everything else, rebalancing requires a degree of common sense.
The most common reason to not make a trade was when it will trigger short-term capital gains. But surprisingly few advisors actually experienced that problem in this downturn—especially in cases where the software shows the tax position down to the individual lots.
Other reasons involved situations where the trades would have shifted a carefully tailored asset location strategy, or where the cost outweighs the potential benefits.
“We have the real estate positions in our clients’ IRAs for tax reasons,” says Abascal. “To rebalance, the software told us to sell the real estate out of the IRA and buy it in the taxable account. We rejected that trade.”
Her AdvisorPeak software will also flag whenever a trade will trigger a custodial transaction fee, and if the position is small, then Abascal will reject it and let the portfolio stay a little bit out of balance.
Issue: It might be easier to outsource rebalancing for clients. But you might still have to take the wheel under unusual market circumstances.
“Our custodian, SEI, does the rebalancing for us based on our models and the sensitivity we set for each asset subclass and style,” says Clark Blackman, President of Alpha Wealth Strategies in Houston, TX. “But in the middle of March, SEI indicated that they were going to delay the March 27th scheduled rebalancing to April 10, due to the bond market disruption, primarily in the muni bond markets.”
Because his portfolios were not heavily invested in munis, Blackman decided to manually rebalance, sent out notice to his clients and only one asked him not to. “We rebalanced four market days following what I believe was the bottom at that time,” he says. “Meanwhile, I had some fairly sophisticated investors investing cash into the market as it was falling.”
Andy Fagan, who practices in Gig Harbor, WA, takes the simplest possible approach: invest in one of Vanguard’s four target risk funds, which rebalance minute-by-minute as a result of the money flows. “One is conservative for income, one is moderate risk, one is balanced and one is aggressive growth,” he says. “They invest in the Vanguard mutual funds, they’re well diversified across asset classes, and they are always in balance to the target allocation,” he says, adding: “I’ve always wondered why more advisors aren’t simply using them and keeping things simple.”
Issue: For tax-loss harvesting, just because the market drops 35%, it doesn’t mean clients are sitting on losses that can be harvested. And if you do take losses, it can spook the unsophisticated client.
“Our clients had been holding many of their positions since the Great Recession,” says Jedziniak. “So even after the downturn, there were gains all over the portfolios. People who were very committed to the buy-and-hold concept tended to have gains, not losses, even when the market went down.”
Bear says that five of his clients experienced a bout of fear and panic, not when they read about the downturn in the papers, but only when when they saw that he had booked losses on their behalf. “They see it on the statement, and it makes it real to them,” he says. “Even though I tell them we are going to buy right back, it pours a little fuel on the fear fire.”
Issue: Many advisory firms set tolerance bands on tax-loss harvesting as well as rebalancing.
Admire says that Willow creek generally will not harvest a loss unless it is at least $3,000 and at least 5% of the position. Otherwise, he doesn’t feel like there is enough value to the client to justify the time to execute the trade.
For Aspiriant, the limit for equities is at least a 10% decline in the position and at least a $10,000 loss. Fixed income has a 5% decline threshold; 8% for real estate. Wilson will only harvest if there is more than a 10% loss and more than $1,000 in any position.
McNerney says that FJY Financial doesn’t harvest unrealized losses lower than $10,000. Accredited Investors will normally harvest only positions that are down more than 5% from the original cost and, at the same time, if the trade will generate more than $1,000 in losses.
But those limits can be situational. In March, Accredited raised the limit to 10%, and still managed to harvest $45 million in losses, from roughly $1 billion of taxable dollars in client portfolios.
Other situations were individual to the client. “Our planning team will proactively suggest harvesting losses incrementally across the portfolio for clients who need them,” says Wolkowitz; “usually due to the sale of a business or another significant capital gains event. Since those losses are more valuable,” he adds, “we will be much less sensitive to creating portfolio deviations relative to the target model.”
Issue: Market drops like what we experienced in March can be a great opportunity to help clients move out of positions that the firm wanted to sell anyway.
“Several of our clients had large legacy holdings that our advisors wanted to diversify out of for years,” says Jedziniak, adding that the tax bite would have been too painful for clients to stomach. “But then came March, and we were able to use that time period to allocate out of those positions with large embedded gains into more diversified ETFs.” Of course, the firm also looked at harvesting losses elsewhere in the portfolio that would mitigate the already-reduced tax consequences.
Finnigan recalls a client who was clinging to a big, longstanding position in Wells Fargo, which had significant gains. “In March, we were able to harvest enough tax losses that the client was finally okay letting go of it,” he says, “because we were able to show him that there would be no net tax consequences for selling the position.”
Others took the opportunity to replace an underperforming fund or two. Even though Wealth Advisory Group rebalances quarterly on anniversary dates, the firm took advantage of the March downturn to tidy up client portfolios. “There were a couple of funds that we had been wanting to replace,” says Gooden. “We had a mutual fund that we had intended to get rid of for years, so we could replace it with an index ETF. But those positions were highly appreciated across a number of accounts, so we were holding off. When the markets dropped,” he adds, “we saw that as an opportunity to make changes while the cost basis was down.”
Issue: The recent downturn, then rapid recovery, illustrates the need to have a strong backup “second string” of investment options to buy whenever you harvest a tax loss.
“You have to be careful with tax-loss harvesting,” says Schneider, “because you don’t want to replace your position with something that you might end up being stuck with, if the market rallies and that is not your preferred vehicle.”
This hypothetical became common with losses harvested in March that showed gains in the 31 subsequent days of market recovery. “We use active managers for our international exposure, and we have a preferred emerging market manager that we use,” says Muse. “We had clients who were in a taxable loss position, so we moved them to a passive fund, intending to hold that for 31 days and switch back.”
Then the markets came roaring back. “New we have 18% short-term gains in the passive fund,” says Muse. “In this case, we harvested the short-term gains because we believe the active managers are a better place to invest than the benchmark for emerging markets, and the short-term losses the portfolio produced in March more than offset the short-term gains. But,” he adds, “it was really interesting to go through that psychological side of things. Do we want to take a short-term gain? Can we offset it? I would be curious how other advisors face those same decisions.”
FJY Financial maintains at least two approved funds in each sub-asset category that it has vetted and regularly tracks. “We call it our ‘substitute list,’” says McNerney. “The funds are already approved, and we want to be comfortable if we’re holding them for extended time periods.” In fact, since the downturn, clients are holding a number of those substitute funds—and the firm is okay with that.
Bragar says that Aspiriant has a policy of harvesting gains in mutual funds, and temporarily replacing the positions with ETFs. “That may seem like a bizarre trade to you,” she says. “But we have so many assets under management, and mutual funds hate money coming into their funds for a short period of time and then leaving. We found that it is much easier to get into and out of ETFs without upsetting any managers. We trade into ETFs, have conversations with our preferred managers about why we’re getting out, and the expectation is that we’ll be coming back in in another 31 days.”
O’Brien actually prevented his Total Rebalance Expert software from taking losses on certain positions because he worried about this exact same scenario. “We had tax loss opportunities in the Vanguard Large Cap Value ETF in our taxable portfolios,” he says. “But if we take that out, what are we going to put them in?” Another large cap value ETF would trigger the wash sale rules. “We would have to replace it with something different enough,” says O’Brien, “and we don’t think the tax trade is going to make up for the potential returns we might have lost.”
For some advisory firms, it’s easy to find substitutes. “We use DFA’s tax-managed funds in taxable accounts,” says Admire. “If we harvest a loss, we can move to the non-tax-managed DFA fund in that asset class.”
Kilner does exactly the same thing, and found that he, too, was trapped by the unexpectedly rapid recovery. “For one client, I harvested $300,000 in losses when I moved him out of the DFA tax-managed fund,” he says. “Now that 31 days have passed, if I wanted to undo those positions, I would have to generate $130,000 in gains.”
Did he do it? “Why would I give up $130,000 of tax benefits?” he asks. “I don’t think my tax-managed fund is going to give me that much extra value in ten years.”
Issue: There are still benefits to tax-loss harvesting at the end of the year.
“I’m frankly not sold on the idea that when you do a lot of tax-loss harvesting, it adds 1-2 percentage points to your clients’ portfolio return,” says Schneider. “All you’re doing is resetting your basis. Unless you die owning the assets, you will pay the tax eventually.”
But, he says, the end-of-year process can be visibly beneficial to clients. “You use it to mitigate the pain of taxable distributions,” he says.
Jennerjohn looks for loss harvesting opportunities in November, and tries to match them up with fund distributions—which, she says, have been high for the last several years. “I find out what the estimated distributions are going to be using Capital Gains Valet,” she says. “You look up who’s going to distribute gains and how much, and if they’re over a certain amount, I’ll look at my clients and see who holds that position. If we have a loss we can harvest to offset that, I’ll take the loss.”
Finnegan also harvests at the end of the year, but he warns advisors not to neglect opportunities like March. “If you’re simply trying to harvest losses at the end of the year, they may not be there,” he says, “when you might have been able to harvest earlier in the year.”
We should not pretend that even with 200 responses and 20 interviews, this is a definitive snapshot of how the financial planning profession handled the significant advisor alpha opportunity the markets handed us earlier this year. But I think we can conclude that some best practices are emerging, with some bandwidth among them. As we enter a period of uncertainty, with the possibility of more sharp downturns and volatility, advisors who have a defined strategy will add more value than those who don’t. Advisors who use advanced rebalancing software will have a huge advantage over those who don’t, and the custodian-provided solutions may not always be the best options.
Should you rebalance based on time periods (monthly, quarterly or annually), or opportunistically? If opportunistically, should you set tolerances at the broad asset class level or individually for investment positions of different sizes? If opportunistically, how often should you look at the portfolios?
Is rebalancing a redundant activity for clients whose inflows and outflows allow you to maintain something close to the original allocations in real time?
I think all of the advisors I talked with have reasonable methodologies, even though they differ. I hope that you benefited from their explanations of what they do and why, as you chart your own course toward the next advisor alpha opportunity.