The Future Of Passive Investing

As we have all become painfully aware of this year, the Federal Reserve’s pivot to the most aggressive monetary tightening policy in a generation has ushered in a new investing cycle that’s very different from the last 10 years.

Volatility and comparatively lower returns are likely to be the norm going forward, now that we no longer enjoy the spoils of an accommodating Fed and zero interest rates. And as this reality has set in, we have seen growing numbers of wealthy investors and family offices adopting tax-managed equity strategies, or TME, as their core passive investing approach.

Today’s markets are tailor-made for TME. Volatility causes greater dispersion among the performance of stocks within sectors. And the greater the dispersion, the more opportunities there are for TME processes to systematically sell securities to generate losses. Those losses can then be used to offset taxes on realized capital gains in any part of a portfolio, at any time in the future. A similar process can also be applied to fixed income allocations.

TME is all about keeping more of what you make in the markets, and even during less volatile years, turning stock losses into tax savings can make a big difference long-term.

Create Tax Losses And Earn Benchmark Returns

TME is a customized strategy that delivers the diversification benefits and returns of an index, while also harvesting tax losses to offset realized capital gains. Those gains can come from any part of your portfolio.

TME usually represents a significant portion of a client’s total equity exposure, with the rest actively managed. But there is no typical percentage for the allotment of passive investments to a TME strategy—it’s up to you and your goals. We even have family offices where nearly all their public equity exposure is in TME accounts. 

A TME strategy is typically executed in a separately managed account and holds an optimal subset of individual stocks to mirror the index of your choice. The TME process requires sufficient diversification to buy and sell individual stocks to lock in tax losses, without too much deviation from the benchmark. As TME portfolios are most often used as a core element of an equity allocation, most clients choose traditional indexes like the S&P 500 or Russell benchmarks, but others can be used.

A critical part of the investment process is the tax-aware optimization engine, which systematically highlights potential tax-loss harvesting opportunities as they arise. It does so while modelling the gain/loss impact and tracking the trade-off between risk and tax efficiency. The TME managers are then able to apply their portfolio management oversight and opportunistically rebalance the portfolio.

Don’t Try This At Home

Of course, anyone can harvest a tax loss in their portfolio by selling a stock for less than they bought it. But it’s almost impossible for an individual, let alone a family with multiple investment accounts, to do it successfully by themselves. Or more to the point, it’s nearly impossible to do it and keep your passive investment closely tracking its benchmark at the same time.

The issue is the wash sale rule. The IRS will not consider the sale of a stock at a loss as a tax deduction if you sell it and then turn around and buy it or an equivalent instrument back within 30 days of the sale. That’s really 60 days’ worth of restrictions, as it applies to 30 days before and after the sale. The IRS has a pretty broad definition of what’s “equivalent” and can include options or other synthetic securities.


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