The most optimal tax alpha portfolio can be built with a custom index of 60 to 100 stocks that tracks an index.
I've written previously about how taxes are a killer of investment returns, why investors should focus on minimizing their three "partners", and the generation of planning alpha. In this post, I want to focus on six ways to generate tax alpha. By "tax alpha", I mean excess returns generated by using tax strategies that minimize capital gains and income taxes and maximize the benefits from realizing losses.
Focus on where you own your assets
As I've written about, you want to own fixed income in tax-advantaged accounts such as IRAs and 401(k)s and not in taxable accounts. This is also true of other types of high yielding investments such as REITs. By doing this, an investor can essentially turn higher yielding assets into tax-free higher yielding assets. Growth assets, such as stocks, should be held in taxable accounts so they can benefit from long-term capital gains tax treatment and where investors can control the timing of when gains and losses are realized.
Buy low dividend stocks
Historically, buying high yielding stocks has not generated alpha, quite the contrary, it has been a poor performing strategy. (Meb Faber has done great research on this.)After you add in the disadvantage of getting taxed on quarterly dividend distributions, this is a really bad strategy. (This is true even if all the dividends are “qualified” and are taxed at long-term gain rates, which will be true for most investors.)
Tax loss harvesting
Another simple way to generate tax alpha is to book losses on losing positions and holding on to winners as long as possible, if not permanently. The losing positions can be repurchased after 30 days without triggering a wash sale and the investor then has the losses to carry forward and can use them to offset any future gains.If the losing position comes back and is sold for a profit later, the lower cost basis will give back some of the tax benefit, but on a net basis, this strategy could generate 20 basis points of tax alpha annually. (I have seen academic literature claiming tax alpha of 60 basis points annually from tax loss harvesting, but think this is overstated.)
There are a number of techniques that can mitigate or even completely avoid realizing capital gains when rebalancing a portfolio. Recall that rebalancing is when the asset allocation (stocks/bonds/cash) is brought back to target percentages. Usually, this involves selling stocks and buying bonds or adding to cash, although after a bear market it would involve selling bonds to buy stocks. Either way, there will almost always be gains realized on the sales of the appreciated assets.
Rebalance inside tax-advantaged accounts
This is the easiest solution and has no tax consequences, however, if an investor's tax-advantaged accounts are already invested 100 percent in fixed income assets (which is our general recommendation), this can't be used.
Rebalance with donations of appreciated assets
Most investors have one or more non-profits they support every year. These commitments can be met by the gifting of appreciated assets, instead of the sale of the same assets and gifting of cash. In the former scenario, the investor would completely avoid capital gains tax and help to rebalance her portfolio. In the latter scenario, the investor would pay tax to achieve the same rebalancing.
Rebalance with new money
If there are systematic or known future cash flows, those can be directed into the asset class that has not appreciated. (In most instances, fixed income.) This will help to keep the asset allocation in line with the target and not require sales of the appreciated assets.
Tailor the taking gains to the client's cash flows
While many advisors default their rebalancing to the annual completion of 12 lunar cycles, this is completely arbitrary. When rebalancing would result in realized gains, it can be spread out over two years or deferred until the new year in order to push the payments out. Furthermore, rebalancing does not have to be purely mechanical. If a client has a 60/30/10 (stocks/bonds/cash) target allocation and stock market appreciation takes it to 70/20/10, the first step could be to rebalance back to 65/25/10. This is especially true if the returns were generated right after a bear market and further positive returns are probable, or if the gains could be spread over two tax years. As discussed above, if there are known cash inflows coming that could rebalance by adding to the non-appreciated asset (bonds, in this example), then that also makes a partial rebalance more viable.
In order to maximize the ability for tax alpha generation, investors are better served by owning custom indexes. These can be built most easily using sector ETFs. However, this is somewhat sub-optimal because there will be a lot of canceling out of winners and losers inside each ETF. The most optimal tax alpha portfolio can be built with a custom index of 60 to 100 stocks that tracks an index. These portfolios will generally have 99 percent correlation to the benchmark index and will allow the strategies discussed above to be implemented across the entire portfolio. To access the podcast version of this and all my blog posts, please visit iTunes.