By John Memminger, CFA, CIPM, MyVest Product Management Director
As we end yet another month of market volatility brought on by the coronavirus pandemic, our historic 10-year market bull run feels like a distant memory. It’s likely your advisors and clients are — understandably — feeling uneasy.
While there’s nothing your advisors can do to calm the market, they can attempt to calm investors’ nerves with a sound tax management strategy.
“From a tax management perspective, the recent volatility has exposed more opportunity,” said our CEO, Anton Honikman, in a recent interview with ThinkAdvisor. “Now, it’s possible that there are many more portfolios with unrealized losses, more so than ever before.”
Tax management strategies in a high volatility market
This period of extreme volatility, particularly when following unprecedented gains, shines a spotlight on the critical nature of tax management. Furthermore, effective tax management requires a comprehensive, systematic approach to portfolio management — rather than simply being a one-time annual event. Following are several strategies to make this a regular part of your practice:
Manage client tax expectations with a tax budget: A capital gains budget sets a maximum total capital gain (and therefore the maximum capital gains tax) their client is willing to accept during a given year. A broader total tax budget for the year can also be defined to set a maximum tax to be incurred by their client across all portfolios and positions based on their tax bracket.
Avoid selling legacy positions with security–level substitutes: When taking on a client’s existing portfolio, advisors often need to avoid the large tax hit of selling a legacy security with a large embedded gain. Instead, let that legacy security permanently substitute for a security in their target model. For example, if your client brings you a portfolio holding KO, you might determine that KO can become a permanent substitute for the PEP position in your model.
Allow for greater drift with a second rebalancing band: To address the trade-off challenge between rebalancing vs. tax impact, advisors could supplement their standard drift rebalancing band with a second larger tolerance band in higher volatility markets, allowing for greater drift to avoid incurring a large capital gain in a given position.
Use substitute securities to maintain your strategy: When harvesting losses, a temporary substitute security enables advisors to continue to satisfy asset allocation requirements during the wash sale period. Advisors can add rules to unwind these new positions at the end of the target’s wash sale period, which helps to ensure adherence to the strategy.
Make tax-loss harvesting an ongoing practice throughout the year: Instead of trying to employ tax-loss harvesting only once at year-end, make it a regular part of ongoing portfolio management. There will be many more opportunities to take losses to off-set gains at different points in the year following big market moves. This is one of the main ways advisors can actively work on achieving tax alpha throughout a volatile year. Use a technology that can automate these practices, creating systematic, holistic tax management within your organization.
Show your client their tax alpha: And finally, to address your clients’ uncertainty and to demonstrate your systematic approach to tax management, create a summary report to show clients the benefits of tax management over time. This should include the income shielded from taxes due to proper asset location and gain deferral, as well as the losses harvested throughout the year to reduce the investor’s taxes.
Help clients understand long-term value of their portfolio
Proactive tax management requires deploying creative strategies and having the right technology to support advisors’ efforts, especially in today’s highly volatile markets. It allows advisors to quell investor fears and help them understand the long-term value of their portfolio. It’s critical to find an enterprise platform that can automate these practices, creating systematic, holistic tax management within your organization.
Learn how our Strategic Portfolio System can automate tax management in your organization.
John Memminger, CFA, CPIM, is Director of Product Management for MyVest’s Investment Management Team.
As a product manager and business analyst with over 20 years experience, he has worked on a host of solutions, developing product strategy, validating and analyzing solution requirements, and crafting product marketing plans.
John began his career as an investment professional, where he worked with clients to maintain and update their portfolios to align with their investment goals and needs.