'Tis that season again: tax time, when investors turn their attention toward their annual IRS tax filings. Except investors shouldn't wait until spring to start thinking about their taxes, argues Bob Holderith, CEO of Green Harvest Asset Management, a N.Y.-based asset management firm specializing in tax beneficial ETF investing. (Note: Green Harvest does not provide tax advice.)
Instead, says Holderith, investors and their advisors should make tax management part of a year-round plan, something that's easier than ever before, with the use of ETFs and better portfolio management technology.
ETF.com recently sat down with Holderith to discuss how using ETFs can save investors significant amounts of money on their taxes, even if they don't have a large asset base to start with.
ETF.com: Your philosophy is that tax management must be a year-round business. Why can't investors just wait until the end of the year to take care of their taxes?
Bob Holderith: Say you had broad S&P 500-like exposure, whether in a mutual fund, a group of stocks or whatever, in the period between 2010 and 2019. If you had waited until Dec. 15, then there was only one year in the past nine that you could have taken any losses at all. That was in 2018. Every other year, the market was up for the year and on Dec. 15. You'd have been out of luck.
Market volatility doesn't happen when you want it to. It happens when there’s a driver for it, like coronavirus or interest rates or elections. So the way to be most effective and efficient is to be ready all the time, every day.
ETF.com: Maybe, but for what size asset base does regular tax-loss harvesting truly become a meaningful use of time?
Holderith: When we capture tax benefits … and, by the way, we don’t call them "losses," because people think that you have to lose money to capture losses, which is not the case. Let's say you're making $75,000/year, and we can capture $3,000 in tax benefits for you, through regular mortgage payments, a little of this and that. Then we have meaningfully lowered the amount of tax you have.
On a percentage basis, we may be just as helpful to somebody who makes that much money as we are to someone who's ultra-high-net-worth. Our average account is about $1 million to $2 million, and we may save those people 3%, 5%, even 7% on their taxes. It ends up being a much greater dollar amount for them, though, because they're paying more taxes.
So it all depends on how tax-sensitive you are. For example, people who own mutual funds that pay short-term capital gains … in 2018, I think the average was 10% in short-term capital gains distributions. So if I had $100,000 and $10,000 distributed to me, and I had a $5,000 to $6,000 tax bill, I'd be tax-sensitive. But that's also true if I had $10 million and I had a $50,000-500,000 tax bill.
ETF.com: Can you walk us through the process you use for your clients?
Holderith: Let's say you want to own the S&P 500. You could buy the SPDR S&P 500 ETF Trust (SPY); you could buy the Vanguard 500 Index Fund; you could buy each of 500 stocks. We use 11 sector ETFs, in the appropriate weights.
For every exposure we have, we assign what we call an "anchor security." In this case, they're the Sector SPDRs, because they're the purest expression of each sector in the S&P 500 and they're very low cost.
Then we pre-assign additional tiers of "swap candidate" ETFs [that can be substituted for the anchor security]. In tier 2, we typically (but not always) have the Vanguard fund, then tier 3 is iShares. Other tiers might include Fidelity, First Trust, etc.
ETF.com: So if you're holding the Energy Select Sector SPDR Fund (XLE), you might have the Vanguard Energy ETF (VDE) in your tier 2, correct?
Holderith: Exactly. Our technology allows us to monitor every position in every client account, every minute of every market day. When one of our anchor securities goes down below a precalculated threshold—for example 4%—we’re alerted, and we put in an order for one of our swap securities. We call that "sweeping and swapping," as in, we're sweeping our book for opportunities, and swapping when those opportunities pop up.
Let's say the client's energy position is down. Whenever that position hits a precalculated threshold, we can sell XLE and buy VDE.
ETF.com: How do you decide which ETF should be your anchor security and which should be a swap candidate?
Holderith: We have a formal optimization tool. Most of our assets are in global strategies, so on top of these 11 [sector ETFs], we have another typically eight or nine ETFs that we buy. The global index we compare ourselves to looks like the MSCI All Cap World Index. If we're buying exposures, we'd like to start with an MSCI All Cap World Index-based ETF.
To decide, we look at exposure, first and foremost. [We also look at] if it's liquid enough and the cost is right. We also look at things like the likelihood of fund closure, of taxable distributions, and that kind of thing.
ETF.com: What sort of automation software do you use to facilitate your tax planning process?
Holderith: Without technology, this couldn’t be done. The short version is this: We have multiple custodians that our assets are held in, and they don’t all provide information in the same format. We draw data from each custodian into a single data aggregator, which scrubs it to make sure there are no obvious problems. Then it's put into a format our portfolio management system can consume.
Once you have all that data in one format, you can look at the losses you captured yesterday or last week; you can look at your exposures. Our portfolio management system already has our algorithms [built in], which are the points at which we trade, as well as anchors and tiers.
[To build it] we went to a small but fairly sophisticated portfolio management software company that was really tax-sensitive. We worked with them for about eight months to do the programming we needed to assign all these different tiers and be able to trade quickly and accurately, without violating the IRS' wash sale rules, and so on.
ETF.com: Stepping back to something you said earlier, one of the big misconceptions of ETF tax-loss harvesting is that your portfolio must lose value in order for you to benefit. Could you speak a little to that misconception?
Holderith: Believe it or not, a few days ago, the market was still at an all-time high, meaning all of our accounts were also at an all-time high. Yet all of our accounts still had losses in them, every single one.
For example, if you had energy exposure, energy has gone down even though the market's gone up. It's about the value of the components of your portfolio, as opposed to the whole portfolio.
Probably 15% of our accounts have never been down at all [by virtue of when we invested]. But those accounts still have tax benefits that we've captured, because the individual components have gone down and we've swapped them, capturing tax benefits for our clients.
Taxes are the greatest cost to taxable investors. It’s not expense ratios, or spread, or commissions. Those are all measured in basis points. But taxes are measured in percentage points.
ETF.com: That's the same argument made by proponents of direct indexing.
Holderith: True, but we think ETFs are clearly a better tool to capture tax benefits. Let's say you wanted to link your return to the S&P 500. With individual stocks, you can't do this and stay fully invested to all the right securities all the time, because there is only one Apple (AAPL), there's only one Facebook (FB) one Amazon (AMZN).
(Use our stock finder tool to find an ETF’s allocation to a certain stock.)
If you bought Apple last Friday, and it's down 9% today, there's nothing you could replace it with to stay fully invested. And if the market goes up 10% tomorrow after you sold all your Apple, now you have tracking difference you don't want.
We have an advantage, because we have multiple securities in ETFs that are substantially similar. The Sector SPDRs, the Vanguard funds and the iShares funds that represent the same sector are, by legal definition, substantially similar.
Also, we can do hedging strategies. Let's say you want exposure to equity markets, but you're feeling a little skittish right now. If you wanted to hedge your portfolio 50%, we could build you that allocation with ETFs.
We'd short SPY to 50% of the value, so that when the market goes down 9%, you're only down 4.5%. And if the market goes up, then we can swap the short position—we can sell SPY and buy the iShares Russell 1000 ETF (IWB) to capture tax benefits.
ETFs are democratic in a lot of ways. They're democratic in that any client can use them, but they're also democratic for managers who want to implement different strategies, such as risk management strategies.
Contact Lara Crigger at [email protected]