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Portfolio Rebalancing: The Search for Tax Efficiency in a World Being Reshaped by COVID-19

Unrealized gains create an enviable problem for investors but managing the potential tax impact efficiently can be challenging for advisors.

The effects from the coronavirus pandemic has only begun to ripple through the US economy. We’re in the middle of what could be a 2008-like market downturn and we don’t know exactly when it will end.

However, we can’t forget that 2019 was a year of extraordinary gains for financial markets. The S&P 500 ended 2019 up by more than 28% while intermediate maturity US Treasuries and high-grade corporate bonds returned an average of 8% and 17% respectively CNN Business: Why this is the ‘most hated’ bull market of all time. These advances have caused the value of investment portfolios to swell, with global equities alone producing more than $17 trillion in gains for the year CNBC: Global stock markets gained $17 trillion in value in 2019.

Strong returns such as these have left many affluent clients facing the prospect of large potential tax bills this year. High net worth households hold unrealized capital gains that could reach 34% of their taxable income, if not balanced out by taxable losses. Even though the IRS has announced an extension of the tax payment deadline until July, large embedded gains make it imperative for advisors to take advantage of tax optimized investment strategies and tax loss harvesting to reduce their clients’ tax footprint.

With billions of dollars in potentially taxable gains, the ability to reduce a client’s tax bill through portfolio rebalancing plays a critical part in every advisor’s value proposition. However, most rebalancing software does not deliver the most tax efficient results due to a lack of optimization capabilities. In this article, we will be your guide in the search for a portfolio rebalancer with true tax efficiency.

Striking a Balance

Every client portfolio has competing priorities that must be balanced to deliver holistic advice. These include keeping all positions within their tolerance bands, honoring any restrictions, and minimizing the overall tax bill.

There are a number of options when prioritizing the tax consequences:

  • Losses First – prioritize selling positions that have an unrealized loss
  • Gains First – prioritize selling positions that have an unrealized gain
  • Zero Gain-Loss – optimize the rebalance to net the gains and losses as close to zero as possible

Most rebalancing applications have the first two, but only the best software has a Zero Gain-Loss option as it requires a highly sophisticated engine that can evaluate hundreds of scenarios and select the one that comes closest to net zero.

As financial advisors feel the pressure from the digital offerings of Vanguard, Schwab, and Betterment, they require new tools to help them increase scale and differentiate themselves. A multi-pass rebalancer would enable better tax efficiency across more accounts with less effort.

Another troublesome area for standard rebalancers is ranking positions during tax loss harvesting. The most common approach is to first harvest the largest lots, or the lots with the largest gain or loss, which is not necessarily the most tax efficient method. Advanced rebalancers evaluate every position and consider all combinations to ensure the best outcome is generated for each client.

Failure to evaluate every position before generating sell orders can produce unusual results that leave the client with an unexpected tax bill.

Beyond Just Tax Loss Harvesting

One example would be selling shares of an already underweighted position because it has the largest unrealized loss. This might generate the required tax loss while pushing the overall portfolio farther away from the model target. Selling shares from multiple overweight positions with a smaller loss would create more trades but would meet the two goals of generating losses while keeping the portfolio closer to the model.

Of course, real-world examples are seldom so simple and often involve portfolios with a diverse group of securities with multiple cost basis lots:

Legacy assets, such as securities held in 401K rollovers or accounts with outside managers, add another wrinkle requiring advisors to factor in additional exposures that fall outside the underlying models as part of the rebalancing review. Additionally, typical client households include a mix of taxable and tax-advantaged account types.

Dealing with bigger portfolios of 15 or more positions and 2-3 tax lots each creates an extraordinary level of complexity that requires a sophisticated rebalancing engine to support. Considering the large number buy/sell combinations that must be evaluated to keep the portfolio within the tolerance bands and balance tax consequences, advisors should be looking for rebalancing software that can handle this workload.

Choose the Best Technology for Optimal Results

The best tax-efficient rebalancing software has the following key features:

  • Quadratic programming that can analyze all aspects of a client household and decide on optimal gain and loss taking.
  • Algorithmic solutions that allow for analysis within exposure tolerance bands versus inflexible targets allowing advisors greater control.
  • Portfolio adjustments on a zero gain-loss basis with the ability to preserve unrealized losses for potential future use.

When searching for a rebalancer that delivers true tax efficiency, wealth management firms should insist on these features to help set them apart from competitors and better attract higher net worth clients.

Today, the competitive landscape for financial advisors demands greater integration and more customized services. At the same time, enhanced access to financial markets and strategies for affluent households requires an increasingly sophisticated approach to investment management that is best supported by the right portfolio rebalancing software.

About SoftPak Financial Systems

One the earliest players in FinTech, SoftPak has developed innovative products at the intersection of business solutions and IT infrastructure since 1994. Our rule-based rebalancing and risk-based optimization software powers some of the largest financial institutions in the world, processing over $500 billion in assets. Headquartered in Massachusetts, SoftPak has offices worldwide.

Click on the link below to have a Softpak representative contact you with more information.

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