Rise of the Machines: Tax-Loss Apocalypse?
In what was a turbulent 2015, several leading robo advisors are now boasting that vigilant computers tasked to scour markets for tax-loss harvesting opportunities wound up adding anywhere from 2% to 3% in extra returns – what they commonly refer to as tax “alpha.”
But traditional brick-and-mortar advisors who’ve been tapping many of the same technologies that robos now pitch say such topline gains mask many of the risks posed by blindly following robots.
Relying on computers alone, they argue, can easily blur a client’s full tax picture and throw a monkey wrench into long-term estate planning strategies.
“The knowledge of talking to someone and understanding their complete financial picture shouldn’t be totally usurped by a machine – it still pays to inject some sort of human judgment into the tax-loss harvesting process,” says Cal Brown, an advisor in McLean, Va., for Savant Capital Management, which oversees $4.1 billion.
Even the best software can miss TLH openings, points out the advisor. His firm uses a popular package, iRebal, to spot opportunities. The program also lets him set target ranges to send out alerts when prices drop within different asset classes and funds.
Recently, a retiree who transferred his seven-digit portfolio to Brown decided to sell most of his actively managed mutual funds to conform with the FA's investment strategy. Such a move created tens of thousands of dollars in capital gains, but it did not trigger a robo call-to-action.
Of course, TLH is where underwater securities are sold so that short-term losses can be booked against capital gains and income. A month later, those investments can typically be repurchased.
“In this case, we decided to go ahead and manually harvest some losses,” says Brown, “since it could still prove materially helpful to this person's overall estate tax picture for 2015.”
In fact, such helpful prodding by humans is turning out to be a common theme for many of the advisor's high net worth clients as they review last year’s tax situation with their CPAs.
Brown and his colleagues recently put out a report to clients showing that of the 25 biggest stock mutual funds trading in the U.S. last year, 17 are estimated by Morningstar to produce more in capital gain distributions than total returns (see chart).
“So in filing their 2015 taxes,” says Brown, “many investors are going to find out that in a lot of cases they came out on the wrong side of the tax equation.”
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The notion that robos can out-do brick and mortar advisors is no more than “marketing fluff,” argues Chris Cordaro, chief investment officer at RegentAtlantic in Morristown, N.J., which manages about $3 billion.
“We’ve been using this technology to rebalance portfolios and tax-loss harvest for more than a decade,” he says. “We were robos before there were robos.”
In the mid-2000s, RegentAtlantic’s managers started licensing their proprietary software to other wealth management firms. That eventually led to a deal with TD Ameritrade to make the program, now marketed as iRebal, a part of the broker-dealer’s toolkit for affiliated advisors.
By automating the TLH process, Savant figures it’s saving more than 4,000 man-hours a year.
Still, computers are used as only a partial tool in uncovering TLH possibilities. For example, Cordaro met last week with a couple who told him they’d sold a vacation house and planned to deposit $500,000 into their taxable account in coming months.
After coming back from lunch with his longtime clients, the FA got alerts from iRebal recommending trades to keep their portfolios in balance.
But he decided to hold off on making any changes which would’ve created capital gains and led to possible TLH headaches down-the-line.
What he knew – that his software didn’t – was that the parents wanted to pass along part of the proceeds to their adult offspring. In order to do that properly, Cordaro wanted more time to work with the family’s CPA to figure out the best way to make sure their lower-earning children were given cash and higher-income earners received appreciated securities.
Also, since their windfall was likely to produce more trades in the future, the FA figured that waiting until all of the money was settled in their accounts would help him to limit transaction costs.
“As an advisor, you’ve got to be smart about differentiating each individual tax situation,” says Cordaro. “Right now, existing TLH technology just isn’t able to make that sort of a distinction.”
Another chink in robos’ armor is that they often miss nuances such as corresponding real estate valuations and how trusts can feed into a client’s entire tax planning picture, points out Josh Mungavin, an advisor at Evensky & Katz/Foldes Financial Wealth Management in Coral Gables, Fla. The independent RIA, which manages $1.4 billion, also uses iRebal.
While he finds that such software makes for a good complementary tool, Mungavin uses conversations with clients and their CPAs as a sort of check-and-balance system to pair with robots.
“A lot of our value as advisors comes from keeping a person’s emotions out of the investment planning process,” he says. “The human touch is still necessary to manage client behavior – that shouldn’t be forgotten just because technology is improving.”