Tax-Loss Harvesting Gets Too Much Attention

Tax-loss harvesting in direct indexing portfolios gets all the attention, but mutual funds and ETFs also harvest losses. Separately managed accounts offer other rarely mentioned tax advantages.

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Tax-Loss Harvesting is Common

Most direct indexing vendors and investors don't know (or conveniently ignore) that mutual funds and ETFs internally tax-loss harvest their portfolios.

This is easily verified by looking at carryforward losses on many mutual fund and ETF reports.

Source: Vanguard Total Stock Market ETF (VTI) 12/31/2023

Comparing the tax efficiency of a mutual fund, ETF, or direct indexing portfolio in a separately managed account requires more than a casual mention of tax-loss harvesting.

Peeling the onion back another layer, separately managed accounts have two concrete tax advantages over mutual funds and ETFs:

1. Passthrough taxation of capital losses

2. Granularity

Granularity?

With tax as the deciding factor, holding individual stocks and bonds in a separately managed account means more tax-loss harvesting opportunities, but also:

1. Surgical rebalancing

2. Individual tax-lot gifting

3. Holding period management

4. HIFO-specified lot selection

5. Dividend curtailing

6. Detailed transition planning

While mutual funds and ETFs generally cannot match the granularity afforded by the separate account wrapper, they have some unique tax attributes worth noting.

What’s the hype about ETF tax efficiency?

ETFs have a bizarre structural advantage over separately managed accounts. In-kind redemption allows ETFs to rebalance with essentially no tax consequence, enabling indefinite tax deferral. This is on top of their internal tax-loss harvesting capabilities.

So, while separately managed accounts must regularly rebalance to keep tracking error in check and thus emit capital gains, ETFs don’t have this problem.

In an infamous case, ETFs use so-called “heartbeat trades” to defer capital gains indefinitely. It’s worth reading about in this Bloomberg article, but the gist is that ETFs rarely distribute capital gains, even in extraordinary cases like index drops or cash acquisitions.

Are mutual funds tax-inefficient?

Mutual funds have a structural disadvantage relative to ETFs. They don’t use in-kind redemptions or heartbeat trades and distribute capital gains with some regularity. However, a recent development worth monitoring is the growth of ETF share classes. 

Ben Johnson at Morningstar keeps track of ETF share class filings

In the early 2000s, Vanguard invented a way to access in-kind redemptions through a mutual fund by introducing an ETF share class. You can read about it in this Bloomberg article. 

Nowadays, in addition to their tax-loss harvesting activity, many mutual funds are either converting to ETFs outright or introducing ETF share classes. Mutual funds are increasingly more tax-efficient. 

Without too many caveats, the ETF structural advantage of in-kind redemptions makes it a more tax-efficient vehicle than the mutual fund.

Does granularity beat the heartbeat?

Generally, yes. 

In “A Tax-Loss Harvesting Horserace: Direct Indexing vs. ETFs,” Roni Israelov and Jason Lu show that direct indexing outperforms post-tax.

This means that even the advantages of in-kind redemption are no match for the granularity of a direct indexing separately managed account (assuming an acceptable level of tracking error).

But what about active strategies where a portfolio may only hold 40 or so different names? In this instance, keeping tracking error low when tax-loss harvesting is difficult. Doesn’t the structural advantage of the ETF wrapper make it the superior choice? Not exactly. 

John Hill at Quorus, an advisor focused on tax management for active strategies, tells me that if an investor makes regular portfolio contributions, the active model has moderate annual turnover, and the portfolio has ample capital gains to offset, a separately managed account still outperforms an ETF post-tax.

He cautions that higher active turnover may change the results and that active strategies vary substantially, so it is worth challenging the vendor to back up their assertion an ETF or separately managed account is superior for a given use case.

The point is that we have to hunt for examples, and investor profiles, where an ETF outperforms a separately managed account on a post-tax basis.

What’s more, Iraklis Kourtidis at Rowboat Advisors, which offers direct indexing software, tells me portfolios can be customized to further enhance tax-loss harvesting.

And if we look at the spectacular research that AQR has done on tax-aware long-short strategies, ETFs are nearly always left in the dust.

But tax-loss harvesting is just the tip of the tax management iceberg. Zooming out, separately managed accounts have other tax advantages that are rarely mentioned.

Granularity at the total portfolio level

While tax-loss harvesting gets the spotlight, rebalancing is another source of tax alpha.

Suppose an investor holds a portfolio of ETFs and needs to rebalance. She sells a slice of the overweight ETF. In so doing, she may churn the portfolio unnecessarily by selling some tax lots at a gain. 

In a separately managed account, however, portfolio managers may select individual-name tax lots to minimize capital gains realization.

We can, of course, extend this beyond stocks to rebalance across asset classes too.

Gerald Michael at Smartleaf, a separate account software vendor and holistic portfolio advisor, tells me this is why ETFs may have lower tracking error at the portfolio level, but separately managed accounts with individual holdings likely have lower tracking error at the total portfolio level. 

Joe Smith at Parti Pris, a holistic separate account software vendor, says this another way: “Unbundling this exposure with more direct use of indexes or well-diversified models can… [help] maintain the proper exposure to the household benchmark as ongoing tax management is occurring in the underlying accounts of the household.”

Asset location, putting the right assets in the right tax-exempt/advantaged/able accounts, is a whole other area of portfolio tax strategy that rarely sees the light of day.

Taking things a step further, we can combine asset location with surgical rebalancing to further limit capital gains realization.

Finally, few have all-cash accounts. Transitioning assets in and out of a separately managed account in-kind is wildly valuable.

While tax-loss harvesting is the buzzy, well-branded strategy that gets a lot of attention, it is far from the whole story.

Wrapping up

Direct indexing vendors market tax-loss harvesting aggressively, but it is common in mutual funds and ETFs. The value of direct indexing is 1) the separately managed account wrapper with capital loss passthrough and 2) granularity, which unlocks several other tax management opportunities, particularly at the total portfolio level.