WEALTH MANAGEMENT

Wealth Management



Wealth Management

Question 15

Every day, we compare your existing portfolio with the “optimal” portfolio that we would buy for a new client who opened an account that day. The optimal portfolio takes into consideration the most recent prices and any updates to our outlook on future profits and cash flows. With prices changing rapidly in today's volatile markets, optimizing your portfolio has taken on added importance. But we still approach trades cautiously—excessive turnover is disruptive and costly. So when we compare a potential new purchase to an existing holding, we consider a number of factors, including:

Does the potential new purchase have a higher expected return and/or reduce risk?

How will transaction costs affect the return?

What will be the tax impact of the trade, based on the client's tax profile?

The tax impact typically is a headwind that reduces the appeal of selling any security—it requires us to believe that the security to be purchased will “make up” for the tax cost incurred. But in 2010 the tax cost of many trades has been reduced, in some cases to zero: Investors may still have substantial carryover losses from previous years (Calvet, 2005, 329). Therefore, we have made adjustments to the way we calculate both short-term and long-term gain tax penalties. Let's look at the short-term gains situation first.

The recent financial crisis has created an unusual environment for tax-aware trading, providing several areas of opportunity for us to reduce the bite of taxes in 2010 and in years to come:

Eliminating the incremental short-term gain penalty

Many investors sustained losses in 2008 and hence have tax loss carryovers that can be applied to 2010 gains. At the same time, we are trading more frequently than usual to maintain diversification and manage risk in volatile markets. In normal conditions, we avoid short-term gains because their tax cost is higher than that of long-term gains, but when “net” tax losses are present (in other words, when short-term and long-term gains/losses net to an overall loss), there is no incremental penalty to a short-term gain.

Reducing the long-term gain penalty

We calculate the cost of paying long-term capital gains tax before selling one security to buy another, and sometimes a client's tax situation will dictate against making the trade. But if loss carryovers can defer the realization of long-term gain taxes into the future, we will adjust the weighting of the long-term gain penalty to reflect that.

Loss harvesting—when appropriate

For clients who have a net capital gain going into the fourth quarter, we generally endeavour to offset the gain by harvesting positions at a capital loss where possible. The goal is to minimize year-end taxes.

However, for clients who continue to have a net loss at year-end, we do not recommend harvesting additional losses. Although many states follow the federal rules and allow loss carryovers, some do not. We will be taking this into consideration when evaluating the tax impact of trades in your account. Second, this summary does not address the potential impact of the federal alternative minimum ...