What is the Tax Loss Harvesting Good For?

Tax loss harvesting is quite obscure to most investors. And it is so for a good reason. For most folks, the tax code is so arcane that it is next to impossible to crack them. For the more learned, tax management is not considered as a major source of alpha. They argue that tax management can only defer tax obligation, not obliterate it. What is the big deal?

However, there are serious research arguing that the tax loss harvesting is "undervalued", among which included Robert D. Arnott et al (2001) , the founder of the Research Affiliates LLC. In short, their simulations appear to show that tax management alone produces 50bps annual alpha for the past two decades, or an enviable cumulative alpha of 10%. They argue that most active manager does not manage to track the index in the long run, let alone beating it. Thus tax management is a hidden treasure.

My view is that Mr. Arnott is right in the long run, but only in the long run. To achieve this goal, it requires quite demanding quality of short run tax management over a long time horizon, a skill and a will that most non-institutional investors do have possess.

I. The source of Alpha from Tax Management: the W-W.

At the heart of the tax management lies the W-W: When and at What rate  to pay tax [1].

Let me start with the obvious choice. There are two tax rate, 15% or 35%. Which rate will you prefer?

For most people, the answer is the lower one. This is in essence what tax loss harvesting buys you in the first place: we arbitrage short term gain to long term gain, effectively reduces tax rate and produces positive alpha for the portfolio. 

Now consider the slightly complicated timing question. Consider two options:

Option 1, pay $100 tax today. 

Option 2, defer the tax for 1 year, invest the money in the stock market [2] and pay the tax 1 year later.

Which one shall I choose?

Let me rephrase: 

IRS is willing to lend me $100 free of interest for a  year to invest in the market. Shall I take it?

Yes if I expect the market to go up, No if I expect the market to go down.

Conditioning on never paying short term capital gain tax, the essence of tax loss harvesting is a interest free loan from IRS. If one could make positive return on the investment, it makes sense to defer; otherwise, it is a money loser. Thus in the short run, unless one has perfect market timing skill, tax loss harvesting can be either a bless or a curse, depending on how market turns out to behave.. However, in the long run, since we expect a positive capital appreciation, tax management is expected to yield considerable positive alpha. 

Knowing this too well, IRS sets out to sabotage your easy alpha generating strategy with the dreadful Wash Sales Rule. 

II. How Bad is the Wash Sale Rule?

Say I buy stock A at $10. It tanks to $5 in a week. I decide to wait it out. But in the mean time, I want to register a capital loss so that I can use it to offset other gains [3]. I sell it at $5 and buy it back immediately.

IRS prohibits me from doing this by the Wash Sale Rule. It bans reopening a new position on identical or sufficient similar investment within 30 calendar days of covering a loss position. 

Under this rule, I cannot register the $5 dollars as capital loss yet. It will carry over to the next trade as tax basis. Instead $5 of the purchase price, my tax basis for the new position is $10. If the stock rises back to $10, on the broker balance,  I make $5 profit since my cost basis is $5 for the new position, while for tax purpose I make even because the tax basis is $10 for the new position. It should be noticed that loss does not DISAPPEAR if one fails to pass the wash sale rule, it is merely DEFERRED.

In contrast, profitable recognition is not hindered by the Wash Sale Rule. So I register a short term profit whenever I close a winning position. 

By doing so, IRS forces me to recognize loss late and in the long run while register profit early and in the short run. In fact, IRS tries to nudge me to pay at a higher tax rate (for short term capital gain) and pay it early (tax credit generated by loss is deferred to later days). 

It is clever, you have to give IRS that. But it is far from perfect.

III. How to Manage Capital Tax for Long Term Investment

Retirement saving are typical long term investment, which makes tax management a necessity.

For starters, full in IRA/Roth/401K as much as possible. They are tax free until withdraw. 

Now for the taxable account, one should relentlessly pursue Fabianism[4], which means delay at all cost. 

One way is to reduce trading frequency. Tax is not calculated unless a position is closed.

Other than avoiding active trading, which is not a good habit anyway, when a position is sufficient underwater, say 20%, close it and cool down for 30 days. Other than registering tax loss, it forces one to combat the behavior fallacy of not letting it go when in loss, thus save him/her from felling prey to the momentum trade on the wrong side.

IV. Simulation (Yet to Come)

V. Conclusion

Contrary to what many believed, tax loss harvesting does help to enhance portfolio return in the long run, thanks to the generosity of the interest free loan from IRS.

However, such alpha requires both uncompromising discipline and methodical infrastructure to implement the strategy. In reality, such inhumane work is best left to computer algorithm.

 

EndNote

[1] There are one fringe benefits of shrewd tax management. Each fiscal year, individual can offset other tax income with capital loss, up to $3,000. 

[2] Throughout the article, I will assume reinvesting of the tax savings.

[3] Loss can be carried over multiple tax years.

[4] For the historical origin of this term, check it out here.

What is in Your Retirement Portfolio?

Recently, Fidelity launched a massive ad campaign to market its retirement product. The ad is certainly impressive, but how good the Fidelity Fund really is?


Here I am going to do a  "back-of-the-envelope-analysis" of its fund performance, using target date fund 2040 from Fidelity and Vanguard as case studies. The result confirms my prior belief, retirement product with purely passive index tracking, as exemplified by Vanguard, is superior to "active" asset allocation, as represented by Fidelity.


Disclaimer: The article is not an investment advice and the opinion expressed here does not represents my personal opinion.


I. The Repackaging Game


It is an open industry secret that each power house constructs their retirement finance product by repackaging the funds bred within the institution. For example, Vanguard retirement funds use other vanguard funds as basis while Fidelity retirement funds are exclusively composed of Fidelity funds.


But how? One can do it in two ways, cheap or expensive.
The cheap way is just to pool funds that represent the market in the most general way without worrying too much about the fine tuning.  Because there is not much work involved once the style funds are nailed down, the institution cannot charge too high a fee in a competitive market.
The expensive way is to pool funds based on a proprietary view point. Managers try to represent asset styles of the market on a finer grade and even impose their own investment view on the portfolio. Because all the human work that goes into the sausage making process, the seller feel entitled to charge for a higher expense ratio.


That is all mumble jumble. What does that mean in English exactly? :Let me illustrate the two styles with Vanguard and Fidelity 2040 target date Fund.


Vanguard is the text-book case of the cheap repackaging.  It only consists of 3 funds, which tracks three major asset style: US equity, International Equity and US Bond market. 
  

Fund Composition: Vanguard 2040

Vanguard Total Stock Market Index Fund Investor Shares

Vanguard Total International Stock Index Fund Investor Shares

Vanguard Total Bond Market II Index Fund Investor Shares

In contrast, Fidelity has much finer asset style classification. It has 16 funds in total. Not only it has specific exposure to commodity and real estate, it also has very subjective asset allocation strategy, such as "disciplined equity fund" and "small cap opportunity fund". There appears to be a lot of sleepless nights involved to carve out the investment allocation, or at least so the investor should hope.

Fund Composition: Fidelity 2040

Fidelity Series AllSector Equity Fund

Fidelity Series Large Cap Value Fund

Fidelity Growth Company Fund

Fidelity Disciplined Equity Fund

Fidelity Series 100 Index Fund

Fidelity Blue Chip Growth Fund

Fidelity Series Small Cap Opportunities Fund

Fidelity Small Cap Growth Fund

Fidelity Small Cap Value Fund

Fidelity Series Real Estate Equity Fund

Fidelity Series Commodity Strategy Fund

Fidelity Series Investment Grade Bond Fund

Fidelity Series High Income Fund

Fidelity Series Floating Rate High Income Fund

Fidelity Series Emerging Markets Debt Fund

Fidelity Series Real Estate Income Fund

II. Methodology: Synthetic Portfolio Replication


How can we compare the performance of two totally different funds? 


The naive view is to compare the expense ratio. Vanguard charges 19 bps a year while Fidelity charges 78 bps a year. So Vanguard 2040 is a better choice than Fidelity 2040.


Wrong. Because Fidelity folks will argue that their portfolio offers better risk-return reward than its index tracking vanguard peers. 


So why not just compare their historical performance? If one plotted on Google finance, it is indeed the case that Vanguard 2040 is doing better than Fidelity 2040 since 2006 (LINK). The Vanguard fund over perform Fidelity fund by 11%, while the expense ratio only accounts for 3.5% of the difference.


Fidelity folks still have excuses for their sorry performance. They chooses a more risky market portfolio, and they just have a tough ride thanks to the Global Financial Crisis.[1]


To account for this argument, one could run a Fama-French three factor model and see if the alpha comes out different for the two funds. But here, I will introduce a more practical version of test:


Can one replicate the fund performance using a series of ETF that serves as proxy for the asset style?


If one can perfectly replicate the fund performance with a cheaper ETF portfolio, it is hard to argue that high expense has any merit. Of course, it is next to impossible to find an exact replicate. 


So the natural question is that is the alpha over the synthetic portfolio justifies the high expense ratio? 


For a more detailed version of the method, please refer to Razor Hedge LLC's website. Here I will use a water down version of it. Leveraging Morningstar's public info, I will use SPY (US equity), EFA (international equity) and AGG (US bond) to replicate the fund. 


To be more specific, I recorded the alpha of the each composite over the style benchmark reported by morning star. I chose the longest history possible and annualized them according to the available time length. Then I aggregate the alpha according to the composite weight of the original portfolio. It is the alpha of the true fund over a synthetic portfolio replacing style benchmark with aforementioned ETFs. There will be tracking error of the ETFs but I choose to ignore them in this excise. The fund allocation is not constant over time, and I also ignore them for convenience. As such, the simulation provided here is by no means 100% accurate, but I would argue it is accurate enough to make qualitative judgement call.


Since I know the expense ratio of three ETFs, I can also estimate the "real return" had one actually constructed the portfolio. In fact, one could read the quarterly release of the fund and rebalance accordingly. So this is not entirely an ivory tower thought experiment.


III. Result


I offer the full excel working sheet for download HERE


Here is the big picture:

	expense	synthetic  expense	fund alpha
Fidelity	0.78%	0.16%	0.05%
Vanguard	0.19%	0.17%	0.07%

If we generate the synthetic portfolio for the two fund, neither fund outperform the synthetic portfolio by a wide margin. For Vanguard, it is expected, because it is engineered to track the index. However, for Fidelity, it is quite embarrassing: with all the allegedly effort, they did not even beat the dumb synthetic portfolio.


But wait, Fidelity is charging an expense that is 3 times higher than that of vanguard. 


I rest my case.


ENDNOTE
[1] In a perfect efficient market, this is non-sense. There will be one market portfolio if we can agree on what the market is. Since neither fund can leverage, their risk characteristics should be exactly the same. Well, in reality, people do not agree on what market looks like (part of the thesis for active management) and market may not be perfect efficient, so please forgive my theoretical sloppiness here. 

The Hidden Danger of Target Risk/Date Retirement portfolio Without Hedging Human Capital

Why Target Risk

The recent decade has witnessed an explosion in investment vehicles for retirement finance. By vehicles, I did not mean IRA or 401(k) plan but what one can do with their money in IRA or 401(k). If one does not make their own decision but to invest in professional solutions, what can they do?

Most of these vehicles are designed according to the blue print of risk targeting. It is industry wisdom that different risk return appetite of the investors can be satisfied by provide a cascade of risk levels, i.e. equity exposure.  But why is it a good idea to target risk, or more specific, to target equity exposure?

The straight forward answer is that equity level is easy to track, if not the only thing to track.  Yet it is not always good idea to do something only if it is possible to do.

How to Target Risk

The old school of Target Risk Fund (TRF) is a good place to start the investigation. The funds are generally divided into three styles, aggressive, balanced or conservative.  Aggressive style targets high equity exposure, which floats around 80% of the total portfolio value. Conservative style targets low equity exposure, which usually is about 20% of the total portfolio value. Balanced style stands somewhere in between and breeds to sub style such as moderate aggressive or moderate conservative.  

The textbook usage of these funds has no bearing with retirement finance directly. People choose more aggressive equity style if they have a large risk. In contrast, people pick conservative equity style if they are fainthearted.

 However, a case could be made that individual at different phase of their retirement planning fit into these two categories neatly. When individuals are young, they have ample income other than that from their savings, so they could withstand market volatility. Such strong ability to resist volatility puts them at a vantage point to harvest the risk premium in the long run. In contrast, when individuals go into their twilights, they have to live off the income stream of their savings. They are scared of market turmoil and rightly so. So ideally, people at their youth will invest in aggressive funds while phase into conservative portfolio as they age.

Such is the corner stone of risk targeting. Notice the argument has no bearing with risk return tradeoff, at least directly. The logic is not that young people have higher risk exposure because they want higher return. Quite the contrary, they are rewarded with higher return because they are able to withstand greater risk. This difference appear to be nuanced but will prove to be a crucial  problem for standardized risk targeting, which will kick in the next paragraph.

The nice fairy tale is not happening in real world. Even if we take the assumption about people’s age risk aversion profile as granted, it is just an outrageous assumption, behaviorally, to require people to consistently shift their portfolios, let alone acquire the knowledge needed to calibrate such shift. However, industry has already solved this problem by providing an innovating instrument called Target Date Fund (TDF). The idea is simple and elegant. Professional manager can do the portfolio diversification and re-balancing for the clients.  Once a redemption/liquidation date is set (hence the name target date), manager will diversify the fund into a high equity level portfolio when it is far from redemption and switch it gradually to a fund that weighs heavily on bond side. All participants need to do is just to cash in at a consistent pace.

What is Wrong with Such Risk Targeting?

How can such scheme go wrong, since it has a good theoretical foundation and a good practical solution?  One may ask.

The caveat is that standardization kills the optimization. Once the investment concentrates a portfolio, it is impossible for the fund manager to cater people’s demand individually because managers can only optimize for the “average Joe” yet “average Joe” is neither you nor me.

For conveniences, let’s assume individual do maximize their utility by hitting constant risk level with their asset portfolio. Does that imply the savings account, or rather, the entire investment portfolio should hit that level?

The answer is obviously no. For starters, home equity is left out. But the elephant in the room is human capital, which is bulk part of the “asset” one has when they are young. The crucial problem here is that human capital is quite mercury  in its risk character.

Let’s give our “average Joe ” a PhD degree in computer engineering from MIT. He can choose to be a professor and thus earn a decent tenure wage, close to be risk free. He can choose to be a high frequency trader on wall street, which promise a fat bonus tied to financial market. Alternatively, he can kick off a tech startup, which could either be next google if it works out and bust if not. It is a gamble, but one that is not entirely correlated with financial market. Intuitively, these three career path will lead to three different retirement saving plan, under the constant risk aversion assumption.

For the professor “Joe”,  the TDF is a good deal. His human capital basically resembles a bond and he owned a lot of them. Therefore, he should be 100% in equity. Further more, consider the job security of tenure professorship, he has the potential to deal with a lot of equity risk, thus he could even consider leverage up when he is young.

For the trader “Joe”, however, the TDF does not make sense. His earning is already very risky and there is no reason for him for pile on more risk with his retirement money. It is bad to lose you job in a market crash. It will be worse that you lose your retirement saving along the way. Consequently, his risk bearing capability is low on the retirement finance side. He should be 100% in bond.  

For the entrepreneur “Joe”, TDF is not so great. His income is partial determined by the cyclical economy [hard to thrive if economy enters recession]. So does his human capital. If his adventure paid off, he will be in a good position to take serious risk. Otherwise, he will be very worried about his financial situation.Thus his retirement package probably should be split between stocks and bonds, a mediocre contingency plan for every scenarios.

Conclusion

Such is the hidden hazard of blindly investing in TDF funds. Unless investor know how their human capital behaves and hedge correspondingly, TDF exposes them to excessive risk taking. Although it is in general a sound philosophy to target the risk for retirement planning, it requires considerable sophistication as how to target the risk in the right way.

What does an Aging Population Mean for the Financial Market in the Next Decade?

I. What does Aging Mean for the U.S. Equity Market?

Zheng Liu and Mark Spiegel (2011) at the San Francisco Fed wrote a letter arguing that aging population bodes ill for the stock market.

Their argue that the age structure of the population, measured by the M/O ratio of middle age(40-49) over old age(60-69), seems to explain the PE of the stock market quite well. They postulate this process is driven by the fact that middle age people are saving thus buying stocks, while old age folks are dis-saving thus selling stocks. Therefore, when M/O is high, demand exceeds supply; when M/O is low, supply overwhelms demand. By projecting the historical trend, they painted a very bleak picture for the stock market going forward.

Figure 1: M/O ratio(Red) and PE(Blue), Dash is the projection

In response, John Cochrane wrote a blog arguing that age structure may not be the only variable that can explain the PE movement. In fact, it could be as simple as the mean reversion of the on-going cash flow. For example, when market is expansive in terms of PE, people expect the cash flow will lower, which pushes down the PE going forward. 

Nevertheless, the "grumpy economist" does seem to agree that the expected real return on equity market is not likely to be 8%, and aging is not the only suspect.

Professor Cochrane did not stop there, however. He laid out another sharp observation:

The right statistics to look at is not PE but the equity premium. When people are young, they take more risk and thus have a stock dominated portfolio. When people grow old, they shift their portfolio to a bond dominated portfolio. Thus if  Liu&Spiegel is right, we should observe that the equity premium is trending with the age structure.

II. What does Aging Mean for the Chinese Financial Market?

What light does the two paper shed on the Chinese financial market?

According to Liu&Spiegel, if M/O ratio is the driver, China appears to have a couple more good years before the M/O ratio starts to heading south. But that is too optimistic because the life cycle consumption pattern is different in China from that in U.S. 

In U.S. it is reasonable to assume that inter-generational transfer is relatively unimportant, considering the well developed mortgage market and the cultural emphasis of culture independence. Thus the peak saving rate may occur around 45 when the student loan and the first home mortgage are about to be paid off and people start to save for their own retirement.

In very contrast, the life cycle consumption decision in China cannot ignore inter-generational transfer. Parents 

provide finance the children from college to marriage, which is likely to deplete the bulk of their savings. The second generation, starting with a very healthy balance sheet, will save right away. And they had better save enough, because they are about to shoulder the financial burden of financing the retirement of their parents and the expenditure of their children. Consequently, the peak saving rate in China is likely to be earlier than that in the States, possible around 30-35. 

If we are only concerned by the the gross demand for saving, I am afraid China may have already passed its peak of saving. Household balance sheet is likely to deteriorate very soon once my generation start to feel the pain of the a 2/1 supporting ratio.

Not all hope is lost for the equity market, though. Another major difference between U.S. and China is the strength of the bond market. While their U.S. counterpart can effortlessly phase their portfolio into a conservative allocation, the Chinese household do not enjoy such luxury. Thanks to the ill-developed bond market, the saving account becomes the only viable solution for less risky allocation. To make things worse, the real return on the saving account is negative for half a decade. Simple portfolio optimization tells us that to shoot for fixed expected return(which may not be the case), the Chinese household has to over-allocate on equity market, and subsequently take more risk. Thus Chinese stock will experience less shock than the U.S. counterparts because Chinese households are forced into holding more equity position than they would like.

The flip side of the argument above is that Chinese bond market is going to be  BIG  in the next decade .  

III. What does Aging Mean for the Global Financial Market?

Previously I am confining myself to ignore the global flow of funds.

There are a few good reasons why that may not be a bad idea. For one thing, home bias is a well known mis-allocation pattern. For another thing, quirky regulation makes household difficult to diversify their asset globally, especially for countries that have capital control.

If all frictions are off and households are doing optimization correctly in a global scale, what will aging means for the global financial market?

It is an incredible hard question if one thinks twice about it. I have to leave it here for future exploitation. However, if the world consists only China and U.S., I would guess that Chinese people will be very interested in holding U.S. bonds rather than U.S. equity, which is contrary to John Cochrane's postulation of 1 billion Chinese buying S&P 500.

The Magic 65: The Origin of the Pension Age Eligibility

Liability of the defined benefit pension scheme is a curse for numerous organizations on this planet, private and public alike. Among the floating solution to the problem, one proposal is to raise the age eligibility of the pension benefit.

Obviously, it is not well received by the elderly or quasi-elderly, as well as the campaigns of the liberal camp. It is reasonable that seniors, after devoting most of their lives to the country, would be object to a break of promises forged long ago. It is also imaginable that for the working class, 40 years of boring work is hard enough to bear while beyond that limit is outright inhumane.

However, why do all the countries around the world choose 60-65 as a cutoff to the working history? Why not 55, why not 70? Inspired by a Q&A session with former Bundesbank president Axel Webber, I set out in this post to investigate the historical root of the magic 65, which sheds interesting light on the political implication of the pension finance.

A Legacy of Bismarck

Enacted in 1889, the Old Age and Disability Insurance Bill is the first national pension scheme the history has ever seen. It may strike casual reader as odd that a diehard arch-pragmatist such as Bismarck would turn out to be a cover-up socialist. And he will be right. Bismarck designed the social security system to be a cheap buyout of the working class support. Therefore, the Bismarckian pension system was designed to be solvent, if not profitable, from its inception.

At first glance, it is remarkably similar to the modern Pay-As-You-Go (PAYG) system. A tax labor income is levied on the employee and the employer. They would split the 19.9% tax levy evenly whose total amount is subject to a ceiling limit. The Government would pay for up-to-3 years of child bearing and a long term care insurance fund after the worker reached 70[1].

However, there are a key difference between the Bismarckian model and the modern PAYG system: the proportional payment. According to the 1889 bill, worker would receive payment proportional to their contribution. It implies that worker is not likely to receive more than they pay. It fundamentally guarantees that the social security will be solvent because of this over-draw protection.

Even without guarantee of the proportional payment clause, the Bismarckian model is very likely to be solvent because not so many people lived long enough to celebrate their 70s birthday. In 1889, the life expectancy in Germany is under 50[2].  Although some claims that the life expectancy is dragged by mainly by high infant mortality rate, the number won’t improve too much. According to life table reported by WHO, a Germany teenage boy at age 15 has a life expectancy of 72.8 years. Good luck in living that long a century ago.

In sum, the Bismarckian pension system is a gold-egg-laying loose rather than a ticking bomb to the Treasury of the German Empire.  It has limited downside thanks to the proportional payment clause, while a great upside thanks to the limited life expectancy.

A legacy of the World War I

In 1916, the eligibility age was lowered to 65. Most of the commentators I have read overlooked the fact that it is right in the middle of WWI. In the time of war where every penny matters, why would German government suddenly picked up generosity?

The simple answer is that it is something they must do rather than something they would like to do. 1916 was not a good year for the German Empire. In the western front, a promise of quick and easy victory against France has been proved false. In the age of modern warfare, the world was about to witness the massive slaughter capacity for the first time in 1916, which involved battle of Verdun, Battle of Somme and the Defense of the Hindenburg line. In the eastern front, Russia engaged Germany troops in 1915. Although they proved to be no match of the Germany army, it put German in a strategic disadvantage. In the home front, socialist were active in rejuvenating the class warfare that plagued Germany politics before the world war. Overall, Friedrich III desperately needed the domestic support and he was not getting it.  

It is all but natural to understand why the eligibility age was lowered to 65 in 1916. As its predecessor, it is a calculated political bet to shore up the domestic support. It is not expensive in the near future because there are not many people eligible anyway. Yet it makes good public image of a benevolent emperor and provide the right incentive for the working class to put up with the government policy: after all, had the Germany lost the war, there would not be a penny left on the table for the working class.

A Legacy of Politics

So what can we learn from the history?

It is tempting to conclude the takeaway is to go back to the good old days where the pension system is solvent by design. Certainly, there is no business reason to hang on to  the age eligibility at 65 when the life expectancy has been prolonged so dramatically during the past century. If we raise the eligible age to 70,75 or even 80, in the spirit of the Bismarckian cunning, the pension system will be solvent instantaneously.

Nevertheless, I think it is not the only takeaway. For Bismarck and Friedrich III, providing and extending pension is not something they would like to do, but something they have to do. It is about politics, not about business. Pension system, from its inception, is not evaluated by its fiscal solvency alone, but also by its political bang of the buck.

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[1] “The German Pension System in Brief”, Towers Watson Website, accessed Jan. 29^th, 2012, http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=20358

[2] “Will 75 become the new 65? ”,New letter, Feb, 2011,  Abraham financial group, accessed Jan 29^th, 2012, http://www.abrahamsengroup.com/content.asp?p=news_past&issueID=1102&articleID=0