Many financial advisors know that tax-management strategies, such as tax-loss harvesting, can help preserve returns in investor portfolios. However, they may not realize that searching for opportunities to harvest losses more frequently --as often as daily --can help investors save even more on their tax bills than less frequent approaches.

We analyzed the potential value of a daily vs. monthly approach to monitoring portfolios for tax-loss harvesting opportunities in individual stocks by measuring the difference in tax savings between the two processes¹ over 16 different time horizons between 2018 and 2021. Each scenario started one quarter after the previous scenario, allowing us to observe results that began at different points in the year and in different market conditions.

In the daily approach, the portfolio is reviewed on a daily basis, with the flexibility to realize losses when individual positions and the overall portfolio meet predetermined thresholds. The monthly approach, on the other hand, is limited to harvesting losses every 31 days, albeit using the same thresholds.

Our analysis found that by taking advantage of natural equity market volatility, the daily approach provided, on average, about 30 basis points (bps) of additional annualized tax savings for clients compared to the monthly approach.

Maximizing tax-loss harvesting opportunities

Direct indexing offers advisors and investors more potential to employ tax-managed solutions in a portfolio. In a direct indexing strategy, an investor owns individual securities within an index in a separately managed account, rather owning an ETF or mutual fund that tracks the index. This structure enables significantly more opportunities for tax-loss harvesting because losses can be realized at the individual security level, not just the vehicle level.

In addition to providing more opportunities, direct indexing strategies can introduce tax-loss harvesting on a more frequent basis. Historically, tax-loss harvesting has been a highly manual and time-consuming process. As a result, most advisors reviewed allocations only following major market downturns or at the end of the year, when capital gains taxes become a reality for investors.

Technology now enables a direct indexing strategy to run a tax-loss harvesting strategy without manual intervention. However, the frequency and process vary across providers. Some take a calendar-driven approach, looking for losses at a set time such as at the end of the month or quarter. Others use a trigger-based approach – waiting to take losses until they reach a certain level – but will only trade on a monthly basis.

A continuous approach reviews accounts every day for tax-loss harvesting opportunities, realizing losses when the predetermined cost-benefit threshold is met -- potentially multiple times during a month. With the right safeguards, a continuous approach could provide more opportunities for tax-loss harvesting than other approaches.

Uncovering tax losses even in strong markets

Recent performance of the S&P 500 Index provides a good example of how many tax-loss harvesting opportunities exist both within the index and over the course of a year.

As shown below, In 2023, the S&P 500 gained roughly 26%. However, this doesn’t reflect the experience of each stock within the index: 22% of the stocks actually finished the year down 5% or more. These stocks could certainly be candidates for tax-loss harvesting at the end of the year.

In addition, ordinary market volatility creates even more opportunities over the course of the year. When looking at 2023 S&P 500 performance on a daily basis, 72% of stocks finished any given day down 5% or more.

And over the long term, the results are even more interesting: on average, 30% of stocks finish the year with a negative return and 75% are down more than 5% at some point during the year. The potential to take advantage of these individual losses on a day-to-day basis is important considering that the S&P 500 has delivered positive returns in eight out of the last 10 calendar years. 

A robust process is critical to success

A continuous tax-loss harvesting approach can maximize the potential for creating tax losses while still delivering an investment experience similar to the index being tracked. However, this approach requires a diligent process that can:

• Analyze the cost vs. benefit of every trade: Trading too early can realize a loss that may have quickly reversed into a gain. Finding the optimal threshold for realizing a loss prevents unnecessary turnover in the portfolio.
• Control for wash sale violations: Wash sale rules do not allow the same security to be sold and bought again within a 31-day period. Violations result in the loss no longer being eligible for tax purposes. A daily review can often generate opportunities to harvest losses more than once a month, so having a systematic way to monitor the potential for wash sale violations is critical.
• Incorporate up-to-date pricing data: Daily opportunities that use pricing data from the start of the trading day provide a more accurate indication of whether a loss should be taken than data from the previous day, which may not factor in news from after the market close.

Ultimately, efficiency in tax management frees up time for financial advisors and has the potential to produce more tax savings for clients. Direct indexing improves the potential of tax-loss harvesting by increasing the frequency of the process and the volume of opportunities. A daily approach goes a step further. By taking advantage of daily volatility across a larger opportunity set, advisors may be able to add value by helping investors keep more of what they earn.

¹ Tax savings is measured as the amount that a tax bill could potentially be reduced by harvested losses, as a percentage of the amount invested in the tax-loss harvesting strategy.