The battle between accountants and investment managers

This post is from staff writer Richard Barrington.

I was recently invited to review an investment technique called “automated tax-loss harvesting.” It reminded me of the never-ending struggle for primacy between investment managers and accountants when it comes to portfolio management.

By way of disclosure, I should note that I have never been an accountant, while I did spend more than 20 years working for an investment management firm. So, you can guess which side of this battle I come down on. Still, before closing this post I will mention why accountants so often win this debate, and why that might not be such a bad thing.

Reasons why investment considerations often outweigh tax considerations

People have a strong aversion to paying taxes. On the other hand, those taxes only come about when an investment has made money. So, which is better – making money or avoiding taxes? Here are some arguments for favoring investment considerations over tax considerations:

1. Taxes are assessed only on the amount of a gain, while market volatility affects the entire value of the security. Let’s say you hold a stock that is up 20 percent, and selling it would incur a 15 percent capital gain tax. That tax may be much less significant than it seems. For example, if that 20 percent gain took the stock from $100 to $120, selling would give you a tax liability of $3. That $3 is just 2.5 percent of the current value of the stock, and market fluctuations could change that value by much more than 2.5 percent in the blink of an eye.
2. The tax value of losses may be more limited than the potential for price recovery. This is largely based on the same principle as the above. The tax value of your loss is a percentage of just the change in price since you bought the stock, whereas the appreciation potential is a percentage of the entire value of the stock. Also, if you fundamentally still like the stock, selling low means compounding the mistake of having bought too early. Yes, you could potentially repurchase the stock after 30 days, but securities which have spiked downward often rebound equally suddenly, so you risk missing at least part of the recovery opportunity.
3. Deferring taxes isn’t the same as eliminating them. People often hold off taking gains so they can delay the tax liability. However, the tax liability will simply compound along with any future gains in the stock. You don’t really win unless the capital gains tax rate is reduced sometime in the future, which seems unlikely under current circumstances. Meanwhile, you don’t really have use of the money in that stock, since you have barred yourself from selling it.
4. Substitutions are not an exact science. One strategy is to sell an exchange-traded fund at a loss, and immediately buy a similar fund so you are not out of the market. You have to be careful about this. IRS “wash sale” rules disallow the tax loss if you buy “substantially identical stock or securities” within 30 days. If instead you buy a fund different enough not to be considered substantially identical to the one you sold, then you can’t expect to capture the same investment characteristics.

Certainly, investment considerations do not always outweigh tax considerations. As with so many things, it is a matter of degree. The larger a potential gain or loss becomes, the more the math starts to favor factoring in tax considerations. Also, the closer you are to a significant date — such as the end of a tax year, or the date at which a gain would go from being short-term to long-term, the more you might gain a tax benefit with a minimal amount of investment disruption.

The point is that ideally, neither investment managers nor accountants should be tone-deaf to each other’s concerns. Unfortunately, that is too often precisely the case.

Who wins the debate?

Investment managers who don’t want to be handcuffed by tax considerations have strong arguments on their side. Still the reality is that accountants often win the debate; clients instruct investment managers to make portfolio moves based on tax considerations, or berate those managers when their gains result in higher tax liabilities. So why do those clients so often come down on the side of the accountants?

Perhaps it is because tax consequences are immediately tangible, whereas investment outcomes often fall into the “what if” category. Therefore, clients who opt to favor tax over investment considerations are simply choosing the bird in the hand rather than the potential of two in the bush — and that may not be such a bad thing.

The bottom line is that it doesn’t ultimately matter what the accountant or the investment manager prefers — it’s the client’s opinion that counts. Clients who can strike a fair balance between tax and investment considerations may find they get the best out of both their investment managers and accountants.