Loss Harvesting and the Myth of Tax Alpha (EP.158)

Episode Summary

Executive Summary: In this episode of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore discuss a range of topics including the Dog Days of Summer, a book review of 'Playing to Win' by Roger Martin and A.G. Lafley, ETF market trends, and a deep dive into tax loss harvesting. The main segment critically examines tax loss harvesting, revealing that its benefits are often overstated, especially for Canadian investors due to differences in tax rules. The hosts argue that while tax loss harvesting can provide a small tax alpha under specific conditions, it is not a guaranteed strategy and comes with risks like tracking error and transaction costs. The episode also covers listener feedback, a bad advice segment on UK pension fees, and a promotion for their merchandise.

Main Topics: Tax Loss Harvesting Analysis (Priority: 5/5): A detailed examination of tax loss harvesting, its benefits, and limitations. The hosts challenge the common marketing claims of 1-2% tax alpha, presenting a more nuanced view with Canadian-specific considerations. Book Review: 'Playing to Win' (Priority: 3/5): Cameron reviews the book by Roger Martin and A.G. Lafley, highlighting the five strategic choices for business success: winning aspiration, where to play, how to win, core capabilities, and management systems. ETF Market Trends (Priority: 3/5): Discussion on the growth of ETFs in Canada and the US, including record sales, the rise of crypto ETFs, and the increasing share of ETFs among top asset managers like BlackRock and Vanguard. Robinhood and Retail Investing (Priority: 3/5): Analysis of Robinhood's IPO filing, user demographics, and the implications of gamification and zero-commission trading on investor behavior. Bad Advice: UK Pension Fee Caps (Priority: 2/5): A critique of the UK's proposal to allow performance fees within the 75 basis point charge cap for defined contribution pension schemes, potentially leading to higher costs and lower returns. Listener Feedback and Community (Priority: 2/5): The hosts share positive listener reviews and discuss the community's reaction to Ben's comment about not having goals, emphasizing preparation over goal-setting.

Key Arguments: Tax loss harvesting is a tax deferral strategy, not a tax savings strategy; it defers taxes but creates a larger future tax liability. The benefits of tax loss harvesting are highly sensitive to assumptions like future tax rates, return expectations, and whether the investor has realized gains to offset. For Canadian investors, the lack of a step-up in cost basis on death, average cost accounting, and no distinction between short- and long-term capital gains make tax loss harvesting less attractive than in the US. The 1-2% tax alpha often marketed is based on US-specific assumptions and historical periods with high volatility (e.g., Great Depression), which may not be replicable. Fund structures can be more tax-efficient than individual securities due to positive tax externalities from cash inflows and allocation to redeemers. Success in business strategy, as per 'Playing to Win', comes from making integrated choices about winning aspiration, where to play, how to win, core capabilities, and management systems.

Data Points: Canadian ETF sales year-to-date: $29 billion - 35% increase over same period last year, which was also a record. Crypto ETF sales in Canada: $315 million in June - Down from over $1 billion in May, still a small part of the market. Number of listed ETFs in Canada: 1,118 - As of the recording date. Percentage of assets in ETFs for top US asset managers: BlackRock 34%, Invesco 29.6%, State Street 29.3%, Vanguard 27% - Among the 25 largest US-based asset managers, these four have the highest ETF penetration. Robinhood active users: 18 million - With $80 billion in assets, $12 billion in crypto. Robinhood daily active user engagement: 47% use daily, 7 visits per day - 98% use the app monthly. Robinhood revenue: $522 million in Q1 2021 - More than half of 2020's $1 billion revenue. Tax alpha from loss harvesting (base case, Canadian-adjusted): 10 basis points - After accounting for transaction costs and no additional contributions. Tax alpha from loss harvesting (US base case, 1926-2018): 1.1% - From the paper by Chartery, Burnham, and Lowe, assuming 1% monthly contributions and differential tax rates. Tax alpha with constant 27% tax rate (Canadian equivalent): 39 basis points - Before transaction costs, from the same paper. Transaction costs for loss harvesting (US large-cap stocks): 16 basis points per year - Based on 0.5 basis points per 1% annual turnover. UK pension fee cap: 75 basis points - Average charge rate is 48 basis points; proposed to allow performance fees within the cap.

Pivotal Quotes: "Tax loss selling is a tax deferral strategy. And you're right, that is important to everything else that we're going to talk about here. Tax deferral is a good thing. Like, don't get me wrong. I'm not saying that tax loss selling is bad because it's just a deferral. Deferring taxes is good." — Benjamin Felix: Clarifying the fundamental nature of tax loss harvesting as a deferral, not a permanent savings. "It should be obvious that it's not obviously." — Benjamin Felix: Summarizing the complexity and non-obvious nature of tax loss harvesting benefits. "Success comes when opportunity meets preparation." — Cameron Passmore: Reflecting on Amazon's pandemic success and the importance of preparation over goal-setting.

Implications: For Canadian investors, tax loss harvesting offers limited benefits (around 10 basis points) under realistic assumptions, and should not be a primary reason to choose a high-fee managed account. The strategy is most valuable for those with high expected returns, realized gains to offset, and a lower future tax rate. The episode underscores the need for critical evaluation of financial products and the importance of understanding tax rules specific to one's country.