Sorry for venting, but with a combined Fed&State short-term capital gains tax rate at nearly 40% (thank you California), I’m starting to look more seriously at buy and hold strategies. Holding ETF’s for the long term and phasing hedges in and out depending on economic, or market conditions come to mind. Thoughts? I encourage R2G designers to create some tax efficient solutions.
Thanks,
–Stu
There has much discussion on this board regarding transaction costs yet taxes are almost never mentioned. Yet all of the transaction costs that are discussed are minuscule relative to the tax drag if one invests in a taxable account in the USA. In your case a hypothetical 20% year becomes 12% which likely is true for many others. You could increase your tax efficiency by using a system like Steve’s, ETF’s with slow timers and/or hedges as you suggested, and/or modifying your current systems by increasing the number of stock positions (ex:100) and decreasing the turnover. It is easier to control your tax drag than your returns.
Scott
Thanks Steve, I’ll give her a try… Thanks Scott, I agree with your assessment.
I’m also thinking about a strategy that never sells selective ETF’s, and then handles volatility by buying and selling hedges ie. market shorts, or adding more bond ETF’s during troubled economic periods. Thoughts?
–Stu
Stu - we can’t hedge with ETF systems. So what you are asking would have to do some math gymnastics. I’ll have to see how feasible it is.
Steve
Steve, I was thinking about using the book simulation for this by including multiple hedge simulations and adjusting their % contribution. Create a book port from the simulation. For you to generate an R2G solution, you can create an artificial portfolio by advertising multiple book ports used to generate one combined port. One caveat, when a hedge is out of the market, the book simulation assumes the hedge assets move to cash. Thoughts?
Thanks,
–Stu
Stu,
Why would you not ever want to sell certain etfs? For tax efficiency one should hold winners for over a year and sell losers in under a year.
Scott
The benefit of holding a stock for more than 1 year is that it will qualify as long term capital gain which is taxed at a lower rate (15% Fed tax rate). If you buy a stock in year 0 and hold the stock for 1 year, and then sell in year 1, you will be taxed in year 1 for the long term gain, thus reduce your annualized return by your tax burden. If you hold an ETF indefinitely, you would push out the the tax burden, except for applicable dividends, and (I think) applicable stock turnover within the ETF. Please confirm with a tax expert.
Thanks,
Stu
Stu - with the short sales, you will have to pay taxes on profits,and you will be forced to buy back at the end of each year (I believe).
Steve
Hi Steve,
If I understand your thought, I would only short when the market is in decline, and I’m trying to minimize portfolio losses. In this case, the tax burden is secondary. In a nutshell, hold selective ETF’s indefinitely, then to minimize volatility, short the market (or buy SH) and/or buy additional bond ETF’s occasionally. Thoughts?
–Stu
Stu,
I am not a tax professional but my understanding after researching this topic is that stocks and etfs are treated the same at tax time. If you sell either in under a year you will pay short term capital gains tax and if you sell either in over a year then you will pay long term capital gains tax. So if you hold an etf or a stock for 5 years for example then you will pay long term capital gains tax on the capital appreciation at year 5 as well as a yearly dividend tax (similar to long term capital gains tax) for every year the stock or etf issues a dividend which is 5 years in this case. It also is easier to tax loss harvest with etfs (free alpha from your losers) rather than using stocks since it often is easier to find a similar etf than a similar stock. So for maximum tax efficiency you want to sell your losers in under a year and hold your winners as long as possible. You can equally push out the tax burden with both stocks and etfs.
Scott
Scott,
I agree (I think). So, in a nutshell I’m looking at two approaches… the ETF buy and hold approach coupled with intermittent hedging. And the buy and hold stocks for 1 year approach (Like Steve’s R2G example) to qualify for long term capital gains, and bring my tax rate from 40% to 15%… that is if I move from California to Nevada (no state income tax) 
.
Regards,
Stu
Stu,
You can do some other things. First, give away all your income producing assets (joking).
SOME ‘solutions’
Or, try to build sell rules to maximize ‘losses’ and the ‘acrruing of losses.’ For example, on the ETF front, somebody like the roboadvisor Wealthfront will basically sell all ‘losing ETF’s’ from the buy and hold ETF portfolio and replace them with similar ETF’s. In this way you are accruing tax losses to offset future gains. This is a smart thing to do and fairly easy. You can build these in P123 fairly easily.
Re: FEATURE REQUESTS that have been around forever. It would help if P123 showed after tax returns and allowed users to input ‘tax assumptions’ for short and long term gains. So, the system didn’t have to calculate tax rates, but did calculate after tax returns based on user specified tax rates. This has been a feature request forever.
Re: STOCKS. The question is, at what point to cap gains drags on compounding outweight excess returns of shorter holding periods. I have built many long-hold fundamental based models for myself and use one (a yearly rebalance 30 holding system). I settled on 1 year for this. I actually offered one ( a 50 holding large cap system) for 6 months as an R2G and it did better than many of my higher-turn systems out of sample (both pre and post tax), but no one signed up so I took it down a few months ago. However, given the short data history in P123, you are basically betting on a philosophy (i.e. quality-value forever) - not on a backtest. Holding periods longer than 1 year is not really something you can get any meaningful backtests on.
Re: ETF’s. For the dynamic hedging to work, would be very helpful if P123 significantly upgraded the book capability. If you could add a) variable leverage at the book level based on rule based conditions (i.e. book level DD or subsystem performance evaluation) and b) variable hedging or use of additional ‘systems’ based on rule based hedging. So… bear market one system is added to a book if and only if it’s ‘in the market’, that kind of thing. If you want ‘simple options’, just create a basket of hedged systems and/or a book of only timing systems that enter SH or short IWM or whatever, when various conditions are met. They will gradually hedge the total portfolio.
PRACTICAL SUGGESTIONS:
Re: Expectations / Place in the market cycle. Discretionary market timing is not even close to an exact science and can be off by years. However, if you believe buy and hold will return, say 4%/year for the next 5 years and vol will be high, then a 20% reduction in annual returns paid to taxes is costing you under 1%/yr and higher turn systems may give much better risk-adjusted results. If you think buy and hold will get you 20% AR / yr over next 5 years, then the 20% reduction for annual rebalance is 4% / year roughly and may be better in buy and hold. So, I would suggest a ‘market timing’ / ‘market cycle’ component to the bucket sizes. At the current time, I would be more inclined to hedge more and be long less.
Best,
Tom
All,
If anyone knows, I am interested in how strict the “Wash Sale” rules are. If one of us rebalanced once per year–possibly holding the winners 366 days and the losers 364 days–and followed the rebalance recommendations would we be likely to get into problems with the wash sale rules? Would some of the new stocks in the portfolio be similar enough to the sold stocks that the IRS would give us a problem?
Thank you.
Jim,
The wash sale rule doesn’t apply to the sell of one stock and then buying a different company even if the new company is in most respects similar as the sold company. In fact, it doesn’t apply to selling the common shares on one company and buying the preferred shares of the same company unless the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.
That includes selling one index ETF and buying a different ETF based on the same index.
I’ve tried to create versions of my ports that hold stocks for at least a year, but the potential tax savings didn’t seem to be large enough to offset the lower returns from being constrained. Perhaps others have had more success, like Steve’s R2G.
My solution thus far has been to maximize contributions to tax-advantaged accounts.
Have you heard of the backdoor Roth IRA that could add $5,500 per year?
http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html
Or the “mega” backdoor Roth IRA that could potentially add ~$30,000 per year?
Thanks Denny!!!
Tom,
As always, thanks for the great advice. The tax feature, and the improved dynamic hedging Book capabilities would be great.
A simple approach to the dynamic hedging book might be to combine multiple hedges in a book simulation. For example, include your favorite system, and include 2 TLT systems. Each TLT system buys and sells under different conditions. Adjust the percent contribution of each TLT system in your book. The problem with this is that the book holds back cash for each TLT system that is out of the market.
Before Book was available, I had created my own version of Book using excel. Exact same concept as the book, except when systems go out of the market it puts the resulting cash back into systems that are still in the market. I could dust it off if interested.
Best Regards,
Stu
Stu - here is an ETF port that I believe captures the essence of what you are trying to do (hedging not included).
https://www.portfolio123.com/port_summary.jsp?portid=1346994
The performance isn’t great but slightly outperforms the S&P 500 equal weight benchmark. I would have to put a lot of hours in on this to get better performance and I don’t have the time.
Losses are cut short so you can write them off against winners in other ports. The winning trades are held greater than 366 days. You would have to do your own hedge to cover the 2008 bear market. I did a 10 year run because there aren’t that many ETFs prior to 2005.
If anyone comes up with an improvement to this port then perhaps they can share/make it public.
Thanks
Steve
Steve,
I made a few mods to your ETF Test Sim. Here is my mod Sim .
I moves your Taxonomy buy rule to a custom universe so I could play with Rank rules.
I added RankPos < 4 to your first sell rule and removed the GainPct>60 requirement.
I added a simple bench buy rule requiring the 6 month bench return to be > 0% or the 1 month bench to be > 10%.
The annual return = 16%, the max DD = 20%, and the % winners increased to over 50% from 30%.
1/2 of the holdings were held for over 1 year and all of the rest were sold with loses between -4.4% & -13.6%.