A basic service financial advisors provide is monitoring a client's mix of assets, and rebalancing that mix back to the desired target allocation (proportions for different asset classes) if, over a period of time, some asset classes go up in value more than others. This prevents the portfolio from being riskier than a client's risk preferences warrant.
Rebalancing entails selling the asset classes that are "overweight" (i.e. their proportion of the total portfolio is higher than desired) and buying the underweight ones. However, in the case where selling incurs capital gains, there is a tradeoff between:
The purpose of our optimization algorithm is to trade off different objectives against each other. We want to track a target mix of asset classes closely (including assets held externally), but also want to minimize capital gains taxes and transaction costs. These goals can clearly conflict; by trading every day we could achieve almost perfect asset class tracking, but incur large short-term capital gains taxes and trading costs. Conversely, if we were to focus solely on taxes, our portfolio could drift quite far from its target mix. Our system is able to find the best portfolio subject to these trade-offs.
The goal of this backtest is to demonstrate how we evaluate this trade-off to create the best possible portfolio:
We can see the trade-off between tracking and taxes clearly in the Asset tracking tab for each scenario. In the tax aware scenario, the tracking is somewhat worse than in the tracking only scenario, as we would expect. On the other hand, in the Net tax owed tabs, we see that the tax aware scenario ends with more taxes still owed (i.e. having paid less in taxes) than the tracking scenario. You can see the taxes for both scenarios in the same place here.
It may be counterintuitive, but owing more taxes in the tax-sensitive case is a good thing; it usually means that realized taxes were even lower. Avoiding rebalancing when it would cause large tax gains to be realized increases after-tax returns in this scenario slightly, by about 32 basis points (annualized).
There is no guarantee that tax-sensitive rebalancing will always do that. If, by tracking slightly less well, we end up overweight an asset class that happens to perform poorly, then after-tax returns would be worse. However, since that can go either way, tax sensitive rebalancing should increase after-tax returns, on average. It may help to think about it as a mild form of tax-loss harvesting.
Note: Both scenarios do their first large rebalance trades exactly one year after the backtest begins. Since stocks had risen steadily for the year and we had optionally specified 'no short-term capital gain sales', the system could not rebalance until the gains had turned long-term.
Our system suggests optimal orders by considering the trade-off between tax and portfolio tracking, without resorting to rules. We can do this because we have built a sophisticated optimization infrastructure (see our blog for more). This results in higher after-tax returns and saves money for clients.