Robots & Personalized Indexing
A new and improved way to kick the can.
Few things function like the stock market. The term ‘market’ doesn’t even do the mechanism justice, implying a simple forum slightly evolved from its farming roots. Sure, if the forum is also open to purpose-built algorithms, arbitrates who controls critical global institutions and conjures capital out of thin air.
Last I checked the best my famers market could do was $2 off a dozen eggs.
The stock market uniquely enables a person to exchange dollars for ownership in property and profits, then exchange it back in nanoseconds. Further, it is one of few markets where what is being sold is likely to appreciate. It’s one of the main points.
Capital
Gains
Those two words by themselves are good, but together they ring in the ears like chemically enhanced bass drops at Coachella. They are the reason we risk our money in uncertain ventures. What we dream of when buying assets priced as low as their promise. The main reason we invest. We like them big and loud.
And for the prudent investor, it usually works out. Unfortunately, the sweet sound of coins stacking higher also attracts the tax collector. The devil demands his due and your only escape outside of an IRA plan is deferment.
Some deferment strategies are better than others. Individual stocks and exchange traded funds (ETFS), especially those with low or no dividend yields, are among the best in terms of tax efficiency. In his 2024 annual shareholder letter, Warren Buffet wrote:
“On January 3, 1967, we disbursed our sole payment – $101,755 or 10¢ per A share. (I can’t remember why I suggested this action to Berkshire’s board of directors. Now it seems like a bad dream.)”
One dividend payment since 1967, now that’s some serious tax optimization. A well thought out strategy from one of America’s most successful business managers. This is not to suggest investors should avoid dividends, mind you, only that they do not serve to defer taxation.
But buying Berkshire Hathaway and calling it a day is not a tax solution without problems. Accumulating gains in either an individual stock or an ETF both present their respective issues.
Individual Stock ownership concentrates your capital into the hands of a single management unit, subjecting it to the desultory nature of idiosyncrasies. A classic eggs in one basket dilemma.
ETFs offer a solution to the concentration problem; however, they do not permit tax lot selection for withdrawal needs nor do they permit loss harvesting when the total position is positive.
In comes the tax managed Separately Managed Account, or SMA for short. Think of an SMA as a purpose-built fund managed just for you by a professional fund manager. SMAs have been around for some time, but now they’ve discovered a reason why you may want to invest in one instead of one of the many popular index funds – tax alpha.
Using personalized indexes, investors can pile existing positions and cash into a non-IRA (non-qualified) investment account and have a manager target your favorite index. With much higher minimums (often $100,000 or more), they drive down costs substantially into the low double digit basis point range.
Let’s say on a whim you bought NVIDIA ten years ago and now have an impressive gain of 1,200%, is there any hope of diversifying this position without triggering a taxable event? Why yes, this is one of the exact scenarios in which personalized indexes shine.
Robots, Energy Orbs & Tax-Loss Harvesting
Imagine there was a discovery of energy orbs floating 10,000 feet above your house. In an unbelievable Disney-like fortuitous coincidence, you also have a genius teenager living in your house capable of capitalizing on the discovery.
Immediately, she gets to work designing a robot that can harvest the energy orbs. Through a montage of trial and error, a solution is found and is immediately put to work. The first harvest of energy orbs hits the stores, and everyone raves.
You can eat them, power your car with them, energize robotics, and they even wash your unsuspecting cat. As with all innovation, the miracle attracts government regulators who quickly set up systems of control to foster order. Buzzkills.
All this overhead comes at a cost: a harvest tax. Your robot must now give 20% of its energy orb bounty to the regulator each time it descends with the harvest. To encourage long-term farming, this amount is reduced to 15% if the robot can sustain operation for 12-months or longer.
As things progress, it becomes apparent that your genius teenager made a few design flaws. Probably the result of consulting ChatGTP to fill in the blanks. In any case, the robots are not consistent in their quality and performance.
Some of them massively outperform and harvest ten times the average. Others just spin around in circles and do nothing. Others still are so terrible that they crash to the ground, losing their entire bounty and damaging your house.
You bring this matter to the attention of the regulator, asking if a bargain can be struck. You tell him that this year alone you’ve lost ten robots, and a few are on the fritz. “Is it possible that my good robots can get a break they bring down energy orbs equal to my losses?”, you plea.
“Yes, but there are some rules”, he says. “First, you can only harvest energy orbs free of tax equal to the amount of damages you sustain. There’s no benefit for the energy orbs lost when your robots crash. Second, when you die, I’ll waive the entire tax on the full harvest amount as of the date of your death.”
“Thanks”, you say with modest apprehension. That last rule confounds you and may even have been a threat.
With this blessing, you call down your highest performing robot to offload a portion of its harvest. It’s been operating for nearly five years now flawlessly, but you never know. The extracted energy orbs are then used to create more robots, and you send them on their way, hoping one could be your next banger.
That is tax-loss harvesting in a sci-fi nutshell, a process used in most personalized index programs. Its purpose is to diffuse capital gains into other positions for the sake of diversification by using loss-harvesting as an offset mechanic. This requires losses, mind you. There are no freebies.
This strategy can be programed into an algorithm and automated to harvest losses and gains using a defined rule set. Such a ruleset could be designed to approximate an index and harvest a specified range of gains/losses per year. It can be tailored to your particular tax profile, a potentially attractive value worth real money.
Ultimately, deferment is only just that: deferment. Eventually taxes must be paid when the can hits a wall. If that wall happens to be your death, then the Grim Reaper makes a deal with the tax man. The current market value of your assets becomes your cost basis on the date of your death. Strange fiction becomes an even stranger fact.
The only catch is you will not live to benefit from it. I hope you love your family. They certainly will appreciate your assets even more unencumbered by capital gains tax.
Questions or comments? Email us at planning@nwmgadvisors.com
Investment advice is offered through National Wealth Management Group, LLC.
The information in this newsletter is provided for educational and informational purposes only. It does not constitute investment, tax, legal, or personalized financial advice, nor is it a recommendation, offer, or solicitation to buy or sell any security, product, or service. References to specific securities (including NVIDIA and Berkshire Hathaway) or strategies are for illustrative purposes only and do not represent actual client holdings or recommendations.
All investing involves risk, including the possible loss of principal. Past performance is no guarantee of future results. Tax rules are complex and subject to change; tax-loss harvesting and other strategies discussed may not be suitable for all investors and can produce unintended tax consequences. Opinions expressed are those of the author as of the publication date and are subject to change without notice.
Readers should consult qualified tax, legal, and financial professionals regarding their individual circumstances before implementing any strategy.