The Certainty of Death and Taxes

Benjamin Franklin famously said “in this world nothing can be said to be certain, except death and taxes”. In investing I think the proper quote would read:

“In investing nothing can be said to be certain, except Fees and Taxes”

We’ll get to the fees part in a future post, but for now let’s tackle taxes.

Readers ask about the tax implementations of Geometric Balancing all the time. It’s a meaningful question of the strategy. It’s clear the strategy benefits from a tax advantaged account. The frequent trading does trigger frequent tax events. But when comparing to the entire investing landscape, I believe the tax implications of Geometric Balancing hold up well against other investment strategies as long as you set up the tax accounting correctly.

I am Not a Tax Advisor

I need to get this out of the way to start. I’m not a tax expert or tax advisor. Taxes are very complicated, and often very personalized. It’s not possible to provide blanket tax advice for any strategy. I’m going to tell you a bit of what I have done, and how I look at the tax implications. In no way should you think what I’m saying in this post applies to you personally, because it doesn’t.

I can’t stress this enough, you need to do your own research on tax implications.

And to all my international readers, I’m sorry to say I don’t know anything about tax structure or laws outside the USA. Hopefully my thoughts on how I look at American taxes helps you think through these issues in your own country.

Most Investment Strategies Don’t Consider Taxes

If not planned out, taxes can dramatically reduce total realized profits. And unlike many things in investing, each investor can know the the implications of taxes for each year. Tax decisions don’t have random impacts. Therefore, since the effects of taxes are certain, you should make an effort to optimize them.

Many funds are run without any consideration to taxes. Many strategies are built without consideration to taxes. I was a bit surprised at this, as the government can take upwards of 30+% of profits.

And yet everyone has a different tax situation. Simply put, people are in different tax brackets. A trading decision to help some people’s taxes may hurt others. Dividends are tax free for some people, for others they can be taxed highly.¹ It’s not really possible to design a strategy or run a fund that is tax optimal for everyone.

But there are two key points everyone should try and focus on:

1. If you can help it, you’d rather not sell, and trigger a tax event at all.
2. If you do sell, long term gains (gains held for over a year) reduce taxes compared to short term gains.²

No Taxes vs. Long Term vs. Short Term Gains

First off, just paying taxes each year hurts total investment returns. I’m not saying this because taxes obviously reduce your wealth. The “each year” part hurts too. If you had a choice of paying out 20% of the profits each year to taxes, or paying the 20% taxes after holding for 5 years, you’d wait the 5 years every time.

You would rather the wealth stay in your possession and continue to compound. Subtracting the wealth out of the account for taxes means it’s no longer compounding for you, which reduces long term returns. So all things being equal, you would rather never trigger a tax event. This is part of the reason tax differed accounts are so great.

Secondly, long term gains should be taxed at a lower rate than short term gains. Long term gains are often taxed at the capital gains rate. Short term gains are taxed at the marginal tax rate. For most people, short term gain taxes will be significantly higher than long term gain taxes.

Therefore we prefer long term gains over short term gains.

Tax Structure

One tool investors have to address tax optimization is how they structure their trades. There are multiple ways of structuring and organizing the gains and losses in your investments:

• First In First Out (FIFO)- In this method, the “oldest” stock in the portfolio is sold first.
• Last In First Out (LIFO)– In this method, the “newest” stock in the portfolio is sold first.
• Selecting Each Trade– In this methods, you actually select which stock is sold in each transaction.
• Other Optimized Trade– Some platforms allow for other optimized trades like maximize long term gains, or maximize short term losses.

Which is the best?

I’m fairly certain that strategically selling certain stocks each time would end up being the best tax strategy. Maybe one of the optimized strategies would work well too. But I’m also certain this would be complicated to plan out. So let’s just leave these alone for now and try and understand the implications of the simplest accounting methods: FIFO and LIFO.

FIFO is Bad for Geometric Balancing

FIFO is often the default. It is probably a good choice for many strategies, but in my opinion it’s awful for Geometric Balancing. The problem comes from the strategy’s high turnover.

Let’s imagine a scenario where every week you buy 4% of an asset, and the next week you sell 4% of an asset. Obviously Geometric Balancing is more complicated than this, but it’s a good, very simplified mental image of what’s happening in the portfolio.

In this scenario, if the assets start at 40% of the portfolio, the FIFO method means that every 20 weeks you will have “churned” and sold each stock in the asset.

4% * 10 two-week periods = 40% sold in 20 weeks

Therefore, with FIFO the strategy sells stocks purchased around 20 weeks ago. Much less than a full year. And this would roll every couple of weeks, so that all profits become short term gains. Not what we want.

In practice Geometric Balancing would work similarly to this example. With FIFO, almost all profits fall under short term gains.

LIFO Works Better

Thankfully LIFO works better. With LIFO, large parts of the portfolio stay untouched for years. Using our mental example of buying and then selling 4% of an asset every other week, you can see that LIFO sells 4% of the portfolio which was bought the prior week. Any gains (or losses) in that part of the portfolio become short term gains (or losses).

But the rest of the portfolio (nearly all of it) remains untouched and unsold.

Not only does that part of the portfolio become long term gains after a year, but it also isn’t going to register a tax event until you need to actually use the wealth.

A Look at Taxes with Geometric Balancing

Geometric Balancing is definitely more complicated than the simple buy 4% and sell 4% example. But the mechanics are the same.

Look back at the last year of the published live track record. Let’s say you started with the strategy at this time last year.

You can see that gold never fell below 7%, and stocks and bonds never fell below 11%. So with LIFO right now 28% of the portfolio has remained untouched for over a year, and would fall into long term gains today if sold.

Last Year Was Not Normal

This example very clearly shows how some of the portfolio becomes long term gains. But most years transfer far more than 28% of the portfolio into long term gains. Just 6 months ago we experienced the COVID crash and the strategy sold off every asset aggressively. It wasn’t a typical year (and hopefully won’t be going forward).

These are the type of events that often harvest prior gains. Even through one of the worst financial sell offs, 28% of the strategy still survived to become long term gains.

If you look back at the historical positions of the strategy, you will see that with LIFO, 50%+ of the portfolio would often pass untouched through multiple years.

As an example, from mid 2010 to mid 2015, stocks never fell below 28%, bonds stayed above 16%, and gold stayed above 4%. Five full years of nearly 50% of the portfolio remaining untouched. During this time individual years (2012 for example) left nearly 70% of the portfolio untouched, passing most of the profits into the next year untouched by taxes.

Oh, and of the 28% that passed through the last calendar year untouched, the 18% stock and gold portion has been in the portfolio since the great financial crisis of 2008-09. Bonds stayed above 16% for 8 years, until dipping in 2017. So over a third of the portfolio compounded untouched for nearly a decade.

Each year is different. Some years are more volatile than others and would register plenty of short term gains (and losses). But with LIFO, I believe the taxes effectively churn the “top” part of the portfolio through short term loses and gains while leaving the bottom to compound longer, ultimately becoming long term gains (or losses, but hopefully gains).

Using Futures for Tax Benefits

Futures can provide some investors with a different tax treatment all together. Futures contacts have a unique feature where they automatically split gains and losses into 60% long term and 40% short term. I believe this ultimately produces a similar tax performance to how LIFO would distribute taxes using ETFs, albeit in a much more stable fashion year after year. Futures are not for everyone, but it’s something to consider for some.³

Other Strategies have Tax Implications Too

Many fancy “quant strategies” trade quite frequently. Frequent trading is much more likely shift profit into short term gains. Other strategies also trade in and out of positions fully, meaning the tax event will trigger the entire position cutting off multi-year compounding.

Momentum

On paper relative momentum strategies trade every few months into mostly new portfolios. No matter what tax strategy is chosen, these gains will nearly always fall into the short term bucket.

Trend Following

Trend following strategies can also trade in and out of securities quite often. Short term gains will be very common. Not as common as relative momentum, as trend following may hold a position for over a year. There are different kinds of trend strategies, some more likely to produce long term gains than others.

Other Factor Strategies

Other strategies wait to adjust the portfolio every year in order to ensure gains are long term. Think of some slower evolving factor-based strategies that don’t rebalance as often.⁴ This is better on one level. However adjusting nearly every asset after a year still forces a tax event each and every year on the majority of the portfolio. This interrupts the compounding and reduces the total return.

60/40 Does Really Well with Taxes

Simple 60% stocks / 40% bonds investing rebalanced annually does very well with taxes. You get a bit of the best of all worlds, with all gains falling into the long term bucket, and most of the portfolio compounding for multiple years. This is the ideal situation.

Please Consider Your Tax Strategy

It’s very clear, Geometric Balancing (without leverage) works best in tax advantaged accounts. But I think it holds its own with many other strategies in standard accounts. With LIFO, much of the portfolio falls into long term gains, and much of that portfolio compounds for years and years before it’s taxed.

This entire post simplifies the issues. It ignores the impact of plenty of other considerations like dividends, losses, and wash sales. Taxes are very, very complicated. I’m working on a more detailed analysis and will post it when it’s done.

I’m also fairly sure some of the fancier tax optimization strategies may work better than LIFO. I am researching them further.

However, no matter what strategy you use, I would recommend you also research tax implications further. You should do what you can to understand the best tax accounting method for your strategy. The default may not be the best choice. Unlike many decisions in investing, tax decision impacts are known, very personalized, and guaranteed.

There is enough randomness in investing that it’s important to get the “certain” parts right.

1-Unless you just assume everyone is in the top tax brackets, which I feel like the investing world usually does. I’ve never liked that assumption.

2-If there is a third it would be to try and put losses into the short term bucket.

3-Futures can be dangerous if you don’t know what you’re doing with them, as they come built in with a form of leverage. Also because of their size, it would be hard to run a Geometrically Balanced strategy without a good bit of capital.

4-As an example, think of something like a value factor strategy re-formed every year. By re-forming the portfolio every year, you only get long term gains. But, by reforming the entire portfolio every year, you are paying taxes on the returns of the entire portfolio every year, reducing it’s ability compound growth.