The 3 factor Engine™, five person-years in the mak­ing, is our pro­pri­etary soft­ware based on the lat­est aca­d­e­mic and indus­try research. The engine allows 3 factor to seek the best real­is­tic expected invest­ment returns, while min­i­miz­ing taxes and keep­ing our fees among the industry’s lowest.

The 3 factor Engine™ imple­ments sophis­ti­cated tech­niques such as:

– Tax Loss Harvesting
– Opti­mal Asset Location
– Whole port­fo­lio Re-Balancing
– Tax Lot Accounting

By opti­miz­ing your whole port­fo­lio across mul­ti­ple accounts, both tax­able and non-taxable, we can find more oppor­tu­ni­ties to min­i­mize taxes than most other advi­sors. Whole port­fo­lio rebal­anc­ing looks at each asset class across all accounts to build trades required to get a port­fo­lio back in bal­ance, so you get the max­i­mum tax advantage.

 

Sim­ple re-bal­anc­ing can be done with a spread sheet. But tax-optimized re-bal­anc­ing of the type that 3 factor does requires sophis­ti­cated soft­ware. Clients typ­i­cally have mul­ti­ple accounts, both tax­able and non-taxable, with spe­cific secu­ri­ties often resid­ing in more than one account. More­over, the secu­ri­ties in tax­able accounts often have been pur­chased on dif­fer­ent dates at dif­fer­ent prices. And of course the value of each asset fluc­tu­ates accord­ing to the vicis­si­tudes of the market.

Taxes can cre­ate a sig­nif­i­cant drag on returns. Whole port­fo­lio re-bal­anc­ing looks at each asset class across all accounts to build the trades – buys and sells – required to get a port­fo­lio back in bal­ance, so max­i­mum tax advan­tage is achieved.

The first step is mak­ing sure your most tax effi­cient assets are in your tax­able accounts, your least tax effi­cient assets are in your non-taxable accounts. This is called opti­miz­ing asset loca­tion. The dia­gram to the right out­lines the tax effi­ciency of selected assets, and where they should be placed.

The 3 factor Engine™ works through assets in order of tax effi­ciency. When sell­ing assets in tax­able accounts it starts with the least tax effi­cient assets, pro­gress­ing toward the most tax effi­cient. Mean­while, in non-taxable (IRA, etc) accounts, it starts with the most tax effi­cient, pro­gress­ing toward the least tax efficient.

When pur­chas­ing assets, it reverses the order. In tax­able accounts it starts with the most tax effi­cient assets, pro­gress­ing toward the least tax effi­cient. Mean­while, in non-taxable (IRA, etc) accounts, it starts with the least tax effi­cient, pro­gress­ing toward the most tax effi­cient. Fol­low­ing this sequence main­tains opti­mal asset location.

Dur­ing re-bal­anc­ing, if there is an excess of an asset (i.e. it is above its desired thresh­old), the 3 factor Engine™ will first look for that asset in tax­able accounts where there is a cap­i­tal loss, with short term losses pre­ferred over long term losses. Next to be con­sid­ered are sales of that asset in non-taxable accounts (the pro­ceeds from the sale will remain in the non-taxable account, of course, unless a dis­tri­b­u­tion is desired). Last to be con­sid­ered are sales from tax­able accounts where there is a cap­i­tal gain, with long term gains pre­ferred over short term gains.

There are mul­ti­ple ways to account for gains and losses on sales – includ­ing LIFO, FIFO, aver­ag­ing, and tax lots. Tax lots pro­vide the great­est tax advan­tage but also require the most detailed record-keeping and analysis.

To see the advan­tage of tax lots con­sider this example:

Sale of $20,000 of an asset is needed to get into bal­ance
The cur­rent price is $10.00 per share.
There are three tax lots on the security:

# shares Pur­chase price

3000 $13.00

3500 $7.00

2000 $8.00

Using aver­age cost account­ing: $1,294.12 Gain
Using spe­cific tax lot account­ing: $6,000.00 Loss

Exam­ple: Tax Advan­taged Re-Balancing

Now let’s dive a bit deeper and see how the 3 factor Engine™ selects which accounts and spe­cific hold­ings to sell:

In the above table we see that the com­bined value across all a client’s accounts of two asset classes, US and Emerg­ing mar­kets are above their desired (or ‘tar­get’) dol­lar value.

Note: The 3 factor Engine™ would have cal­cu­lated the aggre­gate val­ues as per­cent­ages of the over­all port­fo­lio. Based on the oppor­tunis­tic re-bal­anc­ing algo­rithm, it would then decide that the adjusted tar­get value should be a cer­tain per­cent­age. How­ever, to make this exam­ple more eas­ily under­stood, we sim­pli­fied the scenario.

The US Mar­ket asset class includes hold­ings from both the tax­able and IRA accounts. Since there is a gain in the tax­able account, we chose instead to sell assets from the IRA, the most tax advan­taged way to reduce the US Mar­ket asset class to the desired level.

The Emerg­ing Mar­ket asset class also has hold­ings in both accounts. Although you could make the sale in the IRA, the 3 factor Engine™ sees an even bet­ter oppor­tu­nity: sell hold­ings from the tax­able account, pro­duc­ing a loss that can reduce taxes. But the 3 factor Engine™ looks even deeper to select those tax lots with the high­est cost basis, there­fore pro­duc­ing the max­i­mum loss:

Finally, in this sim­pli­fied exam­ple, the 3 factor Engine™ has brought these two classes back to within the allowed range while min­i­miz­ing taxes and, in this case, pock­et­ing a tax loss.

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(1) Analy­sis com­par­ing after tax per­for­mance of other advi­sors (or a self-managed, sophis­ti­cated investor) to 3 factor based on a glob­ally diver­si­fied port­fo­lio with a 60% equity, 40% fixed income allo­ca­tion. Ini­tial port­fo­lio val­ues assume the fol­low­ing: (a) $750k tax­able and $250k IRA with yearly addi­tions of $20k to tax­able account and $5k to IRA. (b)Taxes deducted via shares each April, assum­ing the high­est tax bracket for a Cal­i­for­nia investor. 

Past per­for­mance is not a pre­dic­tor of future performance.

3 factor has con­ducted exten­sive analy­sis con­cern­ing port­fo­lio per­for­mance. See “3 factor‘s Method­ol­ogy and Invest­ment Risks” for details and dis­claimers regard­ing our state­ments con­cern­ing per­for­mance, and the var­i­ous assump­tions we have made in our analysis.