Smart Beta

Understanding Smart Beta

  • What is Smart Beta?

    Smart Beta is a broad term used to describe systematic rules-based investment strategies that do not use conventional market capitalization weights to construct a diverse portfolio. In an attempt to deliver a better risk and return trade-off than conventional market cap-weighted indices, these portfolios use alternative weighting strategies based on measures such as value, volatility or dividends.

    Smart Beta products do not usually involve as many active investment decisions as pure active management, but they are slightly more complex than market-weighted passive products. This is reflected in the typical cost for these strategies, which tends to be in the middle between active and passive strategies.

  • How are IB Asset Management Smart Beta portfolios different from other portfolios on IB Asset Management?

    The IB Asset Management Investment Management team, under the leadership of Chief Investment Officer Sanjoy Ghosh, manages IB Asset Management’s Smart Beta portfolios. The team is responsible for undertaking a systematic process to select stocks, construct the portfolios, continually monitor for any relevant events and periodically (at least quarterly) rebalance the portfolios.

    The other portfolios on the IB Asset Management platform are managed by third-party investment advisers or hedge fund managers. These portfolio managers fund and trade a proprietary manager-owned brokerage account. In contrast, for each IB Asset Management Smart Beta portfolio, IB Asset Management funds and trades a proprietary IB Asset Management-owned brokerage account. In both cases, each trade made by the portfolio manager (or IB Asset Management) is automatically replicated in clients’ brokerage accounts based on which portfolios the clients have selected to invest in.

  • Why should I invest in a Smart Beta portfolio?

    Smart Beta portfolios are similar in some respects to passive index funds, except that the rules used to construct these portfolios are designed to slightly outperform a conventional passive index fund, particularly when adjusting for risk taken. Smart Beta portfolios typically charge higher management fees than passive index funds. But these portfolios have lower management fees than pure active investment strategies.

    These features make these portfolios suitable for a client that desires exposure to the broad stock market but is not sure which portfolio to pick.

Working with fractional shares

  • What is a 'fractional share'?

    A fractional share is a unit of stock that amounts to less than one full share. More information here Nasdaq

  • Why are fractional shares useful to the Smart Beta portfolios?

    Fractional shares allow you to invest in diverse portfolios with many holdings even with a low investment amount. In essence, fractional shares allow investors to invest lower amounts in a larger selection of stocks, some of which may be too expensive for the investor to purchase in whole shares. IB Asset Management is able to diversify the Smart Beta Portfolios and offer them to IB Asset Management clients investing a relatively small amount due to its ability to trade fractional shares.

  • Can fractional shares be traded on public exchanges?

    Stocks cannot be traded in fractions on public exchanges, which means that you need a counterparty willing to transact with you in fractional shares.

  • How can I trade fractional shares in my IB Asset Management account?

    Interactive Brokers LLC, IB Asset Management’s affiliated broker-dealer, facilitates trading in the Smart Beta Portfolios by executing all fractional share orders on behalf of IB Asset Management clients against one or more liquidity providers. These liquidity providers will sell or buy fractional shares that IB Asset Management clients would not otherwise be able to trade in the open market.

  • Is there anything else I should know about the fractional share trades in my IB Asset Management account?

    Note that there is a potential conflict of interest in connection with fractional share transactions in your IB Asset Management account as Interactive Brokers LLC will act as broker for both IB Asset Management clients and the liquidity provider counterparty to these transactions. You have consented to these transactions in the Investment Management Agreement. You may revoke your written consent to such transactions at any time by written notice to IB Asset Management or Interactive Brokers, but you will no longer be able to invest in the Smart Beta Portfolios as they rely on fractional shares.

  • How do corporate actions work for fractional shares?

    You will receive payments or value commensurate to your fractional ownership in the case of stock dividends, stock splits, mergers or other mandatory corporate actions (including cash dividends). You will not, however, have any voting rights or a mechanism to make voluntary elections on your fractional share holdings, and will not receive any shareholder documentation for holdings of less than one share.

  • How do I liquidate my holdings in a Smart Beta Portfolio when I own fractional shares?

    You can redeem from a Smart Beta Portfolio and close out your Smart Beta positions at any time. If you do this, Interactive Brokers will sell your whole shares to the market and your fractional shares to the liquidity provider. You will incur commissions in connection with these trades.

  • What will happen to the fractional shares if I want to transfer my Smart Beta investment to another broker?

    You will not be able to transfer fractional share holdings to another brokerage firm and will need to sell them to the liquidity provider. You will incur commissions on these trades.

How lockout periods work

  • What is the ‘lockout period’ and how does it apply to my IB Asset Management account?

    A lockout period starts 3 business days before each Smart Beta portfolio rebalance and ends right after each rebalance. During each lockout period, we will not allow clients to make any initial, additional or recurring investments in any Smart Beta portfolios. If you request such a transaction during a lockout period, IB Asset Management will send your transaction request for execution on the first trading day following a rebalance.

  • Does this mean I cannot redeem my money from Smart Beta in the lockout period?

    No. The lockout period does not affect any partial or full redemption instructions for Smart Beta portfolio investments you place in your IB Asset Management account (i.e. partial or full divestments from any of the Smart Beta portfolios). You may redeem some or all of your investments in any Smart Beta portfolio at any time. But, if you have a cash (rather than margin) brokerage account at Interactive Brokers and engage in redemptions less than 3 business days after a rebalance, Interactive Brokers may require you to fully pay for any purchases in your account on the date of each trade for the next 90 days.

  • Why do you have a lockout period?

    Pursuant to Regulation T (see related SEC Investor Bulletin), cash accounts can make purchases with unsettled sale proceeds as long as they do not run afoul of the freeriding restriction by selling unsettled securities (i.e. do not close positions within 3 days of opening them). Since investments made within 3 days of a rebalance might lead to a position being closed at the time of the rebalance, we restrict such investments to prevent violations of the freeriding restriction.

  • How will I know whether one of my investment instructions has occurred during a lockout period?

    The confirmation you receive when you submit an investment instruction will indicate that the portfolio is under lockout and will also inform you of the date on which your instruction will be processed.

  • How will I know when the investment instructions I place during a lockout period will be processed or when the lockout period ends?

    The confirmation you receive when you submit an investment instruction will indicate that the instruction is pending and will also inform you of the date on which your instruction will be processed. You can cancel this instruction anytime before the specified processing date.

  • Outside of a lockout period, when will my instructions to invest in any Smart Beta portfolio or redeem any of my Smart Beta portfolio investments be processed?

    To avoid price swings around market open and close, client requests to invest in or redeem any investments in the Smart Beta Portfolios will be processed in the order in which they are received between 9:35 am and 3:50 pm ET.

Tax loss harvesting

  • What is Tax Loss Harvesting (TLH)?

    Tax Loss Harvesting (“TLH”) is a strategy of selling those securities in your portfolio that have decreased in value and using the capital losses from selling the security for less than your cost basis to decrease your taxes while using the proceeds from the sale to purchase a similar but not identical security. The principal way to realize and claim a capital gain loss for taxation purposes is to sell the depreciated security. The expected risk and return characteristics of the portfolio used for TLH can be maintained by exchanging the security sold with a suitable replacement while the tax savings effectively boost after-tax returns.

    Capital losses may be used to offset taxes on capital gains and/or up to $3,000 per year on income. Tax-loss harvesting rules pertain to individual investors who are US taxpayers or US persons. They may or may not apply to other types of investors.

  • What are the benefits of TAX.IB over a passive ETF?

    Tax loss harvesting is a way to improve your after-tax investment performance over a passive ETF. Owning a basket of individual stocks provides the opportunity to effectively harvest your losses based on price changes in each security position. Every quarter, TAX.IB is rebalanced, and stocks with losses are replaced with stocks that have similar expected risk and return characteristics and those losses are harvested. In an ETF you have to wait for a general market downturn and the total value of the ETF to drop below the cost basis to be able to harvest any losses. Capital gains in your IB Asset Management account and other investments and up to $3,000 of ordinary income annually can be offset with the losses experienced in the TAX.IB portfolio. Any excess losses can generally be carried over indefinitely and applied against future year capital gains and income.

    IB Asset Management does not provide tax advice and does not represent in any manner that investing in this portfolio will result in any particular tax consequences. The tax consequences of investing in this portfolio are complex, uncertain and may be challenged by the IRS. Current and prospective clients should consult their personal tax advisers regarding the tax consequences of investing in this portfolio or any other IB Asset Management portfolio, based on their particular circumstances. IB Asset Management does not assume any responsibility for the tax consequences for any investor or any transaction. Clients and their personal tax advisers are responsible for how the transactions conducted in their accounts are reported to the IRS or any other taxing authority on the Client’s personal tax returns. For additional information on claiming tax losses on your tax filings, review the IRS instructions on Schedule D (Form 1040) Capital Gains and Losses or IRS Publication 550.

  • Who benefits most from tax loss harvesting? Is it for everyone?

    Tax loss harvesting works through tax deferral. Tax Loss Harvesting (TLH) defers tax liability and allows the opportunity to invest the tax savings until the future tax liability comes due and the taxpayer may be in a lower tax bracket. TLH thus works best for high-tax bracket investors with a long-term horizon and is maximized for those who do not liquidate the portfolio. TLH may be most beneficial to investors who regularly recognize capital gains. TLH is less useful for investors in low-tax brackets who expect to be in a higher tax bracket in the future when the taxes come due. Also, individuals in the 10-15% tax bracket do not owe certain capital gain taxes so a tax-loss harvesting strategy may not make sense for them. Additionally, TLH only benefits taxable accounts: tax-advantaged accounts (e.g., traditional or Roth IRAs) will not benefit from this strategy because they are already tax-free or tax-deferred. Often the strategy is most effective for investors that harvest losses for use against high-rate income (i.e., short term capital gains) and convert future realized gains to long-term capital gains subject to the preferentially lower rate.

  • Are the benefits of tax loss harvesting the same every year?

    No. The losses that can be harvested are highly dependent on the performance of the stocks within the portfolio and general market conditions. In certain years there would be large losses to harvest while in others very few. We have run simulations and found that a tax loss harvesting strategy was most valuable in major down markets.

  • How do you decide on replacement stocks?

    Replacement stocks are chosen based on their ability to closely match the expected risk and return characteristics of the original security. Based on similarity of fundamental characteristics like capitalization, valuation metrics, market beta as well as other traits such as the business group and industry, we determine a suitable replacement stock. But we do not represent or guarantee that the replacement stocks we select will perform the same or similarly to the stocks being replaced.

  • What are the disadvantages of TLH?

    By attempting to capitalize on the losses on individual positions in the portfolio, the tax-loss harvesting method faces higher turnover. This higher turnover could result in bid-ask spread expenses, higher transaction costs, and dividends being disqualified from qualified dividend treatment. We mitigate this disadvantage with low basket trading commissions available through our affiliated broker-dealer Interactive Brokers LLC and quarterly versus more frequent rebalancings.

  • What is a wash sale?

    A wash sale is a sale of stock or securities at a loss within 30 days before or after you buy or acquire a contract or option to buy, or acquire in your IRA or Roth IRA substantially identical stock or securities. The wash sale period consists of 61 calendar days: 30 days before the sale and 30 days after the sale. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation, but they may be substantially identical in some cases. For instance, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical. A wash sale does not completely eliminate benefits of TLH but reduces that benefit by the amount of the wash sale itself. A wash sale defers the recognition of the loss: the amount of the loss is added to the cost basis of shares purchased during the wash sale period, and upon the sale of the newly acquired shares, the disallowed loss is incorporated into the calculations of the gain or loss on those shares and recognized. Additionally, the holding period of the original shares is added to the holding period of the newly acquired shares or securities. The IRS guidelines on wash sales are designed to prevent investors from artificially generating losses where they do not actually intend to reduce their holdings in the assets sold.

    IB Asset Management does not monitor for wash sales in client accounts and will not provide notice of wash sales to clients investing in any of its portfolios. Clients are responsible for monitoring their and their spouse’s accounts, including their IB Asset Management portfolios, Interactive Brokers investments, and other investments, to confirm that transactions do not create wash sales. The wash sale rule applies to all of a client’s accounts, including IRAs, as well as spousal accounts for joint filers. Clients may find information on wash sales in their Interactive Brokers 1099-eligible accounts on their daily, monthly and annual activity statements. Clients may violate the wash sale rule and be unable to harvest certain of their tax losses if they use multiple tax-loss harvesting providers or brokers.

    For more information on the wash sale rule and other tax-loss harvesting-related issues, please review IRS Publication 550 and the Interactive Brokers website.

  • How can I monitor the tax losses in my IB Asset Management and Interactive Brokers accounts?

    You can view information on your capital gains and losses in your Interactive Brokers periodic activity statements. Interactive Brokers’ Tax Optimizer, available in Account Management, also lets you manage the gains and losses in your IB account. You can change the default matching method for your account or for the current or prior trading day, run real-time "what-if" scenarios to see how different lot-matching methods affect your gains and losses and manually match specific lots to trades, and view year-to-date profit and loss data by symbol. See the Tax Optimizer Users’ Guide or Tax Optimizer Tour for more information.

  • What rules apply to capital loss carryover?

    Capital losses on your investments are first used to offset capital gains of the same type. Thus, short-term losses first offset short-term gains and long-term losses first offset long-term gains. Afterwards, net losses of either type can be deducted against the other type of gain. If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other types of income, such as salary and interest income. Excess capital losses can be carried over indefinitely to subsequent years to be deducted against future capital gains and up to $3,000 in other income. The maximum amount of net income that capital losses may be netted against is only $1,500 for each spouse with married filing separately filing status. Until the entire loss is used, the taxpayer goes through the “netting’ process each year. First, the current year gains and losses are netted and then any excess gain is offset by the carried forward loss. Capital losses cannot be carried over after a taxpayer’s death and are deductible only on the final income tax return filed on the decedent’s behalf. These rules apply to individual investors who are US taxpayers or US persons. They may or may not apply to other types of investors.