Data processing: financial – business practice – management – or co – Automated electrical financial or business practice or... – Finance
Reexamination Certificate
1999-05-28
2004-02-03
Chilcot, Richard (Department: 3627)
Data processing: financial, business practice, management, or co
Automated electrical financial or business practice or...
Finance
C705S037000
Reexamination Certificate
active
06687681
ABSTRACT:
BACKGROUND
The present invention relates to a method and apparatus for managing investment portfolios. More particularly, the present invention relates to a method and apparatus for automatically managing an investment portfolio comprising a plurality of securities modeled on an index and for actively managing tax lots for individual investors.
One common goal of many investors today is diversification of financial holdings to minimize financial risk while pursuing returns which substantially meet or exceed the performance of indexes such as the Standard and Poor's 500 (S&P 500). Consequently, there are a number of financial products available today which provide a means for both small and large investors to easily diversify their holdings. Among these are mutual funds, annuities, and individually managed accounts. While all of these products provide the desired diversification, however, they suffer from disadvantages in terms of the cost associated with managing accounts, tax efficiency, or both.
Mutual funds are one common means for providing a diversified portfolio to investors. Mutual fund investments, however, are among the least tax efficient financial products in the marketplace, and are particularly unsuitable for medium to high net worth individuals because mutual funds cannot distribute losses. Therefore, investors can receive a taxable distribution, resulting from capital gains allocated among holders of the fund, even if they have a net loss in the investment in the fund. Furthermore, due to accumulated but undistributed capital gains in a fund, new investors may assume a tax deferred liability upon investing in the fund. Mutual funds, therefore, are not suitable investments for investors who require tax efficient investment performance. Furthermore, the performance of such funds frequently lag the performance of indexes such as the S&P 500, since performance is highly dependent on the skill of the manager.
Index funds are a subset of mutual funds designed to track the performance of an index such as the S&P 500. Generally, there are two types of index funds: passive index funds and enhanced index funds. Passive funds generally include all of the securities which comprise the index, weighted to match their weight in the index. These investment funds, therefore, track the performance of the index. In enhanced index funds, a fund manager selects a subset of the securities found in the index and determines the weighting of the various securities in the fund. Rather than matching the performance of the fund, the fund manager seeks to exceed the performance of the fund. Both of these types of funds suffer from the same disadvantages, in terms of tax advantages, as mutual funds. Tax losses associated with the purchase and sale of individual securities held within the fund cannot be allocated among the investors. Furthermore, in the case of enhanced index funds, the performance of the fund is greatly affected by the performance of the fund manager.
Annuities offer another means for diversifying financial holdings. However, while taxes are deferred for annuity holders, annuities also suffer from disadvantages in terms of tax losses. Specifically, when an annuity is eventually converted, all of the capital gains generated are taxed as ordinary income. In many cases, the tax rate on ordinary income is higher than the capital gains tax which would have been paid on the investment.
Separately established individual accounts offer a means to diversify and to efficiently manage tax losses. However, due to the management resources which must be devoted to such accounts, the brokerage costs, and minimum purchase levels, costs are often prohibitive to all but a few wealthy investors. Individual accounts which seek to replicate an index fund are particularly difficult for small-to-medium net worth investors, since full replication of such an index fund in a manner allowing trading efficiencies requires a minimum investment, at present rates, of over a million dollars. For individual accounts that do not replicate an index, the effectiveness of the accounts depends heavily on the skill of the individual manager. Individually managed accounts often do not meet the performance of the S&P 500.
There remains a need, therefore, for a financial investment product that can provide a grossreturn that substantially tracks the returns of a selected index fund, while minimizing taxable gains through efficient use of individual tax lots and minimizing management costs. Preferably, this financial investment product would provide a means for small to medium sized investors to gain the financial advantages of both diversification and (active tax management) tax loss harvesting.
It is therefore an object of the invention to provide a financial investment product that provides diversified investments and tax loss harvesting for small to medium sized investors.
It is another object of the invention to provide an automated investment product for systematically harvesting tax losses.
It is yet another object of the invention to provide an automated investment product for small to medium investors for systematically rebalancing an investment portfolio to track an index fund.
SUMMARY OF THE INVENTION
The present invention provides a method and apparatus for automatically passively managing an individual investment portfolio for each of one or more investors while actively managing tax lots. An individual portfolio modeling an index is established for each investor, such that each investor owns each of the securities in his or her individual account. Because the securities are owned by the individual investor, losses can be harvested to offset gains for tax purposes. The investment portfolio is preferably periodically rebalanced to substantially model the selected index, as will be explained more thoroughly below.
Periodically, preferably at a time exceeding the minimum interval required by internal revenue service wash sale rules, each of the securities in the investment portfolio are automatically evaluated for tax loss harvest purposes. For each tax lot, the difference between the present market value of the security and a past historical value of the security is calculated and compared to a predetermined tax loss threshold. If the difference meets or exceeds the tax loss threshold, the security is automatically sold to provide tax losses for offsetting gains in the portfolio.
The investment portfolio is also automatically periodically rebalanced based on a capitalization weight parameter and an index balance parameter. Preferably, the capitalization weight parameter is determined such that each portfolio contains all of the major holdings of the index. Based upon their respective weight in the index, additional securities are purchased to provide an appropriate industry diversification, substantially the same as the actual holdings in the index fund. Rebalancing assures continued tracking of the index fund.
Trades of a specific security necessary to harvest tax losses or rebalance individual accounts are combined with similar trades for other accounts into a single block trade. Brokerage costs are shared among the individual investors, thereby decreasing the costs for managing the accounts. Upon completion of a trade, the brokerage fees and tax losses are allocated to each individual account. As trades are executed, purchased securities are stored in tax lots, wherein each tax lot associates the number of units of a given security purchased with the value of the security on the day of purchase. Therefore, each individual portfolio may include multiple tax lots of the same security purchased at different times, with a different base purchase value that is used as a comparison for tax harvesting purposes.
The rebalancing, tax loss harvesting, and trading functions are preferably performed automatically by computerized systems. Preferably, individual portfolios are stored and maintained by an automated accounting system. The rebalancing and tax loss harvesting functions are controlled by a second co
Blaser John M.
Brown Daniel Patrick
Hanson Todd
Schulz David W.
Chilcot Richard
Marshall & Ilsley Corporation
Reinhart Boerner Van Deuren s.c.
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