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Quick Clips: Long-Short Tax-Loss Harvesting Strategies

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Quick Clips: Long-Short Tax-Loss Harvesting Strategies

Taxable investors in the United States use tax-loss harvesting strategies to gain long equity exposure to an index while taking advantage of opportunities to harvest losses along the way. These strategies can be effective, but their long-only nature presents major limitations. Hear from the AQR Specialized Investments Group on the benefits of incorporating shorting into tax-loss harvesting strategies.

What are tax-loss harvesting strategies?
Commonly referred to as “direct indexing” or “custom indexing,” these strategies typically aim to match an index’s return on a pre-tax basis while seeking to outperform on an after-tax basis. They hold long positions in individual equities and may seek to increase returns using well-known factor tilts like value, momentum, and quality. They may incorporate ESG tilts or screens aligned with investor preferences. They tend to defer the recognition of gains and harvest capital losses. These losses may help offset capital gains from other sources.

AQR Specialized Investments Group on Traditional Approaches to Tax-Loss Harvesting (0:22)



What are the potential limitations of these types of strategies?
Traditional tax-loss harvesting strategies can deliver tax efficient equity returns, even improving on the after-tax returns of an index ETF. But that does not mean they cannot be improved. Broad equity indices typically appreciate, and more so over longer investment horizons. This might be ideal from a pre-tax perspective, but it can complicate things for investors looking to harvest losses. The tendency for broad equity indices to appreciate leads to at least two shortcomings of a long-only approach to loss harvesting:  
1) Tax benefits last far less than a typical investment horizon.
2) Tax benefits in rising equity markets are limited.


Can we improve upon existing tax-loss harvesting strategies? 
Adding short positions to tax-loss harvesting strategies can improve both pre-tax and after-tax returns. Short positions yield loss harvesting opportunities when they appreciate. As such, a long-short strategy may realize tax benefits in both rising and falling equity markets. Incorporating shorting also allows for more flexible active stock selection, allowing the manager to identify both “winners” (stocks to overweight) and “losers” (stocks to underweight or even short). To the extent that the strategy aims to improve on the performance of an index using factor tilts, short positions are valuable. 

AQR Specialized Investments Group on Implementation of Short Positions in Tax-Loss Harvesting Strategies (0:37)

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. This material is not intended to be marketing. The recipient should conduct his or her own analysis and consult with professional advisors prior to making any investment decisions.

Risks of Tax Aware Strategies (Not Exhaustive)

1. Underperformance of pre-tax returns: tax aware strategies are investment strategies with the associated risk of pre-tax returns meaningfully underperforming expectations.

2. Adverse variation in tax benefits: deductible losses and expenses allocated by the strategy may be less than expected.

3. Lower marginal tax rates: the value of losses and expenses depends on an individual investor’s marginal tax rate, which may be lower than expected for reasons including low Adjusted Gross Income (AGI) due to unexpected losses and the Alternative Minimum Tax (AMT).

4. Inefficient use of allocated losses and expenses: the tax benefit of the strategy may be lower than expected if an investor cannot use the full value of losses and expenses allocated by the strategy to offset gains and income of the same character from other sources. This may occur for a variety of reasons including variation in gains and income realized by other investments, at-risk rules, limitation on excess business losses and/or net interest expense, or insufficient outside cost basis in a partnership.

5. Larger tax on redemption or lesser benefit of gifting: gain deferral and net tax losses may result in large recognized gains on redemption, even in the event of pre-tax losses. Allocation of liabilities should be considered when calculating the tax benefit of gifting.

6. Adverse changes in tax law or IRS challenge: the potential tax benefit of the strategy may be lessened or eliminated prospectively by changes in tax law, or retrospectively by an IRS challenge under current law if conceded or upheld by a court. In the case of an IRS challenge, penalties may apply.

Disclosures
The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. Past performance is not a guarantee of future performance.

This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation.

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

The information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. 

The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.

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Diversification does not eliminate the risk of experiencing investment losses. Targets may be subject to change and there is no guarantee that they will be met. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected.

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