Tax Matters

Can Your Loss-Harvesting Strategy Still Harvest Losses?

Topics - Tax Aware

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Can Your Loss-Harvesting Strategy Still Harvest Losses?

As equity portfolios appreciate over time, opportunities to harvest losses become few and far between. Whether you’ve been invested in a passive equity portfolio or in a Direct Indexing strategy, you’ve likely found that harvesting losses was much easier in the first few years after inception. Beyond that, not only does harvesting losses become a challenge but even keeping up with index reconstitutions might be difficult without recognizing capital gains. 1 1 Close In our earlier post “Direct Indexing and the Proposed Biden Tax Plan", we show that investors can enhance the tax benefits of a direct indexing strategy by contributing capital periodically  or by combining the strategy with a charitable giving program.   Appreciated portfolios—once a benefit—become a liability later in their life cycle. 

So how appreciated is your equity portfolio? It largely depends on when you invested and how long you’ve held it for. Unrealized gains can grow faster than many investors realize—and especially fast during bull markets like those that have characterized the past decade. 

In Figure 1, we quantify the total unrealized gains of two hypothetical strategies, a passive index-tracking strategy and a Direct Indexing strategy—also passively indexed but actively tax managed. Each bar represents a strategy simulation incepted in a different year: at the start of 2021 (a newer portfolio), 2020, and so on, until 2012 (an older portfolio). The height of a bar is the total unrealized gain as of the end of 2021. After just 3 years since inception, the unrealized gains of a hypothetical Direct Indexing strategy can grow to about half the portfolio value: look at the simulation that starts in 2019, where the unrealized gain has grown to about 55% by the end of 2021. Maybe surprisingly, even for a purely passive equity strategy that doesn’t systematically harvest losses, the unrealized gains are not all that different. 

Figure 1. Your Equity Portfolio May Be More Appreciated Than You Think

Source: AQR, XpressFeed, Barra, FTSE Russell. For passive equity, the simulations simply track the Russell 1000 benchmark. For Direct Indexing, the simulations rebalance the strategy on a monthly frequency, maximizing the tax benefit while limiting the tracking error to the Russell 1000 benchmark at 1% (using the MSCI Barra risk model). Results shown are for 10 backtest simulations starting January 1 of each year from 2012 to 2021, all ending on December 31, 2021. For example, the 2012 simulation runs for 10 years, whereas the 2021 simulation runs for only 1 year. All results are gross of fees.

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Conceptually, it should be more difficult to find loss-harvesting opportunities in highly appreciated portfolios, but how difficult is it in practice? Starting with an appreciated index-tracking portfolio, we compare two approaches to tax loss harvesting: (1) a traditional Direct Indexing strategy and (2) an Enhanced Indexing strategy—a novel approach to tax loss harvesting that allows for a limited amount of shorting, which we described in an earlier post. We want to see how effective these two tax loss harvesting strategies are at rejuvenating appreciated portfolios. 2 2 Close Equity markets don’t always go up like they have over the past decade. So, to make this analysis robust to the choice of time period, we run 10-year simulations starting at one-year intervals from 1986 onward (i.e., one simulation from 1986-1995, the next, 1987-1996, etc.), and report the averages.

Figure 2 shows that for portfolios with smaller unrealized gains (left half of the chart), both Direct Indexing and Enhanced Indexing may realize a tax benefit. The story changes, though, for portfolios with larger unrealized gains. When the initial unrealized gains are greater than 60%, the Direct Indexing strategy stops realizing a tax benefit. In other words, some portfolios can be too appreciated for a Direct Indexing strategy to work. In contrast, an Enhanced Indexing strategy may not only realize higher average tax benefits than Direct Indexing, but these benefits may be high and positive even when the starting portfolio is highly appreciated. 

The past few years may have already pushed equity portfolios of many investors to the right side of Figure 2. Enhanced Indexing might give investors with highly appreciated portfolios a chance to get their tax loss harvesting programs working again. 

Figure 2: Enhanced Indexing Improves Tax Benefits, Regardless of Initial Unrealized Gains

Source: AQR, XpressFeed, Barra, FTSE Russell. The simulations first solve for a diversified 500-stock portfolio (one that has the least tracking error, using the MSCI Barra risk model, to the Russell 1000 benchmark), and then allocate the specified unrealized gains on a pro-rata basis. For Direct Indexing, the simulations maximize the tax benefit while limiting the tracking error to the Russell 1000 benchmark at 1% (using the MSCI Barra risk model). For Enhanced Indexing, in each monthly rebalance, the simulations maximize exposure to a defensive factor model and minimize taxes, subject to a 1.5% tracking error. Both strategies are rebalanced on a monthly frequency. The results shown are averages across 27 ten-year historical simulations starting January 1 of each year from 1986 to 2012. Tax results are reported excess of the Russell 1000 Index. Short-term capital gains are taxed at a rate of 40.8%, while long-term capital gains and dividend income are taxed at 23.8%. All results are gross of fees.

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The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. 

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. 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. This material 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. 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. You should conduct your own analysis and consult with professional advisors prior to making any investment decision. Changes in tax laws or severe market events, among various other risks, as described herein, can adversely impact performance expectations and realized results.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. 
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Information contained on third party websites that AQR Capital Management, LLC, (“AQR”) may link to are not reviewed in their entirety for accuracy and AQR assumes no liability for the information contained on these websites. 

This document is not research and should not be treated as research. This document 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. 

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.