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.
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