Exhibit 1. Low-Basis Stock De-Risking Methods
Tax Matters
Regardless of How You Deal with Low-Basis Stock, Long-Short Strategies Can Help
June 23, 2022
Topics - Tax Aware
Most investors recognize that concentrated stock holdings are risky. Our recent paper, When Fortune Doesn’t Favor the Bold, shows that even over just a few years, concentrated positions can lead to catastrophic losses of wealth.
One of the main reasons that investors are reluctant to sell (non-restricted) concentrated stocks is taxes. An outright sale of low-basis stock allows for the possibility of building a better investment portfolio, but at punitive tax burden. This dilemma led to development of several tax-efficient alternatives to an outright sale:
1. Completion portfolios
2. Exchange funds
3. Hedging strategies
4. Charitable techniques
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See, e.g., Welch, S. 2002. “Comparing Financial and Charitable Techniques for Disposing of Low Basis Stock.” The Journal of Wealth Management 4 (4): 37–46; Brunel, J. L. P. Integrated Wealth Management: The New Direction for Portfolio Managers, 2nd ed. London: Euromoney Institutional Investor Plc. 2006; Wilcox, J., J. E. Horvitz, and D. diBartolomeo. Investment Management for Taxable Private Investors. Charlottesville, VA: The Research Foundation of CFA Institute. 2006. We do not consider here complex tax structuring transactions that artificially create basis in a low-basis stock. Such transactions carry a significant tax risk, as can be seen, for example, in Jade Trading, LLC ex rel. Ervin v. United States, 598 F.3d 1372 (Fed. Cir. 2010) and Stobie Creek Invs. LLC v. United States, 608 F.3d 1366 (Fed. Cir. 2010), both of which were lost by taxpayers.
Exhibit 1 compares all five approaches, including an outright sale. The outright sale eliminates the idiosyncratic risk of the stock but results in a large tax burden in the year the stock is sold. In the completion portfolio approach, the overall portfolio risk is typically dominated by idiosyncratic risk of the stock, so, while the liquidation tax is avoided, the idiosyncratic risk exposure remains unacceptably high. 2 2 Close To acquire a completion portfolio, the investor could raise funds via borrowing against the concentrated stock, using available savings, or combining borrowed and saved funds. In any event, sufficiently diversifying the portfolio might require significantly more cash that the investor could raise. The exchange fund solution suffers from several well-known deficiencies: adverse selection in the stocks contributed to the fund, a 7-year lockup, high fees, and a potentially high tracking error with respect to a broadly diversified market portfolio when positions are distributed at the end of the lockup period.
The last two approaches, hedging strategies and charitable techniques, are interesting for several reasons. First, in contrast to completion portfolios, they can substantially reduce or even fully eliminate exposure to the idiosyncratic risk of the stock. Second, they do not suffer from the inherent drawbacks of exchange funds. Finally, they may allow for deferral of gain recognition beyond the calendar year in which the idiosyncratic risk of the stock is diversified.
*At the cost of gain realization.
**The stock can be liquidated immediately within a charitable entity such as a charitable remainder trust, a private foundation, or a donor advised fund. In the case of charitable remainder unit trusts, the investor has a partial exposure to performance of the portfolio replacing the liquidated stock.
**The stock can be liquidated immediately within a charitable entity such as a charitable remainder trust, a private foundation, or a donor advised fund. In the case of charitable remainder unit trusts, the investor has a partial exposure to performance of the portfolio replacing the liquidated stock.
An important consideration for all five approaches is time—specifically, the time between diversification of idiosyncratic risk and the recognition of a taxable gain (see column “Realization of the Stock’s Built-In Gain”). With an outright sale, the investor only has until the end of the year to harvest losses. With hedging strategies, such as variable prepaid forwards, gain recognition is generally deferred until the forwards are physically settled. This can postpone gain recognition for several years and give the investor a longer runway for tax-loss harvesting. With charitable techniques, such as charitable remainder unit trusts, gain recognition is spread out over a couple decades and can even be backloaded into the future via proper structuring of the trust.
So where do long-short strategies come into play? In all these approaches, whether the investor has several months, a few years, or a couple of decades until the liquidation gain is recognized, long-short strategies can help achieve tax-loss-harvesting objectives more effectively than traditional long-only direct indexing strategies. We discussed this fact in an earlier post, Improving Direct Indexing, where we showed material improvements in loss harvesting capabilities that long-short strategies offer in comparison to direct indexing. Moreover, long-short strategies may also help investors to tax-efficiently realign the portfolios that they receive from exchange funds which may not be aligned with their long-run investment objectives. This can be achieved by using techniques described in our earlier post Tax-Efficient Portfolio Transition, or How to Rejuvenate Ossified Equity Portfolios.
Exhibit 2 compares tax-loss-harvesting capacity of tax-aware long-short beta-one strategies that utilize various levels of leverage—130/30, 150/50, and 250/150—to that of a traditional long-only direct indexing strategy. 3 3 Close Importantly, all the long-short strategies use a factor-based alpha model to inform their active portfolio longs and shorts. The tax-aware approach to trading the portfolio balances expected pre-tax benefits of the trades (profit motive) with their tax attributes (tax costs of realizing gains and tax benefits of realizing losses). The direct indexing strategy on average realizes a cumulative net tax loss of just under 30% of the initially invested capital over 10 years (see the left chart) but has a meaningful chance of not delivering any net tax losses (see the right chart plotting 10th percentile outcomes). In contrast, long-short strategies achieve much higher levels of cumulative net tax loss realization, both on average (left chart) and in the case of a relatively poor outcome (10th percentile in the right chart).
Exhibit 2. Tax-Loss-Harvesting Potential of Long-Only and Long-Short Strategies
Source: AQR, XPressFeed, S&P, MSCI Barra. We run 27 separate 10-year strategy simulations starting on January 1 of every year from 1986 to 2012 and show the average (left chart) and the 10th percentile (right chart) cumulative net loss outcomes for every year since inception across these 27 vintages. Each month, for direct indexing, we minimize tax costs, subject to staying within a 1% tracking error (computed using the MSCI Barra risk model) to the Russell 1000. For tax-aware 130/30, 150/50, and 250/150 in each monthly rebalance, we maximize exposure to a value-momentum-quality factor model and minimize tax costs, subject to staying within a pre-specified tracking error (computed using the MSCI Barra risk model) to the Russell 1000: 1.5%, 4% and 6%, respectively. The tax cost term in the optimization treats realization of gains as a cost and realization of losses as a benefit.
Bottom-line: whether an investor diversifies idiosyncratic stock risk via an outright sale or via tax-efficient methods, such as hedging strategies or charitable techniques, using long-short tax-loss-harvesting strategies in the mix can help enhance the tax efficiency of diversification.
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. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. 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. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper 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 author nor AQR undertakes to advise you of any changes in the views expressed herein.
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 author 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.
The information in this paper 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 document, 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.
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.