Exhibit 1. Low-Basis Stock De-Risking Methods
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 1 1 Close 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.
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
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.
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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.
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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.