Our first post in this series showed the power of deferral for building wealth; our second showed how robust the value of deferral is to changes in future tax rates on capital gains; our third considers whether deferral is still the right choice if an investor is able to find a strategy with a higher expected return (i.e., when is an investor better off compounding a larger portfolio at a lower rate of return; and when is the investor better off compounding a smaller portfolio at a higher rate of return? 1 1 Close A key part of the answer to part 3 is the amount of unrealized gain in the starting portfolio. In our example, an investor with a 20% unrealized gain would be better off selling that portfolio and reinvesting the proceeds into one with a 1% expected return advantage – regardless of investment horizon. In contrast, if that starting portfolio had an 80% unrealized gain, then for investment horizons less than 16 years, the investor would be better off sticking with the starting portfolio.   )

Here, we build on Part 3 by adding a tool investors and advisors increasingly have access to: tax-aware transition. 2 2 Close See, for example, Sosner and Krasner (2021).   What if the investor had capital losses available to facilitate the transition from the lower-returning strategy to the higher-returning strategy?

Consider an investor who holds a $1M equity strategy with an 80% unrealized gain. This investor identifies a similar strategy, but with a +1% expected return advantage. 3 3 Close Here we assume a 7% expected return for the starting portfolio, and an 8% expected return for the second. For simplicity, we also assume the pre-tax return is the same as the after-tax return for the two strategies. Examples of these are described in Sialm and Sosner (2018).   Should they make the switch? We know from Part 3 that for horizons of less than 16 years, this investor is better off sticking with the original strategy (as shown in the dashed curve below). 4 4 Close To make this analysis apples-to-apples, these comparisons use post-liquidation values.   But what if they are able to make the transition more tax-efficiently?

Suppose the new strategy realizes 10% of NAV in net capital losses in the first year, which are used to offset some of the tax cost of transition (solid curve below). 5 5 Close I.e., in this case, net capital losses of $100,000 used to offset $100,000 long-term capital gains.   In this case, the investor realizes a modest benefit from the tax-aware transition (about 2.4% of NAV), and the higher expected return strategy requires a shorter, 10-year investment horizon to outpace the foregone deferral benefit. 6 6 Close While a net loss of 10% of $1M NAV may seem like a large benefit to the tax bill, there is a counter-acting force of basis depletion of the new strategy due to the immediate capital loss. So in Year 1, this $100k lower basis leads to a lower post-liquidation value, which contributes to the negative difference in the first 10 years.   In other words, the investor who previously needed an investment horizon of more than 15 years to be better off switching to the higher expected return strategy, is now better off switching in only 10 years.

Of course, a 10% net capital loss is not an upper limit; some transitions can be made more efficiently than that. 7 7 Close See for instance Liberman et al. (2023) and Sosner and Krasner (2021), which shows that active long-short strategies with pre-tax return objectives can also realize net capital losses through regular portfolio rebalancing. The authors show these net capital losses are typically larger than those achieved by long-only strategies, particularly when the starting portfolio is highly appreciated.   The chart below adds one curve to the preceding chart: a transition facilitated with capital losses amounting to 30% of NAV. Clearly, there is plenty of value in making any portfolio transition tax-efficient—in the specific case of the top curve, making the investor better off switching to the higher expected return strategy over any investment horizon.