Reviewing the Early Benefits of Tax Loss Harvesting

 

Most direct indexing strategies offer two main advantages. The first is the ability to customize the account in line with the client’s preferences (e.g., not holding a stock to which the client is exposed elsewhere, or ESG considerations), which we will discuss in another paper. Here, we will focus on another important benefit – tax management.

 

To review, by owning the individual stocks in an index (or typically a subset), a savvy manager can take advantage of the equity market’s natural volatility by selling individual names as they fall below their cost basis. This cannot be done in a fund as the fund will have only one holding that will either increase or decrease in value.

 

However, within the index, there are almost always stocks that are down no matter what the overall equity index is returning. Direct indexing managers will replace the stocks that have been sold at a loss with a similar (but not the same, given the IRS wash sale rules) basket of stocks so that the account can continue to track the index with a typically small tracking error (relative risk of the account versus the index).

 

The capital losses generated by the direct indexing manager can then be used to offset capital gains from other investments on the client’s IRS schedule D, thus saving money that otherwise would have been taxable. (Losses not used in the current tax year can be carried forward indefinitely.)

 

This can be very valuable, especially for clients in a high tax bracket, high tax state and/or clients with significant short-term capital gains outside the direct indexing (DI) account.

Exhibit 1 shows Northern Trust Asset Management’s (NTAM) estimates of the amount of losses that can be expected to be generated from an all-cash funded Separately Managed Account (SMA) that regularly harvests losses.

 

At NTAM, we seek to harvest losses on a monthly cadence (again outside the wash sale period) in order to capture losses when they are available and reinvest dividend income. Assuming a reasonable market return of 7% and typical volatility, we can see loss generation starts out very strong and tends to decline over time.

 

In the later years, the losses are mostly derived from reinvesting dividends and cash from corporate actions. Note that in year one, all losses will be short-term and new losses from dividends and cash will also be short-term. It is also possible that some long-term holdings might turn into losses due to volatility spikes, down markets, or idiosyncratic stock situations.

 

The Continuing Benefits from Compounding

 

We’ve seen that the potential benefits from loss harvesting diminish over time but don’t disappear completely. We now turn to the continuing benefits realized from the compounding of taxes saved.

 

An illustrative example might help. Let’s assume that in a typical account we were able to generate 10% in capital losses in the first year. So, for a $1 million account, that represents $100,000 in realized short-term losses that can offset $100,000 in realized capital gains, thus resulting in no immediate tax bill for those gains.

 

This can potentially create a near-term tax savings of anywhere from $40,000 to more than $50,000 (40% to more than 50%) for high-net-worth clients, depending on the client’s state of taxation and the nature of the outside gains.

 

Those tax savings can potentially remain invested and generate a market return. This is where the continuing benefits come into play. By keeping that money invested, those savings will compound over time. The longer this deferral of gains can be kept going, the better for the client’s after-tax wealth.

 

One other important fact to mention is that as losses are harvested from a DI account, the cost basis of the account is decreased. This is due to the fact that because stocks are sold at a loss, new replacement purchases are incepted at the lower amount, thus lowering the overall cost basis of the account.

If we add the continuing benefits to the graph, you can see that the total tax alpha, including the compounding of the tax savings invested in the portfolio, continues to grow.

 

This is modeled by assuming that any tax savings are invested in the DI account as a proxy for other investments. Here we can see the benefits of that compounding of the tax savings.

The benefits of tax savings compounding may become a larger component of the annual tax alpha than the immediate tax savings once the loss harvesting activity slows down, prolonging the benefits.

 

As mentioned, the longer these tax savings can be deferred, the higher after-tax wealth that can be created. Holding the direct indexing account until death and passing onto heirs will potentially result in the highest benefit given the DI account will experience at step up in cost basis, thus allowing the beneficiary to sell the portfolio tax-free if desired assuming no further appreciation.

 

Value After Taxes

 

Next, we look to answer the question of: If we factor in investment management fees for a direct indexer versus simply investing in an index ETF (which can be both inexpensive and tax efficient) does the benefit remain?

 

If we assume the fee for DI is 25 bps (0.25%) and the fee for an equivalent index ETF is 5 bps (0.05%), we can say the fee differential is 20 bps (0.20%). Expected total annualized tax alpha typically ranges from 1% to 2% depending on the state in which the client resides, the inception date, cash flows, and the market environment.

 

Even at the lower end of this range the answer to the question posed is yes. Note that we have ignored dividends for this analysis as we assume that dividends and taxes on dividends are similar, whether in an ETF or SMA wrapper.

 

Potential Considerations for Direct Indexing Accounts

 

The ability to generate losses may be lower than expected, especially in markets that are rising significantly. Furthermore, the continuing benefits may not be fully realized in flat or falling markets because reinvested tax savings could potentially be low or negative.

 

Additional Strategies for Seasoned Accounts

 

It is not uncommon for clients to take additional steps in order to “rejuvenate” the loss harvesting opportunities in direct indexing accounts. Here are a few of the most common practices:

 

• Add cash to the account

  Depositing cash into the account will create fresh tax lots that can be turned into future losses. Note that during the first year, losses generated from the fresh cash will be short-term.

 

• Gifting securities from the account

  Appreciated direct index portfolios are an ideal source for charitable gifting. Of course, the gift is tax deductible as is gifting cash. However, by gifting low-cost basis securities, the investor removes the tax liability from the account as well. It may be best to replenish the DI account with cash that otherwise would have gone to charity, which would have the impact described in section above.

 

Conclusion

 

Direct indexing strategies in separately managed accounts have become very popular with advisors and clients because of the flexibility and benefits they provide, especially the benefits of tax management. There is a misperception in the industry that DI portfolios lose their value after losses slow down.

 

As we have seen from our analysis, it may not be the case. Gain deferral is a critical component of tax loss harvesting strategies including direct indexing. Deferring gains created in these portfolios, after taking advantage of the potential immediate benefits of offsetting gains from other investments, takes advantage of the power of compounding to potentially increase long-term after-tax wealth.