Taxpayers invest to make money and hope to earn a decent return on their investments. Tax-loss harvesting can be used as part of a taxpayer’s overall investment strategy without affecting investment returns, while offsetting tax otherwise due on capital gains.[1] In this part of the series, I look into some popular investment strategies that are often combined with tax-loss harvesting methods.

First, what is meant by “standalone loss harvesting”?

“Standalone loss harvesting” is when a taxpayer sells loss assets to “mop up” tax otherwise due on capital gains but ignores the reinvestment of sales proceeds. Without reinvestment, however, a taxpayer’s portfolio will shrink over time to the point when no securities are left from which the taxpayer can harvest losses.

For these reasons, it is unusual for a taxpayer to engage in standalone loss harvesting. Taxpayers typically reinvest their sales proceeds in accordance with their preferred investment strategies. Two of the most common strategies are “direct indexing” and “long-short portfolios.” These investment techniques support taxpayers who buy securities to replace those they sell from their portfolios, while allowing them to continue to track a specific designated benchmark index (either a public or custom index).

Explain the popular investment strategies taxpayers use in combination with tax-loss harvesting approaches?

The investment strategies available to taxpayers are varied and extensive. For purposes of our discussion, I will focus on four strategies that can be followed separately or combined. First, a taxpayer can invest in a passive fund where the taxpayer simply holds an investment in that fund. Second, a taxpayer can hold, in their own account, a securities portfolio that consists of shares of stock that replicate a broad-based index. Third, a taxpayer can engage in what is referred to as a long-short strategy where the taxpayer holds both a long portfolio and a short portfolio. And fourth, a taxpayer can combine a long-short portfolio and an investment in a passive fund that replicates a broad-based stock index. Each of these approaches have advantages and disadvantages, which I discuss below.

Passive Fund

As a starting point, a taxpayer can invest in a passive fund that replicates a broad-based stock index. This passive investment exposes the taxpayer to general market risk. The taxpayer has no decision-making authority with respect to the stocks held in the fund. The only decision is whether, where, and when to keep or sell the shares in the fund. There is no direct connection between a passive fund investment and tax-loss harvesting, but a taxpayer who sells fund shares can use the capital gain or loss as part of a tax-loss harvesting strategy.

Direct Indexing

A popular variation on passive fund investing is direct indexing. With direct indexing, a taxpayer holds an actively managed securities portfolio that replicates a broad-based stock index or a custom mix of securities. The portfolio is structured to hold enough stocks to track the designated index, but unlike holding shares in a passive fund, taxpayers can control when to buy, sell, or otherwise dispose of individual stocks. The taxpayer has the flexibility to sell gain stocks and mop up the tax on capital gains by selling loss stock. Short-term losses can be used to mop up short-term gains, and long-term losses can be used to mop up long-term gains. When stocks are sold, new stocks are purchased and added to the portfolio, so the portfolio continues to track the specified index.

Long-Short Strategy

Another common investment strategy involves setting up two different portfolios: one long portfolio and one short portfolio. Referred to as the “long-short strategy,” these two portfolios allow a taxpayer to benefit from either a rising or declining market.

Long-Short Portfolio with Passive Direct Index Fund

A related strategy combines long-short portfolios with a passive investment in a broad-based index fund. The taxpayer can benefit from market movements (by holding the index fund) which tracks general market trends. The taxpayer can also benefit from the long-short managed portfolios that provide the taxpayer with a “market-neutral position.”

So, let’s get into some of the details now.

What is direct indexing?

In direct indexing, a taxpayer establishes a “benchmark portfolio,” a diversified portfolio that tracks a custom or benchmark index, such as the S&P 500 or the Russell 1000 (benchmark index). When the taxpayer holds a benchmark index portfolio, the portfolio is exposed to market fluctuations so that portfolio movements basically track general market trends, or those of the particular industry, sector, geographic region, or other factors that the portfolio is modeled after.[2]

The taxpayer sells securities from the benchmark portfolio to generate gains and harvest losses. To ensure that the portfolio continues to track the benchmark index, the taxpayer typically buys another security or securities included in the benchmark index to replace those securities sold. Buying the same security sold at a loss can trigger the wash sales rule, so taxpayers avoid reacquiring substantially identical securities. The wash sales rule was addressed in Part II of this series.

What is a long-short strategy?

With a long-short strategy, the taxpayer establishes two separate investment portfolios: a long portfolio and a short portfolio. The long portfolio holds securities that the taxpayer hopes will benefit from a rising market. The short portfolio holds short positions that the taxpayer hopes will benefit from a declining market. If a taxpayer has a market-neutral strategy, holding the two portfolios in a market-neutral position protects the taxpayer from market movements, regardless of whether the market goes up or down. In other words, such a long-short strategy would establish a market-neutral position. When taxpayers also want to track an index, such as the S&P 500, this portfolio would not be market neutral.

Who invented long-short portfolios?

The first long-short equity fund is said to have been formed in 1949 by Alfred Winslow Jones. His objective was to “hedge investors from downside market swings by shorting certain stocks he expected to perform relatively poorly.”[3] Jones reportedly said, that with long and short portfolios, the taxpayer could “buy more good stocks without taking as much risk as someone who merely buys.”[4]

The long-short market-neutral position means that the portfolios generates investment returns whether the market moves up or down. This is because being both long and short reduces the taxpayer’s sensitivity to market volatility. As a result, long-short strategies “historically generate higher risk-adjusted returns with lower volatility” than simply holding only long positions in the equity markets.[5]

How are long-short portfolios structured?

The long portfolio is typically constructed using “low risk, high quality stocks across a highly diversified long-short global equity portfolio of large and small cap stocks.”[6] The short portfolio is typically constructed using borrowed securities that the taxpayer believes will decrease in value. The borrowed securities in the short portfolio, referred to as “short positions,”[7] typically “are riskier and lower quality”[8] securities than those included in the long portfolio.

The long and short portfolios are not equal in size. To provide the taxpayer with a net “long” market exposure, the long portfolio is generally larger than the short portfolio.[9] A taxpayer with a larger long portfolio is likely to be less sensitive (than equal long-short portfolios) to market movements and better able to withstand a declining market.

How is the short portfolio funded with short positions?

To sell securities short, the taxpayer borrows securities from a securities dealer and uses them to cover the short position by delivering them to a buyer. The taxpayer/borrower then enters into a loan agreement with the securities dealer/lender to return the borrowed shares (delivered to the buyer) at the end of the loan period, paying the lender a fee to borrow the securities plus the value of any dividends received on the borrowed shares (referred to as “in lieu of payments”) while the loan is outstanding. At the end of the loan period, the taxpayer/borrower closes out the short positions by purchasing securities in the open market and repays the loan.

If the taxpayer purchases the securities at a price that is lower than the price the taxpayer initially paid to the lender to borrow the securities,[10] the taxpayer profits from the transaction. If the market value of the borrowed securities has declined in value, the taxpayer/borrower will close out the loan with cheaper securities. Buying cheaper securities allows the taxpayer to generate a profit.[11] If, on the other hand, the market value increases, the taxpayer delivers more expensive securities to the lender, to close out the loan, generating a loss.

What are some benefits of holding long-short portfolios?

Long-short portfolios allow the taxpayer to (1) profit from appreciation in both portfolios; (2) harvest tax losses to apply against gains to optimize net after-tax returns; (3) acquire replacement securities that track the benchmark index; and (4) (properly structured) avoid application of the wash sales rule.

First, when the taxpayer combines tax-loss harvesting with both a long and a short portfolio, the taxpayer levers up, and the leverage increases standard deviation (from the mean), which increases the likelihood that the portfolios might overperform or underperform against the benchmark index.

Second, because the taxpayer holds more positions, holding a long-short portfolio increases the taxpayer’s opportunities to generate more capital gains and losses (which in turn creates more opportunities to loss-harvest losses).[12]

And third, a taxpayer with long and short portfolios can isolate the gains or losses on the portfolio securities from the portfolio’s overall sensitivity to general market movements. Isolating gains and losses on portfolio securities is referred to as “alpha,” while the portfolio’s sensitivity to overall market movements is referred to as “beta.” Holding both a long and a short portfolio—each of which tracks the same benchmark index but with different stocks—provides alpha. Depending on the taxpayer’s investment strategy, the strategy can—but need not—remove beta from the taxpayer’s portfolio.

Explain what you mean by alpha and beta?

“Alpha” and “beta” are the names given to two key investment metrics used to evaluate an investment’s performance and risk profile.

Alpha refers to returns (positive or negative) from the securities in the taxpayer’s investment portfolio when compared to a benchmark index such as the S&P 500. Alpha shows whether an investment is outperforming (positive alpha), or underperforming (negative alpha) compared to the designated benchmark. It is used to assess whether an investment adds value beyond those that would be available if the taxpayer were a passive investor benefiting from or hurting from general market movements. It is an important metric in evaluating whether actively managed funds are performing better than the market as a whole.

Beta refers to portfolio-wide volatility that results from overall market movements. Beta measures how sensitive the investment is to changes in market movements. It helps taxpayers assess risks and manage the volatility of their portfolio in relation to their risk profile. Because beta is based on historical market data, it is not a useful metric in assessing the future performance of the investment. A beta of 1, for example, shows that the investment moves with the market; a beta of less than 1 indicates lower volatility for the investment; and a beta of more than 1 shows the investment has higher volatility than the market as a whole.

Alpha shows how well an investment performs against benchmark expectations. Beta refers to how much the investment fluctuates when compared to market movements. Alpha measures excess returns while beta measures market sensitivities. These metrics are used to evaluate whether an investment meets the taxpayer’s goals for risks and returns.

What is “tax alpha”?

“Alpha” is a measure of portfolio-related performance. Similarly, “tax alpha” is a measure of tax efficiency in how the taxpayer’s investments perform. That is, whether the taxpayer’s after-tax return is improved (or reduced) when they use tax-efficient strategies in conjunction with their portfolio management strategies. In other words, tax alpha is a measure of the extra benefits accrued by an investor who is aware of the tax consequences of their trading decisions.

Can tax alpha be increased through tax-loss harvesting?

Yes. In fact, the desire to increase tax alpha is the raison d'être of tax-loss harvesting. Harvesting tax losses allows taxpayers to sell their depreciated securities to offset capital gains from appreciated securities. Tax alpha can also be increased, for example, when taxpayers hold capital assets for the long-term holding period; which, in turn, can reduce taxable income and increase after-tax returns.

Is there a “tax beta”?

No. As a measure of market volatility in a portfolio—it allows taxpayers to evaluate the additional risks they take on with a given investment—and as such can be used to evaluate tax-loss harvesting opportunities.

Tracking portfolio beta in conjunction with tax alpha can aid taxpayers in understanding the ways in which their investments fluctuate, and thus help them to understand the combined effect of their portfolio management and tax-efficiency strategies.

Digging deeper into this concept; combining long-short portfolios with tax-loss harvesting can provide taxpayers with opportunities to harvest more losses while deferring tax on more gains. It is possible that long-short strategies could result in positive tax alpha because taxpayers may be able to defer short-term gains on long positions until such time as these qualify as long-term gains for tax purposes.[13] This, in turn, could create an additional tax alpha opportunity on a specific investment in different tax years. It is possible that taxpayers who seek to maximize returns might hold portfolios with different securities than those that they might otherwise hold to minimize risk.

As a practical matter, AQR Capital Management (an investment advisory firm that writes about “tax-aware” investing) suggests that a portfolio that focuses on taxes might not be that different from a portfolio that is constructed without a specific tax focus.[14]

You mentioned an investment strategy that adds a passive direct index fund to long-short portfolios. What about that?

According to AQR, a taxpayer can receive additional tax benefits by adding a passive direct index fund to active long-short portfolios. This investment strategy takes alpha and beta into consideration. As AQR notes, “The turnover of a traditional active strategy causes capital gain realizations on both the active and market components of the strategy returns.”[15] On the other hand, AQR also notes that a “strategy that separates alpha from beta is aimed at the active exposures and enables the deferral of capital gain realizations on the passive market exposure.”[16]

Do the tax-loss harvesting opportunities decline over time?

Maybe. Depending on the taxpayer’s investment strategy, the pool of securities from which to harvest tax losses can decline over time. If a taxpayer simply harvests losses without also replacing the securities, available loss securities decline over time so that the taxpayer ultimately runs out of loss securities to sell.

A taxpayer engaged in direct indexing typically has more tax losses in the early years of the investment strategy than in later years. As was noted in The Tax Alpha Insider blog, “Tax alpha starts with a bang especially in volatile years and compounds but ultimately decays as the portfolio basis resets lower and lower following each harvested loss.”[17] This is because a taxpayer typically replaces loss securities with other benchmark securities at a higher tax basis. After all, the taxpayer is anticipating that the overall value of the benchmark index securities they hold in their long portfolio will increase over time. At a future date, a direct indexing taxpayer is likely to hold mostly gain positions.

As a result, a taxpayer who combines tax-loss harvesting with long-short portfolios, as compared to a direct indexing portfolio, is arguably more likely to benefit from tax-loss harvesting over time. Holding both a long and a short portfolio gives the taxpayer more opportunities to generate losses on the front end so that their ability to harvest losses might not decline over time. Decreasing leverage quickly can become difficult, however, because of gains that build up in the short portfolio.

What are some costs and risks associated with tax-loss harvesting and investing?

Some of the following observations on costs and risks are inherent in investing generally; they do not relate to a tax-loss harvesting strategy specifically.

All securities transactions have transaction costs. Obviously, when a taxpayer holds actively managed accounts, they will incur more costs than when they hold passive investments in, say, a broad-based index fund.[18] Direct indexing and long-short portfolios are actively managed portfolios, so they incur management and trading fees, as well as the costs associated with the leverage itself. Direct indexing involves less trading than a long-short portfolio so their associated trading-related fees will be lower than those associated with long-short strategies. Index funds, as passive investments, have minimal transaction costs compared to direct indexing and long-short portfolios.

When a taxpayer’s investment strategy includes short positions, this increases the taxpayer’s overall risk profile. In addition, leverage increases the amount of deviation from the benchmark index, up or down.

Taxpayers with short portfolios enter into short sales, borrowing securities to cover their short positions. They have obligations to return the borrowed securities to their lenders at the end of the loan period. They incur short sale fees and make substitute dividend payments (“in lieu of” payments) to their lenders equal to the amount of any dividends they received on the borrowed securities while the loan is outstanding. If the taxpayer is shorting in one portfolio, they can unintentionally be causing constructive sales, straddles or wash sales in other portfolios—possibly undoing some of the purported tax efficiencies.

Given the additional leverage in long-short portfolios, a taxpayer’s market risks increase. For example, long-short portfolios are likely to generate more capital losses than they would if the taxpayer were simply engaged in direct indexing. Long-short portfolios can underperform or overperform direct indexing[19] because holding both portfolios allows the taxpayer to hold more investment positions.