Recent headlines regarding potential capital gain tax increases targeted at the nation’s wealthiest investors have led to an increased focus on strategies that may help to manage tax liabilities. Opportunity Zones and Private Placement Life Insurance may be two options, but can come with long holding periods, complexity, and underlying investment options that may be difficult to underwrite.
One of the most liquid options uses public equities as a vehicle for tax benefit generation. Tax-loss harvesting can be as simple as selling a few positions near year end that are at a loss and buying back those stocks a month later to avoid wash sales. Commercially available options that have been around for decades take a more systematic approach to the same idea, but can come with some shortcomings that may decrease their long-term effectiveness.
There is an inherent conflict between holding an equity portfolio that seeks to track an index and trading actively to generate tax benefits. This conflict is primarily due to the fact that stock prices tend to rise over time (i.e., positive equity risk premium). As time passes and as tax losses are harvested, market value relative to cost basis increases, yielding fewer and fewer opportunities to harvest future losses. As a result, this approach winds up with a portfolio that tends to get “stuck” after a few years, resulting in little to no tax benefits being generated until the market sells off. Once “stuck,” investors may hold a relatively high-cost equity portfolio with elevated levels of tracking error versus the benchmark, with little to no tax benefit to show for it.
Even a modest amount of tax benefits generated for a few years can be helpful, but we believe the results can be vastly improved by taking a core equity portfolio and adding a modest long/short extension.
The short side of the extension is important to help the strategy consistently generate losses in both rising and falling market environments. As markets rise, short positions may be a helpful tool to generate tax losses. When markets fall, the long side of the portfolio may generate tax losses. The amount of the long/short extension, for example an additional 60% in a 130/30 strategy, may also increase the opportunity set of potential tax losses.
The long/short extension may also allow investors the option to pursue additional uncorrelated investment returns over the benchmark, potentially adding an additional amount of after-tax return on top of the benchmark return and any tax benefits generated.
More consistent and significant tax benefit generation may be a powerful benefit that can be helpful in a wide variety of use cases, including the ability to diversify concentrated stock holdings in a tax-efficient manner.