Stock Gains Without All the Taxes? How the Hottest Trade on Wall Street Works
The stock-market surge has propelled the use of a new kind of tax-loss harvesting. We break it down.
With the stock market near record highs, it isn’t enough to be winning anymore. Wealthy investors are now obsessed with losing, too.
The hottest investment on Wall Street promises a magical-sounding mix of both: Index-beating performance that also comes with losses to offset capital-gains taxes.
Millions of investors are sitting on big gains in concentrated stockholdings, be they shares of Magnificent Seven tech giants, plain-vanilla index funds or employee shares of hot tech companies.
The traditional move would be to turn to direct indexing, a form of tax-loss harvesting that has been an investing mainstay since the early 2000s. There is now $1.1 trillion invested in that strategy, according to research firm Cerulli Associates.
But for many investors who have ridden this ebullient stock market, direct indexing is no longer generating the losses it once did.
So financial advisers are trying to turn up more losses for their clients by employing strategies that use leverage. Over $150 billion has flowed into this newer breed of tax-loss harvesting, known as long-short tax-aware, or tax-aware alpha, according to Brent Sullivan, who writes about the industry on his Substack, Tax Alpha Insider.
The strategy comes with some risks for investors.
Let’s start by looking at how direct indexing works.
If the S&P 500 is up 15% for the year, the goal is for the client’s portfolio to rise that much, while also distributing losses. These losses could be used to offset gains in highly appreciated securities elsewhere in the portfolio.
But direct indexing gradually loses steam as a method of generating losses as the market continues to rise. Around half of such portfolios industrywide are now “ossified,” meaning they are no longer generating losses, estimates Jon Diorio, head of U.S. wealth product at BlackRock.
A new strategy took shape. Hedge-fund firm AQR Capital Management developed the tax-aware long-short strategy for clients such as family offices and ultrawealthy individuals. Around five years ago, the firm and its rival, Quantinno Capital Management, began allowing individual investors and their advisers to tailor the strategy inside their own separately managed accounts, or SMAs.
Custodians, most notably Fidelity Investments, made the strategy accessible by lowering the investment minimums. It was a hit. AQR now manages nearly $70 billion in tax-aware long-short strategies, roughly 80% of which is in SMAs. Quantinno manages more than $48 billion. They have spawned numerous imitators.
Long-short managers generally aim for “alpha,” meaning they want to outperform the benchmark in addition to harvesting losses. The strategy must balance these aims.
The strategy has become so popular that Fidelity and Charles Schwab have recently instituted limits on new accounts.
Both strategies come with risks. Direct-indexing managers might not succeed in tracking the index if they can’t find appropriate substitutes for the stocks they sell. The Internal Revenue Service’s “wash sale” rule limits the ability to recognize a loss on the sale of stock if the same stock is purchased within 30 days before or after the sale.
Neither direct indexing nor long-short SMAs are likely to eliminate all capital gains in a bull market like this one. The losses they generate are often used to offset gains in other areas of the portfolio. For example, someone selling a stake in a business at the beginning of the year could invest the money into a long-short SMA to generate losses to offset some of their capital gains by the end of the year.
But holding on to the winners means new gains can build up over time within the strategy. Investors must eventually pay taxes on these if they cash out.
Michael Paulus, founder of wealth manager PCM Encore, recommends direct indexing for nearly all his clients, particularly those close to retirement who will need to sell highly appreciated stocks to fund it. Direct-indexing managers charge annual fees as low as 0.05%.
But he is more cautious about using long-short SMAs. He has used them for clients expecting a major one-time gain such as from the sale of a business or for clients who work in tech and get a large portion of their pay in stock. He otherwise avoids them.
Tax-aware long-short strategies can cost as much as 1.5% to 3%, including investment management, financing and borrowing fees.
“All else being equal, I’d probably rather cut the government a check than a hedge fund in Connecticut,” Paulus said.