2024 Q1 Newsletter – A Revolutionary Approach to Tax-Efficient Investing

SLK Private Wealth > Quarterly Letters > 2024 Q1 Newsletter – A Revolutionary Approach to Tax-Efficient Investing

“…in this world nothing can be said to be certain, except death and taxes.”

– Benjamin Franklin (1789)

Taxes have been a fundamental aspect of civilizations for millennia. The earliest known system of taxation was in Ancient Egypt, around 3000 BC, where the Pharaoh would collect 20% of the crops as a form of income tax. The Roman Empire developed a more sophisticated tax system, including a census to record citizens and their property for the calculation of sales, income, and inheritance tax. The concept of capital gains tax, which taxes the profit from the sale of an asset, emerged in the early 20th century, notably with the United States implementing it in 1913 following the ratification of the 16th Amendment.

The development of taxation systems by governments sparked an intricate dance with taxpayers, who persistently sought ways to minimize their tax burden. In the modern day, one common approach is the use of ‘tax-loss harvesting’, which involves selling investments that have experienced a loss and replacing them with similar investments, allowing the investor to realize, or “harvest”, these losses. These realized losses can then be used to offset capital gains in current or future years, effectively deferring the tax payment.

There are several benefits to deferring taxes. First, long-term capital gains benefit from a lower tax rate whereas short-term capital gains are taxed as ordinary income. Second, by deferring taxes, investors effectively keep more of their capital invested, benefiting from compound growth over time. This advantage is like an interest-free loan from the government, as the funds that would have gone towards taxes remain invested and continue to grow. Finally, investors can eliminate the capital gains tax altogether when passing their assets to their heirs or by donating appreciated assets to charity. Were Benjamin Franklin alive today, he may need to rethink his famous quote. The inevitability of taxes, especially at death, appears less certain.

The limits of tax-loss harvesting

Tax-loss harvesting, while a valuable strategy, comes with certain limitations. A key constraint is the finite amount of net capital losses that can be realized since markets generally trend upward over time. This limitation means that within a few years, most, if not all, tax loss harvesting opportunities could be exhausted, leading to what can be described as a ‘frozen portfolio’ consisting largely of unrealized gains.

A significant repercussion of a frozen portfolio is its tendency to become stale as investors increasingly avoid trading due to the tax implications associated with selling their positions. This hesitance to trade can lead to missed opportunities and a portfolio that no longer aligns with current market dynamics.

Moreover, a lack of trading can cause the portfolio to grow concentrated over time. This concentration is often driven by a handful of successful investments, which, while beneficial in terms of returns, can increase the risk profile of the portfolio (long-time AAPL owners would sympathize). A highly concentrated portfolio is less able to buffer against market volatility and sector-specific downturns.

Kevin Khang, Thomas Paradise, and Alan Cummings, in their study “Expected Loss Harvest from Tax-Loss Harvesting with Direct Indexing,” have provided empirical insight into these limitations. They concluded that tax-loss harvesting strategies on average reach a maximum cumulative loss level of about 30%, beyond which the portfolio is frozen. This finding underscores the point that while tax-loss harvesting can be beneficial, it is not an inexhaustible strategy and has a threshold beyond which its effectiveness diminishes.

Up to eleven

The primary challenge with traditional tax-loss harvesting strategies is markets generally go up, thereby limiting the opportunity to harvest losses. The solution to overcoming this challenge is a long/short implementation of the strategy. Incorporating a balanced mix of long positions (buying stocks) and short positions (selling stocks short), creates a more consistent and adaptable framework for tax-loss harvesting.

A typical long/short strategy involves investing in a portfolio where, for a $100 investment, $150 worth of stocks are bought, and concurrently, $50 worth of stocks are sold short. From an economic standpoint, this approach generates market-like returns since it maintains the same net market exposure of $100, but with a much broader scope for harvesting tax losses. Short positions, which generally lose value in a rising market, complement the long positions, creating a more dynamic and flexible approach to realizing losses. This counterbalancing effect ensures that regardless of market direction, the portfolio is positioned to capitalize on tax-loss harvesting opportunities, thereby enhancing the after-tax returns for investors. Unlike the long-only approach described previously, where tax benefits diminish over time as the portfolio appreciates, the long/short methodology maintains a perpetual cycle of tax-loss harvesting opportunities. This continuous cycle not only circumvents the issue of a ‘frozen’ portfolio but also sustains the tax advantages indefinitely.

Joseph Liberman, Stanley Krasner, Nathan Sosner, and Pedro Freitas examined the tax benefits of a long/short approach in their study “Beyond Direct Indexing: Dynamic Direct Long-Short Investing.” They compare the expected cumulative losses from a long-only strategy, which levels off at the 30% previously mentioned, against various long/short implementations. The 150/50 strategy described above can generate 30% of losses in its initial year and is projected to exceed 100% in realized losses within ten years. A more aggressive implementation could realize 100% of losses in as little as two years, ideal for those expecting substantial capital gains in a short period, often from selling major assets like a business or real estate. This enables deferring all taxes on gains from such sales. It is important to recognize that these figures represent tax losses, not actual economic losses, as the overall portfolio is expected to outperform the market.

A key advantage to this approach is it can be funded with either cash or appreciated securities, enabling investors who have stocks with a low cost basis to broaden their investment portfolio. This is possible because the losses from tax-loss harvesting can be applied to counterbalance the taxes owed from selling these low-basis stocks. Long-time investors are no longer constrained by a frozen portfolio.

Long/short tax-efficient investing represents a significant advancement in wealth management, effectively leveraging the intricacies of the tax system to benefit the savvy investor. Through innovation in technology, investors are presented with increasingly sophisticated tools to navigate the complex interplay between investment returns and tax liabilities. Please reach out to your SLK advisor should you wish to delve deeper into how you can benefit from these innovative tax-loss harvesting strategies.

Razmig Der-Tavitian, CFA, CAIA
Chief Investment Officer & Managing Partner
SLK Private Wealth