In the 1980s, a University of Chicago Booth School of Business professor tipped the first domino, beginning a series of events that would reimagine how financial advisors manage money for individuals. George Constantinides wrote “Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns.” Despite being a mouthful, his paper suggested that the tax code held a valuable option for investors: allowing them to realize short-term losses while deferring long-term gains.[1] First picked up by wealth managers for the ultra-rich, Constantinides's work is the foundation of direct indexing (DI).
As portfolio manager at Quorus, I regularly review research on direct indexing, tax loss harvesting, and tax alpha. I also manage direct index portfolios and helped build our after-tax backtesting tool, so it’s likely unsurprising that I’m bullish on the value of direct indexing for clients.
Beyond the value of DI, my second takeaway from my experience is that certain assumptions can have a major impact on the estimated value of tax loss harvesting. For advisors, it's essential to evaluate results and providers with a critical eye because there is plenty of wiggle room between the simplifying assumptions on paper and the real-world application for your clients.
In the sections that follow, I’ll cover two important and potentially unintuitive assumptions that DI researchers often make when calculating tax alpha, overview other assumptions to note, and finally share how we at Quorus calculate DI performance. The goal of this blog is to pull back the curtain on direct indexing and arm you with an understanding of how providers calculate the value of tax loss harvesting.
Let’s dig in.
Two Assumptions to Know
Researchers must make some assumptions regarding client profiles to measure the value of tax loss harvesting in portfolio simulations or historical backtests. These assumptions are important for advisors to evaluate when researching direct indexers because aggressive assumptions may make returns look strong. And if your client has a profile different from the standard assumptions, then their experience could be materially different from the base case.
I’ll start with two assumptions that are impactful and often aren’t intuitive for advisors new to direct indexing.
External Capital Gains
One of the most critical assumptions that researchers make is how much capital gains a client has each year and the classification of those gains (e.g., short-term, long-term). This assumption is mission-critical for advisors to understand because tax loss harvesting is valuable if and only if the client can offset capital gains.
For example, if you previously had a short-term capital gain of $10,000 and are taxed at a 40% marginal tax rate, you owe the IRS $4,000. If you offset that $10,000 gain with $10,000 in short-term capital losses, your net gain and tax bill are now $0. You are $4,000 better off than you were before.
Short-term capital gains are the most valuable to offset because they are taxed at a higher rate than long-term gains. If you offset an equal amount of long-term and short-term capital gains, the netted short-term gains save the client more in taxes.
There are three primary sources of short-term capital gains for investors:
- Liquidating assets with a holding period shorter than one year
- Receiving short-term capital gain allocations from pass-through investment vehicles (e.g., hedge funds)
- Holding derivative contracts whose profits are taxed as 60% long-term capital gain and 40% short-term capital gain on a marked-to-market basis (i.e., Section 1256 contracts) [2]
These sources are most prevalent for wealthy clients, particularly those with extensive investment portfolios.
That said, clients with limited short-term capital gains and more gains classified as long-term can still benefit from tax loss harvesting. Estimates for tax alpha for clients with only long-term gains that are regularly contributing to their portfolio is about 30 basis points annualized. [2]
The standard assumption, mainly for ease of calculation, is that an investor has unlimited short and long-term capital gains available to offset. This assumption reduces complexity in calculating tax benefits, but it doesn’t represent reality for most investors. Many clients, most really, won’t have unlimited short-term capital gains. For some, gains may be a mix of long-term and short-term, while others may only experience long-term gains.
Advisors should consider the expected capital gains profile of their clients and focus on delivering direct indexing to those who will benefit most from it. Does the client have regular short-term gains? Do they realize long-term capital gains from regular rebalancing, active mutual funds, or another source? Does the client expect to liquidate stock options from selling a small business? The more capital gains present in a client’s financial life, the more valuable direct indexing will be.
Reinvestment of Tax Refunds
As we covered above, the primary benefit of DI comes from offsetting capital gains with losses harvested within the portfolio. However, there is an additional benefit associated with reducing a client’s tax bill: the growth of reinvested tax savings.
In the example above, most researchers assume that the client reinvests the $4,000 tax savings into the direct index portfolio. In some ways, this makes sense. The DI portfolio generated the $4,000 value for the client, and in rational economic thinking, the client would reallocate that money from paying taxes to investing in the stock market. Further, it is a helpful way to compare DI portfolios to other investments because it allows the DI portfolio to internalize the value it creates.
Presumably, the client had the money to pay those taxes, and now that money can be allocated to the client’s investment portfolio instead of the IRS. The less intuitive part of assuming tax refunds are reinvested is that the tax refund can grow over time, increasing the value of tax loss harvesting and tax alpha.
In the real world, clients may not reinvest their tax savings. They may buy a sports car, handbag, vacation home, forget about it in their savings account, etc. Does this matter for evaluating the value of direct indexing? Well, on one hand, it’s difficult to compare the utility of a new purse to the compound growth of reinvested tax savings. On the other hand, DI provides clients with a benefit, and they can choose the best way to consume it.
While we may be agnostic to how clients consume their tax benefits, it’s important to know that your client's experience may differ from the empirical research.
Other Assumptions to Consider
There are other assumptions outside of reinvested tax refunds and external capital gains that are important to understand. The following are critical inputs for calculating the value of DI that advisors should consider when viewing results.
- Tax rates: What federal and state tax rates does the analysis use? Calculations often default to the highest federal and California rates.
- Contributions: How much does the client invest over the evaluation period? Larger and more frequent contributions will increase the value of tax management.
- Time Horizon: Shorter time horizons generally yield higher annualized tax alpha estimates because tax benefits decay with time; however, market performance can impact results.
- Liquidation: How is the evaluation period ended? Is the account liquidated or passed down to heirs through an estate? This assumption can significantly impact the final value of the portfolio.
- Wash sales: Does the analysis account for wash sales or assume a client can purchase identical securities? While ignoring wash sales makes the analysis straightforward, it ignores operational complexity in running direct index portfolios.
Quorus is Different; A Lot Different
At Quorus, we educate advisors about direct indexing and help them select the most valuable client relationships for tax management. In these conversations, the number one piece of feedback we heard was, “Help me understand and demonstrate the value of direct indexing for my clients.”
To help advisors with this thorny problem, we developed an after-tax backtesting tool that is customized to individual client profiles. We can customize tax rates, tracking error, loss harvesting aggressiveness, investment strategy, and expected capital gains for each client.
Further, we are unique because we ground our DI analysis in reality. We run backtests using the same optimization software that powers our live portfolios. That means our backtests mirror how we implement portfolios: daily optimizations, no perfect substitution (i.e., we reinvest harvested losses in other securities), wash sale avoidance, and auditable trade files.
To get even more nerdy, our analysis calculates a client’s taxes for each calendar year. Tax refunds are invested back into the portfolio in the days following April 15th, while tax payments are withdrawn.
Is this level of detail overkill? Maybe.
However, because we go through the effort of calculating after-tax returns at the client level, we can compare direct indexing to owning a comparable ETF. We help advisors move past generalities and focus on client-specific tradeoffs.
The wealth of academic research on the benefits of DI is a good reason to consider adding a tax loss harvesting solution to your practice. However, it is important to understand the value to your clients and practice. At Quorus, we deliver personalized analysis so advisors can assess the value of direct indexing for each of their clients and identify relationships that warrant the additional cost of a custom SMA.
Want to learn more?
If you’re interested in learning more about direct indexing or evaluating after-tax returns for your clients, email me at kyle@quorus.io.
Let’s chat.
[1] Constantinides, George M., Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns (August 1983). NBER Working Paper No. w1176
[2] Sosner, Nathan and Gromis, Michael and Krasner, Stanley, The Tax Benefits of Direct Indexing, and How They Are Affected by the Biden Tax Plan (May 24, 2022). The Journal of Beta Investment Strategies, Direct Indexing Special Issue 2022, 13 (2) 28-51
Disclosures
Investing in securities involves risks, including the risk of loss, including principal. Quorus Inc., is an RIA registered in the States of Connecticut and Pennsylvania. Neither regulator has approved this message.
Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Quorus has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation.
This content is provided for informational purposes only, as it was prepared without regard to any specific objectives, or financial circumstances, and should not be relied upon as legal, business, investment, or tax advice. References to any securities are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not intended as a recommendation to purchase or sell any security and performance of certain hypothetical scenarios described herein is not necessarily indicative of actual results. Any investments referred to, or described are not representative of all investments in strategies managed by Quorus, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
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