Practical Applications of The Tax Benefits of Direct Indexing: Not a One-Size-Fits-All Formula

Abstract

In <ext-link><bold><italic>The Tax Benefits of Direct Indexing: Not a One-Size-Fits-All Formula</italic></bold></ext-link>, from the Summer 2022 issue of <bold><italic>The Journal of Beta Investment Strategies</italic></bold>, <bold>Nathan Sosner</bold> and <bold>Stanley Krasner</bold> (both at <bold>AQR Capital Management</bold>), and <bold>Michael Gromis</bold> (a student at <bold>Harvard Law School</bold>), explore the magnitude and sources of the tax benefit of a direct-indexing tax-loss-harvesting strategy. The authors note that capital losses realized by loss-harvesting strategies are most valuable when investors use them to offset short-term capital gains from other investments and that investors most likely to experience regular short-term capital gains are high-net-worth investors with allocations to hedge funds and derivatives. In fact, they show that only this subset of investors is situated to enjoy a long-run tax benefit from direct indexing that comes from the difference in short-term capital gains and long-term capital gains tax rates—what the authors call a <italic>character benefit</italic>. More typical investors, with mostly long-term capital gains from other investments, can only enjoy a deferral component of the tax benefit, which declines to zero as the strategy portfolio appreciates. However, the authors show that the deferral benefit is still available in the long run to those investors who make systematic contributions to their portfolios. Furthermore, the future tax liability that results from gain deferral can be reduced by combining the direct-indexing strategy with a charitable-giving program. Absent regular short-term losses or systematic contributions to the portfolio, the tax benefits of direct indexing decay and disappear after five years, on average. Given these nuances, it is important that advisors deepen their understanding of the tax-loss-harvesting strategies as platforms for implementing the strategies become more popular and widespread.