How the ticking clock affects tax-loss harvesting

Tax-loss harvesting is increasingly prevalent through applications like direct indexing, but academics and professionals haven't studied it widely, according to a new research paper.

The "complex strategy" of using net losses to reduce or eliminate capital gains taxes and cut income by up to $3,000 per year "makes sense" for wealthy investors in the higher brackets, said the working academic paper posted in August by Harry Mamaysky, a Columbia Business School professor and chief investment officer of asset management firm Quant Street Capital.

"Despite the prevalence of [tax-loss harvesting] in practice, there is only a small academic and practitioner literature focused on the topic," Mamaysky wrote. 

The method "is not suitable for everyone" and requires offsetting capital gains alongside the losses, he wrote, recommending that investors engage with the industry on the topic. 

"Investors should consult a financial advisor and a tax professional to fully understand how these strategies apply to their specific cases," Mamaysky added.

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Potential benefits for wealthy clients combined with the growing number of major wealth management firms designing technology and services around direct indexing have drawn hundreds of billions of dollars worth of investments into those products in recent years. The tax impact of investing directly into companies' stocks through separately managed accounts rather than using index funds with holdings across a whole sector or group such as the S&P 500 is fueling the appeal. 

As long as investors comply with "wash sale" rules forbidding them from buying a "substantially identical" security within 30 days of selling the stock at a loss, they can use tax-loss harvesting to offset capital gains through direct indexing in their portfolios.

Even though asset management firm Parametric, which is part of Morgan Stanley Investment Management, has been using those methods for more than three decades, they're "a relatively new concept" that is "helpful to dive in and understand" through research like Mamaysky's paper, according to Jeremy Milleson, Parametric's director of investment strategy. Milleson also delved into another key concept in direct indexing — a number called "tracking error," or the amount that an investment varies from its benchmark — in a recent blog on the firm's website.

"We actually look at the portfolio on a daily basis for an opportunity to realize losses in the portfolio," Milleson said in an interview, noting that Mamaysky's research displays how "tax management is an important consideration" in direct indexing. "If you own that ETF, for example, the whole market has to go down to have that tax benefit," Milleson added. "You can take advantage of that by owning those individual names."

Mamaysky's paper, which hasn't been published in an academic journal and is called "Tax-Loss Harvesting: A Primer," cites four other articles over roughly the past two decades about the tax strategy. While previous studies have calculated the annual tax value at a range of between 0.50% and 1%, Mamaysky's research suggests the "alpha" is between .30% and .65%, depending on the design of the models used in any estimates. Most of the benefits of tax-loss harvesting "accrue in the first few years of the strategy," according to Mamaysky's paper.

"We have shown that tax-loss harvesting needs two ingredients to work: First, there must be intermediate capital gains that can be offset by the realized losses," Mamaysky wrote. "Without this, the tax benefit of realized losses upon portfolio liquidation is exactly offset by the tax liability that arises from a lower cost basis." 

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"Second, either the tax savings generated from offsetting intermediate capital gains must be reinvested and earn a positive return over time, or the capital gains tax rate at the time of portfolio liquidation should be lower than the capital gains tax rate applied to offset intermediate capital gains," the paper continued. "The following all increase the tax benefit of tax-loss harvesting: lower stock return correlation, fewer years elapsed from the portfolio formation date and a larger differential between intermediate and terminal capital gains tax rates (with the terminal tax rates being lower)."

The paper's portfolio simulations assume investors liquidate their entire holdings after a given time span, and most calculations would be expected to display a higher value from tax-loss harvesting in the short-term because the capital gains rates fall when an investor has held an asset longer than a year, Milleson noted. 

The timing and a client's tax bracket and corresponding rate will always be "a big component of the value of tax-loss harvesting," he said. Mamaysky's research displays why it's important for advisors and clients to be thoughtful about how they try to tap into the advantages, according to Milleson.

"If you just open a portfolio and you don't have any need for the losses and then you liquidate it, then there's not really a benefit there," he said, pointing out that any extra capital losses above $3,000 in a given year can transfer forward into subsequent ones. 

"You can roll those losses over year to year and use them when they'll be beneficial," Milleson said. "Even if the client may not have the need for losses today, in the long-term perspective, there's still that benefit."