Miriam Gottfried & Peter Santilli (Wall Street Journal): Stock Gains Without All the Taxes? How the Hottest Trade on Wall Street Works
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.
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.
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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.
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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.
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Direct-indexing managers charge annual fees as low as 0.05%…Tax-aware long-short strategies can cost as much as 1.5% to 3%, including investment management, financing and borrowing fees.
Related:
Zachary R. Mider & Surya Mattu (Bloomberg): The Top 1% Reap Most From Tax Loophole Costing $48 Billion: The ETF industry is exploiting the tax break at an unprecedented scale.
What was once a minor leak in the US tax system is now a torrent that’s costing the government around $48 billion a year.
That’s the amount lost to the Treasury Department from a loophole used by exchange-traded funds to defer or avoid capital gains tax, according to new Bloomberg estimates. The savings go almost exclusively to the highest-earning Americans, the estimates show, and could be set to nearly double following a recent policy shift.
As with an individual, when a fund sells a stock for more than it paid, it’s responsible for tax on the capital gain. In the case of a mutual fund, that tax liability is passed on to investors.
But ETFs don’t always sell their assets. As part of the mechanism that keeps their prices in line with the value of their holdings, they often swap them with banks or other firms in exchange for fund shares. A 1969 law says such “in-kind” transactions don’t trigger a tax bill.
That means appreciated securities can be easily offloaded without a taxable gain, and most ETFs avoid them completely.
Even when a fund doesn’t have enough regular trading activity to let a manager get rid of an appreciated stock, there’s a workaround. The manager can ask a friendly firm — typically a bank or market maker — to make a big investment for a day or two. The stock can then be swapped away as the money is withdrawn.
Congress never spelled out why it provided the special tax break for “in-kind” fund withdrawals back in 1969, but whatever the reason, it wasn’t a big deal at the time. Mutual funds rarely took advantage of it. Only later, when ETFs were invented, did it start to be used routinely.
“Congress did not fully appreciate the magnitude of this benefit when it was initially enacted,” said Daniel Hemel, a law professor at New York University. “It’s an accidental tax break.”
