For taxable investors, an appreciating portfolio can be a mixed blessing. But regular loss harvesting isn’t the only way to reduce your portfolio’s tax bill, especially as its value rises. We share some important tax-management techniques for the future.
The goal for most long-term investors in the stock market is to build wealth through long-term appreciation. Despite some volatile periods in the last decade, the average annualized return of the S&P 500® over the 10 years through June 30 has been almost 13%. With this index as its benchmark, a direct indexing portfolio could not only capture this appreciation but also systematically increase total after-tax return—harvesting losses when available and deferring gains by holding onto the most appreciated lots.
The good news is that the account has grown in value over the decade. Yet as the portfolio has appreciated, the opportunity for harvesting losses has decreased over time. How many loss-harvesting opportunities are left depends on the scale of that appreciation, which can make the portfolio feel locked up.
Investors still have multiple tax-management techniques available at this stage. Let’s take a look at these techniques and when to use them.
How does tax management work in a direct indexing portfolio?
Working with their financial advisor, an investor has several decisions to make before their portfolio reaches the point of feeling locked up at some point in the future:
Choose their desired exposure and the best vehicle to get it
Investors may choose ETFs, which provide diversified, tax-efficient exposures to standard benchmarks at a low cost. For investors who prioritize active tax management and customization, a separately managed account (SMA) may be better. This typical vehicle for direct indexing can provide exposure to a wide range of indexes, harvesting tax losses and adding customizations like blended benchmarks or responsible investing screens.
Decide how to fund the account
Direct indexing investors can fund their SMAs with cash, in-kind securities or a combination of the two. With in-kind securities, the typical goal at inception is a tax-efficient transition to the benchmark. With cash, the investor and their advisor will decide on the exposure and customizations. The resulting portfolio aims to track the customized benchmark as tightly as possible.
As the SMA begins to appreciate after inception, the goal is to realize capital losses when available, while aiming to track the benchmark. Investors can use losses to offset current capital gains realized outside the SMA, which can help reduce overall portfolio taxes or be carried forward for use in the future. If the account is funded with legacy positions, the investor can use some losses to offset realized gains, reducing the risks from any positions held at inception.
Over the portfolio’s lifespan, as its value appreciates with the market, opportunities to harvest losses may diminish—but they won’t disappear. Even with the market’s strong appreciation over the last 10 years, portfolios experienced new losses to realize during volatile periods like 2020 and 2022. However, appreciated portfolios do tend to reach a point where gain deferral can become more important than loss harvesting. At that point, other tax management techniques become more useful.
Consider the benefits of active tax management
Contribute additional cash
Adding cash to a direct indexing portfolio can be helpful from both risk and tax management perspectives. This simple technique refreshes the basis of a portfolio, creating new lots with a higher basis that may be likely candidates for loss harvesting as the market fluctuates during more volatile periods.
For example, a direct indexing portfolio invested in the S&P 500® might hold 300 to 400 positions within the benchmark, managed at the lot level. The investor would hold multiple lots of most positions, which all have a different cost basis.
When making tax-management trades, managers would target the most tax-efficient lots first. They may use additional cash contributions to purchase a basket of securities that matches the benchmark’s overall risk profile, potentially filling in any underweights in the portfolio.
Donate appreciated securities
For investors who are charitably inclined, gifting securities from their direct indexing portfolios can help to reduce or eliminate tax liabilities. This technique provides the same deduction as donating cash, while allowing the investor to transfer out the tax liability of highly appreciated securities.
Portfolio managers could identify a list of securities that would reduce overall portfolio risk if specific lots were donated. Investors can also consider replacing the value of gifted securities with cash, which can help increase the portfolio’s cost basis.
Realize long-term gains
When investors face a steady supply of short-term realized gains that are taxed at the highest rate, they may benefit from strategically realizing long-term gains. This technique refreshes the basis at the lower long-term tax rate, which may create more potential for generating short-term losses in the future to offset the short-term gains.
Portfolio managers can provide a tax-lot analysis that highlights the potential benefits of strategic gain realization. Even investors who don’t need to increase short-term losses can benefit from gain realization, primarily to reduce their portfolio’s tracking error.
Maintain gain/loss match optimization
Some investors may not have additional cash to contribute to their portfolios. Others may be averse to using gain realization to increase basis. In these cases, it may be better to keep tax managing the portfolio in the traditional ways: using limited losses to offset some gains and strategically deferring others.
Benchmarks change over time, and customizations can change along with the investor’s needs and goals. In our view, portfolio managers should be prepared to adapt to these changes over time—continuing to track the benchmark, with the goal of long-term deferral until the eventual step-up in basis. If investors need to make withdrawals for short-term income, managers can help to make these tax efficient by using an optimization process that balances tracking error and gains.
The bottom line
An appreciated portfolio is a good problem to have, especially when there are several techniques to help unlock a locked-up portfolio. Whether contributing additional cash, gifting appreciated securities, realizing long-term gains or maintaining gain deferral through gain/loss match optimization, that choice is up to the investor and their advisor. For over three decades, Parametric has offered tools to help make these decisions easier.
Parametric and Morgan Stanley do not provide legal, tax or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
