Elevating Tax-Loss Harvesting Strategies
A sophisticated strategy designed to help clients manage tax exposure on highly appreciated assets
What can advisors offer affluent clients who appear to have everything?
For wealth managers, one answer may be a strategically positioned investment that generates after tax alpha and unlocks unrealized gains.
Tax-loss harvesting involves selling investments at a loss to offset taxes owed on gains realized elsewhere in a portfolio. It is a powerful tool commonly used in equity portfolios, but it has an important limitation: investors do not always have losses available to harvest. That challenge can be especially pronounced in a U.S. stock market that has continued to reach new highs after roughly tripling over the past decade.
This is where a tax-aware long-short strategy can be particularly effective. This approach combines elements of hedge fund investing with personalized portfolio management by using leverage within an individual investment account to take long positions in some stocks and short positions in others. The objective is to generate returns while also creating a consistent opportunity to harvest losses across what may be hundreds of positions.
With equity markets near record highs and the AI boom having created a new wave of technology millionaires—many of whom face substantial tax consequences if they sell highly appreciated stock—this strategy is gaining momentum. At AQR Capital Management, a pioneer of the approach, assets in tax-aware long-short strategies have increased significantly over the past two years.
“Every client lives on after-tax returns, not pre-tax returns,” says Cliff Asness, co-founder of AQR. “Frankly, any taxable investor—regardless of wealth—is not being served as well as they could be by an investment process that ignores taxes.” We agree with Cliff.
Realizing Losses
Tax-aware long-short strategies can be more complex and more expensive than traditional approaches, and they are generally most effective for investors with meaningful capital gains. However, for clients in the right circumstances, they can be highly effective.
These strategies are typically most useful when an investor has significant unrealized capital gains elsewhere in their balance sheet, generally outside a diversified investment portfolio. Common examples include the anticipated sale of a private business, the disposition of low-basis concentrated stock, or the sale of a highly appreciated home as part of a downsizing plan.
To illustrate how a tax-aware long-short strategy works, consider a client who came to us with a concentrated position that had grown to be VERY large relative to the rest of the portfolio. The client was no longer comfortable holding that much wealth in a single stock and wanted to sell shares and diversify.
Selling that position outright could trigger a substantial tax liability because of the embedded capital gains. Instead, the client may use the highly appreciated shares as collateral to establish a portfolio of long and short exposures. This is typically implemented through margin and short selling rather than derivatives. In a portfolio that is, for example, 145% long and 45% short, the investor is more likely to generate losing positions and to realize them more quickly.
As with more traditional forms of tax-loss harvesting, those losses can be realized by selling select positions. The proceeds are then reinvested in economically similar securities to maintain the portfolio’s overall positioning, while the realized losses are used to offset capital gains elsewhere. Over time, the client can gradually reduce the concentrated holding while helping to minimize the associated tax burden through losses generated within the long-short strategy.
Some time later, if the client needs to access the asset for purposes such as funding education expenses or purchasing a second home, previously harvested losses may be available to help offset gains from the sale of that stock.
How Long-Short Portfolios Can Harvest Tax Losses
Long-short strategies are often implemented through separately managed accounts, which are professionally managed portfolios that can be tailored to each client’s specific needs. While these vehicles have existed on Wall Street for decades—primarily for high-net-worth investors—technological advances have made them easier to administer and more accessible than in the past.
Much of the demand has been driven by their usefulness in tax-loss harvesting, particularly in strategies such as direct indexing. In this approach, an investor owns the individual securities that make up a benchmark such as the S&P 500 rather than holding an index fund, creating more opportunities to harvest losses when they arise.
The key advantage of tax-loss harvesting strategies, including long-short approaches, is that clients retain flexibility in determining when to realize gains or losses on their investments.
The underlying stock-selection strategy may also seek to outperform an equity benchmark by approximately 0.8% annually before taxes. Asness has described the harvested losses as an added benefit layered on top of AQR’s established investment models, which support the firm’s broader platform. AQR’s tax-aware products build on its long-standing equity selection process while incorporating tax considerations into implementation. For example, if the signal to sell an appreciated stock is only modestly negative, a strategy may delay the sale until the position qualifies for long-term capital gains treatment.
“We are first and foremost focused on delivering pre-tax alpha,” Asness says. “We were fortunate that many aspects of our process naturally lent themselves to a tax-aware framework.”
Pre-tax alpha, as Asness puts it, is short for “outperforming the market.” No strategy can guarantee it will perform well, much less outperform the market. All of the strategies described carry the risk of investing in stocks as well as selling short. The holder of a short position exposes themselves to unlimited risk. If you are long a stock, you risk losing 100% of your investment. If a stock that is held short rises, there is no limit. This risk is mitigated by diversification across a large number of shares, limiting the exposure to any single short position.
A significant amount of wealth has been created in growth technology and AI-related companies, and many of these investors are now seeking ways to preserve and diversify that wealth in a tax-efficient manner.
This article includes excerpts adapted from Bloomberg.
https://www.bloomberg.com/news/features/2024-10-24/tax-loss-harvesting-wall-street-s-new-strategy-cuts-rich-americans-bills?sref=1kJVNqnU
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AQR Capital Management and Cliff Asness are not affiliated with B. Riley Wealth Management nor with any of its subsidiaries. Investing involves risk including loss of principal. Past performance does not guarantee future results. The use of margin is required for short positions and involves additional risk, including but not limited to, the potential for margin calls and forced liquidations. The information provided is not directed at any investor or category of investor and is provided solely as general information or general investment education. None of the information should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither B. Riley Wealth Management, Inc. nor its affiliates are undertaking to provide you with investment advice or recommendations of any kind. The information herein has been obtained from sources believed to be reliable, but we do not guarantee its accuracy or completeness. The views and opinions expressed in this article are those of the author and do not necessarily reflect those of B. Riley Wealth Management, Inc. Opinions are subject to change with market conditions. The information provided does not account for any individual investor’s specific financial situation, objectives, or risk tolerance. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice. B. Riley Wealth Management, Inc., does not provide tax or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.