Direct Indexing with Tax-Loss Harvesting: The Importance of Held-Away Gains

Abstract

Direct indexing (DI) combined with tax-loss harvesting (TLH) is a popular approach to generate capital losses to offset a client’s capital gains, while attempting to track a specified index. To quantify the tax alpha of DI/TLH, we must make assumptions about the amount of client capital gains that can be offset. The most common simplifying assumption is that the client has unlimited long-term (LT) gains to be offset and either unlimited (or perhaps zero) short-term (ST) gains. We relax these assumptions by using a schedule of expected yearly LT and ST “held-away” net gains. We show that as yearly expected gains decrease, the effectiveness of DI/TLH also decreases. Instead of fully offsetting capital gains, some TLH capital losses become carryover losses. These are still valuable, but delay the conversion of capital losses into a tax benefit. We quantify this effect using our tax-aware backtester.