In this issue: Using an Active Indexing strategy to tax-efficiently divest of employer stock, opportunities, tradeoffs, and what makes one strategy different from the next? 

Corporate professionals who are hesitant to sell their employer stock because of the tax bill, can use the losses generated from an active indexing strategy to offset the gain from selling. What is an active indexing strategy? Rather than buy an index mutual fund, investors in an active index strategy buy the actual stocks in the index or a close approximation. Why? The problem with owning an index mutual fund is there is no way to harvest the losses in the underlying index. In any given year, there could be dozens if not hundreds of stocks in the index that trade at a loss, even if the index finishes up for the year. For example, in 2023 there were stocks in the S&P 500 Index which experienced a loss at some point in the year even though the index finished positive (see Figure 1 below). If an investor only owned one S&P 500 index mutual fund, they missed the opportunity to harvest the losses from those underlying stocks. That is a huge, missed opportunity, here's why: 

The IRS allows taxpayers to net stock gains with stock losses. The net result at the end of the calendar year is a taxable gain or taxable loss. Unused losses are carried forward to future years on Federal Tax Returns (state rules vary). This is especially important for executives of public companies who are routinely compensated in their employer stock. 

How I Use an Active Indexing Strategy for My Clients

Executives of publicly traded companies - Chubb, Johnson & Johnson, Google, Microsoft, for example - can use this strategy to tax-efficiently divest out of their company stock. Why is that important? Corporate professionals may be unwilling to sell their company stock due to the tax consequences - if they sell, they will incur an income tax or capital gains tax depending on their holding period. However, holding a large concentration in any one stock can be risky. 

For my clients who are reluctant to sell their company stock due to the tax bill, we use an active index strategy for the core of their taxable money (non-IRA or non-401k). We buy the underlying stocks in an index - or a close approximation - at varying entry points in the market to create different tax lots. Buying different tax lots creates additional tax loss harvesting opportunities - the ability to specifically identify which tax lot to sell. We then screen out the client's company stock if it’s included in the strategy, so we don't buy any more than what he or she may already own. As the year goes on, if some of the stocks trade at a loss, beyond a predetermined range, we book the loss for the client then immediately buy a like-kind security to stay fully invested. The client can then use the loss to offset the gain from selling his or her employer stock. 

We buy the underlying stocks in an index - or a close approximation - at varying entry points in the market to create different tax lots. Buying different tax lots creates additional tax loss harvesting opportunities - the ability to specifically identify which tax lot to sell.

 Figure 1 - Tax-loss Harvesting in an Up Year? 

The S&P 500 Index was up for the year, however, there were opportunities for tax-loss harvesting:

Tradeoffs and Solutions

Every investment has its tradeoffs. The tradeoffs with this strategy may include transaction costs and the cost of the  program. When weighing the costs versus the benefits  it’s important to add back the value of the losses harvested. For instance, Parametric – a leader in this space – “seeks up to 2% in after-tax excess returns on an annualized basis” by adding back in the value of tax-loss harvesting. 

Actively harvesting losses may lead to more losses harvested in the early years. This is because as the strategy employs active tax-loss harvesting techniques - selling at a loss and buying like-kind stocks at lower prices – this lowers the cost basis on the overall portfolio over time and could mean less opportunities to harvest losses in the future. If that happens there are solutions.

Charitably inclined clients can gift the low basis stocks in the strategy to a donor advised fund or gift directly to their favorite charity. Other clients plan to hold their stocks indefinitely and leave the portfolio to their kids who can, under current tax rules, inherit with a step-up in basis. There are other solutions beyond the scope of this post, one involving using a "short" bias to smooth out the tax-loss harvesting over time. Please reach out to me for further information. Ideally, you employ this strategy in the years you need the losses – when selling out of employer stock or you have a large gain somewhere else in your portfolio. 

Ideally, you employ an active index strategy in the years you need the losses – when selling out of employer stock or you have a large gain somewhere else in your portfolio. 

Not all Strategies are Created Equal

As more and more investment firms introduce similar strategies, it's important to note the differences. Tracking error measures how much the strategy differs from the underlying the index. Some strategies have wide tracking errors, while others hug the benchmark closely. It depends if you truly want index-like returns or if you are okay with some latitude. Also, how experienced is the manager? Do they have the teams, technology, and infrastructure to produce the desired effect? Can they smooth out the tax-loss harvesting so as not to clump in the early years, if that is important? Also, what are the fees? Fees are a drag on a portfolio's return. As independent advisors, we source from a variety of institutional quality strategies which we screen for tracking error, management tenure, fees, and other due diligence criteria. 

Finally, can the overall advisor help holistically in your financial planning? Maybe this strategy is or isn't for you? Or maybe a covered call strategy is a better fit or even an Exchange Fund? An advisor with experience in concentrated stock strategies can develop a plan suitable to your goals and objectives. 

As independent advisors, we have access to a variety of institutional quality strategies which we screen for tracking error, management tenure, fees and other due diligence criteria.

Final Thoughts

No one invests with the express purpose of taking a loss. But stock market investors know losses may occur.  Actively harvesting losses if they come up throughout the year takes those underlying losses and makes lemonade out of lemons. Executives sitting on large unrealized gains of their employer stock can use the losses generated to offset the gains from selling their employer stock. It's a win-win. The executive diversifies out of their employer stock but does so in a smart way. I believe in index mutual funds, but I also believe index funds are not enough for executives routinely paid in their employer stock. In my opinion, having an Active Indexing strategy is a better approach.

Are you sitting on a large unrealized gain in your stock portfolio? 

Email me to schedule a complimentary stock analysis. 

See also my article in Kiplinger's: 4 Ways to Dilute a Concentrated Stock Position

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Disclaimer:

Past performance is not a guarantee of future results. This strategy isn't right for everyone, as it requires a sufficient amount of capital to implement effectively. The views and opinions expressed in this post are solely those of the author and do not represent those of, nor should they be attributed to Summit Financial LLC.

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