--- title: Elm Wealth Research | Tax Matters description: Tax Matters | Regular Elm Posts --- [![Elm Partners](https://insights.elmwealth.com/hs-fs/hubfs/elm%20logo%20mini.png?width=100&height=100&name=elm%20logo%20mini.png "Elm Partners")](http://elmwealth.com/) Open main menu Close main menu # Elm Wealth Research Select Category Featured Insights How Elm Works In the News Investing 101 Risk and Return Tax Matters Uncategorized Posts about: ## Tax Matters ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/113-tax-harvest-banner-1024x488.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [Direct Indexed Tax Loss Harvesting: Is the Juice Worth the Squeeze?](https://insights.elmwealth.com/elm-wealth-research/direct-indexing) Aug 27, 2024, 12:00:00 AM August 27, 2024 Tax Matters ## Direct Indexed Tax Loss Harvesting: Is the Juice Worth the Squeeze? *By Victor Haghani and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-11335) Estimated reading time: 6 min. The content on this page is being provided as general market commentary and for educational purposes only. It does not constitute any form of investment advice, or any form of recommendation to buy or sell any securities or adopt any investment strategy mentioned herein, or any form of advertisement for Elm Wealth services or strategies. Any investment strategies and investment results discussed herein are for illustration purposes only in the context of the commentary, and do not reflect actual or hypothetical Elm Wealth strategies or results, or an offer to provide such strategies or results. This content is intended only to provide observations and views of the author(s) at the time of writing, both of which are subject to change at any time without prior notice. The information contained in the commentaries is derived from sources deemed by Elm Wealth to be reliable but its accuracy and completeness cannot be guaranteed. This material does not have regard to specific investment objectives, financial situation and the particular needs of any specific reader. Any views regarding future prospects may or may not be realized. Past performance is no guarantee of future results. ### Introduction Most people have come to agree that investing in low cost, diversified index funds is a good idea. Most people also like paying less in taxes and deferring their payment into the future.[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-11335) Direct Indexed Tax Loss Harvesting (DI) programs combine these benefits into one package. And wealth managers like them too, as they can charge extra fees by putting their clients into DI programs rather than steering them into index funds offered by Vanguard or Blackrock. Investors have been so convinced of the benefits of DI that Goldman Sachs, Morgan Stanley and JPMorgan manage upward of $300 billion in these programs.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-11335) In this note, we’re going to throw some cold water on the DI love-fest by explaining why most tax-sensitive investors would be better off with a simpler approach to tax loss harvesting.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-11335) We call this approach Segmented ETF investing, and it involves building your desired portfolio using low-cost sector and (optionally) international ETFs. Segmented ETF investing is expected to generate a similar amount of tax losses as Direct Indexing, but without DI’s costs, risks and limits on diversification. The main problems of Direct Indexing stem from the difficulties of attempting to harvest single-name losses, while tightly tracking a benchmark index and complying with the Wash Sale rule. ### How does Direct Indexed Tax Loss Harvesting work? Most DI programs involve a separately managed brokerage account in which the investment manager buys a portfolio of hundreds of individual US stocks, with the goal of matching an index such as the S&P 500.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-11335) Then, the manager routinely sells any stocks below their cost basis in order to realize those capital losses.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-11335) Once a loss is realized, 30 days must elapse before the same stock can be repurchased – the “Wash Sale” rule – so the manager must buy different stocks to replace those which were sold. In doing so, they attempt to keep the portfolio statistically matching its benchmark index as closely as possible – but it’s impossible to perfectly match the benchmark once harvesting has commenced. ### How much capital losses should you expect to realize? To evaluate DI against alternatives, we need a sense of the magnitude of losses we can expect to realize, and what it depends on. Let’s say there was no Wash Sale rule, so you can realize losses anytime they’re available without changing your portfolio composition. For each stock, the amount of losses we should expect is related to the value of a put option on the stock.[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-11335) Just as with a put option, the expected harvest will depend on the stock’s volatility, its dividend yield, the risk-free rate and the horizon. In the chart below, we show an estimate of expected harvesting over different horizons and volatility levels.[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-11335) The average volatility of individual US stocks over the past five years has been 35%, as shown on the chart above. Notice that the amount of losses harvested is roughly proportional to the stock’s volatility. This makes it pretty clear why DI was developed: individual stocks are much more volatile than broad stock indexes. Notice also that as horizon lengthens, the amount of expected harvesting increases (as shown by how much each line rises above the line below it), but by less and less. We’ll come back to discuss the implications of these characteristics shortly. ### Direct Indexing headwinds There are three major consequences from complying with the Wash Sale rule, which together reduce the amount of harvesting expected in real-world DI programs: 1. Over time, the portfolio will not match the index exactly and may earn higher or lower returns than the index. This is known as “tracking error.” 2. Managers and clients are worried about too much tracking error – with reason, because it can be hard or impossible to distinguish “random” tracking error from systematic underperformance. As a result, managers generally operate under a relatively tight tracking-error constraint, which can significantly limit the amount of harvesting available. 3. In the long term, some of the tracking error will be hard-baked into the portfolio, since bringing the portfolio back to the index would realize capital gains which is at odds with the tax-loss harvesting objective. One particularly disturbing aspect of DI tracking error is that there is reason to fear it has a negative expected return. Whenever an investment strategy veers away from the market portfolio, it is engaging in a zero-sum activity requiring some other market participant to be on the other side of the trades it is doing. The trades that DI portfolios need to make are largely predictable by sophisticated market participants. While it’s not possible to know exactly who is on the other side of DI trades, we do know that there are a number of hedge funds and trading firms – Citadel, RenTec, Virtu and DE Shaw, to name just a few – that make a pretty steady and sumptuous living by being at the top of the stock-trading food chain. With the passage of time and the general expected upward drift of the stock market, there will be fewer and fewer tax loss harvesting opportunities for the portfolio. Eventually the portfolio will have investments almost entirely with unrealized gains. This is mitigated to a small degree by the potential of investing incoming dividends, although with the 1.25% US stock market dividend yield, this doesn’t help much over typical horizons. Unfortunately, even though a “seasoned” DI portfolio may not be generating significant harvesting opportunities, it’s still a complex portfolio of hundreds of stocks which must be monitored and re-balanced, and will usually continue to be subject to DI management fees. ### A better way: Segmented ETF portfolios We believe that for most investors, Segmented ETF investing is a better way to combine the benefits of index investing with tax-loss harvesting. Start by choosing the baseline portfolio of asset classes that is right for you. Next, build your portfolio using the most segmented, broadest range of low-cost index ETFs to represent that baseline. For example, the broad US stock market can be segmented into eleven low-cost sector ETFs, and regional international ETFs can be used for the broad non-US stock market if desired. Finally, realize losses in that portfolio of ETFs whenever available. *The key here is that this can typically be done with considerably less tracking risk – and effort – than in Direct Indexing.* This is because multiple ETFs tracking similar, but not identical, indexes are available for most asset buckets. For example, there are multiple “flavors” available in ETF form for the US Real-estate sector – they’re different enough that moving between them doesn’t trigger the Wash-Sale rule, but similar enough that switches introduce much less tracking error compared to Direct Indexing. Recall that the expected amount of harvested losses is roughly proportional to the volatility of the assets in the portfolio. Industry sector ETFs and regional international ETFs are, on average, more volatile than the broad stock market, and have exhibited about 70% of the volatility as the average individual US stock. The table below compares realized volatility over the past five years.[9](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-9-11335) | | Realized Annual Volatility | | --- | --- | | US Single Stock Average | 35.1% | | US Sector Average | 25.2% | | S&P 500 | 21.2% | | Intl. Region Average | 21.1% | | Intl. Total Market | 19.6% | To a first approximation, a TLH program using sector ETFs would deliver about 70% of the capital losses that a DI program could potentially generate – but remember that most DI programs do not deliver on their full potential, because most programs put a limit on tracking risk. From our own experience and from discussions with people who have been in popular DI programs, we believe these programs typically harvest less than 70% of their potential harvesting, were tracking risk not a concern. In summary: *you should expect roughly the same amount of loss harvesting from a portfolio of sector and regional international ETFs as can be expected from Direct Indexing with typical limits on tracking risk.* ### Segmented ETF investing: have your cake, and eat it too Segmented ETF investing is superior to Direct Indexing in almost every dimension beyond the roughly equivalent expected harvesting generated by the two approaches. 1. Tax-loss harvesting an ETF portfolio is usually offered for zero additional fee from most ETF portfolio managers. The weighted average expense ratio of the underlying ETFs in a segmented ETF portfolio is 0.1% or lower. This compares to fees for DI of around 0.35% for very large accounts, and in many cases more than 1%. For most investors, the effective cost of these fees is considerably higher due to IRS limits on deducting managed account fees against income. Such fees can completely eliminate the expected risk-adjusted benefit of Tax-Loss Harvesting for many investors. 2. Segmented ETF investing involves much lower tracking risk and, more critically, no reason to believe that the tracking error will be negative. 3. The Segmented ETF portfolio will continue to represent the desired baseline, rather than drift into an unbalanced single stock portfolio with baked-in tracking risk versus the desired index and the need for ongoing management even when the portfolio has limited opportunities for generating capital losses. 4. Another advantage of the Segmented ETF approach is that it gives you the ability to choose a more diversified baseline, including exposure to international equities, rather than being limited to a portfolio of several hundred of the largest US stocks. For example, Vanguard’s eleven US industry sector ETFs give exposure to over 2,500 individual US stocks, and their international ETFs give exposure to another 10,000 stocks! Recent research has highlighted the importance of investing with the broadest diversification possible by showing that the best-performing 4% of listed companies account for the net gain for the entire US stock market since 1926.[10](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-10-11335) A DI program which invests in just 10% or less of available stocks runs the risk of missing out on some of those 4%. There is one advantage of DI worth noting, which is that it is expected to generate a steadier stream of harvested losses than a Segmented ETF portfolio. This is because the idiosyncratic risk of individual stocks is much higher than that of industry sectors or international regions. Even if the market goes up, there will usually be quite a few individual stocks that will offer the opportunity to realize losses. If desired, the lumpiness of the capital losses generated by a Segmented ETF approach can be offset by owning a modest extra amount of each ETF. This hedge will compensate you for having fewer losses to realize if the market goes up. Both approaches can be customized to reflect your desire to underweight a particular sector, such as a finance industry professional wanting to avoid financial stocks. However, there are some customizations – such as wanting to only own companies with headquarters in particular US states – which Segmented ETF investing will not be able to accommodate. ### Conclusion: Don’t Let the Tail Wag the Dog We believe the all-in net benefit of Direct Indexing programs can be improved upon for many investors by instead taking advantage of Segmented ETF investing, and harvesting losses if and when they present themselves. In short, why wouldn’t you prefer an approach which delivers about the same expected amount of capital losses via a more diversified portfolio, but without the high fees, risks and complexity of investing in hundreds of individual stocks? ### Investors with an abundance of short-term capital gains For investors who tend to have a steady stream of short-term capital gains, the conventional tax-loss harvesting approach can be significantly improved upon – and in a seemingly counter-intuitive way. Instead of trying to defer realizing a long-term gain as long as possible, it can make sense to realize the gain immediately after one year has passed since purchase and the gain becomes subject to the preferential long-term tax rate. If the asset is sold and repurchased, the basis in the asset and the “basis clock” are both reset, thereby creating the option to realize a valuable short-term loss if the asset falls in the year ahead. We call this a “clock reset” strategy. The benefits of the Segmented ETF approach over the DI approach hold in mostly the same ways discussed above for this flavor of Tax-Loss Harvesting, too. For more details, see our research note: [When it Pays to Pay Capital Gains (2019)](https://elmwealth.com/when-it-pays-to-pay/). --- ### Further Reading and References - Haghani, V. (2015). [“Infographic: How much do taxes matter in investing?”](https://elmwealth.com/sharing-your-drink-with-the-taxman/) *Elm Wealth.* - Haghani, V. (2017.) [“Tax-Efficient Investing for US Citizens Long-Term Resident in the UK.”](https://elmwealth.com/tax-efficient-investing-for-us-citizens-long-term-resident-in-the-uk/) *Elm Wealth.* - Haghani, V. and White, J. (2017.) [“How Much Should the Tax Tail Wag the Asset Allocation Dog?”](https://elmwealth.com/how-much-should-the-tax-tail-wag-the-asset-allocation-dog-a-rule-of-thumb-for-weighing-capital-gains-taxes-in-portfolio-rebalancing-decisions/) *Elm Wealth.* - Haghani, V. and White, J. (2018.) [“US Tax Reform Leaves Even Less of the Pie for Individual Investors in Alternatives.”](https://elmwealth.com/us-tax-reform-leaves-even-less-pie-investors-alternatives/) *Elm Wealth.* - Haghani, V., Hilibrand, L. and White, J. (2019.) [“When it Pays to Pay Capital Gains.”](https://elmwealth.com/when-it-pays-to-pay/) *Elm Wealth.* - Haghani, V. and White, J. (2020.) [“To Realize, or Not to Realize.”](https://elmwealth.com/to-realize-or-not-to-realize/) *Elm Wealth.* - Haghani, V. and White, J. (2023.) [“Chapter 17: Tax Matters.”](https://www.amazon.com/Missing-Billionaires-Better-Financial-Decisions/dp/1119747910) *The Missing Billionaires: A Guide to Better Financial Decisions.* --- 1. This is not an offer or solicitation to invest, nor are we tax experts. **Past returns are not indicative of future performance.** Thank you to our Elm partner Jerry Bell, Larry Bernstein and Vlad Ragulin for their comments and encouragement. 2. However, sometimes there are good reasons to pay taxes sooner rather than later, such as if an investor expects higher tax rates in the future and/or wants to reduce tax rate risk. 3. “The Direct Indexing Landscape,” March 2023, *Morningstar.* More than $260 billion at the end of 2022. 4. We recognize there are some special situations where DI may make sense, and we’re also limiting our discussion to long-only programs that do not use leverage and shorting. 5. Some DI programs do allow a modicum of international diversification but implemented using ADRs which add another layer of costs and don’t exist for many foreign stocks. 6. Either to offset same-period gains, or carry forward the losses to offset future gains. 7. The right to sell the stock at a pre-agreed strike price at an agreed future option expiration date. In fact, the value of harvest to a given horizon is well-represented by what is called a lookback put option, where the payoff is a function of the lowest price the stock hit over the horizon. 8. Assuming weekly harvesting of one stock to the horizon, 4% risk-free rate, and 2% dividends. We recognize that it’s actually the expected value of harvesting, not the expected quantity, which is directly related to the value of put options, and not dependent on the stock’s expected return, but we’ve somewhat elided this distinction in the interest of readability. 9. Assuming weekly harvesting of one stock to the horizon, 4% risk-free rate, and 2% dividends. We recognize that it’s actually the expected value of harvesting, not the expected quantity – which is directly related to the value of put options, and not dependent on the stock’s expected return – but we’ve somewhat elided this distinction in the interest of readability. 10. Bessembinder, H. (2020). “Wealth Creation in the U.S. Public Stock Markets 1926 to 2019.” *SSRN.* [Elm Admin](https://insights.elmwealth.com/elm-wealth-research/author/elm-admin) [Read More](https://insights.elmwealth.com/elm-wealth-research/direct-indexing) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/bitcoin-sizing-840x420-1.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [Bitcoin is Nothing Either Good or Bad, but Sizing Makes It So](https://insights.elmwealth.com/elm-wealth-research/bitcoin-allocation-investment-sizing) Jul 7, 2022, 12:00:00 AM July 7, 2022 Tax Matters ## Bitcoin is Nothing Either Good or Bad, but Sizing Makes It So *By Victor Haghani and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-5455) *“There is nothing either good or bad, but thinking makes it so.”*   – William Shakespeare, *Hamlet* Act II (1602). If you had put $100,000 of your savings into Bitcoin at the end of 2020 and are still HODLring (crypto-nese for “holding on for dear life”) those coins today, you’d be down 20% on your investment given its drop in price from $25,000 to $20,000 (as of July 5th). If going long was no good, how about going short? An investor who put $100,000 into a crypto-brokerage account to short $100,000 of Bitcoin, with no further trading, would have been wiped out just a few months later in mid-February 2021 when Bitcoin more than doubled. This kind of shorting is effectively a form of automatic doubling down, since as the value of the asset goes up, the value of the capital supporting it goes down, causing the short position to get bigger and bigger (quickly) relative to capital.[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-5455) So, while “buy and hold” is a real strategy, “sell and hold” isn’t generally workable in practice. Instead, the short position that most closely represents the opposite of the buy-and-hold long position can be thought of as funding an account with that same $100,000 and then establishing and managing the short position so that at all times the size of the short is equal to the account’s liquidation value. How would this managed short have done since the end of 2020? While avoiding total wipeout, an investor shorting Bitcoin in this way would still have lost 50%. That’s right…over the past 18 months, you’d be down 20% from a 100% Bitcoin long position, *and* down 50% from the opposite managed short.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-5455) Naturally, this seems strange and unfortunate! To help understand why it’s the case, we’re going to see if there’s some other constant proportion of capital – other than 100% long or 100% short – that the investor could have maintained, with regular rebalancing, which would have turned a profit. We could simply search over all possible constant proportions to see which gave the best result over this period, but before we do that, let’s reason from first principles to figure out what we should expect to find. We tend to think about the quality of an investment by calculating its historical Sharpe Ratio, which takes the realized return of an asset in excess of the risk-free rate and divides it by the asset’s risk. Over this period, Bitcoin’s realized Sharpe Ratio, *calculated from average daily returns,* was +0.2. (for a deeper dive into how Bitcoin could have had a negative return of 20% but a positive Sharpe Ratio, see this footnote ➚)[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-5455) This suggests that Bitcoin was a fair, but not great, investment over this period – by comparison, broad equity markets have expected Sharpe Ratios of around 0.3. The optimal allocation to not-so-great, but very risky investments should be fairly small, so if there’s a capital proportion that’s profitable at all, we’d expect it to be fairly small too. And indeed, this is exactly what we find, as indicated in the chart below. The maximum profit of $3,000 was realized for an investor who kept a constant 25% of capital in Bitcoin over the whole period.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-5455) In fact, any positive proportional investment up to about 50% would have resulted in a profit.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-5455) However, you don’t make twice the profit from taking twice the exposure; in fact, at 50% exposure, the profit is zero, rather than two times $3,000. Note that this is not a buy-and-hold strategy; to maintain a constant proportion of capital in an asset, regular rebalancing is required.[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-5455) We can also see that there are not any constant proportions generating a profit from both the long and short sides. You can *lose* money from a wide range of symmetric longs and shorts, but the only way to make money was to have constant long exposure in the range 0% to 50%. Put another way, you have to both correctly judge the quality of the investment, and then size your investment consistently with that quality, and getting either materially wrong will generally result in losses. There are a few things we can take away from this mini case study: 1. These ideas are not specific to Bitcoin. We chose Bitcoin to illustrate them because they are easiest to see for highly volatile assets, and there are few assets that have been more volatile. 2. We can’t say that an investment is good or bad without considering how we will manage its sizing over time: sizing is as important as evaluating an investment’s expected risk and return. 3. While there are an infinite set of investment strategies involving a given asset,[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-5455) we can learn a lot from focusing on the simplest strategy: Constant Proportion investing. 4. Among Constant Proportion investment strategies, there will be a range of investment sizes that will be profitable, with sizing above and below that rapidly becoming increasingly unprofitable. And the range of profitable sizes is strongly related to the quality of the investment. 5. For a given investment, the realistic strategies which turn a profit are typically quite a small subset of the infinite number of total strategies to choose from. --- 1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. **Past returns are not indicative of future performance.** 2. For example, if Bitcoin goes up 50%, the size of the position relative to the amount of capital supporting it would have moved from 1:1 to 3:1. Such an approach requires an unlimited amount of capital, which is an amount few real-world investors have access to. A leveraged long position requires the same sort of position management, since as the asset goes down, capital goes down faster, and the investor will need to sell some of the asset to keep the leverage ratio constant. 3. You can read more about why this is the case in [George Costanza At It Again: The Leveraged ETF Episode (2020).](https://elmwealth.com/george-costanza-at-it-again/) Throughout, we assume daily rebalancing, no transactions costs, no borrow fees and a zero risk-free rate. All data from Yahoo Finance. 4. The reason the Sharpe Ratio was positive even though the Compound return over the period was negative is because Sharpe Ratio is computed using the Arithmetic average daily return of Bitcoin over the period, which for a risky asset will always be higher than the Compound, or Geometric average, return. Under some stylized assumptions, the difference between the Compound Return and the Arithmetic Return of a risky asset is equal to one-half of the variance of returns, a quantity known as “variance drag.”   For Bitcoin over this period, the variance drag was about 30% per annum (*30% = 0.5 \* 0.772* )! The Arithmetic Return was not sufficiently positive to offset the 30% variance drag, and so the Geometric Return was negative, but it’s the Arithmetic Return that ultimately determines the quality of a regularly rebalanced investment opportunity. Another perspective is to say that Bitcoin’s realized Sharpe Ratio would be positive as long as it’s Compound Return was better than -30% pa, given its realized volatility.   For a simple example of variance drag, consider an asset that goes up and down 10% each day for 10 days. The average daily return is 0, because it went up 10% an equal number of times as it went down 10% – but the Compound return will be negative because every time it goes up 10% and then down 10%, the asset winds up 1% lower than where it started, and so the Compound return will be negative. That’s the effect of volatility, and boy has Bitcoin been volatile! 5. Readers familiar with the bet-sizing literature will recognize that the 25% proportion of capital corresponds to the Kelly Criterion, which over many bets– and here we have 557 daily bets– gives the highest end wealth. The Kelly calculation takes the Sharpe Ratio of 0.2 and divides it by the standard deviation of returns of about 80%, to arrive at a bet size of *0.2 / 0.8 = 25%* . 6. Note that we will not find cases where one can find long and short fractions that would both make money, i.e. the range of profitable proportional sizing will always start at 0 and either go positive or negative from there. 7. Over this period, it didn’t make a material difference if you rebalance daily, weekly, or monthly. The Sharpe Ratios based on weekly and monthly returns were 0.21 and 0.23. 8. For example, strategies involving buying or selling puts or calls, or other kinds of dynamic scaling strategies. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/bitcoin-allocation-investment-sizing) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/092-options-main.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [Do Options Belong in the Portfolios of Individual Investors?](https://insights.elmwealth.com/elm-wealth-research/do-options-belong-in-portfolios) Mar 23, 2022, 12:00:00 AM March 23, 2022 Tax Matters ## Do Options Belong in the Portfolios of Individual Investors? *By Victor Haghani and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-5208) Judging by retail investor stock option trading volumes, the answer would seem to be an emphatic and resounding “YES!” For the first time since the introduction of listed equity options in 1973, the average daily notional trading volume of options on individual stocks has matched that of the underlying stocks themselves – at about $450 billion per day – with retail investors reckoned to account for about a quarter of this activity. On top of this is another $1 trillion per day in trading in options on stock indexes, plus further volume in non-exchange traded activity in structured products and exotic options.[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-5208) In our article just published in the Journal of Derivatives, written with our friend and Elm investor Vlad Ragulin, we ask whether options make sense for a broad class of investors. The Base-Case investor that we use throughout our analysis is risk-averse, with preferences modeled on a typical Elm investor – indeed, pretty close to those held by Vic, James and Vlad.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-5208) Of course, one perspective on whether all this options trading makes sense is to argue that anything people do voluntarily must be in accord with their preferences and therefore is just fine. This has become a popular line of reasoning, but would have resulted in one of the shortest research articles ever.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-5208) Instead, we take a less reductive approach, and start by defining what it means for options to “make sense” for our Base-Case investor. The use of options can have a complex impact on an investor’s portfolio – in practice, they can transform the expected return, risk and shape of the distributions of outcomes. As we’ve discussed in many previous articles, Expected Utility is the natural metric for making choices between different combinations of risk and return, and it can handle ranking arbitrary shapes of return distribution as well. So we’ll say that a particular options strategy warrants a place in an individual’s portfolio if it increases his Expected Utility. Here are our main findings: - Under classic textbook assumptions, fairly priced options don’t add Expected Utility, and therefore don’t make sense for our Base-Case investor.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-5208) - If the investor cannot rebalance his portfolio frequently and/or the risky asset is prone to discontinuous price jumps or high transaction costs, then options can add Expected Utility by effectively replacing the continuous rebalancing that the investor is unable to do directly. However, the benefit from this use of options is very, very small in typical cases. This situation would most commonly call for *selling* a small amount of options, as that’s the correct options position for rebalancing an unlevered risky asset to a constant portfolio weight. - When we relax the other textbook assumptions one by one, we find that fair options still don’t add much value for an investor who is willing to periodically rebalance his portfolio to account for changes in the investing environment, such as the return and risk profile of risky assets, and his current degree of risk-aversion. - Turning to the use of far out-of-the-money put options as portfolio insurance, we compare buying insurance on your portfolio to buying insurance on your home. We conclude that if the probability of the risky part of your portfolio “burning to the ground” is at least as likely as your home going up in smoke, then buying options for protection might make sense, depending on how they are priced. However, it’s harder to know the true odds of a massive stock market decline than of estimating the risk to your house, and also in practice it’s difficult to buy portfolio protection that only covers a huge drop in value without also paying – and perhaps overpaying – for protection against smaller declines as well. - At first it may seem strange to find a bad investment, like an options strategy which doesn’t add Expected Utility, and also find that the opposite of it is also bad. If we only consider the expected return, we can’t find such a case.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-5208) But when we bring risk into the picture, and also require the investment to come in some quantum of size, then we can find many such cases. In the context of options strategies, we find that two popular and opposing strategies are both “bad” from a historical point of view, and are unlikely to make sense prospectively too, due to their both being very inefficient in the dimension of time-diversification. The two strategies are: - *selling* and rolling one-month put options on the stock market, keeping the rest of the portfolio in T-bills, and - *buying* and rolling one month put options on the stock market and keeping the balance of the portfolio invested in the stock market. The two strategies can be thought of as opposites in terms of their options exposure, and both have delivered a lower return and lower quality of return–in terms of Sharpe Ratio and maximum drawdowns – compared to a simple portfolio of 50% in stocks and 50% in T-bills over the past 30 years. - Volatility should not be considered an asset class, as options are a zero-sum game. If it were an asset class, which side of the market would it be? - The volatility skew[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-5208) is probably not something investors can materially benefit from. It’s devilishly difficult to determine the fair value for options, particularly for short-term and/or far out-of-the-money options. - There’s an argument made that many young investors should use equity call options to have leveraged exposure that takes account of being in a state of low financial capital and high human capital.[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-5208) We’re not convinced there’s a big enough Expected Utility gain to make this strategy worthwhile in practice, but we accept that it’s plausible and in the right direction. - When an investor trades an option on an individual stock, he engages in two zero-sum games at once: stock picking and options trading. Thus, any benefit would require either winning these zero-sum games or achieving a more efficient risk profile. - Many investors view far out-of-the-money options as lottery tickets. For example, on many days in late 2021, Tesla options alone represented about one third of options volume, and about 80% of the Tesla options volume was on short-dated, far out-of-the-money call options. It may be that these options are a better deal, dollar for dollar, than a lottery ticket, but our Base-Case investor would be better off spending $10 a week on lottery tickets than spending $50,000 a year on far out-of-the-money options. Americans spend about $70 billion each year on lottery tickets. We think retail investors are spending multiples of that figure on options that are acting as a surrogate for lottery tickets or trips to Vegas. - Investors should stay away from structured volatility notes, volatility ETFs, and exotic options. While literally hundreds of books proffer instruction on how to make money trading options,[9](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-9-5208) there is not a single mention of options in many books on personal finance, including those written by such well-regarded experts as Jack Bogle, Charles Ellis, and Burton Malkiel. Our article is an attempt to bridge this gap, and in sum we find that options are unlikely to be welfare-enhancing, let alone a panacea, for individual investors with risk preferences similar to those of our Base-Case investor. This should not come as a surprise, given the zero-sum nature of the options market, in contrast to the generally recognized positive sum activity of investing in the broad stock market. If you’re interested in diving more deeply into our analysis and conclusions on whether options warrant a place in individual investors’ portfolios, or more specifically whether they make sense in your personal circumstances, we’d love to hear from you. --- 1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. **Past returns are not indicative of future performance.** 2. And all of this is just in the US, not counting non-US equity options volumes. 3. We assume the investor has CRRA utility with a standard risk-aversion coefficient. If such an investor is a utility-maximizer, then for bets with the same expected return and variance they will have a preference for positively-skewed bets (high chance of a small losee, low chance of a large gain) over negatively-skewed bets. 4. No article can beat Dennis Upper’s “The Unsuccessful Self-Treatment of a Case of ‘Writer’s Block'” in the Journal of Applied Behavioral Analysis (1974) which contained zero words! 5. The main assumptions are of a risky asset (or portfolio of assets) following geometric brownian motion, and an investor with CRRA Utility who is able to continuously rebalance without transactions costs. 6. Ignoring transactions costs and taxes. By Expected Return we mean the Expected Arithmetic (not compound) Return. 7. Low strike options trading at a much higher implied volatility than high strike options. 8. Most prominently by Ayres and Nalebuff in *Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio* (2010). 9. Just type “options trading” into the Amazon.com search window. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/do-options-belong-in-portfolios) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/realize-or-not-840x420-1.jpg) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [To Realize, or Not to Realize](https://insights.elmwealth.com/elm-wealth-research/to-realize-or-not-to-realize) Oct 22, 2020, 12:00:00 AM October 22, 2020 Tax Matters ## To Realize, or Not to Realize *By Victor Haghani and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-3628) This is a note about taxes, however: *we are not tax experts and nothing in this note should be construed as tax advice.* With the US presidential election just a few weeks away, it’s a good time to think about capital gains taxes. A number of our clients have been concerned about the possibility of significantly higher tax rates in the future and have asked us how we think about the investing implications of such a change. In this note, we suggest a framework based on maximizing expected risk-adjusted wealth for answering some of the important questions arising from the interaction of taxes and investing.[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-3628) We believe this framework is superior to a conventional static analysis, and we’ll explain why as we dive into the central question arising from tax rates potentially increasing in the near future: to realize gains now, or to defer realization to the future. Investment theory holds that in a world of efficient markets, random walks and no taxes, horizon shouldn’t materially affect many types of investment decisions. However what we have found is that as soon as tax enters the picture, horizon in many situations becomes the single most important input an investor needs to think about. We find that for investors with long horizons and moderate-size unrealized capital gains, it will usually make sense to defer realization even if the investor expects the tax rate to jump by 20 percentage points. We were surprised to find that at intermediate time horizons, the optimal decision can be to realize some, but not all, of the unrealized gains. Investment horizon isn’t the only critical input, and the interaction of all the relevant variables puts the development of a generic rule-of-thumb out of reach. Optimal decision-making in light of taxes is a function of many idiosyncratic and personal inputs, which is why we decided to provide a calculator you can use along with the note. [You can find our Decision Calculator here.](https://elmwealth.com/tax-calculator/) [You can find the math and code behind the framework here.](https://colab.research.google.com/github/ElmPartners/Public/blob/master/Cap_Gains_Decisions.ipynb) *The central question we will address in this note is whether it is better to sell (and re-purchase) appreciated assets now and pay today’s long-term capital gains tax rate, or wait to realize gains in the future and pay a likely higher capital gains tax rate.* At first, this may seem like a fairly straightforward problem of weighing a bigger payment in the future against a smaller payment today: simply a question of the time value of money using an appropriate discount rate.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-3628) In many circumstances, the decision would ride on a choice between different plausible discount rates. For example, in the base case we’ll discuss below, we’d want to realize early if we chose the risk-free interest rate, while we’d defer realization to the horizon if we used the expected return of a plausible risky asset. But as we’ll explain in this note, there is no robust way to choose an appropriate discount rate in a static framework. There are three main problems with the conventional approach, which all arise from the fact that risk is an integral part of the problem: 1. The conventional analysis captures only one of many possible scenarios. For example, the asset may drop below its cost basis resulting in no tax liability in the future, as the government doesn’t pay us “negative taxes” when we have a capital loss.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-3628) A sound analysis needs to take account of all possible outcomes. Chart 1 shows how realizing gains now vs. later can result in dramatically different changes in value depending on the final level of the risky asset at the investment horizon.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-3628) 2. Considering many possible scenarios and making decisions which maximize your expected wealth still may not lead us to the correct decision. The problem is that maximizing expected wealth leads to absurd decisions around risk-taking: for any investment with a positive expected return above the risk-free rate, investing more in that investment will always lead to higher expected wealth, so it can’t help to answer any questions involving trade-offs between risk and return.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-3628) 3. The conventional static comparison, by construction, cannot find that a partial realization of gain is optimal, even though (as we’ll see below) there are cases when that’s exactly what an investor should do. In addition, although of lesser impact, the static analysis doesn’t take into account the effect a higher future tax rate may have on how much of the risky appreciated asset you want to hold going forward, nor can it determine how tax rate uncertainty impacts the optimal allocation decision. The goal in sound financial decision-making is to make choices which offer the best risk-adjusted result. This requires accounting both for uncertainty in outcomes and for the decision-maker’s personal level of risk-aversion. The standard approach to quantifying an individual’s aversion to risk is through their utility function: a mapping between wealth and the benefits of wealth, its utility. Classical utility functions show utility increasing with wealth – but as wealth increases, it produces diminishing marginal gains in utility, as illustrated in Chart 2. This has a deep connection to risk-aversion and risk-taking: given a risky situation, the more your loss of utility is disproportionately large relative to a potential gain, the more compensation you require to bear that risk. Thus, the more concave the utility curve, the more risk-averse the individual. To make good risk-adjusted decisions, we need to find choices which maximize an individual’s expected utility, not expected wealth.[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-3628) There’s a direct correspondence between utility and risk-adjusted wealth (they’re interchangeable) – so going forward, we’ll perform our calculations using utility, and then express our results in terms of risk-adjusted wealth. That will allow us to compare different decisions in dollars rather than units of utility, which some readers may find too abstract. Armed with this tool, and assuming a typical degree of investor risk-aversion, we can determine to what extent we should realize a capital gain at the lower tax rate today.[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-3628) To do this, we calculate expected risk-adjusted wealth for each possible amount of immediate realization and each possible allocation to the risky asset, as follows: 1. For each possible price of the risky asset at the investment horizon, we calculate how much *after-tax* wealth the investor would have.[9](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-9-3628) 2. We use the investor’s utility function to translate that amount of after-tax wealth into personal utility. 3. We multiply each amount of utility by the probability of the risky asset realizing the corresponding price at the horizon, using the risky asset’s assumed expected return and risk. We add up the probability-weighted utility values, and this gives us expected utility. 4. Using the investor’s utility function, we translate from expected utility into risk-adjusted wealth. The result is an Expected Risk-Adjusted Wealth curve as a function of how much gain to realize immediately, given an optimal allocation to the risky asset. To illustrate this analysis, we’ll assume the investor has a 20-year horizon, that the risky asset (a stock ETF, for example) has an expected return of 6% with 18% volatility, and that the long-term capital gains tax rate will go from 30% today to 50% in the future. We’ll also assume that the investor must pay tax at the horizon, without the benefit of tax mitigations such as step-up basis for estate and charitable purposes, 1031 exchanges or moving state tax jurisdictions (although all of these could be modeled within this framework).[10](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-10-3628) If the investor has a capital loss at the horizon, we assume a zero value for the loss carryforward. The full set of assumptions are in Table 1. Chart 3 displays the risk-adjusted wealth curves for different initial levels of current unrealized gain, assuming an optimal risk allocation and a starting portfolio worth $100 (ignoring the tax liability). These curves allow us to find the decision – the percentage of gain to realize today – that maximizes expected risk-adjusted wealth. For an asset with 0 initial unrealized gain (blue), whether we sell the asset now or later doesn’t matter as there is no gain to realize; as expected, we see expected risk-adjusted wealth is constant. For our base-case unrealized gain of 35% (orange), realizing nothing now produces the highest gain in expected risk-adjusted wealth of approximately $20.5, the leftmost point on the curve. If the investor instead chose to realize all gains today, the rightmost point on the orange curve, their expected risk-adjusted wealth would fall to roughly $18.5. Things get more interesting in the case of a starting unrealized gain of 70% of the portfolio value (green) – an admittedly extreme case of the asset having a zero basis. In this case, we get the intriguing result that it is optimal to realize about half the gain immediately, which delivers about $4 more risk-adjusted wealth than no immediate realization, and $2 more than full immediate realization. In the base case, a discount rate of 3.7% would produce the same conclusion to defer realizing the gain and an increase in value of $2[11](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-11-3628) – but notice that in the case of a higher unrealized gain of 70%, there exists no discount rate to use in a static analysis which would suggest optimally realizing half the gain, or optimally realizing any fractional amount. Notice also that the green curve of this 70% gain case gets very flat around the optimal decision to immediately realize 50% of the gain. If the investor decided to realize 40% or 60% of the gain, their expected risk-adjusted wealth would be almost the same. This is a general feature of decisions that come out of this framework: getting close to optimal delivers almost all the expected benefits of the precise optimal decision. But, the further away one moves from optimality, the expected welfare of the investor declines ever more swiftly. To get a better feel for what’s going on, let’s look at how the optimal amount to realize changes with time horizon, as illustrated in Chart 4. We can see that if you have a short horizon, it’s optimal to realize a high fraction of current gains – but as horizons lengthen out, you want to realize less and less. Why might this be? For a very short horizon, say just one minute, it makes sense to realize 100% of the gain right away, re-establish the position and then liquidate it after the 1 minute has elapsed.[12](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-12-3628) Over that very, very short horizon, it’s fair to expect very little price change in the risky asset, so taking the gain now is pretty much a no-risk, no-brainer. However, as the horizon gets longer, risk enters the calculus as the relative benefit of the realization decision is tied to the risky asset price at the horizon, as illustrated in Chart 1. The risk of early realization has the general profile of being short an option: if the asset price doesn’t move much, the investor is better off taking advantage of the lower tax rate by realizing early, but if the asset price goes down or up dramatically, deferring realization will have been the better decision. A big drop in the asset price will leave the investor with a non-refundable tax loss,[13](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-13-3628) while a big rise in the asset price favors deferral as it allows the investor who hasn’t paid tax early to have a larger exposure to the risky asset. At the same time, the time value component of deferring paying taxes goes up with an increasing horizon. These two effects shift the balance towards deferring realization as horizon lengthens. So far we have treated the future capital gains tax rate as known with certainty, but it’s easy enough to see how tax rate risk impacts the realization decision. In Chart 5, using the assumptions in our base case, we plot the optimal realization decision comparing the case where the capital gains rate increases to 50% versus the case where there’s an equal chance that it’s unchanged at 30%, goes up to 50%, or goes up to 70%. Notice that all we’ve done is introduce tax rate risk, as we’ve left the expectation of a 50% future tax rate the same in both cases. What we find is that tax rate uncertainty pushes the investor to realize more gains at every horizon up to a horizon a bit beyond 20 years, when full deferral is suggested under both sets of future tax rate assumptions. The reason we get this result is that our investor is risk-averse, and uncertainty in the future capital gains tax rate introduces risk into deferral.[14](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-14-3628) ### Conclusion Making sound financial decisions under uncertainty requires finding the decision that maximizes your expected *risk-adjusted* wealth. Doing so often involves more than a back-of-the-envelope calculation, but the math is not terribly complex – and we’ve provided a calculator to do the heavy lifting for you. While the cases we’ve dealt with in this note have been simplified, the framework we’ve proposed is flexible enough to handle more realistic setups, including a more general, multi-period lifetime saving, spending and investment framework, and also an integration of correlations between tax rates, asset prices, inflation and interest rates. If you’re interested in building your own calculator to handle more complex or personalized cases, we’ve shared our Jupyter Notebook with the core framework, equations, and Python code. The core points we’d like to leave you with are: 1. The expected-utility framework is superior to a static analysis for answering tax questions involving uncertain outcomes and produces sensible results which maximize risk-adjusted wealth. This approach can suggest partial realization as optimal, a solution that is not possible within the conventional solution. 2. Horizon is very important: At shorter horizons, it tends to make sense to realize some amount of gains early when capital gains tax rates are expected to rise, while deferring gains is more attractive at longer investment horizons. 3. Under many circumstances, the difference in risk-adjusted wealth between the optimal decision and a bad decision is great enough to warrant an investor spending some time to make a thoughtful decision. However, in the neighborhood of the optimal decision, risk-adjusted wealth differences are small, so it’s reasonable to get in the ballpark of the best decision without worrying about a high degree of precision. In practice, most investors see themselves as having multiple horizons over which they expect to liquidate assets to fund spending, and portfolios generally have a mix of assets with different cost bases and different characteristics. This adds complexity to the analysis, but doesn’t change its basic character – making decisions that maximize expected risk-adjusted wealth is the best way to improve your expected welfare. We encourage you to spend some time with our calculator, and please do get in touch with us if you’d like to discuss using this framework or how it might be applied to your individual circumstances and decisions. --- ### Disclaimer: In this note, we’ve provided a framework for thinking about tax-related investment decisions. Nothing in this note should be construed as tax advice pertaining to any individual’s specific circumstances, and your authors are not tax experts. We have simplified the problems we have discussed considerably, ignoring many important tax rules, including (but not limited to) discussions of the impact of different rates for long-term versus short-term capital gains tax, different rates at different income levels, the value of capital gains tax loss carryforwards, estate, trust and charitable considerations, and many, many more. --- ### Technical Appendix The capital gains tax rate *τ0* will be changing tomorrow to *τ* . You have some amount of homogenous unrealized gains *g0* , and you want to know whether you should realize your gains now (or more generally, what fraction should be realized), given that you also want to hold the optimal of the risky asset to horizion *T* , at which point you’ll realize any additional gains and pay any taxes. We assume the risky asset *S* follows a GBM with mean return *μ* and volatility *σ* , and that you have CRRA utility with elasticity *γ* . *S* also pays a dividend at rate *δ* which is taxed at *τd* . As usual, we want to optimize expected utility: U(θ,κ) = 𝔼 \[u P̂T\] where: u(w) { w1 – γ – 1 1 – γ , γ ≠ 1 u(w) = ln(w), γ = 1 P̂T = PT  – (φ+ + α(1 – T Tc )+ φ–) τ φ = (1 – θ – ε)g + PTe–κ T δ(1 – τd) – P0 ε = 1 κ0 ((κ0 – κ)+ – κ0 θ)+ PT = P0e(κ(μ – δTd) + (1 – κ)(1 – τ1)r – ½ κ2 σ2)T + κ σ ZT P0 = 1 – (θ + ε)gτ 0 Note: *ε* is the amount of extra immediate gain realization (if any) additional to *θ* called for by rebalancing the risk asset from *κ0* to *κ* . *α* is the multiple applied to the asset value of a loss carryforward if received today, and *Tc* is the time after which loss carryforwards have no asset value. --- ### Further Reading and References: - Domar, Evsey D. and Richard A. Musgrave. [“Proportional Income Taxation and Risk-Taking.”](https://academic.oup.com/qje/article-abstract/58/3/388/1896885?redirectedFrom=fulltext) The Quarterly Journal of Economics. Vol. 58, issue 3, 388-422. 1944. - Feldstein, Martin. Capital Taxation. Harvard University Press. 1983. - Feldstein, Martin. [“The Effects of Taxation on Risk Taking.”](https://www.journals.uchicago.edu/doi/10.1086/259560) Journal of Political Economy. Vol. 77, No. 5, 755-764. 1969. - Haghani, Victor and James White. [“How Much Should the Tax Tail Wag the Asset Allocation Dog?”](https://elmwealth.com/how-much-should-the-tax-tail-wag-the-asset-allocation-dog-a-rule-of-thumb-for-weighing-capital-gains-taxes-in-portfolio-rebalancing-decisions/) 2017. - Haghani, Victor, Larry Hilibrand and James White. [“When it Pays to Pay Capital Gains.”](https://elmwealth.com/when-it-pays-to-pay/) 2019. - Stiglitz, J. E. [“The Effects of Income, Wealth, and Capital Gains Taxation on Risk-Taking.”](https://doi.org/10.2307/1883083) The Quarterly Journal of Economics. Volume 83, Issue 2, 263–283. 1969. --- 1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. **Past returns are not indicative of future performance.** We are very grateful for the help of Larry Bernstein, Larry Hilibrand, Peter Hirsch, Mark Perwien, Marlin Risinger, Jeffrey Rosenbluth and Roberta Sydney. All errors are our own. 2. For those familiar with Utility theory, Risk-Adjusted Wealth is equivalent to Certainty-Equivalent Wealth. 3. Assuming the price of the asset at the horizon is at or above its current price. 4. The taxpayer does get a capital loss carryforward, which can be used against future capital gains. In our analysis in this note, we’ll be assuming that capital loss carryforwards have no value beyond the investor’s chosen horizon. However, the proposed framework can handle multiple horizons and assigning value to capital loss carryforwards, a feature we have built into the calculator. 5. The chart assumes the investor makes the same percentage allocation to the risky asset regardless of realizing the gain early. 6. Assuming the ability to borrow at the risk-free rate to invest arbitrarily more. 7. This decision framework is a superset of the well-known Kelly Criterion, not an opposing framework as it’s sometimes portrayed. Optimizing expected utility given log-utility and binary bets reproduces the Kelly Criterion exactly. 8. We’ll assume the investor exhibits Constant Relative Risk-Aversion (CRRA) utility with coefficient of 2, which means the investor would have an optimal allocation to equities of about 70% based on an expected excess return of 4.5% and equity volatility of 18%, ignoring tax effects. See our survey on CRRA risk aversion [here.](https://elmwealth.com/measuring-the-fabric-of-felicity/) 9. In calculating the value of the portfolio at the horizon, we make the unrealistic (but non-impactful) assumption that the investor maintains the chosen percentage asset allocation over the entire period without incurring taxes in the process of rebalancing the portfolio to keep the allocation constant. 10. Nor in this note will we consider other tax mitigation approaches such as hedging of appreciated assets, splitting assets between taxable accounts and non-taxable accounts such as IRAs or tax-loss harvesting strategies run on portfolios of many individual equity holdings. 11. Explanation of 3.7% discount rate: realizing a $35 gain today at a 30% tax rate creates a tax payable of $10.50, while realizing $35 at a 50% tax rate in 20 years produces a tax payable of $17.50. Discounting $17.50 at 3.7% per annum for 20 years gives a present value of $8.50 which is $2 less than the $10.50 generated by realizing today. 12. We assume there are no transaction costs, and there are no wash sale restrictions on realizing gains and re-establishing positions, as far as we know, although as stated already, this is not tax advice. 13. For an investor with multiple horizons, a tax-loss at an early horizon will have some value as a carryforward to a longer horizon. This is straightforward to incorporate into the framework described herein, and it is built in to the calculator that accompanies this note. 14. Tax rate uncertainty can also support the decision to convert a traditional IRA into a Roth IRA even for an investor who doesn’t expect higher tax rates in the future, as the conversion and resultant tax payment upfront reduces the risk associated with uncertain future tax rates. A number of other variables also significantly drive the conversion decision. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/to-realize-or-not-to-realize) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/64-pays-to-pay-banner-1024x487.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [When it Pays to Pay Capital Gains](https://insights.elmwealth.com/elm-wealth-research/when-it-pays-to-pay) Mar 11, 2019, 12:00:00 AM March 11, 2019 Tax Matters ## When it Pays to Pay Capital Gains *By Victor Haghani, Lawrence Hilibrand and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-2546) US taxable investors know the importance of managing their investments tax-efficiently. A standard approach to the management of capital gains and losses is to defer realization of gains for as long as possible, while aggressively realizing losses,[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-2546) particularly short-term losses, a strategy often referred to as “tax-loss harvesting”. However, upon closer examination, this can be significantly improved upon for investors who tend to have a steady stream of short-term capital gains – and in a seemingly counter-intuitive way. Instead of trying to defer realizing a long-term capital gain as long as possible, it can make sense to realize the gain shortly after one year has passed since purchase and the gain becomes subject to the preferential long-term tax rate. If the asset is sold and repurchased, the basis in the asset and the “basis clock” are both reset, thereby creating the option to realize a valuable short-term capital loss if the asset falls in the year ahead. This sounds good, but does it actually add net expected value? We need to compare the expected value of a short-term loss “option” to the expected cost of giving up deferral of a long-term capital gain.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-2546) We value a realized short-term loss at 17% of the loss amount, which is the difference in Federal tax rates for short-term versus long-term capital gains. The value of deferring a capital gain is primarily a function of the expected horizon of the deferral – all else equal a longer deferral period has greater value.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-2546) We set up a Monte Carlo simulation to estimate the expected value of the accelerated realization approach compared to both a buy-and-hold approach and to the standard tax-loss harvesting approach. The results and assumptions of the simulation are laid out in the table below. What we find is that an investor following the accelerated realization approach would have an expected pre-tax equivalent return about 1.3% pa higher than a simple buy-and-hold approach,[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-2546) and 1% higher than the standard tax-loss harvesting approach. The results appear quite robust. For example, taking a shorter horizon of ten years, the difference between the approaches changes by only about 0.15% pa, with the buy-and-hold looking a bit worse and the standard tax-loss harvesting looking a bit better (both compared to the accelerated realization strategy). Higher tax rates, maintaining the same difference between the short-term and long-term rates, don’t have much impact on the difference in expected returns either.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-2546) The accelerated realization approach may be more valuable for some investors and portfolio strategies than for others. It will be especially effective for those who regularly incur short-term capital gains and highly value short-term capital losses,[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-2546) who have relatively static or slow-moving portfolio allocations,[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-2546) and who can trade their portfolios with low transaction costs. The approach we describe keeps the portfolio more “evergreen” from a tax perspective, in that it slows the build-up of large long-term gains which can then unduly bias allocation decisions. While there will be variability in the tax advantage an investor experiences depending on the path the asset takes, it is an added bonus that the realized tax benefit will tend to be higher the worse the asset performs and the more volatility the asset experiences. That’s to say, you get some extra tax benefit in environments which are otherwise not so great. So it looks like in certain situations, paying your taxes early and often might be a surprisingly tax-efficient way to go. If you’d like to learn more about our approach to delivering tax-efficient returns, or more about our investment approach in general, you can request more info on our home page [here](https://elmwealth.com/) or schedule a call [here](https://elmwealth.com/contact-us/schedule-a-call/) with James, our CEO. --- ### Further Reading and References: - Constantinides, George, [“Optimal Stock Trading with Personal Taxes: Implications for Prices and the Abnormal January Returns”](https://www.nber.org/papers/w1176) NBER Working Paper No. 1176, (1983) - Dammon, Robert, Dunn and Spatt, Kenneth, [“A Reexamination of the Value of Tax Options”](https://doi.org/10.1093/rfs/2.3.341), The Review of Financial Studies, Volume 2, Issue 3, (July 1989), Pages 341–372. - Andrew Kalotay has written extensively on this topic. You can find his research on [Kalotay.com](https://www.kalotay.com/). This idea was described by Joseph Stiglitz as a strategy of “immediate realization” in his paper, [“Some Aspects of the Taxation of Capital Gains”](https://www.nber.org/papers/w1094.pdf). Journal of Public Economics, pp 2, 5-7, (1983) --- 1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. **Past returns are not indicative of future performance.** Thank you to our friend and accountant David Untracht for his helpful comments. Of course, any errors are our own. 2. Subject to wash-sale rules. 3. We also need to take account of transaction-costs and the risk associated with complying with the wash-sale rule when realizing a loss. 4. The value of deferral is also greater the higher the effective tax rate and the higher the expected rate of return on the asset. Deferral is also more valuable if the investor expects to avoid capital gains tax completely by donating or bequesting the appreciated asset in the future. Expected changes in tax rates and tax rules also impacts the value, or potential cost, of deferring capital gains. 5. A simple back-of-the-envelope estimate for this difference, if we could only trade once at the end of every year and using the other assumptions in the table, would value the option to realize a short-term loss at the end of the year as 4.7% (the value of a one-year at-the-money put option with 16% volatility and a 4% risk-free rate) times the value of converting a short-term gain into a long-term gain of 17%, which gives a value of 0.80% after-tax. The value of a 30-year deferral is the difference between the return of investing for 30 years at 4% and paying tax at the end versus paying the tax every year, which is 0.33% after-tax. So, the net benefit is 0.47% (*0.80% – 0.33%* ) after-tax, or a pre-tax equivalent of 0.62% pa. We find a much higher benefit of 1.3% in our simulation primarily because we can trade once every month, which is of significant incremental value. 6. Choosing to not realize long-term gains if they were particularly high improved results, but only marginally. 7. For investors who do not expect to have short-term capital gains every year, the incremental value of this accelerated realization approach will be eroded, or even erased. For example, if we assume the investor has only a 50% chance of having short-term gains in a given year, and will only find out whether he has gains after the year ends, the extra expected return from accelerated realization compared to standard tax-loss harvesting drops from 1% to about 0.25% pa (assuming that if the investor doesn’t have short-term gains in a particular year, short-term losses can still be offset against long-term gains). Also, the value will be impacted negatively for investors who are more likely to have short-term capital gains in years when the stock market has risen. 8. Not having any tax-lots with a long-term basis can be inconvenient for dynamic strategies which may need to sell and would like to avoid realizing short-term gains. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/when-it-pays-to-pay) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/tax-pie-840x420.jpg) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [US Tax Reform Leaves Even Less of the Pie for Individual Investors in Alternatives](https://insights.elmwealth.com/elm-wealth-research/us-tax-reform-leaves-even-less-pie-investors-alternatives) Jan 29, 2018, 12:00:00 AM January 29, 2018 Tax Matters ## US Tax Reform Leaves Even Less of the Pie for Individual Investors in Alternatives *By Victor Haghani and James White* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-1871) *Let me tell you how it will be There’s one for you, nineteen for me ‘Cause I’m the taxman, yeah, I’m the taxman Should five per cent appear too small Be thankful I don’t take it all ‘Cause I’m the taxman, yeah I’m the taxman…* *“Taxman,” by The Beatles (1966)* The Tax Cuts and Jobs Act passed into law last month will increase the wedge between pre-tax gross and after-tax net returns of many hedge funds and other private investments for high-income taxable US investors.[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-1871) Imagine a hedge fund that produces a 15% pre-fee, pre-tax return in short-term capital gains, charges the standard 20% incentive fee and 2% management fee, and also passes through 1% of miscellaneous investment expenses.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-1871) Assume the investor lives in New York City and so pays a combined marginal tax rate of 53.5% on ordinary income.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-1871) While the hedge fund proudly reports a salubrious 9.6% return after fees, as you can see in the table below, the investor will only be left with 2.9% after taxes. That’s an effective tax rate of 70%. Ouch! ### Tag Team of Fees & Taxes Crunches Taxable Investor Returns | Pre-fee, pre-tax return | **15.0%** | | --- | --- | | less management fee and misc. investment expenses | -3.0% | | less Incentive fee: 20% of 12% | -2.4% | | Return after fees reported to investors | 9.6% | | Taxable income, after adding back in non-deductible 3% expenses | 12.6% | | less Taxes: 53.5% of 12.6% | -6.7% | | less management fee and misc. investment expenses | -3.0% | | After-fee, after-tax return | **2.9%** | What’s going on? Not only is our NYC investor paying a higher marginal tax rate than before due to the cap on deductibility of state and local taxes, but she’s also being hit by the new and total non-deductibility of management fees and investment expenses that show up in the box for “Miscellaneous Itemized Deductions” on the k-1 she receives. This is a subtle yet very significant drag on after-tax performance.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-1871) The wedge turns into an iceberg at lower gross returns. For example, if the hedge fund had a gross return of 8.5% that would leave just 0.5% for our investor, and she’d be singing the same despondent tune as the Beatles under the 1966 Labour government’s 95% tax rate. Meanwhile, the tax efficiency of long-term investing in the public equity market was left mostly intact by tax reform, or even slightly improved with the lower effective individual tax rate on public market pass-through vehicles, such as REITs and MLPs.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-1871) Investors did have a momentary fright from the Senate’s “FIFO” proposal, dropped at the 11th hour, which would have taken away the benefit of choosing specific tax lots on sales. An equity market return of just 4.5% in the form of long-term capital gains and qualified dividends would deliver the same after-tax return to our investor as the hedge fund earning 15% before fees and taxes. The wedge widens significantly further when we consider the value of tax deferral in long-term equity investing,[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-1871) and the fact that neither the IRS nor most hedge fund managers return previously paid taxes or incentive fees when you have investment losses. Conclusion: taxable investors must expect incredible out-performance to close the after-tax return gap between high fee, tax-inefficient alternative investments and long-term investing in public market equities. While the Beatles had to leave the UK to avoid being left with one Shilling on a Pound of their income, U.S. taxable investors who want to keep a higher fraction of the gross return on their capital can achieve that goal without ever leaving home. --- 1. Victor is the Founder and CIO of Elm Partners, and James is Elm’s CEO. **Past returns are not indicative of future performance.** This not is not an offer or solicitation to invest. Thank you to Larry Hilibrand for his always-helpful comments. 2. The authors are not tax experts. This should not be construed as tax advice. 3. This is an illustrative example. The tax characteristics of different private investment vehicles vary widely, and some may be quite tax efficient. However, what we present here is a relatively common case, and by no means the worst case. 4. 37% Federal, 12.7% NY State & City and 3.8% Obamacare Investment Tax gets us the 53.5% top marginal tax rate for NYC residents. The rate is 40.8% for investors who live in states with no income tax. 5. This is an even bigger issue with investments such as private equity and venture capital that charge management fees on capital committed but not drawn in the early life of their funds, resulting in a non-deductible expense that is very large as a percent of average capital invested. These deductions were excluded under the prevailing AMT rules before the recent tax changes. 6. While the cut in the U.S. corporate tax rate from 35% to 21% was a tremendous improvement in the overall tax efficiency of stock market ownership, our analysis in this note is focused on direct taxes paid by individual high-tax-rate investors. 7. Deferral has several potential benefits: 1) compounding at the pre-tax rate and paying tax at the end is better than compounding at the after-tax rate, 2) appreciate assets can be donated or bequeathed without paying capital gains tax, and 3) investors tend to retire to lower-tax states. See our [note](https://elmwealth.com/sharing-your-drink-with-the-taxman/) from November 2015 for more detail. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/us-tax-reform-leaves-even-less-pie-investors-alternatives) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/048-discussions-banner-1024x487.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [Discussions on Risk Parity and the Sharpe Ratio](https://insights.elmwealth.com/elm-wealth-research/clarity-risk-parity) Dec 11, 2017, 12:00:00 AM December 11, 2017 Tax Matters ## Discussions on Risk Parity and the Sharpe Ratio In our ongoing writing on the topic of investment sizing and portfolio choice, we recently published two articles that discuss the use of Sharpe Ratio in building portfolios with the highest expected risk-adjusted return. In the first note, [Some Clarity on Risk Parity](https://elmwealth.com/some-clarity-on-risk-parity/) ([Bloomberg Prophets](https://www.bloomberg.com/view/articles/2017-10-16/some-clarity-on-risk-parity)), we showed how a levered Risk Parity portfolio and a Traditional unlevered equity/fixed income balanced portfolio could both be derived from the same basic expected utility maximization toolkit. We went on to show that a relatively small difference in investor risk and leverage preferences would tip the investor to preferring one versus the other type of portfolio. In our second note, [A Brief History of Sharpe Ratio and Beyond](https://elmwealth.com/a-brief-history-of-sharpe-ratio/), we dug deeper into the question of how much investors can rely on maximizing the Sharpe Ratio in choosing the investment portfolio best for them. As we discussed in our first note on Risk Parity, we explain why Sharpe Ratio isn’t enough for investors who have an aversion to leverage. We show why, and to what extent, investors should be willing to trade off a lower Sharpe Ratio versus a higher expected return on their portfolio. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/clarity-risk-parity) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/031-USUK-main-1024x487.png) [Tax Matters](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters) ### [Tax-Efficient Investing for US Citizens Long-Term Resident in the UK](https://insights.elmwealth.com/elm-wealth-research/tax-efficient-investing-for-us-citizens-long-term-resident-in-the-uk) Feb 3, 2017, 12:00:00 AM February 3, 2017 Tax Matters ## Tax-Efficient Investing for US Citizens Long-Term Resident in the UK *By Victor Haghani* [1](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-1-395) US citizens who have been living in the UK for a long time, like me, are facing significant changes in how we will be taxed in the UK. Unfortunately, we got caught in the cross-fire when the UK set its sights on about 100,000 long-term UK residents who don’t pay tax on investment income to the UK, under the UK’s generous non-domicile rules, or to their country of domicile either, as almost no country in the world taxes its citizens when they live abroad. No country, that is, but one: the US. These new UK rules mean that US citizens who are long-term resident in the UK face the risk of being punitively taxed, or even double-taxed, by the UK and the US. I’ve attended half a dozen meetings with accountants, lawyers and financial advisors who have done their best to explain the new rules to me. Even more complex than the rules are some of the remedies being proposed. At Elm Partners, we think we’ve got a simple and tax efficient investment solution for US-UK investors. We’ve taken our Separately Managed Account offering, which is already cost efficient and tax efficient for most US investors, and made some modifications that should also make it tax efficient from a UK perspective for US-UK investors like me. --- ### But, before telling you more: I’ve got to remind you that this is an area of tax law that is complex, and each of us has a different tax situation. Even within a family, different pools of savings are taxed differently. You should always seek professional advice. I’m not qualified to give, and this note is not, tax advice. The information in this note is purely illustrative and for purposes of encouraging discourse and further research. --- ### What’s changing? From April 2017, individuals who have been resident in the UK for 15 of the last 20 years will be deemed to be UK-domiciled for income tax and capital gains tax purposes. Many US-UK investors currently elect the remittance basis of taxation, which means that for an annual remittance fee, they are only taxed on income and gains that they bring into the UK. The remittance basis of taxation allows US-UK investors to focus almost exclusively on the US tax efficiency of their investments, and to give limited attention to UK taxation. As the IRS taxes offshore investments made by US citizen punitively (e.g. PFIC taxation), US-UK investors tend to invest in US-domiciled products such as LLCs, LPs, or US-listed equities, mutual funds and ETFs. Unfortunately, from April 2017, US-UK investors who remain in the UK will be stripped of the safe harbour of the remittance basis, and will have to think about whether their investments are tax efficient from both a US and UK perspective. ### What’s the Problem? Most (but not all) US-domiciled funds are taxed unfavourably in the UK. In a typical UK-domiciled fund, income and capital gains are treated separately. Income is taxed as it arises at the rate of 45%[2](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-2-395) and Capital Gains is taxed at realisation at a lower rate of 20%. Just as the US is tough on US investors investing in offshore vehicles, the UK is too. And just as the US tends to treat the UK as if it were a tax haven, the UK treats US-domiciled funds as “Offshore Funds” too.[3](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-3-395) This means that a UK investor in a US domiciled fund will have all returns, whether Income or Capital Gains, treated as Income and taxed as they arise at the higher rate of 45%, which isn’t good as it’s higher than the rate at which they’d be taxed in the US.[4](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-4-395) This isn’t so bad if the US-UK investor intends to keep his investment in the US fund until he leaves the UK, as that investment will not be subject to tax at all in the UK if there are no distributions and the investment is not sold.[5](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-5-395) However, if he wants to liquidate that investment or if it’s a private equity fund that makes distributions, then the capital gains are taxed at the higher rate of 45%, which will be well above the long-term capital gains rate in the US and hence leave our investor with a tax inefficient outcome. The problem is more complex, and can potentially be worse, if the investment is in a US LLC, which is a typical structure for many hedge fund and private equity investments. In the US, an LLC is treated as a partnership and investors are taxed on an arising basis (via a k-1) whether or not there have been distributions. By contrast, the UK will likely tax this income as it is received at 45% as a dividend. The UK will not allow an offset for US taxes paid in the past on that income, and it may be difficult to get an offset in the US on the tax paid, due to timing and character differences.[6](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-6-395) ### Benefits of US funds under the HMRC’s Offshore Fund Reporting Status Regime: To mitigate the onerous treatment of Offshore Funds, the HMRC allows funds to apply for “Reporting Status”. An offshore fund which benefits from reporting status is taxed similarly to a UK-domiciled fund. Under the regime, a Reporting Fund reports its income (whether distributed or not), which is then taxed on an arising basis at 45%, and the remaining Capital Gains are taxed on realisation at 20%. A full list of Offshore Funds which benefit from the HMRC’s Reporting Status can be found [here](https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds). At Elm, we’ve been searching through this list (about 50,000 line items) and have identified a sufficient range of low-cost US-listed funds and ETFs which have UK Reporting Status to be able to build a balanced and diversified portfolio that should be tax efficient from both a US and UK perspective. Through our existing relationship with our brokerage in the US, we can offer this solution to US-UK investors through our Separately Managed Accounts, which we can help open with minimal hassle. --- ### Summary: Thoughts on the efficiency of investment options from a US-UK perspective *Individual equities and bonds:* This is probably the most tax efficient solution[7](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-7-395) for US-UK investors, but it is difficult and expensive to build and maintain a portfolio of the hundreds (or thousands) of individual equities and bonds you would need to be well-diversified, unless you’ve got a really big portfolio to invest. *US listed Index funds and ETFs with UK Reporting Status:* Tax efficient from a US and UK perspective, and a cost efficient manner of creating and managing a globally diversified balanced portfolio. Elm Partners offers Separately Managed Accounts for US-UK investors constructed of these US listed ETFs with UK Reporting Status.[8](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-8-395) See this short slide deck for details on all the changes we made to our basic SMA program to be a better fit for US-UK investors. Vanguard is currently the only blue-chip provider whose ETFs benefit from Reporting Status, but we would expect more providers to follow suit. We are in discussions with a number of index fund and ETF sponsors encouraging this to happen. *US domiciled funds without UK reporting status*: For US-UK investors who are confident they will not sell their holdings until they leave the UK, these investments may be tax efficient from a US-UK perspective, as they should not generate taxable gains in the UK if they are not sold.[9](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-9-395) Income, however, would be taxable in the UK, but as long as interest rates and dividend yields remain low, the overall tax efficiency should remain high. Elm Partners has a non-distributing Delaware fund which fits this category. However, if the investor has a change of plans, or heart, and liquidates the investment at a gain while still subject to UK tax, this may turn out to be tax inefficient. *Hedge funds and Private Equity:* These investments tend to be relatively tax inefficient for US investors from a solely US perspective (see our note on hedge fund vs long only equity taxation [here](https://elmfunds.wpengine.com/blog/sharing-your-drink-with-the-taxman/)). The tax inefficiency of these investments may be compounded from a combined US-UK perspective, depending on the exact structure of the investment and the circumstances of the investor.[10](https://insights.elmwealth.com/elm-wealth-research/tag/tax-matters#easy-footnote-bottom-10-395) These investments also tend to be cost inefficient and low on diversification and liquidity. --- 1. Victor is the Founder and CIO of Elm Partners. **Past returns are not indicative of future performance.** This not is not an offer or solicitation to invest. 2. I’m using the highest marginal rate as I’m assuming the typical US-UK investor is HNW. 3. An investment in a limited partnership might be treated differently under UK tax rules, with all income being deemed to pass to the investor as it arises and maintaining the character of the income. Limited Partnerships tend to be less commonly used as pooled investment vehicles in the US. 4. For the purpose of this note, I’m going to ignore the effect of withholding tax on dividends from equities, and use of those withholding taxes in US and UK tax returns. 5. For investors who intend to leave the UK before realising their investment, there is a bright side to being invested in a non-distributing LLC, as the HMRC should treat the LLC as a company and will only tax income as it is distributed. However, you need to find an LLC investment that doesn’t make distributions. You won’t be surprised that at Elm Partners, we can offer that option to US-UK investors too. 6. Even this is somewhat complicated by the recent “Anson vs HMRC” case, in which an investor in a US LLC, Mr Anson, successfully argued that the LLC should be treated as transparent by HMRC. HMRC has stated that it intends to continue to treat LLCs as companies, except for in special circumstances matching the Anson case. See here for more details. The implications of this case are not fully known, so it is important to speak to your tax advisors if you are in this situation. 7. It is possible that owning individual equities may be the best way to be able to reclaim dividend withholding taxes on a UK tax return. We have not found a definitive answer on this question. 8. Mutual funds are another good option but may be difficult to buy, as some brokerages such as the one we use, will only allow mutual fund purchases if the investor has a US address. 9. Funds in the form of LPs may not be treated this way by HMRC, but rather as a pass-through. 10. As noted above, whether these investments take the form of an LLC or LP can have a significant impact. We believe there is nothing to stop an LLC applying for UK reporting status, but it may actually prove to be more detrimental to investors, as the payment of income tax would be brought forward to an arising basis. Worse still, the payment of tax in this way may not be able to benefit from double tax relief due to the mis-alignment of tax treatment between the US and the UK. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/tax-efficient-investing-for-us-citizens-long-term-resident-in-the-uk)