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How does custom indexing work?
Tax alpha
Achieving “tax alpha” is the most tangible benefit of adopting a Custom Indexing strategy. Alpha refers to returns in excess of a benchmark—in this case, holding the ETF. Compound believes that tax alpha is the optimal way to measure tax efficiency as it measures the value of active tax management.
Tax alpha occurs when a managed portfolio’s returns versus a benchmark are better after tax than they are before tax.
This tax alpha is typically achieved through tax-loss harvesting, the practice of realizing losses when investments have declined in value, replacing them with similar investments to ensure exposure consistency, and then offsetting realized investment gains with those losses. The magnitude of losses available for harvesting depends on account size and asset volatility. Additionally, the ability to optimize through tax-loss harvesting depends on the investment vehicle selected. ETF losses, for instance, can only be harvested when the entire index has declined in value, while a Custom Indexing strategy can harvest losses when there is a decline in the individual stocks.
Excess after-tax return is the difference between the after-tax return of the portfolio and the after-tax return of the benchmark. Excess pre-tax return is the difference between the pre-tax return of the portfolio and the pre-tax return of the benchmark.
The value of tax-loss harvesting
Tax-loss harvesting is most beneficial when there are large losses in the market and high dispersion of returns between individual stocks. Conversely, benefits will be lower in a year with strong gains and low dispersion of returns between stocks (as in 2017). In other words, tax losses are easily harvested in years with high return/high dispersion and less valuable in years with low return/low dispersion.
In order to determine the scope for harvesting, we looked at four different years that represented clearly distinct scenarios represented by these two variables, using dispersion and returns data for the S&P 500.
We quantified the tax-loss harvesting opportunities with respect to the S&P 500 in these four years. The amount available for tax-loss harvesting can be found under the “Unrealized Loss %” column, and ranges from 39.4% in the volatile year of 2008 to 2.5% in the more standard year of 2009.
Dispersion refers to the range of potential outcomes of investments based on volatility.
The impact of return and dispersion
| Year |
Return |
Dispersion |
S&P 500 stocks down |
Avg return of down stocks |
Unrealized annual loss |
Realized loss on $1M portfolio |
Tax savings at 48% bracket |
Improvement to after-tax return |
|---|
| 2008 |
Low |
High |
95% |
-43.9% |
-39.4% |
-$394,000.00 |
$189,120.00 |
18.91% |
| 2009 |
High |
High |
15% |
-15% |
-2.5% |
-$25,000.00 |
$12,000.00 |
1.20% |
| 2015 |
Low |
Low |
58% |
-21.9% |
-9% |
-$90,000.00 |
$43,200.00 |
4.32% |
| 2017 |
High |
Low |
27% |
-15.7% |
-2.7% |
-$27,000.00 |
$12,960.00 |
1.30% |
Assummes no rebalancing within the year. Stocks delisted or removed from index mid-year are excluded from analysis. All returns shown are price-only. “Realized loss” and “Tax savings” will vary based on the individual’s federal and state income tax brackets. “Tax savings” on realized losses are calculated as short-term capital losses due to the annual rebalancing executed.
Even in the most bullish of years (2009), 15% of stocks had a negative return. This is a year in which holding an ETF or mutual fund would have yielded no opportunity to harvest any losses. While the Unrealized Loss % was relatively low, there were still opportunities to harvest losses in 2009. Conversely, 2008 saw incredible potential for tax-loss harvesting any gains, as 95% of the stocks in the portfolio were down for the year, with an average loss in those stocks of 44%. An individual holding a $1,000,000 portfolio in 2008 would have had an opportunity to realize up to $394,000 in losses, leading to $189,120 in tax savings (assuming the individual was in the 37% federal and 11% state tax brackets).
2020 was a strong year for tax-managed strategies. 2020 had volatility and market drawdowns, both of which created increased opportunities for tax-loss harvesting. The US Large Cap market was up +5.4% early in the year, collapsed in March to a low of -31.1%, and then rallied to end the year up +20.8%.
The graph below shows a comparison between an account that tracked the Russell 1000 and a hypothetical account that used a Custom Indexing approach in 2020. Over the course of the year, the Custom Indexing approach made 24 opportunistic trades, adding up to $241,237 in realized losses. While the opportunities tended to be highly concentrated in the first half of the year (due to the way the market trended), this strategy was able to take advantage of these opportunities and generate tax alpha. An illustration of a tax alpha benefit is further shown below in the tax-loss carryforward example.
Case study: 2020
2020 custom indexing simulation
Russell 1000 benchmark
Custom Indexing Portfolio
Cumulative Losses Harvested
This example is only provided to show the potential post-tax results from tax-loss harvesting and is not to show hypothetical investment results from an OSAM Large Cap portfolio. Individual results will vary for both tax-loss harvesting and index investing.
Illustration: tax-loss carryforward
| Year |
Carried losses |
Capital gains |
Harvested losses |
Capital gains offset with losses |
Total capital gains post-offset |
Additional losses declared |
Total annual capital gains |
Excess losses accumulated |
|---|
| 2020 |
$0 |
$202,500 |
-$241,237 |
-$202,500 |
$0 |
-$3,000 |
-$3,000 |
-$35,737 |
| 2021 |
-$35,737 |
$69,500 |
-$71,165 |
-$69,500 |
$0 |
-$3,000 |
-$3,000 |
-$34,402 |
| 2022 |
-$34,402 |
$100,000 |
-$15,000 |
-$49,402 |
$50,598 |
$0 |
$50,598 |
$0 |
Assume, for example, that a taxpayer recognized the $241,237 in harvested capital losses detailed in the 2020 chart above. Assume that the taxpayer also had a liquidity event where they recognized $175,000 in capital gains income. Lastly, the taxpayer recognized an additional $27,500 in capital gains income from the various sales of individual investments. The taxpayer can use the $241,237 to fully offset the capital gains recognized from the company liquidity event and regular trading ($202,500). The individual can also recognize up to $3,000 in total capital loss (on the Schedule D of their tax return).
The remaining $35,737 in losses will be carried forward indefinitely to offset capital gains and ordinary income in future years. In 2021, the taxpayer is able to use the carry-forward losses in addition to the harvested losses from their Custom Indexing strategy to fully offset capital gains again. And, the investor would still carry forward $34,402 to offset 2022 capital gains and ordinary income. In 2022 (YTD), the taxpayer is able to use the 2021 carry-forward losses plus the losses harvested from the Custom Indexing strategy to offset $49,402 of the $100,000 gain recognized. One benefit of “storing” harvested losses comes from their ability to be deployed over time.
Portfolio personalization
Compound’s Custom Indexing portfolio provides clients with an opportunity to have precise control over what their portfolio looks like. From environmental, social, and governance screens to company exclusions, custom indexing allows Compound’s clients to design a portfolio that’s aligned with their value system without sacrificing their financial goals. Some features require working with Compound's advisors due to their complexity.
Environmental, Social, and Governance (ESG) investing is a method of investing that focuses on the sustainability and impact of companies across different industries. Custom indexing allows investors to exclude positions from their portfolios based on evaluations of their ESG practices.
Environmental evaluation determines the impact companies have on our environment—examples of environmental screens include a company’s carbon footprint and its sustainability efforts throughout supply and distribution channels.
Social evaluation determines the internal and external efforts of the company to promote social initiatives—examples of social initiatives include diversity and inclusion hiring practices to advocate for underrepresented communities.
Governance evaluation measures how the company’s board and management drive positive change—examples of governance include the composition of the company’s board of directors and business ethics.
Over the long term, systematic investing in equities with specific characteristics—like above-average “value,” “growth,” or “momentum”—can improve portfolio performance.
“Factor tilts” are a tool used by investors to preference their portfolios toward a specific thesis. Factors can create alpha opportunities during periods where specific market conditions persist and are a way to add a systematic factor component to your passive Custom Indexing strategy. Most academic and empirical studies show that certain factor exposures over a very long cycle (multiple years) may add a premium above the traditional market. While factor exposures can lead to outperformance, implementing them will increase what’s known as “tracking error.” Tracking error measures how much your portfolio deviates from the indices being replicated. Factor returns can also be cyclical, so you could experience volatile and prolonged periods of underperformance compared with the broader stock market.
Factor investing is an approach that involves targeting specific drivers of return across asset classes. Factors can be broken down further into macroeconomic characteristics, which capture broad risks across asset classes, and style characteristics, which help explain returns and risk within asset classes. Custom Indexing portfolios allow you to tilt towards a specific factor (up to 30%). Factor choices include value, momentum, earnings quality, earnings growth, and income generation. Compound recommends only adopting a factor tilt if you have a long-term view and a willingness to accept a higher degree of tracking error.
Country exclusion allows you to restrict investments in a particular country (e.g. Norway or Zimbabwe). Exclusion can be due to social, geopolitical, economic, or environmental reasons. This type of exclusion furthers the control you have over what your investment strategy looks like and the composition of your underlying positions. Country exclusion at the company level ensures the strategy fully achieves the objective vs. utilizing ETFs or mutual funds which still may contain minimal exposure.
Sector exclusion can be useful if an investor is overexposed to a particular sector elsewhere on their balance sheet (e.g. Saas Software or Electric Vehicles). Overexposure may be due to concentrated company equity position or existing public/private investments. Sector exclusion can help reduce total balance sheet exposure while maintaining a comparable portfolio structure. Compound advisors work with clients to determine if sector exclusion is advantageous to a client’s overall investment strategy.
Company stock ownership can be one of the greatest drivers of wealth creation. However, once liquid, a concentrated position presents excess risk relative to the broader market. This risk can be an impediment to wealth preservation over the long run. Compound can help clients build a portfolio around their concentrated position, de-risking over time by leveraging harvested losses to offset gains realized through the sale of company equity. Additionally, concentrated positions create over-exposure to the industry the company operates within—this overexposure creates inefficiencies for the strategy’s overall diversification plan. A “nearest neighbors” list is designed to counteract the overlapping risk. Nearest neighbors are companies with similar exposure to the concentrated position (e.g. companies that operate similarly to Coinbase)—these companies are restricted or underweighted to create a representative index established around the concentrated position, delivering an investment experience closer to the market while mitigating concentrated risk.
Investors can also exclude specific companies from their portfolio (e.g. Coinbase). Exclusion could be due to negative opinions about individual companies or a need to reduce exposure to companies similar to those already owned. Company exclusion provides a solution to mitigate overlapping exposure without executing a full “nearest neighbors” screen. This exclusion is done at the company level, therefore, allowing you to achieve the highest degree of precision when building your investment portfolio.
