The uncertainty around US tariff policy has significantly increased US equity volatility. Although Parametric had anticipated increased volatility in 2025, nobody knows where the market is headed next. In uncertain times like these, investors are justifiably looking for the tax benefits that loss harvesting can deliver.
Maximizing after-tax return is a key goal of direct indexing, but so is tracking the benchmark. Here’s why we think it would be a pyrrhic victory to let risk management suffer in pursuit of realized losses.
Balancing two objectives
Direct indexing has a dual mandate of seeking to provide pretax performance similar to the benchmark while aiming to outperform on an after-tax basis. We recognize that reaching for more losses can result in greater pretax return differences, yet managing risk too tightly can diminish the ability to capture losses.
To strike a balance between these competing goals, Parametric monitors portfolios daily with trigger-based loss harvesting and simultaneously employs risk controls every time a portfolio trades. At the end of the day, a direct index portfolio is a beta strategy, and clients are seeking index-like returns.
In pursuit of losses
A direct index strategy is often selected for the potential tax benefits it seeks to provide. We would argue that systematic loss harvesting and the resulting capital losses could be the silver lining to volatile periods such as the one we’re in. However, some investors may worry that their portfolio isn’t taking full advantage of the opportunities the market presents.
Over more than three decades of managing direct indexing portfolios, Parametric has been through multiple market cycles and volatile periods. Along the way, we’ve refined our approach to tax management with robust processes and ongoing research.
Parametric screens accounts for harvestable losses on a daily basis, capturing the tax benefit for clients by realizing losses while also managing risk. Given strong market returns over the past two years, even a more recently incepted portfolio may have experienced significant appreciation. Despite the US equity market decline year to date, losses in the portfolio may be limited.
Even if there are losses in portfolios, Parametric honors IRS wash sale restrictions whenever the account traded within the last 30 days.1 That decreases the eligible universe of securities we can buy and sell, while also helping to keep the portfolio well aligned to the benchmark.
Our goal is to harvest losses within a portfolio every time it makes sense to do so—both in and out of the wash sale period. But if we are overly aggressive in pursuit of losses, we may sacrifice risk management.
Prudent risk management
Direct indexing portfolios are often the core equity holding for investors, and priority number one for Parametric is delivering a pretax return similar to the index. However, active tax management tends to result in a portfolio that looks a bit different than the benchmark it tracks: Selling to realize losses results in stock-specific underweights, and those biases increase the risk that the portfolio will deviate from the benchmark on a pretax basis.
To help control risk, we try to limit how much a portfolio can differ from its benchmark by managing both systematic factors—such as industry membership or equity style—and stock-specific risk. Our investment process manages stock-specific risk in two primary ways:
1. Limiting how far we’ll sell down a position to realize a loss
For the larger constituents of an index—such as the Mag 7 stocks—it would be risky to completely sell out of a position to capture the losses. If an investor wants to be more aggressive, we can accommodate them by relaxing that limit and allowing higher risk.
2. Requiring deeper losses to sell more volatile stocks
We differentiate stocks based on riskiness because we recognize that riskier stocks may be more likely to contribute to pretax return differences. With that in mind, we generally look for deeper losses whenever we consider harvesting losses in a highly volatile stock, and we try to reduce preexisting underweights whenever we can.
Why managing stock-specific risk is so important
Here’s an example of how active tax management can introduce stock-specific risk into a direct index portfolio. A large decline in a single stock makes it a good candidate to sell for loss harvesting, but that could also make the portfolio underweight the stock relative to the benchmark. If the stock subsequently outperforms the benchmark, then the portfolio’s pretax return would suffer.
Much of the time, single-stock underweights and overweights have tended to cancel each other out. But in a volatile period, or when an underweight stock’s performance is exceptional, it could create a meaningful drag on pretax return. This is exactly what happened to a handful of large index names in the recent past, and that’s why Parametric’s approach seeks to fine-tune risk management for highly volatile stocks.
The bottom line
Like an army whose victory in battle inflicts such a devastating toll on its own troops that it ends up losing the war, pursuing losses without regard for risk would be a pyrrhic victory. With more than three decades of experience in active tax management, Parametric has spent a lot of time thinking about the trade-off between delivering losses and managing risk. Our stance is that it’s better to take a balanced approach, especially in volatile markets.
1 In a wash sale, the same security sold for a loss is purchased 30 days before or after the sale. If a transaction violates the rule against wash sales, the IRS can disallow the loss deduction and add the loss to the cost basis of the repurchased security, which can effectively defer the benefit of the loss.
Parametric and Morgan Stanley do not provide legal, tax, or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
Investment advisory services offered through Parametric Portfolio Associates LLC ("Parametric"), an investment advisor registered with the US Securities and Exchange Commission (CRD #114310). Parametric is also registered as a portfolio manager with the securities regulatory authorities in certain provinces of Canada (National Registration Database No. 42850) with regard to specific products and strategies. Parametric provides advisory services directly to institutional investors and indirectly to individual investors through financial intermediaries. The information on this website does not constitute an offer to sell, or a solicitation of an offer to purchase, securities in any jurisdiction to any person to whom it is not lawful to make such an offer. Investing entails risks, and there can be no assurance that Parametric (and its affiliates) will achieve profits or avoid incurring losses. All investments are subject to potential loss of principal. Parametric does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the disclosure page for important information about investments and risks.
S&P Dow Jones Indices are a product of S&P Dow Jones Indices LLC (“S&P DJI”) and have been licensed for use. S&P® indexes are registered trademarks of S&P DJI; Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); S&P DJI, Dow Jones, and their respective affiliates do not sponsor, endorse, sell, or promote Parametric and its strategies, will not have any liability with respect thereto, and do not have any liability for any errors, omissions, or interruptions of the S&P Dow Jones Indices.
© Parametric
Read more commentaries by Parametric
