Tax & risk considerations

This article explains the tax and risk considerations shown when you set up, transition, or make changes to your Classic or Long Short direct index strategy. Before you finalize any of your changes on the Review tab, we will display these considerations under the Tax & Risk considerations tab. 

1. Estimated tax impact
2. Projected tracking error
3. Margin call risk

1. Estimated tax impact

The estimated tax impact feature shows you approximately how much in taxes you might owe or save as a result of actions you take that may trigger a stock/ETF sale. It is available for both Classic and Long Short direct index strategies, though there are some differences in how it works for each. 

We take your tax lot information (stock quantity and cost basis) and current market prices (or end of prior market day prices) and run a single simulation of the direct indexing algorithm to estimate the tax impact. Keep in mind that this is an estimate, and not a guarantee of what your tax liability may actually look like. 

Where will I see estimated tax impact?

You’ll see the estimated tax impact whenever an action in your direct index strategy may result in a stock sale, which could realize gains or losses. This includes: 

• Setting up a new direct index with stocks
• Moving stocks in or out of a direct index
• Editing customizations of a direct index

• Withdrawing from a direct index

   

What outcomes will I see?

For every result, you’ll see one of three outcomes: 

1.  Potential taxes owed: the algorithm’s trades are projected to result in net gains, creating a tax liability.
2. Potential taxes saved: the algorithm’s trades are projected to result in net losses, which can be used to offset gains and reduce your overall tax liability. 
3. No tax impact - this is typical when funding a new index with cash or investing one index into another with significant overlap in positions. 

For the outcomes of Potential taxes owed or Potential taxes saved, we display the projected taxes based on the tax rates you provided in your account settings. If you did not provide any tax rates, we default to the following: 
 

You can also edit the rates by clicking on  “View details” at the bottom of the box. From here you can update the tax rates and see the breakdown of your simulated short term and long term gains. Additionally, you’re able to toggle on the losses you’ve harvested on Frec to present and potential future estimates of tax losses. You’re able to apply this number to the taxes you may owe by clicking the toggle next to “Tax loss harvesting.” You’ll know the toggle is on when its background is black. 

How do we calculate the projected tax loss harvesting numbers?

We use the annualized estimated tax loss harvested percentage for each of the long short strategies benchmarked to the Russell 1000 with a Quality Factor tilt. The percentage below is used to calculate an estimate of tax losses harvested based on the total cash value in your portfolio. This is only an estimate and is not a guarantee of future performances. 

The results you’re shown are applying the following percentages: 

The estimated tax impact projection is based on the average first-year tax loss harvesting benefit derived from simulations benchmarked to the Russell 1000 Index for the classic index and benchmarked to the Russell 1000 with a Quality factor tilt applied to 140/40, 200/100, and 250/150 strategies. The results of those simulations are 10.02% for classic, 22.42% for 140/40, 40.85% for 200/100 and 53.59% for 250/150, and are based on 41 simulation runs between 04/01/2005-02/13/2025 of 10-year periods. The results are hypothetical, do not reflect actual investment results, and are not a guarantee of future results. Results will vary if invested in a direct index strategy benchmarked to a different index or utilizing a different factor tilt.

Wash sales and estimated tax impact

When you move stocks in or out of your direct index, they may have wash sale restrictions if you or the algorithm traded the stock in the last 30 days. To estimate your tax impact, our system runs two simulations. The first tries to optimize your portfolio while avoiding any trades that would trigger a wash sale. If that isn't possible or doesn't produce a valid result, a second simulation runs that allows all trades, including those that may trigger wash sales. Any wash sales triggered by the proposed trades are factored in the short-term and/or long-term gain estimates you see on the tax impact screen.

2. Projected tracking error

The projected tracking error shows the potential variation your portfolio is projected to fluctuate from the benchmark index, based on your current setup or the adjustments you've made. This variation reflects a number that can be above or below the benchmark. These estimates are based on a one-time simulation of your portfolio using data from the time you set it up or made changes. 

You’ll see one of four states:

1. Projected tracking error

This language will appear showing the potential range your portfolio is projected to fluctuate from the benchmark index based on the setup or adjustments you made to your long short direct index. This number can move above or below the benchmark.

2. Higher tracking error

This language will appear after you’ve already set up your long short index and indicates your tracking error is projected to increase from its original estimate based on the impact from the changes you requested.

3. Lower tracking error

This language will appear after you’ve already set up your long short index and indicates your tracking error is projected to decrease from its original estimate  based on the impact from the changes you requested.

4. No tracking error impact

This box will be blank and show “No tracking error impact” if the actions you’ve taken on your direct index does not impact your tracking error. This information does not take into account any tax losses harvested. 

3. Margin call risk

This box will only populate if you are currently borrowing from your Personal Line of Credit and you’re setting up a Long Short strategy. Your margin call risk may increase when you set up a Long Short strategy while borrowing and this box will inform you of the new risk of a margin call if it’s higher than your current risk. 

For example, prior to setting up the long short strategy your risk of margin call may have required a drop in your marginable asset value by 25% and utilizing the long short strategy may cause that risk to increase where your marginable asset value would only have to drop by 15%. We’ll inform you of this here. 

Frec is not a tax adviser and does not provide tax advice. We recommend consulting with a tax adviser on your specific tax situation.