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 changes on the Review tab, we'll display these considerations under the Tax & Risk considerations tab:

• Estimated tax impact
• Projected tracking error
• 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's 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, not a guarantee of what your tax liability may actually look like.

When you'll see the 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

Possible outcomes

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

• Potential taxes owed: The algorithm's trades are projected to result in net gains, creating a tax liability.
• 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.
• 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 "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 didn't provide any tax rates, we default to the following:

You can edit these rates by selecting 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. You can also toggle on the losses you've already harvested with Frec to factor them into your potential future tax estimates. Select the toggle next to Tax loss harvesting to apply that number to the taxes you may owe. You'll know the toggle is on when its background is black.

How the projected tax loss harvesting numbers are calculated

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. This percentage 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 isn't a guarantee of future performance.

The results shown apply the following percentages, based on the strategy you're customizing, setting up, or moving investments into:

This projection is based on the average first-year tax loss harvesting benefit from 41 simulation runs between 04/01/2005 and 02/13/2025, each covering 10-year periods. These results are hypothetical, don't reflect actual investment results, and aren't a guarantee of future results. Results will vary if you're invested in a direct index strategy benchmarked to a different index or using 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 into the short-term or long-term gain estimates you see on the tax impact screen.

2. Projected tracking error

Projected tracking error shows how much 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:

3. Margin call risk

This box only populates if you're currently borrowing from your portfolio 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 if it's higher than your current risk.

For example, before setting up the Long short strategy, your risk of a margin call may have required a 25% drop in your marginable asset value. After setting up the strategy, that risk may increase so that only a 15% drop would trigger a call. We'll inform you of this here.

Frec isn't a tax advisor and doesn't provide tax advice. We recommend consulting a tax advisor about your specific situation.