How I Invest with David Weisburd
E150: Tax-Aware Investing: Insights for Family Offices and UHNW Individuals
Fri, 28 Mar 2025
In this episode of How I Invest, Aaron Hodari, Managing Director at Schechter, delves into the world of wealth management and alternative investments. He shares how his firm navigates market uncertainties, crafts resilient portfolios, and uncovers unique opportunities for high-net-worth clients. Aaron's insights provide valuable lessons for investors seeking to optimize their financial strategies.
Chapter 1: How do ultra-rich individuals use tax loss harvesting?
Ultra-rich, the billionaires, the sent-up millionaires are using a very specific type of tax loss harvesting. I know we can't talk about the players, but talk to me about the strategy at a high level.
Let me talk about like industry innovation 1.0. That was, you know, years ago, probably maybe 12 to 15 years ago, investing philosophy called direct indexing came about. If you think about what an index-based investment is, is you buy the S&P 500 and ETF, mutual fund, you're just passive. You just want to own the market, get the exposure. No more, no less.
But let's say you own the S&P 500 ETF, and the market is flat at the end of the year. If you looked under the hood, you've got stocks that shot up 20%, 50%. You have stocks that shot down. But if you just own the ETF, you don't really have an opportunity at that time. Direct indexing, which has been very quickly growing.
One of us from Strategy is saying, I don't want to take the active manager stock risk. Picking Apple versus Google, give me all of them, just like when I buy the ETF. Do it in my own account. That way, I can take advantage of tax loss at an individual security level.
When you think about investing, how do taxes play into your strategy?
There's a famous saying, it's not what you make, it's what you keep. As someone who's helping taxable investors invest, we always have to be thinking about taxes and how to have the most tax efficient.
And how do you quantify that? How much do taxes actually play an effect on your client's returns?
There's a lot of factors. First, what state do they live in, right? If you're in New York, Hawaii, California. Taxes become a much bigger issue, but, you know, still federal income taxes on ordinary income, you know, north of 37%. Capital gains north of 20%, you know, once you factor in state and some other stuff. It absolutely reduces the net return to a client once you start.
So how do you then build a portfolio that pays attention to taxes? Another saying people say is don't let the tax tail wag the dog. You still have to make sound investment decisions, but you should absolutely be aware of what those tax rates are.
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Chapter 2: What is direct indexing and how does it work?
I've seen a lot of very smart, very wealthy people make these almost emotional decisions, putting in their money into investments that they shouldn't have just to minimize taxes.
The worst outcomes that we've seen over time and you've heard these stories going back to the dot-com bubble, is people would take a company public, have huge amounts of net worth, but they don't want to pay the taxes. And then they sit there and watch it go down and down and down. And I don't want to name specific examples.
There's a lot of companies that had great stock prices at one point, and they went down by a lot. So letting the tax tail wag the dog sometimes makes sense, but generally you really have to be thinking both investment return plus taxes when you're making decisions.
Let's say that I start a startup. I'm the founder and CEO. I own 20% of that company goes public. It's worth $2 billion. What's the right way to think about what to do in terms of your stake, in terms of tax strategy. Walk me through how a founder should think about their holding.
This is an interesting question because we deal with this a lot. We're financial advisors. We are risk managers. To us, you may have the best company in the world, but 99% of your net worth is tied up in one company. You should absolutely be diversifying. But We don't know nearly as much about that founder's company. It's not just the tax thing.
It's also this dynamic of someone wanting the exposure and risk to that company where we are not wanting concentrated exposure to anything. First, it's about having that conversation so that when I tell them, I think you should diversify, they know it's not because I think your stock is junk. It's because I think you should diversify because it's not worth that risk. But you start talking about...
Let's say we just pay the taxes. Where are we? Right. And is that a good decision? Then you start looking at things like exchange funds, tax loss harvesting. You can do options overlays to help reduce concentration risk. So I would say it's like a two part thing of making sure they understand where we're coming from and then helping them kind of get to that point. of saying, okay, I get it.
Now, how do we do that in the most tax efficient way possible?
A lot of founders get overwhelmed by they're trying to run and trying to start this $10 billion company. And now they have to deal with hundreds of different tax options. So they end up doing nothing, which is the worst thing. Let me through kind of from an 80-20 perspective, where should founders focus their tax optimization?
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Chapter 3: How do taxes impact investment strategies?
And what would you expect in year two, year three?
It will go down, but not by a huge amount. Maybe you're at 35% the next year, then 32. But over time, you kind of get to a place where... Because remember, we're long and short. And so we're always getting the opportunity to be harvesting when the market's down. We're harvesting losses on the long side. When the market's up, we're harvesting losses on the short side. And so these strategies can
benefit from a tax perspective consistently. It's very exciting. And the managers are, these are very high quality institutional managers that are implementing strategies like this, which by the way, you want. You don't want to be with a small, in my opinion, You don't want to be with a small startup group that's applying leverage in your account.
You'd rather be with a large institution with significant experience and track record and the ability to manage these types of strategies.
These are estimates, but first year you might get 40%, then you may get 35%, then 32%. You're getting a $400,000 short slash long-term capital loss in year one. Correct. And then $350,000. Talk to me about the long-term strategy. When do you sell?
Industry innovation is so great, David. It's like, let's say you want a hedge fund, right? A market neutral hedge fund where you want to take someone's stock selection risk, but you don't want the market exposure. You can go into a market neutral hedge fund. These separately managed accounts now allow an investor to make those decisions in their own accounts.
That gives them more control, more transparency, lower fees. it's almost like you could run these strategies at market neutral. So you don't need to buy 2 million of stock and short 1 million of stock. You could buy 2 million of stock and short 2 million of stock. It gives control to the investor to, to really customize their experience.
And the level of transparency is so important too, because you're in a hedge fund, you're in a black box. These strategies, the investors and their advisors know every position in that account on a daily basis. They have the ability to make changes and you know, For the players out there doing this, please don't raise your fees.
But they are expensive, but I would say very reasonable for the benefits and value we are getting.
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