Glossary

Active weight

The difference between a holding's weight in the portfolio and its weight in the benchmark. A stock that is 2% of the portfolio and 1.5% of the benchmark has an active weight of +0.5%. Tracking error comes from active weights and how the stocks behind them move together, so limiting active weights keeps a portfolio close to its benchmark.

See also Benchmark, Tracking error

After-tax return

The return an investor keeps after paying the taxes the portfolio's trades created. Two portfolios with the same pre-tax return can have very different after-tax returns, depending on how much gain each realized and whether it was short-term or long-term. Some measures also subtract the tax that would be owed if the portfolio were sold at the end.

See also Tax alpha, Realized and unrealized gain

Basis point (bps)

One hundredth of a percentage point, so 100 basis points (bps) make 1% and 25 bps is 0.25%. Small differences in returns, costs and risk are quoted this way because percentages with many decimals are hard to read. A borrow fee of 50 bps a year, for example, costs $50 a year on every $10,000 of shares borrowed.

See also Tracking error, Borrow cost

Benchmark

The index or reference portfolio a strategy is measured against, such as a US large-cap index. Active weights, tracking error and relative returns are all defined against it. In direct indexing the benchmark is also the target the portfolio tries to resemble.

See also Direct indexing, Tracking error, Active weight

Borrow cost

The fee paid to borrow shares for a short sale, quoted as an annual rate on the value borrowed. Large, liquid stocks are usually cheap to borrow, while scarce ones can cost several percent a year or more. A long-short optimizer counts it as a running cost of each short position.

See also Short sale, Long-short portfolio (130/30)

Capital loss carryforward

When capital losses exceed capital gains in a year, up to $3,000 of the net loss ($1,500 if married filing separately) can offset ordinary income. The rest carries forward to later years with no expiry for individuals, keeping its short-term or long-term character.

Source IRC §1211(b), §1212(b)

See also Tax-loss harvesting, Short-term and long-term gain

Cost basis

What a tax lot cost, usually the purchase price plus fees, adjusted for later events such as a wash sale. When the lot is sold, the gain or loss is the sale proceeds minus the basis. A higher basis means a smaller taxable gain.

Source IRC §1001(a), §1012

See also Tax lot, Wash sale, Realized and unrealized gain

Direct indexing

Owning the individual stocks of an index in a separate account instead of buying a fund that holds them. Because each stock, and each tax lot, is held directly, losses on individual names can be harvested even when the index as a whole is up. The portfolio is managed to stay close to its benchmark, measured by tracking error.

See also Tax-loss harvesting, Benchmark, Tracking error

Donating appreciated stock

Giving shares that have risen in value directly to a charity instead of selling them first. For long-term capital gain property given to a public charity, the deduction is generally the shares' fair market value and the built-in gain is never taxed. The deduction is limited to a share of adjusted gross income (generally 30% for such gifts), with any excess carried forward for up to five years. Shares held one year or less are generally deductible only up to their cost basis.

Source IRC §170(b)(1)(C), §170(d)(1), §170(e)(1)(A)

See also Donor-advised fund, Cost basis, Holding period

Donor-advised fund

An account held by a sponsoring public charity. The donor contributes cash or securities, takes the deduction in the year of the gift, and recommends grants to other charities over time. Giving appreciated shares to one works like a direct gift of appreciated stock, and once given, the sponsor has legal control of the assets.

Source IRC §4966(d)(2)

See also Donating appreciated stock

Factor exposure

How sensitive a portfolio is to broad drivers of returns, such as the market, company size, value or momentum. A risk model estimates each stock's exposures, and the portfolio's exposure is the weighted sum. Keeping active factor exposures small keeps a portfolio's behaviour close to its benchmark.

Source Fama & French (1993), Common risk factors in the returns on stocks and bonds

See also Tracking error, Active weight

Gross and net exposure

Gross exposure is long positions plus short positions, as a share of capital; net exposure is long minus short. A 130/30 portfolio has 160% gross and 100% net exposure. Gross exposure shows how much capital is at work, which drives borrow and trading costs; net exposure is the bet on the market as a whole.

See also Long-short portfolio (130/30), Short sale, Borrow cost

HIFO (highest in, first out)

A lot-selection rule that sells the lots with the highest cost basis first. For a given sale, selling the most expensive shares produces the smallest gain or the largest loss. It ignores holding period, so it can sell a short-term lot taxed at a higher rate when a long-term lot would cost less in tax.

See also Specific lot identification, Cost basis, Short-term and long-term gain

Holding period

How long a tax lot has been owned, which decides whether its gain is short-term or long-term. It starts the day after purchase and includes the day of sale. When a wash sale disallows a loss, the replacement shares' holding period includes that of the shares sold, so they reach long-term status sooner.

Source IRC §1223(3); Rev. Rul. 66-7

See also Short-term and long-term gain, Wash sale, Tax lot

Long-short portfolio (130/30)

A portfolio that owns some stocks and sells others short. In a 130/30 portfolio, each $100 of capital supports $130 of long positions and $30 of short positions, so net market exposure stays at 100%. The extra positions give a tax-aware optimizer more lots to work with, so it can realize losses on either side.

See also Short sale, Gross and net exposure, Borrow cost

Net investment income tax

A 3.8% US federal tax on investment income, including capital gains, dividends and interest, for taxpayers whose modified adjusted gross income is above a threshold ($200,000 for single filers, $250,000 for married couples filing jointly). It applies to the smaller of net investment income and the income above the threshold. The tool demos on this site leave it out and price gains at the top federal rates alone (20% long-term, 37% short-term), so for an investor who owes it, the rate on a gain, and with it the value of a harvested loss, can be up to 3.8 percentage points higher.

Source IRC §1411

See also After-tax return, Short-term and long-term gain

Portfolio transition

Moving an existing portfolio, often concentrated or carrying large unrealized gains, toward a new target such as a direct-indexing account. Selling everything at once could realize a large tax bill, so a tax-aware transition spreads sales over time, sells losses and high-basis lots first, and accepts some tracking error along the way. A cap on realized gains often sets the pace.

See also Direct indexing, Realized and unrealized gain, Tracking error

Realized and unrealized gain

An unrealized gain or loss is the change in value of a lot you still hold; it exists only on paper. It becomes realized when the lot is sold, and realized gains and losses are what get reported for tax. Choosing when to realize is one of the main tools a tax-aware portfolio has.

See also Cost basis, Tax-loss harvesting

Rebalance

Trading a portfolio back toward its targets, such as benchmark weights or risk limits. In a tax-aware strategy each rebalance is also a chance to harvest losses, and the optimizer chooses which lots to sell so that taxes, tracking error and trading costs are weighed together.

See also Turnover, Tax-loss harvesting, Tracking error

Replacement security

A holding bought to keep a portfolio's market exposure after a position is sold at a loss. In direct indexing it is usually a different company with similar risk, such as another firm in the same industry, so the portfolio stays close to its benchmark without triggering the wash-sale rule. Once the 30-day window has passed, the original stock can be bought back.

See also Wash sale, Substantially identical security, Tax-loss harvesting

Short sale

Selling borrowed shares in the hope of buying them back later at a lower price and returning them. The short seller pays the lender a borrow fee and any dividends paid while the position is open. For tax, the gain or loss is generally recognized when the short is closed, and special holding-period rules apply.

Source IRC §1233

See also Borrow cost, Long-short portfolio (130/30)

Short-term and long-term gain

In the US a gain or loss is long-term if the lot was held for more than one year and short-term otherwise. Long-term gains are usually taxed at lower rates; short-term gains are taxed as ordinary income. A lot bought on March 1 must be sold on March 2 of the next year or later to be long-term.

Source IRC §1222, §1(h)

See also Holding period, Net investment income tax

Specific lot identification

Choosing which tax lots to sell instead of accepting the default, which is first in, first out. US rules allow it when the seller tells the broker which shares to sell no later than the sale's settlement date. It lets the same sale realize a loss or a smaller gain, depending on the lots chosen.

Source Treas. Reg. §1.1012-1(c)

See also Tax lot, HIFO (highest in, first out), Cost basis

Substantially identical security

The test that decides whether a purchase triggers a wash sale. Buying back the same stock counts; a company's bonds or preferred shares ordinarily do not, unless they convert into its common stock and trade much like it. Shares of two different companies ordinarily are not substantially identical, even in the same industry, and there is no bright-line rule for funds that track similar indexes, so the facts and circumstances decide.

Source IRC §1091; IRS Publication 550

See also Wash sale, Replacement security

Tax alpha

The difference between a tax-managed portfolio's after-tax return and that of a comparable portfolio managed without regard to taxes. It measures the value added by tax management, such as harvested losses and deferred gains. Much of it is deferral, so whether the measure includes tax on a final sale matters.

Source Arnott, Berkin & Ye (2001), Loss Harvesting: What's It Worth to the Taxable Investor?

See also After-tax return, Tax-loss harvesting

Tax lot

A single purchase of a security, recorded with its own date, number of shares and price. Buy the same stock three times and you hold three lots, each with its own cost basis and holding period. Selling a chosen lot rather than the whole position is what makes lot-level tax management possible.

See also Cost basis, Holding period, Specific lot identification

Tax-loss harvesting

Selling holdings that are worth less than their cost basis to realize capital losses, while keeping the portfolio's exposure with replacement securities. The losses offset realized gains and up to $3,000 a year of ordinary income, with the rest carried forward. Because the replacement starts with a lower basis, much of the benefit is a deferral of tax rather than a permanent saving.

Source IRC §1211(b), §1212(b)

See also Wash sale, Replacement security, Capital loss carryforward, Direct indexing

Tracking error

The volatility of the difference between a portfolio's return and its benchmark's, usually stated as an annual percentage. A tracking error of 1% means the portfolio's yearly return usually lands within about one percentage point of the benchmark's. A tax-aware optimizer accepts a little tracking error in exchange for tax savings, within a limit the strategy sets.

Source Grinold & Kahn (2000), Active Portfolio Management

See also Benchmark, Active weight, Factor exposure

Turnover

How much of a portfolio is traded over a period. Definitions vary; a common one is half the total value bought and sold, divided by the portfolio's value. Higher turnover means more trading costs and, in a taxable account, more chances to realize gains, so optimizers often cap or penalize it.

See also Rebalance, Realized and unrealized gain

Wash sale

Selling a security at a loss and buying a substantially identical security within 30 days before or after the sale. The loss is disallowed for now: it is added to the replacement shares' cost basis, and their holding period includes that of the shares sold, so the loss is deferred rather than erased. If the replacement is bought in an IRA or Roth IRA, the loss is lost for good.

Source IRC §1091; Rev. Rul. 2008-5

See also Substantially identical security, Replacement security, Holding period, Tax-loss harvesting

These summaries explain; they are not investment, tax, or legal advice, and the statute and IRS guidance govern. Thresholds and rates can change. Something missing or unclear? Get in touch.