The basics of tax-aware long-short investment strategies

Financial advisors and clients seeking to boost the tax savings available through loss harvesting may consider an increasingly popular leveraging strategy known as the “long-short” method.

The combination of “long” investments on a stock’s positive outlook with “short” ones based on equity declines, plus margin loans that add debt leverage to the vehicle, may turn off some advisors with risk-averse clients who don’t have a lot of capital gains that need offsetting. But tax-aware long-short investing is drawing clients seeking to maximize returns through active management on a lengthy timeline with lower payments to Uncle Sam.

At their root, tax-aware long-short vehicles present “an opportunity to go overweight certain factors and go underweight certain factors and find alpha between the two,” said Brent Sullivan, a consultant on taxable investing product distribution to sub-advisory and ETF firms who writes the Tax Alpha Insider blog. The accompanying tax savings stem from loss harvesting that “oftentimes will exceed a dollar contributed” or could even reach 200% to 400% of the principal, he noted. Continual rebalancing pushes up the losses past the level available from many direct indexing strategies in a process Sullivan compares to a “perpetual ball machine.”

“The loss harvesting paradigm here is just totally different than a direct indexing long-only,” Sullivan said. “As the market goes up, you can continue shorting. Those shorts generate harvestable losses.”

READ MORE: How the ticking clock affects tax-loss harvesting

A ‘rapidly growing but sometimes confusing area’

Much like his research documenting the continual rise in Section 351 conversions to ETFs, Sullivan is keeping close watch on tax-aware long-short vehicles, which have already surpassed his prediction of attracting $30 billion in assets under management by the end of the year. AQR Capital Management, a pioneer in tax-aware long-short strategies, is leading the way with $21.7 billion, but other managers such as Invesco, BlackRock and Quantinno have pushed the total above at least $35 billion, Sullivan noted in a newsletter last month.

“Today, advisers recognize that tax is a practice differentiator and a source of recurring client value,” Sullivan wrote. “They may be torn between low-cost, passive index ETFs and direct indexing, but that debate fades into the background once they learn of tax-aware long/short strategies.”

On the other hand, AQR itself is seeking to “help parse the jargon of this rapidly growing but sometimes confusing area” amid some “blurring of terminology, strategy design and investment objectives,” the asset management firm said in a blog post earlier this year. The company pushed back on the idea that the strategies are “only for billionaires” or simply trying to achieve benchmark returns, along with the notion that they are a form of “supercharged direct indexing.” While their tax benefits “are larger and last longer” than those of direct indexing, the two strategies come from “diametrically opposite starting points (active management for the former versus passive indexing for the latter),” the post said.

“Tax-aware long-short factor strategies realize higher tax benefits than direct indexing not because they try harder, but because they (1) trade quite a bit due to changes in pretax alpha, (2) hold large positions relative to invested capital due to leverage, and (3) can slow unnecessary gain recognition without significantly impacting pretax alpha, thanks to relatively long holding periods and highly diversified portfolios,” the company wrote. “The core strength of tax-aware long-short strategies lies in their ability to align pretax performance with the needs of tax-sensitive investors.”

READ MORE: A complex but tax-friendly approach to diversification

Estate implications

Those characteristics may eventually pose tax problems with a client’s estate plans, Sulllivan noted. Estates face an obligation to settle any debts.

“The strategy is effectively over,” he told FP. “You will realize a ton of capital gains if you suddenly, without planning, close the long and short positions.”

Advisors and their clients could take steps to wind down the leverage “years and years in advance” with as low tax exposure as possible, he said. Or they could set up an intentionally defective grantor trust or another entity instructing the trustee to manage the strategy based on a “prudent investor standard” and a long-term plan for the estate and its heirs, Sullivan said.

Since “you do not want to be auto-liquididated” upon the benefactor’s death, some of the “the brightest minds out there are thinking about trust structures” to hold the tax-aware long-short strategies, he said.

“That can be a real tax drag for any assets passing to beneficiaries,” Sullivan said. “What you do is, make sure that the trust is properly structured to continue holding margin and short positions. You’re essentially transferring the entire balance sheet of the strategy.”