Imagine an investor who made an early bet on a company that worked out. Years after their initial investment, they decide to sell a stake in the low-basis, concentrated stock and now face a $2M long-term capital gain. At the roughly 37% combined federal and state rate that most HNW investors in high-tax states pay, the tax comes to about $740,000.1 For a long time, there wasn't much that could be done to efficiently diversify their investment without substantial tax consequences.
That answer is starting to change. A class of quantitative equity strategies, often called tax-aware long/short, may present an elegant solution to this situation.
The scale of the problem
Investors typically focus on after-tax returns far less than fees, despite taxes being the larger cost. For a long-horizon taxable investor, the tax paid on realized gains will generally cost more over a lifetime than every fee and trading cost they ever pay, combined.
A $10M portfolio compounding at 8% for thirty years finishes near $101M. Taxing the gains each year at the same 37% combined rate lowers the after-tax compounding rate to roughly 5%, and the portfolio finishes near $44M.
The $57M difference comprises both the tax paid and the loss of compounding off a larger capital base. The forgone compounding is the larger share, because every dollar paid in tax stops growing immediately. This is a dire, and somewhat unrealistic, case where gains are fully realized each year. But the same effect holds whenever an investor realizes a gain of any size.
The standard toolkit
The most common tool presented by financial advisors to help defer capital gains while diversifying out of a big winner is tax-loss harvesting. When a position trades below cost, it's sold, and a close substitute is purchased so market exposure stays similar. The realized loss is then applied against gains elsewhere in the portfolio.
Direct indexing applies the same idea across an entire index. Rather than holding an S&P 500 ETF, the investor holds the five hundred composite stocks individually. The concept is that an index which finished the year up 8% still contains dozens of names that may have finished in the red (and therefore harvestable for loss). In the early years, direct indexing generally adds after-tax value of about 0.5% to 1.5% of portfolio value a year.2
Both conventional tax-loss harvesting and direct indexing have inherent limitations over a multi-year period. This is because harvesting requires positions to trade below cost, and an appreciating portfolio typically runs out of them. Research indicates that losses from direct indexing tend to flatten near 30% of starting capital.3
What adding a short book changes
Alongside its long positions, a tax-aware long/short portfolio shorts stocks a quantitative model scores poorly. This means the strategy actively borrows shares and sells them so the position profits if the price declines. Holding positions both long and short means some part of the portfolio will be in decline in any market, which allows the strategy to realize losses in both rising and falling markets.
We have simulated these structures over the last decade of market data. A 150/50 tax-aware long/short portfolio's cumulative net losses pass 100% of starting capital within about three years.4 This is several times the direct indexing peak on the same capital base. The loss generation typically has much higher staying power than conventional direct indexing in a well-crafted tax-aware long/short implementation.
Now think back to the investor with the $2M capital gain. A direct indexing program a few years in might have accumulated enough losses to defer a fraction of the tax bill. An established tax-aware long/short program of comparable size could defer all of it, allowing the full $740,000 to remain invested and compounding.
Potential alpha
In our view, the most important benefit of adding a short book is the ability for a manager to add potential pre-tax alpha to the existing portfolio. By going both long and short, the portfolio gains an uncorrelated return stream (no additional market risk) that may not only add incremental returns, but also help diversify the return characteristics of the portfolio.
Generating alpha in liquid markets is difficult and never guaranteed. That is why selecting a manager who has expertise, a good track record, and the proper infrastructure in place to run these complex strategies is of critical importance.
Why deferral is so advantageous
The most common objection is that deferred taxes eventually must be paid, so deferral merely postpones the bill. While this is true, the benefit of compounding off a larger capital base is so large that it's still worth it to defer in almost all reasonable cases.
AQR simulated this over a full investment lifecycle (thirty years of running the strategy followed by complete liquidation with every deferred gain taxed at exit). Scaled to a $10M start, their modeling has a passive index fund finishing near $78M after the final liquidation, direct indexing near $81M, and tax-aware long/short near $129M.5
Investors who never liquidate do better still, as under current U.S. law, assets passed at death receive a stepped-up basis.
Suitability
These strategies are most suitable for investors with a taxable portfolio in the millions, who are in higher tax brackets, and have a multi-year time horizon. Some natural candidates are founders selling down concentrated stock, PE and VC professionals with foreseeable carry distributions, and families with appreciated real estate or a business sale to come.
Several factors are worth understanding before considering tax-aware long/short strategies. They require years to work rather than quarters, and unwinding the portfolio is a process that needs ample time to be done efficiently. The active long/short book produces intentional tracking error against the benchmark, which some investors find difficult to live with when the strategy trails the index. The operational requirements demand institutional infrastructure, with leverage, margin, and continuous risk monitoring as table stakes.
Most important, the pre-tax investment case has to stand on its own, because the economic substance doctrine in tax law exists to disallow a strategy run purely for its tax treatment.
Where this is heading
Direct indexing went from a niche institutional service at the turn of the century to a standard offering at most major custodians. We expect tax-aware long/short to follow a similar path, because the underlying logic is stronger, the potential for pre-tax alpha is material, and tax benefits are much larger.