Five big questions from readers about tax-aware long/short strategies

Plus, I'm building a tax-aware long/short simulator

Tax-aware long/short strategies like the 130/30 and 250/150 aim for pretax alpha with tons of capital losses

These charts from a 2021 AQR blog post show that tax-aware 130/30 and 150/50 generate more capital losses than direct indexing, especially when allowing more tracking error.

Source AQR: Please see their blog post for the assumptions used to create these charts.

If you need to get up to speed on tax-aware long/short strategies and why I think they’re the new standard for tax-aware core portfolio management, start here.

Then read my interview with Burney and then my interview with AQR.

These strategies are admittedly niche. In mid-2024, I estimated total AUM was around $10 billion. Now, it’s greater than $35 billion and growing rapidly.

The pretax alpha generated by squeezing relative value from outsized long and short positions is tantalizing (though not guaranteed), and the incidental tax management opportunities are eye-popping (though also investor-specific and not guaranteed).

The tradeoff is that the strategies are complex.

I know because I’ve been building a toy simulator for the last few days, and my forehead is sore from all my brow-wrinkling.

But I also know because advisers keep asking me questions (and throwing shade).

"I find the tax-aware long/short love to be a bit more sizzle than substance."

Will tax-aware long/short strategies eventually run out of tax-loss harvesting steam, just like direct indexing?

Advisers keep asking me the following questions:

1. Will tax-aware long/short strategies eventually run out of tax-loss harvesting steam and become expensive index funds? When?

2. What happens if portfolio debt is much greater than equity?

3. What happens if portfolio tax liability is much greater than equity?

4. What about estate planning? Isn’t it enough to maximize step up in basis?

5. How much leverage should I use?

These questions are nuanced and interesting, but I won’t address them fully in this post because I’m building a toy simulator that should answer many of them.

It takes a dozen user inputs, like leverage target, expected growth rate, tax-loss harvesting trigger, etc., and shows how a tax-aware long/short portfolio behaves in a dashboard.

It will take another week to prepare, but here are some early results.

Won't the long/short eventually lock up just like direct indexing?

Yes, maybe, eventually, but it could be a long time. How long? Aperio estimates 20+ years.

Source: BlackRock/Aperio

To understand why, my simulator shows how cost basis evolves when:

1. Regularly realizing capital gains (for rebalancing)

2. Harvesting copious losses in the short positions (assuming markets drift upward)

WORK IN PROGRESS: Illustration of tax-aware long/short strategies deconstructed into long and short with evolving and original cost basis for reference

Here’s the explanation:

1. The blue section (the long side of the portfolio) above:

   1. Portfolio drifts upward

   2. (not shown) regularly realized capital gains

   3. Reinvesting proceeds which resets cost basis higher mitigating lock up

2. The orange section (the short side of the portfolio) above shows:

   1. Regular tax-loss harvesting, which defrays the cost of rebalancing

   2. (not shown) repeated additional shorting, which resets cost basis lower, also mitigating lock up

The long and short chunks of the portfolio work together to extend tax-loss harvesting runway.

The reason I’m building the dashboard is that the words I’m writing are clearly not sinking in

People need to see what’s happening in the portfolios (a toy example, anyway) and play around with assumptions to learn how everything works.

Here’s a preview…

This dashboard will allow users to input parameters and simulate how the whole tax-aware long/short portfolio/ecosystem behaves over time, including portfolio total return, cash flows, leverage, margin, financing costs, and, of course, tax.

The dashboard mostly works, but I need to audit everything, add portfolio metrics for clarity/sanity, and deploy it.

Planning

Advisers keep asking me for two things, and I’m curious if they’re relevant to you:

1. How can I quantify tax alpha, especially for prospects? Is there software for this?

2. How do I choose the best single-stock concentration solution (or combination) and model the outcome? (e.g., exchanges funds, gifting, hedging, tax-aware long/short, etc.)

These are very interesting problems to me.

I'm happy to explore partnerships if I can find a handful of advisers interested in building something in this space. Send me an email if you are interested.

Thanks for reading.