Tax-aware long/short doesn't lockup easily. Why?
Unlimited downside risk on the shorts is the key to understanding
Before jumping in… I’ll be a Future Proof in Huntington 9/7 - 9/91. See you there?
I’m still on vacation, which means lots of time with my 6-year-old and 3-year-old boys.
We listen to Mariners games on the radio (most unfortunately, as of late 🫠 🔱). We draw and paint a lot. It’s during these sessions that I doodle tax infographics like the one above.
When people first learn of tax-aware long/short strategies, they see 1) the market-neutral pre-tax alpha, and 2) the pile of tax losses these strategies produce.
Here’s a 2 sentence, 2 infographic refresher on tax-aware long/short strategies.
One problem tax-aware long/short strategies address is long-only (e.g. direct indexing) portfolio lockup, that is, when the portfolio grows so far above cost basis that further tax-loss harvesting is unlikely.
Once a direct indexing portfolio is locked up, investors have several options:
Add additional cash to inject some fresh cost basis that can be harvested
Use the portfolio to seed a new ETF in-kind (I wrote a silly book about §351 conversion, buy one of 9 copies remaining)
Contribute to a certain kind of exchange fund meant for this purpose (Eaton Vance offers these)
Add tax-aware long and short “extensions”
Supposing we add the extensions, haven’t we just kicked the can down the road? Won’t the long and short extensions just lock up, too?
Not exactly.
See the infographic above.
The gist is that the longs could eventually lock up, but the shorts have unlimited downside risk and therefore (nearly) unlimited tax-loss harvesting potential.
I say that the longs could eventually lock up, but there’s more to the story.
Since the shorts regularly present tax-loss harvesting opportunities (assuming markets tend to rise), those losses can offset realized gains on the long side, which can be reinvested to increase the long cost basis over time, thus delaying lockup.
Even if you think the risk, fees, transaction costs, and financing costs aren’t worth investing in tax-aware long/short, the mechanics are fascinating.
I’m back at it on 9/3. See you then.
This is me (Burns, not the hat guy)
I had the worst coffee at the beach last week. Better than none at all?
A reminder to stay present
