Tax-Aware Investing with Long-Short Equity Strategies

Once the domain of hedge funds, long-short equity strategies have gained traction among a wider range of investors thanks to their growing availability through separately managed accounts (SMAs). These strategies attempt to outperform their respective target benchmarks or indexes while also driving tax efficiency by generating realized losses and deferring capital gains.

Long-short equity SMAs may appeal to investors who have embedded capital gains from a highly appreciated concentrated stock position, the sale of real estate, or a business because the strategies can generate losses that help offset gains. They can also revitalize a mature direct indexing portfolio—a collection of stocks managed to an index—where accumulated gains have made tax-efficient tracking of the index difficult.

What is a long-short equity strategy?

A long-short equity strategy employs both long and short positions to achieve exposure to U.S. equities, global equities, or both. The objective is to outperform a benchmark or index on a before-tax and after-tax basis. The strategy also seeks tax efficiency by generating net realized losses and deferring capital gains where possible.

How do long-short strategies work?

In a hypothetical example, the manager uses an account with $1 million in cash to acquire a diversified portfolio of equities that they believe will outperform the benchmark. The manager short sells securities expected to underperform the benchmark in the amount of 30%, or $300,000. (Short selling involves borrowing shares to sell immediately, generating cash.) The proceeds from the short sales create the “long” extension, as the manager purchases an additional $300,000 in stocks expected to outperform the benchmark. This is called a 130/30 allocation, since the portfolio maintains 130% long exposure and 30% short exposure. The 30% on both sides of the portfolio are known as extensions.

The mechanics of long-short strategies

The chart below shows how these long-short portfolios are constructed:

1. An account is funded with cash, stocks, bonds, ETFs, mutual funds, or a mix of these. When funding with noncash assets, you can allow the manager to either exit the positions in a tax-efficient way or hold the assets, using them as collateral to create the short and long positions.

2. Choose the desired benchmark and leverage. Higher leverage typically results in increased tax benefits and realized losses, but it can also introduce additional risks. The manager will then apply the extensions to the portfolio by overweighting—or going long on—stocks expected to outperform the benchmark and shorting stocks expected to underperform. The manager will select many stocks to purchase and sell short, creating a diversified portfolio in the process.

3. The investment strategy can accelerate tax loss harvesting, as both the long and short sides can generate losses in different market environments. The extensions allow for more dollars at work, increasing the potential tax benefits or realized losses.

How much leverage is available, and how much is appropriate?

Cerity Partners has identified managers for long-short strategies who can manage portfolios with leverage ranging from 120/20 (120% long and 20% short) to 300/200 (300% long and 200% short). The appropriate level of leverage is determined by several key factors:

1. Tax loss needs: Higher leverage increases the amount of estimated losses these strategies can generate. However, more leverage increases potential exit costs, as we discuss later. The timing of when tax losses are needed is also a factor.
2. Tracking error risk: The tracking error represents how much the strategy can vary from the benchmark, both positively and negatively. Higher leverage increases the tracking error and the risk of materially underperforming the benchmark.

Where do long-short strategies fit in my portfolio?

The following scenarios illustrate situations where a long-short investment solution could be included as part of your financial plan.

• Revitalizing an ossified portfolio: Over time, a direct indexing portfolio can accumulate numerous highly appreciated positions, reducing its capacity to effectively track a benchmark index without triggering taxable events. This portfolio would serve as the funding source for the SMA. As losses are generated, the portfolio can trim overweight, highly appreciated positions and add to underweight positions. Implementing a long-short SMA strategy can renew loss harvesting opportunities and realign the portfolio with its designated index.
• Concentrated position: Holding a single stock that comprises a substantial share of your portfolio exposes you to both market risk and company-specific risk. Investors are aware that diversification can reduce company-specific risk, but potential tax liabilities may discourage the sale of the position. A significantly appreciated single stock position can serve as the funding source for a long-short SMA. As the extensions generate capital losses, those losses offset the embedded gains in the concentrated stock as it is sold. The resulting proceeds are then allocated to diversify the portfolio to align with the target index.
• Planning for a significant tax event: If you anticipate a sale of real estate or a business that could result in substantial tax liability, a long-short strategy can be used to strategically realize losses over time. Any realized losses from this approach may be used to offset capital gains from the property or business sale.

What are the risks to long-short strategies?

Leverage alone introduces its own risks, as returns can be amplified both positively and negatively. In addition, some capital gains are deferred but not eliminated. As the portfolio matures, parts of it may have large unrealized capital gains. Below are some additional risks to consider from long-short investing strategies:

• Exit costs: The exit or “unwind” cost refers to the costs incurred when transitioning a portfolio from long-short to long only. These costs are potential tax liabilities, as the extensions on the portfolio need to be closed and the embedded gains realized. If an exit is done quickly, the tax liabilities can be significant. Short positions, when closed, are subject to short-term tax treatment regardless of when they were originally opened. This is because the securities are borrowed rather than owned. Beneficiaries of these portfolios do not receive step-up basis on short positions either. A strategic exit process recognizes that the long-short strategy should be unwound gradually to allow the manager to remove portfolio extensions in a tax-efficient manner. The timeline for a strategic exit is determined by the amount of leverage and the length of time the strategy has been in place prior to transition.
• Underperformance: As noted, the use of leverage involves a risk of underperformance. To seek returns above the benchmark index, a manager must allocate assets differently than the benchmark’s composition. These deviations risk underperforming if the manager’s selection is incorrect. During periods of substantial market downturn, the ability to implement short positions may be restricted or margin requirements may be changed. In such situations, the manager would need to decrease portfolio exposure to comply with the changes. This involves closing out positions, which may result in tax consequences comparable to the exit costs mentioned earlier.
• Management style: Several managers oversee long-short equity SMA portfolios, each employing a distinct style and selection method. Cerity Partners has chosen managers in this area to provide a range of management approaches and leverage amounts.

Other risks and considerations for long-short investing

Long-short strategies typically carry higher fees than long-only direct indexing. This is due to the additional management fees associated with running the portfolio and the cost of margin. The margin cost in these strategies is lower than traditional margin rates, but it remains an expense. Long-short equity strategies are relatively new to the SMA structure, so a limited number of custodians currently support them. Further considerations include:

• Difficulty borrowing on margin: When funding an account with a concentrated position, there is a possibility that the position may not be marginable. In such cases, the manager cannot use the position as collateral to add the extensions. It is advisable to verify whether a stock position is marginable before funding the account.
• Short-against-the-box situations: A “short against the box” situation arises when offsetting positions are held simultaneously. For example, a manager may short sell stock that you own in another account. The Internal Revenue Service categorizes this as a constructive sale because the offsetting positions secure gains without an actual transaction and remove market risk from the position. Consequently, this would create a capital gains tax liability.
• Educating the tax preparer: To ensure these strategies are accurately represented in your year-end tax filings, it is essential that your tax preparer possesses a thorough understanding of the nuances and complexities associated with them. There are key deductions—margin interest paid and short dividends—that can be missed, as they are not directly reported.

Financial advisors can help with long-short strategies

Long-short SMAs are a new tool for clients to use in their investment and financial planning goals. These strategies can be a powerful solution to address concentrated positions, existing low-basis direct indexing portfolios, or the gains from a business or asset sale. However, it is strongly recommended to consult with a financial advisor when determining whether a long-short portfolio is the proper solution for your specific needs.

Please get in touch with your Cerity Partners advisor to discuss your financial circumstances and determine whether a long-short equity strategy is suitable for you. If you are not yet a client, we invite you to request an introduction with our concierge to explore your objectives and be matched to the right financial advisor for your unique needs.