Tax-Aware Long-Short Investing Explained
Everyone wants to see their investments grow, but the tax bill that can accompany that growth isn't always easy to stomach. Tax-loss harvesting can help because it allows investors to use losses in taxable portfolios to offset realized capital gains. But for those with substantial gains accrued during an extended bull market, the challenge may be finding enough losses.
Many investors have turned to direct indexing as a result, but the same problem can eventually arise. As a direct-indexing portfolio ages and appreciates, tax-loss opportunities become harder to find.
Tax-aware long-short strategies offer another approach. They combine active equity management with systematic tax-loss harvesting. By adding long and short positions to traditional long-only portfolios, these strategies may expand the opportunity to realize losses. However, their overall value also depends on investment performance, costs, and the investor's ability to use those losses.
While tax-aware long-short strategies have become increasingly popular in recent years, like any investment strategy, they come with risks that should be well understood before investing.
From direct indexing to tax-aware long-short strategies
Most passive investors gain exposure to markets through exchange-traded funds (ETFs) or mutual funds that are designed to track an index such as the S&P 500®. Direct indexing removes the fund from the equation, giving investors direct ownership of a portfolio of stocks that replicates the market exposure of a target index.
This can make a meaningful difference for tax-loss harvesting. Even during a strong year for the broader market, there are stocks within indexes that fall, but an investor holding an ETF or mutual fund can't sell those individual stocks to realize a loss. Direct indexing allows a portfolio manager to take advantage of these individual stock-price declines to potentially reduce an investor's tax burden. The manager can sell those positions to realize the losses and then reinvest the proceeds in similar—though not substantially identical—securities to help maintain comparable market exposure.
Of course, this type of tax-loss harvesting depends on having losses available. And as noted earlier, portfolios typically offer fewer tax-loss harvesting opportunities as they age, particularly during extended bull markets. The financial industry often refers to this as "portfolio ossification."
Direct indexing breakdown
For illustrative purposes only.
Tax-aware long-short strategies attempt to provide more consistent tax-loss harvesting opportunities by expanding portfolios beyond a long-only structure. A manager holds securities expected to perform favorably and establishes short positions in securities expected to underperform, while coordinating investment, risk, financing, and tax-management decisions within one portfolio. The relative emphasis on pretax outperformance and tax management varies by strategy.
The mechanics are easier to understand through a simplified example. Assume an investor contributes $10,000 to a tax-aware long-short strategy with a common 130/30 structure. The manager would invest the $10,000 in an initial long portfolio, use margin financing to establish an additional $3,000 of long exposure, and borrow securities to establish $3,000 of short exposure. The resulting portfolio has $13,000 of long exposure and $3,000 of short exposure.
Measured by position size, the 30% long extension and the 30% short extension offset in the net-exposure calculation, leaving approximately $10,000, or 100%, of intended net equity exposure. The portfolio may still behave differently from a traditional $10,000 long-only portfolio because its 160% gross exposure, active long and short positions, financing, and securities borrowing introduce additional sources of risk and return.
The larger set of individual long and short positions may create more opportunities to realize losses than a comparable long-only portfolio. Long positions may generate harvestable losses when their values decline, while short positions may generate losses when the borrowed securities rise in price. Actual opportunities vary with market conditions, portfolio holdings, account history, constraints, and the manager's process.
Tax-aware long-short strategies are commonly implemented through separately managed accounts overseen by professional investment managers. The manager coordinates security selection, long and short exposures, financing, securities borrowing, risk controls, and tax-aware implementation within a single account.
More loss-harvesting capacity is not automatically better. Investors should consider whether the losses are economically useful and whether the strategy's investment and tax benefits justify its financing, borrowing, trading, management, and exit costs.
A hypothetical 130/30 long-short portfolio
For illustrative purposes only.
Risks and trade-offs
Tax management is only one component of a tax-aware long-short strategy. These are actively managed portfolios, and results depend on the manager's long and short security selection, portfolio construction, financing, tax management, trading, and risk controls.
Passive investors considering tax-aware long-short strategies should keep this in mind before deciding to invest. These strategies may underperform their benchmarks, and tax benefits may be insufficient to offset weak investment results or high ownership costs. Other important risks and trade-offs include:
- Borrowing costs. Financing additional long exposure and borrowing securities to sell short create ongoing costs that may reduce performance. Borrowing costs and availability may change over time.
- Management fees. Tax-aware long-short strategies implemented through separately managed accounts (SMAs) come with advisory or management fees that typically exceed the expense ratios on passive index funds.
- Leverage risk. The leverage used in tax-aware long-short strategies can magnify losses and, in extreme cases, lead to a margin call that can force the liquidation of some or all of a portfolio.
- Varying tax benefits. While tax-aware long-short strategies are designed to increase tax-loss harvesting opportunities, tax benefits vary and are not guaranteed. Investors should consult a tax professional for further guidance.
- Tax and exit risk. Tax-aware doesn't mean tax-free. Reducing or exiting the strategy may realize gains, use previously harvested losses, and generate additional trading costs.
- Short-selling risk. Losses on an individual short position are theoretically unlimited because the security's price can continue to rise.
Bottom line: Weigh the tax benefits against the costs and risks
There's a reason investors have become increasingly focused on strategies that consider tax implications. A recent study from Columbia University financial economist Andrew Ang found that federal taxes alone could have reduced a hypothetical investor's ending equity wealth by 36.5% between 1996 and 2025 compared with an untaxed portfolio. Strategies such as direct indexing and tax-aware long-short strategies are designed to address this issue.
While many investors dismiss tax-aware long-short strategies as a tool for the ultra-wealthy, they may be a practical option for a broader range of investors who are looking to lower their tax bills. They may be relevant for investors who have eligible gains in taxable accounts, a sufficiently long investment horizon, adequate liquidity, and the ability to accept the strategy's added cost, complexity, leverage, and investment risk. A tax need alone does not mean the strategy is appropriate.
Before investing in a tax-aware long-short strategy, investors should evaluate the manager's investment process, the expected usefulness of potential losses, the strategy's total ownership costs, its potential portfolio role, and the potential tax consequences of an eventual exit. A qualified tax professional can help assess individual tax circumstances.
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The securities, investment products and investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment or trading decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
For illustrative purposes only. Individual situations will vary. Not intended to be reflective of results you can expect to achieve.
Investing involves risk, including loss of principal, for some products and strategies, loss of more than your initial investment.
Past performance is no guarantee of future results.
This tax information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends that you consult with a qualified tax advisor, CPA, financial planner, or investment manager. Depending on the type of account you have, there are different rules for withdrawals, penalties, and distributions. Please understand these before opening your account.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice.
Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and Charles Schwab & Co., Inc. does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager and refer to Internal Revenue Service ("IRS") www.irs.gov about the consequences of tax-loss harvesting.
Opportunities for tax management, such as gain/loss matching and loss harvesting, are more plentiful in the first several years of a portfolio's life than they are in later years.
Investors' actual tax rates, current or future capital loss carry forwards, and other tax circumstances will cause investors' actual after-tax performance to vary from the estimates presented here and the results shown on their individual account statements.
Actual after-tax returns achieved may vary and could be lower than reported due to the investor's specific tax circumstances during the time period shown. Clients who do not pay the assumed tax rates or client-specified rates or clients who do not have offsetting capital gains and income would not achieve the after-tax returns reported.
Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
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Strategies that use screening exclude certain investments and therefore may not be able to take advantage of the same opportunities or market trends as strategies that do not use screens. There can be no assurance that the strategies will achieve their desired outcomes. Each investing strategy brings with it its own set of unique risks and benefits.
Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.