Among the “smart beta” strategies that recently have become popular are funds that go long securities with favorable characteristics and short those with unfavorable characteristics.
For example, to capture the value premium, a fund would go long value stocks and short growth stocks. Similarly, to capture the momentum premium, a fund would go long securities with positive momentum and short those with negative momentum.
Examples of such factor-based funds include AQR’s Style Premia Alternative Fund (QSPRX) and its Alternative Risk Premia Fund (QRPRX). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)
The conventional thinking on long/short funds is that their greater turnover not only increases trading costs, but because higher turnover typically is associated with a negative impact on tax efficiency, that increases the tax burden for taxable investors due to an increase in the realization of capital gains.
In addition, short-selling is often perceived as particularly tax-inefficient, because realized capital gains on short positions generally are taxed at the higher short-term capital gains tax rate, regardless of the holding period.
Clemens Sialm and Nathan Sosner contribute to the literature on this topic with the study “Taxes, Shorting, and Active Management,” which appears in the first quarter 2018 issue of the CFA Institute’s Financial Analysts Journal. The authors examined the impact on tax efficiency of adding short positions to quantitative investment strategies, such as those employed by the two aforementioned AQR funds.
They used strategy simulations to demonstrate that tax-aware strategies that employ short-selling not only eliminate the tax burden, but also realize capital losses that can be used to offset capital gains from other strategies within a broader investment mandate.
To demonstrate the impact that shorting has on tax efficiency, the authors computed the tax burden of a manager who follows a combined value and momentum strategy over the period 1985 to 2015. They chose value and momentum because these strategies tend to exhibit a negative correlation.
In their model, the authors combined value and momentum with equal-risk weights. The tax rates they used were those in effect in 2015—43.4% for short-term capital gains and 23.8% for long-term capital gains. All dividends paid on long positions were assumed to be qualified dividend income and therefore taxed at the lower rate. In-lieu dividends paid on short positions were treated as an interest expense offsetting ordinary investment income. Portfolios were rebalanced monthly.
Following is a summary of their findings: