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:
- Contrary to conventional wisdom, investment strategies that take advantage of short-selling can generate relatively low tax burdens.
- Short positions not only allow investors to benefit from the anticipated underperformance of securities, they also expand the opportunity set for realizing short-term losses, which is particularly beneficial because the short-term capital gains tax rate is substantially higher than the long-term rate. In addition, realized short-term losses are first used to offset highly taxed, short-term capital gains.
- By employing tax-wise strategies, accelerating capital losses and deferring capital gains, tax burdens are reduced. Short-selling creates tax benefits because the long positions of a portfolio tend to realize net long-term capital gains, which are taxed at relatively low rates, whereas the short positions tend to realize net short-term capital losses, which can offset short-term capital gains realized by other strategies in the investor’s portfolio.
- The benefits of tax-aware strategies mostly come from losses realized by short positions. As a result, these tax benefits are positively correlated with the market return, because short positions realize tax losses exactly at the time when other investments in the investor’s portfolio are likely to be at a gain.
- A tax-aware strategy significantly reduces capital gains realizations, and thereby the turnover, of the long-only portfolio.
Sialm and Sosner’s analysis found that “if the strategy is managed as a long-only portfolio, it generates a tax burden of 2.6% per year. On the other hand, if the strategy is managed as a relaxed-constraint portfolio that combines a 130% long exposure with a 30% short exposure, its tax burden reduces to 2.3% per year. For a long-short strategy, the tax burden even turns into a tax benefit of 0.3% per year.”
They added: “The investor can further enhance the tax benefits by systematically deferring the realization of capital gains and accelerating the realization of capital losses. As compared to the tax-agnostic approach, such tax-aware portfolio management reduces the annual tax burden of the long-only strategy from 2.6% to 0.7%, turns the 2.3% tax burden of the relaxed-constraint strategy into a 0.9% tax benefit, and increases the tax benefit of the long-short strategy from 0.3% to 6.1% per year.”
Finally, Sialm and Sosner concluded: “Quantitative strategies that take advantage of short selling can exhibit low tax burdens and can even generate tax benefits if executed with an eye toward tax awareness.”
They added that all the results they reported were gross of transaction fees. The authors also observed that “the annual turnover of the strategies is fairly large and amounts to 606% of the NAV for the long-only strategy, 838% for the relaxed-constraint strategy, and 1,339% for the long-short strategy.” Thus, managing trading costs is important.
After examining the impact of trading costs as a test of robustness, they concluded: “Transaction costs and financing costs while meaningful are not large enough to change our main conclusions.” Importantly, they did note that the benefits they outlined are reduced for mutual fund investors due to their inability to pass through losses.
By demonstrating that tax-aware, long/short strategies can be highly tax-efficient, Sialm and Sosner show that relying on conventional wisdom and our intuitions can often be a mistake. Before drawing conclusions, you should always examine the data. And when the data disagree with your theory, throw out the theory.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.