“Conventional wisdom” can be defined as ideas that are so accepted they go unquestioned. Unfortunately, conventional wisdom is often wrong. Two good examples are that millions of people once believed the conventional wisdom that the Earth is flat, and millions also believed that the Earth is the center of the universe. Much of today’s conventional wisdom on investing is also wrong.
Today we’ll look at the conventional wisdom that the tax burden of an investment strategy increases with its turnover—high turnover strategies exhibit a higher propensity to realize capital gains. In addition, short selling is perceived to be particularly tax inefficient, since the realized capital gains on short positions are generally taxed at the higher short-term capital gains tax rate, regardless of the holding period of the short positions.
Clemens Sialm and Nathan Sosner, authors of the study “Taxes, Shorting, and Active Management,” published in the first quarter 2018 issue of the Financial Analysts Journal, examined the consequences of short selling in the context of quantitative investment strategies in taxable accounts of individual investors.
They computed the tax burden of a quantitative fund manager who follows a combined value and momentum strategy. Combining value and momentum strategies is particularly beneficial because these strategies tend to exhibit negative correlation. Their model combined value and momentum with equal risk weights and targeted a tracking error of 4%. Tax awareness was implemented through a penalty term that incorporates tax costs into the portfolio’s objective function. The sample period is 1985 through 2015.
Following is a summary of their findings:
- Short positions not only allow investors to benefit from the anticipated underperformance of securities, they create tax benefits because they enhance the opportunities to time capital gains realizations.
- The presence of short positions gives investment strategies additional opportunities for realizing capital losses in up markets, when capital losses from long positions are scarce. Up markets are also periods when investors tend to have more abundant capital gains, making the realization of capital losses in these periods particularly valuable.
- Long-short strategies increase the opportunity to realize short-term losses, which are particularly beneficial because the short-term capital gains tax rate is substantially higher than the long-term rate, and the realized short-term losses will first be used to offset highly taxed short-term capital gains.
- The relaxation of short selling constraints generates tax benefits because the long positions of a portfolio tend to generate long-term capital gains, which are taxed at relatively low rates, whereas the short positions tend to generate short-term capital losses, which offset short-term capital gains taxed at relatively high rates.
Specifically, Sialm and Sosner found that “if the strategy is managed as a long-only portfolio, it generates a tax burden of 2.8% 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 2.2% per year. For a long-short strategy the tax burden turns into a tax benefit of 0.5% per year.”
They also found that “the investor can further enhance the tax benefits by deferring the realization of capital gains and accelerating the realization of capital losses. As compared to the tax-agnostic approach, such tax-aware asset management reduces the annual tax burden of the long-only strategy from 2.8% to 1%, turns the annual 2.2% tax burden of the relaxed-constraint strategy into a 0.7% tax benefit, and increases the tax benefit of the long-short strategy from 0.5% to 4.6% per year.”
Tax-aware strategies also significantly reduce turnover of long-short strategies, as they reduce capital gains realizations (delaying realization until short-term gains become long term) and thus trading costs.
It’s important to note that Sialm and Sosner’s results are “specific to investors who realize sufficient short- and long-term capital gains from other investment sources. The reduction in the taxes is smaller if the portfolios are structured as mutual funds according to the Investment Company Act of 1940 or if the investor does not have any other capital gains in the portfolio. In these cases, the remaining capital losses need to be carried forward to future years, which will likely reduce the benefits of capital loss realizations.”
However, they also noted that “despite these reductions in the tax benefits using limited offsets, we find a significant reduction in the tax burden in strategies that take advantage of short selling and tax awareness. For example, a tax-agnostic long-only strategy generates tax costs of 3.1% per year, whereas a tax-agnostic long-short strategy generates tax costs of only 0.7% per year despite a higher pre-tax active return. Furthermore, introducing tax awareness generates a tax benefit of 0.4% for a long-short strategy. This small benefit occurs primarily due to the fact that dividends obtained on the long positions qualify for the dividend tax rate, whereas in-lieu dividend payments on the short positions can be deducted from ordinary income emanating from cash used to finance the long-short portfolio. Thus, tax-awareness and short-selling can also enhance after-tax returns for investors who have limited opportunities to offset capital gains realizations.”
The authors also noted that their examples “assume that the portfolio does not experience any inflows or outflows of funds. Inflows provide additional opportunities to reduce the tax burden of future portfolio rebalancing since these funds are used to purchase new positions and thus increase the cost basis of a portfolio with embedded unrealized capital gains. On the other hand, outflows, if not managed in a tax-efficient manner, may trigger additional taxes as the investor needs to liquidate positions and potentially realize capital gains.”
Superior After-Tax Performance
Sialm and Sosner concluded that their results show that quantitative investment strategies that take advantage of short selling can generate superior after-tax performance by significantly reducing the tax burden, and can even generate tax benefits if executed with an eye toward tax awareness.
They also found “on average the tax benefits of tax-aware strategies come from short positions. Moreover, these tax benefits are positively correlated with market returns meaning that the short positions generate tax losses exactly at the time when other investments in the investor’s portfolio are likely to be at a gain.”
Importantly, they also found that their conclusions “are robust to the target level of active risk, to transaction and financing costs, to the level of tax aversion, and to the historical variation in tax rates.”
Summarizing, Sialm and Sosner demonstrate that the conventional wisdom on the tax-efficiency of long-short strategies is wrong, having found that, “on average, the tax benefits of tax-aware strategies come from short positions.” In addition, they found “these tax benefits are positively correlated with market returns meaning that the short positions generate tax losses exactly at the time when other investments in the investor’s portfolio are likely to be at a gain.”
According to the authors, their evidence demonstrates “that short-selling is a valuable tool for a taxable investor. While portfolio design decisions—market beta, level of risk and tax aversion, and turnover and leverage— might vary, the presence of short positions is likely to enhance after-tax returns and to interact favorably with explicit tax awareness.”
Character Of Tax Benefits Of Relaxed-Constraint Strategies
Sosner, with co-authors Stanley Krasner and Ted Pyne, followed up his original study with the October 2018 study “The Tax Benefits of Relaxing the Long-Only Constraint: Do They Come from Character or Deferral?” which covers the period January 1988 to December 2017.
The authors focus on the tax benefits of a quantitative tax-aware fund manager who follows either a combined value and momentum strategy or a passive index strategy with a quantitative tax management overlay.
They begin by noting there are two ways of achieving a tax benefit at the level of an overall investment portfolio held in a taxable account:
- An investor can favorably affect the character of realized capital gains and income at the overall portfolio level by tilting the balance of net realized gains in a given year from short-term to long-term gains and from highly taxed ordinary income to low-taxed qualified dividends. A character benefit occurs because short-term losses offset short-term gains before offsetting any long-term gains. Thus, a strategy realizing long-term gains and qualified dividend income and short-term losses and ordinary deductions tilts the balance of net realized gains and income in a given year from short term (and ordinary) to long term (and qualified dividends) at the overall portfolio level. This benefit is permanent. However, a strategy’s character benefit only exists when other strategies in the overall investment portfolio realize their gains and income in highly taxed characters—short-term capital gains and ordinary income.
- At the overall portfolio level, an investor can defer the realization of capital gains to future years and benefit from a reduction in the current year’s taxable gains. In this case, the benefit is temporary because, barring a tax-exempt portfolio liquidation due to donation to charity or step-up in the cost basis at death, an increase in current unrealized gains leads to higher liquidation taxes. Despite being temporary, deferral benefits add value, allowing wealth to compound at a faster rate.
Following is a summary of Sosner, Krasner and Pyne’s findings:
- Under their tax rate assumptions, for a relaxed-constraint value-momentum strategy, tax awareness increases after-tax (net of transaction and financing cost) annual returns by close to 1%.
- Most of the benefit comes from the realization of short-term capital losses, with a small benefit from in-lieu dividends expense on short positions.
- The tax-aware, value-momentum, relaxed-constraint strategy tends to realize tax benefits in falling markets and tax costs in rising markets. However, its benefits in falling markets are higher and its costs in rising markets are lower compared to its long-only counterparts—tax-aware, value-momentum, long-only strategy and passively indexed, loss-harvesting strategy. This is because, due to shorting, the relaxed-constraint strategy inherits some of the properties of the very-tax-efficient long-short strategy: The tax-aware, value-momentum, long-short strategy realizes tax benefits in both rising and falling markets, with its tax benefits being even higher in rising markets, when all the beta-one strategies—relaxed-constraint, long-only and passively indexed—tend to realize significant tax costs.
- While dividend income is a tax drag on all strategies, for the long-short strategy, dividend results are more beneficial because the short positions’ dividend expense partially offsets the interest income from money market instruments held by the long-short strategy.
- All the tax-aware strategies—relaxed-constraint (such as 130 long/30 short), long-short, long-only and passively-indexed—convey much larger benefits to those investors who have the ability to efficiently use short-term losses and deductions realized by the strategies against short-term gains and ordinary income from other strategies in their investment portfolio.
Importantly, the new result of Sosner, Krasner and Pyne’s study is that, with the exception of the first few years, in an average year, all the tax-aware beta-one strategies—relaxed-constraint, long-only and passively-indexed—obtain their tax benefits from character, whereas the tax-aware long-short strategy obtains its tax benefits from both character and deferral.
Moreover, since the tax-aware relaxed-constraint strategy—similar to long-short—benefits from shorting, its character benefit is substantially higher than the character benefits of tax-aware, long-only and passively indexed, loss-harvesting strategies. This result is true in an average year and also in rising and falling market years.
The authors concluded: “Empirical evidence shows that for tax-aware strategies relaxing the long-only constraint results in a drastic increase in their tax benefits and in particular in the character benefit. We thus conclude that tax aware relaxed-constraint strategies are more attractive to taxable investors than their long-only counterparts.”
These findings have important implications for investors willing to consider leverage and shorting as part of their equity strategies.
For example, AQR Capital Management employs the tax-aware stock selection strategy in its Alternative Risk Premia R6 Fund (QRPRX). The short-term capital losses realized by the stock selection strategy help offset short-term capital gains from other strategies’ trading futures, forwards and options.
As a result, despite being an alternative hedge-fundlike investment, QRPRX is expected to be highly tax efficient because it: (1) distributes only a small portion of its economic return as dividends; and (2) those dividends predominantly comprise low-taxed long-term capital gains and qualified dividend income. The tax efficiency of QRPRX allows investors to hold the strategy in taxable accounts. For investors with limited capacity in tax-advantaged accounts, this is an important benefit. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.