Swedroe: Long/Short Portfolios & Taxes

December 05, 2018

“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.

Recent Research

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.

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