Tax Aware

Looking Under the Hood of Long/Short Tax-Aware Strategies

October 27, 2023

Topics - Tax Aware Alternative Investing Factor/Style Investing

We’ve published a range of papers that show long/short strategies may be more “tax beneficial” than long-only ones. 1 1 Close For those looking for a very, very short summary: compared to long-only, a long/short approach can facilitate net capital losses that are 1) larger, 2) less sensitive to market direction, and 3) meaningfully longer-lasting.)   

But where do these additional benefits come from? 

Consider two long/short equity strategies. Both have the same underlying investment themes, the same investment universe, and so on. But there’s one difference: one strategy focuses on generating attractive pre-tax returns; the other on generating attractive after-tax returns. Obviously, you’d expect the first to look better pre-tax and the second after-tax, but what actually causes that difference? Specifically, does the second strategy’s (after-tax) outperformance come from being quicker to liquidate its losers, or from it being slower to liquidate its winners? Or, said in tax-speak, is it more about harvesting losses or about deferring gains? 

The answer, according to our latest paper: gain deferral. 

This might be surprising, since for passively indexed strategies such as direct indexing, the source of so-called “tax alpha” is clearly from harvesting losses. 2 2 Close There’s a reason these are called tax-loss harvesting strategies, after all…   But when it comes to long/short factor strategies, it’s mostly the opposite. The benefits of being tax-aware are mostly due to deferring short-term gains on long positions—sometimes it pays to wait! (In contrast, the tax-agnostic version would trade to realize those gains in pursuit of pre-tax alpha.)

A natural follow-on question is whether a long/short tax-aware portfolio ends up looking a lot different than one that doesn’t care about taxes. For example, if you believe in value, momentum, and quality investing, do you have to subvert those beliefs if you want to be efficient about taxes? To answer this, we compare the trading decisions of the two strategies (the tax-aware one and the tax-agnostic one), and we find a resounding, and reassuring, “no”. The majority of turnover in both versions is in the direction of “alpha”. 

Why does all this matter? In general, an investor who cares about one thing (e.g., maximizing return) will hold a portfolio that can look very different from an investor who cares about something else (e.g., minimizing risk). This paper suggests that when it comes to diversified long/short equity factor strategies, the differences between a portfolio that cares about taxes and one that doesn’t may be smaller than you think.

 
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This document is not intended to, and does not relate specifically to any investment strategy or product that Chenguang Capital offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

 

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Chenguang Capital (“Chenguang Capital”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of Chenguang Capital. The views expressed reflect the current views as of the date hereof and neither the author nor Chenguang Capital undertakes to advise you of any changes in the views expressed herein. 

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