Long-short investing often sounds elite and opaque. Many think it’s primarily for hedge funds and billionaires. Yet, a key variant—tax-aware long-short strategies—offers powerful ways to manage taxes while pursuing performance.
Let’s clarify what “tax aware” means in long-short strategies, debunk myths, show why tax-aware design matters, and explain how it works in practice.
What is a long-short strategy?
A long-short strategy is an investment approach that involves buying (going long) certain assets while simultaneously selling (going short) other assets. The idea is to profit from the difference in performance between the long and short positions.
Typically, investors go long with assets they believe will increase in value and short assets they expect to decrease in value.
This strategy can help reduce risk and hedge against market fluctuations while aiming for returns during both rising and falling markets.
What “tax-aware” means in long-short strategies
“Tax aware” refers to deliberately designing a long-short strategy to optimize tax outcomes. It involves generating realizable losses to offset gains, deferring recognition of gains, and aligning trading and structure to minimize tax drag.
Key features include:
- Harvesting tax losses systematically through long and short positions, regardless of market direction.
- Deferring capital gains by avoiding unnecessary realization allows the portfolio to retain unrealized appreciation.
- Pursuing alpha and tax efficiency, not just mimicking a passive index for tax losses like direct indexing.
- Using leverage and shorting to increase opportunities for tax loss generation.
It means embedding tax strategy into the investment design, not considering it as an afterthought.
How tax-aware long-short strategies work
A tax-aware long-short strategy combines a core investment with a long-short approach based on factor models to achieve a predetermined targeted beta exposure—whether neutral, defensive, or aligned with broader market movements. It involves regularly adjusting the portfolio, with the goal of producing consistent tax losses. Even in rising markets, strategies like leverage and short selling can create valuable tax loss opportunities—without compromising portfolio performance.
Investors can participate through separately managed accounts (SMA) or pass-through vehicles, directly receiving their gains and losses instead of relying on pooled funds. This approach was historically available mainly to institutional investors, but thanks to advancements in modern financial platforms, individual investors can now directly access it.
Who benefits most from tax-aware long-short strategies
Tax-aware long-short strategies best suit investors who:
- Have large taxable exposure with unrealized gains.
- Seek to diversify concentrated positions without triggering gains.
- Want more than passive loss harvesting to pursue meaningful alpha.
- Can use separately managed accounts or structures like limited partnerships or LLCs to clearly see and manage the tax implications of each specific investment.
There are many myths about a tax-aware, long-short strategy. Here are some common ones:
Myth #1: Long-short strategies are always tax-inefficient
The assumption is that long shorts involve high turnover, triggering tax inefficiency.
Tax-aware long-short structures capitalize on turnover. Through dynamic rebalancing, you systematically realize losses, not just gains, even in rising markets.
These tax benefits persist over time. Instead of being inherently inefficient, long-short strategies can be highly tax-efficient when designed purposefully.
Myth #2: Shorts can’t help with taxes
Profits from short positions, where an investor anticipates a decline in a stock’s price, are taxed as ordinary income, often higher than long-term capital gains. While some may view short-term losses as unfavorable, they can be strategically advantageous.
These losses can offset gains from long positions. You can mitigate losses and reduce overall tax liabilities by effectively managing both short and long positions. This approach enhances tax efficiency and allows you to retain more investment gains.
Myth #3: Tax awareness hinders performance
Many fear that adding tax optimization means sacrificing investment returns.
The opposite is true. Tax-aware strategies aim to preserve or enhance pre-tax alpha, not undercut it.
AQR’s research shows tax-aware long-short strategies retain most of their pre-tax alpha while generating valuable tax benefits through fewer unnecessary gain realizations.
What to watch for in tax-aware managers
When evaluating a tax-aware manager, review pre-tax and after-tax performance,
Confirm that appropriate investment structures, like separately managed accounts, partnerships, and limited liability companies (LLCs), are in place.
Be sure the technology and processes used in managing investments support effective rebalancing and tracking, which ensures that your portfolio remains aligned with your investment strategy and adapts to changing market conditions.
Evaluate the leverage used and the tolerance for tracking error, which should correspond with your overall risk profile, to ensure you’re comfortable with the level of risk being taken.
Consider the ease of exit from investments and the potential for gain realization. Understanding how easily you can liquidate your position when necessary and what processes are in place for capturing gains can significantly affect your overall investment strategy and financial goals.
Final thoughts
Tax-aware long-short strategies are not tax gimmicks. They are strategically designed to generate meaningful tax alpha while pursuing real performance.
By integrating tax awareness into the structure, these strategies shatter myths. They can be both tax-efficient and return-effective.
