Key Takeaways
- Traditional long-short equity funds differ widely in design, but most focus primarily on pre-tax return generation. Their taxable outcomes depend on turnover, manager approach, and the structure they operate within.
- Tax-Aware Long-Short (TALSTM) strategies integrate tax considerations directly into portfolio construction and trading, intentionally combining gain deferral, systematic loss realization, and structural elements that may enhance after-tax outcomes.
- The differences between TALSTM and traditional long–short equity funds stem from strategy design and the tax treatment of the instruments used. These structures typically operate through vehicles that require professional oversight and, in many cases, investor qualification under securities laws.
Investors with meaningful wealth often look to long-short equity strategies for differentiated return patterns, risk management, or a way to diversify concentrated stock exposure. Yet the tax characteristics of these strategies vary significantly depending on how they are constructed. Long-short equity funds that were originally designed for pre-tax return generation may produce tax outcomes that surprise investors, particularly those in high tax brackets.
Tax-Aware Long-Short (TALSTM) approaches take a different path. Instead of treating taxes as a byproduct of trading activity, TALSTM incorporates tax awareness into the investment process itself.
This article provides an educational comparison of how TALSTM strategies differ structurally from traditional long-short equity funds, why those differences matter, and how investors can think about the implications in the context of eligibility, complexity, and regulatory considerations.
Traditional Long-Short Equity Funds: How They Work and Why Taxes Vary
Traditional long-short equity funds take long positions in companies expected to outperform and short positions in companies expected to underperform. These funds vary widely in philosophy and implementation — ranging from concentrated fundamental managers to diversified quantitative funds. The returns investors may realize differ from fund to fund, but it isn’t just the performance of the fund that drives returns, it’s also the tax consequences for investors.
Turnover and Realized Gains
High turnover is common in long-short strategies because:
- Long positions are adjusted as investment views evolve
- Short positions are covered and replaced
- Market exposure may be actively managed
High turnover often leads to more frequent realization of gains and losses. Research published in the Financial Analysts Journal finds that traditional long-only and long-short strategies frequently realize capital gains that can reduce their pre-tax advantages, particularly in taxable accounts where realized short-term gains are taxed at ordinary income tax rates.
Variation Across Managers
Some long-short equity fund managers incorporate tax awareness — such as holding appreciated long positions for at least one year or adjusting trade sizing to avoid unnecessary gains. However, because most long-short funds were not designed primarily as tax-aware vehicles, tax considerations typically play a secondary role.
Depending on structure, long-short funds may report taxes via:
- Form 1099 (mutual funds, ETFs)
- Schedule K-1 (private funds)
While long-short equity strategies can play a role in a diversified portfolio, the level and timing of taxes they generate can affect an investor’s overall after-tax results. Because most long-short funds are not structured with tax efficiency as a primary objective, investors in taxable accounts may experience outcomes that differ from the fund’s pre-tax performance.
What TALSTM Is: A Structurally Distinct, Tax-Aware Long-Short Framework
TALSTM (Tax-Aware Long-Short) strategies are long-short investment approaches built with tax considerations at the foundation rather than added after the fact. Traditional strategies focus primarily on pre-tax investment results. TALSTM, by contrast, is designed so that portfolio construction, trading decisions, and overall structure work together to influence:
- When gains and losses are realized
- How those gains and losses are characterized for tax purposes
- How portfolio turnover contributes to an investor’s tax profile
- How different accounts or vehicles coordinate taxable outcomes
The objective is not to eliminate taxes, but to manage them deliberately within the bounds of the tax code, recognizing that taxes can meaningfully affect after-tax returns.
In practice, TALS strategies typically combine two coordinated components: one focused on generating investment exposure and one focused on managing taxable outcomes.
1. A Long-Short Portfolio Focused on Investment Exposure and Systematic Loss Realization
The first component is a long-short portfolio designed to provide long-term investment exposure, often through diversified, systematic, or factor-based processes. What makes it “tax-aware” is the design of trading and rebalancing activity.
As positions are adjusted, the portfolio may naturally realize losses even during periods of strong performance. In our Tax-Aware Investing in Practice guide, we illustrate this through a hypothetical example in which a long-short portfolio generated a 10% gain for the year yet still realized approximately $300,000 in losses alongside roughly $400,000 in unrealized gains. The result was a net capital loss for the tax year despite the portfolio’s overall positive return — an outcome that demonstrates how systematic long-short implementation can produce meaningful loss realization while still pursuing long-term growth.
Plus, these losses can be carried forward into future years. Say you intend to sell your business in five years and realize a large gain: having several years of accumulated losses from a TALSTM strategy may give you a significant tax asset you can use to offset the gains realized from a significant liquidity event.
2. A Separate Structure That Determines How Gains and Losses Flow to Investors
The second component involves the vehicle or account structure used to deliver the strategy; often a separately managed account (SMA) or pass-through vehicle. The structure affects how losses and gains are characterized and reported, and how they interact with an investor’s overall tax situation.
In some implementations, the structure may allow for different tax character outcomes or for coordination between the investment activity and the investor’s broader tax planning. The key idea is that the structural design works alongside the investment portfolio to influence the timing and character of taxable events.
Investor Eligibility and Oversight
Because TALSTM strategies rely on specialized structures and ongoing tax coordination, many implementations are limited to investors who meet regulatory eligibility standards:
- SMA-based TALS approaches generally require Accredited Investor status.
- Partnership-based structures often require Qualified Purchaser status.
These strategies also require professional management, careful tax documentation, and compliance with IRS and securities-law requirements.
Long-Short Equity Funds vs. TALSTM: Which Is Best for Your Portfolio?
Traditional long-short funds are designed to pursue investment returns first and foremost, which means their tax results often emerge as a byproduct of trading activity. TALSTM strategies take a different approach, embedding tax considerations into the portfolio’s structure to influence how gains and losses are realized and characterized.
These strategies are sophisticated, involve specific investor qualifications, and must be coordinated with a team that understands both investment management and tax planning. If you’d like help assessing whether a TALSTM approach could complement your long-term strategy — and how it would interact with your overall tax picture — True Wealth Design can provide the analysis and guidance needed to make an informed decision. Contact us to learn more or to discuss whether this approach may be appropriate for your circumstances.
This article is for educational purposes only. The strategies referenced apply to Accredited Investors or Qualified Purchasers per SEC regulations.