Summary
Long-short strategies have historically been tax-inefficient, possibly because these strategies were originally designed with non-taxable institutional investors in mind. As a result, after-tax returns have been less attractive for those of us who live in the real world and have to pay taxes.
A natural question for long-short strategies is whether there is an opportunity to be more tax-efficient. It turns out the benefits of tax loss harvesting and capital gain deferral for many long-short strategies could be substantial in both magnitude and duration. According to two white papers written by leading practitioners in the space, thoughtful tax-aware long-short strategies have:
- Similar pre-tax returns to tax-agnostic strategies
- Significantly enhanced after-tax returns
- Substantial benefits from both tax loss harvesting and capital gain deferral.
Similar Pre-Tax Returns, Significantly Enhanced After-Tax Returns
The paper “Understanding a Tax-Aware Defensive Equity Long-Short Strategy” by Sosner, Pyne, Liberman, and Liu of AQR Capital Management (April 2020) introduces a hypothetical investment strategy called Tax-Aware Defensive Equity Long-Short (TADELS). This strategy seeks to produce attractive returns for investors by holding long positions in low-risk, high-quality, undervalued stocks, while holding short positions in high-risk, low-quality, overvalued stocks. The strategy then becomes tax-aware by including in the rebalancing process some consideration for realized taxable gains and losses that would result from every potential change in position.
As you can see in Exhibit 1, changing the tax-agnostic Defensive Equity Long-Short (DELS) strategy into the tax-aware TADELS has a modest impact on pre-tax returns. Pre-tax annual returns decline by 0.2% from 12.5% annually to 12.3%. In addition, pre-tax risk increases by 0.1% annually, and the pre-tax Sharpe ratio declines modestly from 0.77 to 0.75. Overall, differences in pre-tax returns between the tax-agnostic strategy and the tax-aware strategy are negligible.
After-tax returns, however, are where the tax-aware TADELS strategy differentiates itself. The tax-aware strategy harvests and passes through significant short-term capital losses while deferring capital gains, substantially increasing after-tax returns for TADELS. To calculate the potential tax benefit, the authors assume realized losses can be used by investors to offset capital gains elsewhere in their portfolios. On an after-tax basis, the authors find a substantial 7% improvement in annual after-tax returns for the tax-aware TADELS strategy compared with the tax-agnostic DELS strategy. After-tax returns for TADELS increased to 19.9% annually due to capital losses that are passed through to investors. This compares to a 12.9% after-tax return for the tax-agnostic DELS strategy.
Exhibit 1 – Hypothetical Returns of DELS and TADELS, 1994-2019
Dels
Tadels
Total Annual Return
Pre Tax
Tax Benefit
After Tax
12.5%
0.4%
12.9%
12.3%
7.6%
19.9%
Pre Tax
After Tax
12.9%
12.9%
13.0%
14.4%
Pre Tax
After Tax
0.77
0.88
0.75
1.37
Substantial Benefits from Both Tax Loss Harvesting and Capital Gain Deferral
A second paper, “Loss Harvesting or Gain Deferral? A Surprising Source of Tax Benefits of Tax-Aware Long-Short Strategies,” by Krasner and Sosner of AQR Capital Management (2024) explores the mechanisms behind the tax benefits of tax-aware long-short strategies. This paper builds on previous research showing that these strategies can realize significant capital losses, even while generating pre-tax alpha.
Key Findings:
- Loss Harvesting: The authors find that in their hypothetical tax-aware strategy, trades closed with realized losses increase to 2.4x their tax-agnostic frequency. With a higher trade count, however, losses are taken more regularly and are therefore smaller when taken. For this reason, dollar tax savings from loss harvesting are produced but remain modest.
- Deferred Gains Matter More Than Harvested Losses: According to the authors’ research, net capital losses in tax-aware long-short strategies arise primarily from significant reductions in realized capital gains (mostly short-term gains on long positions) rather than from harvesting tax losses.
- In the hypothetical strategy, cumulative three-year realized gains decline 80% after making the model tax-aware, declining from 138% of initial invested capital when tax-agnostic to only 27% when tax-aware.
- Cumulative three-year realized losses stay approximately the same, moving from 152% of initial invested capital when tax-agnostic to 163% when tax-aware.
- Combining lower realized gains with higher realized losses leads to net realized losses increasing from 12% of initial invested capital when tax agnostic to 136% of initial invested capital when tax aware.
These Benefits Persist Over Time
This research suggests that long-short strategies could potentially offer tax losses in excess of 100% of initial invested capital over three-year periods, and this benefit could potentially continue in perpetuity. By way of comparison, research suggests that traditional long-only tax-harvesting strategies plateau when harvested losses reach around 30% of initial invested capital.
To capture these potential tax benefits, investors must select long-short strategies that are either contained within separately managed accounts (SMA’s) or owned through a pass-through vehicle such as a limited liability company.
Conclusion
Researchers believe that tax aware long-short strategies have the potential to significantly outperform their tax-agnostic versions on an after-tax basis. This outperformance has been as high as 7% annually in hypothetical tests of simple long-short strategies.
Links to white papers
To read these white papers in their entirety, follow the links below.
Paper 1:
https://www.aqr.com/Insights/Research/White-Papers/Understanding-a-Tax-Aware-Defensive-Equity-Long-Short-Strategy
Paper 2:
https://www.aqr.com/Insights/Research/Journal-Article/Loss-Harvesting-or-Gain-Deferral-A-Surprising-Source-of-Tax-Benefits-of-TaxAware-Long-Short-Strategies