Wealthy investors are pouring billions into tax-aware long-short strategies designed to generate losses that can offset capital gains, but advisers and tax lawyers are warning that the products may carry significant investment, cost and regulatory risks.
Assets held in so-called TALS products have risen from about $2 billion in 2022 to more than $170 billion, according to Tax Alpha Insider. The surge has been driven by investors sitting on substantial gains after years of strong stock-market returns, as well as business owners who have sold companies and executives with concentrated shareholdings.
The strategies seek to track equity markets while using leveraged long and short positions to create tax losses. Those losses can then be used to offset gains elsewhere in an investor’s portfolio.
Demand has also been fuelled by the increase in initial public offerings, which has left some employees holding shares that have risen sharply in value. Wealth managers have embraced the products as other parts of the investment industry have become cheaper and more automated.
“These are phenomenally profitable and sticky products that the wealth management industry is incentivised to sell,” said Bob Casey, chief executive of Santa Barbara Management, which advises family offices. “They are growing at eye-popping rates.”
For some investors, the immediate tax benefit can be considerable. Casey said a portfolio with a $1 million investment might generate $250,000 in capital losses during its first year, although the amount would be expected to decline over time. For a California investor using those losses to offset short-term gains, the potential value could be as much as $137,500, he said.
Tax-aware long-short strategies face scrutiny
The rapid growth of TALS has attracted attention from the US Treasury, which has warned against what officials describe as aggressive tax planning involving investment products that generate losses.
At a Wall Street Tax Association seminar, Treasury officials referred to products including Section 351 conversions, box-spread exchange-traded funds and other tax-focused structures. They did not specifically identify tax-aware long-short strategies, and did not say that the arrangements were unlawful.
However, the comments have prompted advisers to warn clients that the authorities could issue new guidance, restrict certain structures or take other action. Mohsen Ghazi, a partner at Ashurst Perkins Coie, said Treasury appeared to be examining a broad range of products using the tools available to it.
“Based on what we’ve heard [from the Treasury], if you’re a potential investor, you should just be a little bit more cautious,” said Vivek Chandrasekhar, another partner at the firm.
Family offices may be particularly sensitive to any future investigation because of the reputational damage associated with being linked to an alleged tax-avoidance scheme.
The products are also not a simple way to eliminate tax. In practice, they generally defer tax by allowing losses from short positions to offset gains from long positions while the portfolio remains invested.
Unwinding the strategy can be difficult. Deleveraging may cause accumulated gains to be realised at the same time, creating a large tax bill after years of deferral.
“You can’t just say, ‘let’s turn this off,’” said Christopher Houston, head of private wealth strategies and family office services at Cambridge Associates. “You could wind up back in the same place.”
Investors who donate appreciated shares to charity or transfer them to certain trusts may be able to avoid realising the gains. Others may be relying on the tax treatment of assets passed on after death.
“Tax deferral can have a true economic benefit,” Houston said. “But you have to know what your endgame is.”
The underlying portfolios can be difficult to assess, even for sophisticated investors. A single account may contain thousands of individual positions, frequent trades, short sales, borrowing arrangements and leverage.
The most common structure is understood to be a 130/30 portfolio: for every $100 invested, the manager takes an additional $30 long position financed by borrowing, while also holding $30 in short positions. Some providers offer more aggressive structures, including 150/50 portfolios.
Leverage can increase the tax losses generated by the strategy, but it can also magnify investment losses. Returns may diverge substantially from the index the portfolio is intended to follow, a risk known as tracking error.
“If you run this strategy long enough, you should reasonably expect to experience periods in which your portfolio materially underperforms the index on a pre-tax basis,” Casey said.
Fees are another concern. The total cost can range from 1 per cent to 3 per cent a year, including investment management, financing and stock-borrowing charges.
Financing spreads have widened for some clients as lenders demand greater compensation for taking on risk. Advisers say investors should establish whether the tax savings are likely to outweigh the fees, borrowing costs and any underperformance.
“There are fees and expenses that are associated with this that you wouldn’t have with direct indexing,” Houston said. “Those can often be justified by the tax benefits. But you still need to understand them and understand how they can change over time.”
