A tax-loss harvesting strategy that applies a modest long/short extension may offer some key advantages over more traditional long-only approaches, but also introduces some additional considerations for investors. In addition to seeking higher amounts of tax benefits relative to long-only tax-loss harvesting, a long/short approach seeks to generate those benefits consistently over time. Leverage and shorting are two essential tools employed to capture these advantages and we believe risks surrounding these tools can be conservatively managed with a common sense approach.
Not all leverage is the same - directional vs. hedged leverage
There is a key difference between utilizing directional leverage to amplify portfolio upside return potential (on the other hand, also amplify the downside risk), or using a hedged approach, which can be used as a tool to control and potentially reduce portfolio risk. For instance, an investor who holds $100 of equity exposure could use leverage in two ways. Directional leverage would be created by the investor going long US equity futures to gain an additional $100 of exposure to equities. This leverage would serve to effectively double the portfolio risk. Another option would be to utilize hedged leverage and to go short $100 of US equity futures, which would in essence neutralize the portfolio risk. A 130/30 approach uses the underlying $100 to capture the benchmark returns while adding modest “hedged” leverage of long $30 and short $30 at the same time. A long/short extension that seeks to balance the amount of long and short exposure utilizes a hedge approach, which may enhance both pre-tax investment performance and tax-loss harvesting. The long/short extension may also help incorporate investment views into the portfolio more efficiently with less constraints than the long-only approach. Finally, it introduces a higher opportunity set of potential tax losses through larger portfolio exposures and the ability to generate tax losses in rising market environments by holding short positions.
Manage gross exposure
A modest long/short extension can be run at many levels of notional exposure, but we believe a 130/30 implementation could be an attractive mix of moderate tracking error that may reduce deviations versus the chosen benchmark and the potential for strong tax benefit generation. Typical equity market neutral hedge fund strategies may use the gross exposures of around 6x (i.e., long 3x and short 3x using hedged leverage). For comparison, a strategy that employs 130/30 has the long/short extension of 0.3x long and 0.3x short, gross exposure of 0.6x. This long/short overlay is essentially 10% of the gross exposure of a 6x equity market neutral hedge fund strategy. Many institutional investors have long utilized 130/30 strategies to allow managers to fully express a view on stocks they prefer to overweight, but also to take advantage of stocks they prefer to underweight by going short. Relative to a market neutral, 130/30 strategies are more in line with traditional benchmark aware long-only strategies, which are typically managed with a stated target amount of tracking error.
Diversify your short positions
As many professional hedge fund investors were reminded in early 2021, shorts can be a source of risk if not managed appropriately. Shorting may worry investors as, in theory, shorting may result in unlimited losses (there is no theoretical limit on how high stock price can go). In early 2021, “meme stocks” such as GameStop (GME) that were highly shorted by hedge funds were driven to all-time highs by retail investors. This “short squeeze” resulted in a painful period for investors who took large short bets on a small number of names. Managers who have concentrated short positions run the risk of those names having an outsized negative impact on portfolio results. Imagine a manager has 10% short position and the stock was short-squeezed and up by 200% in short period of time. The impact on the portfolio is -20%, a significant adverse impact on the portfolio. [1]
Quantinno seeks to manage this risk by holding a broadly diversified short book of hundreds of names and imposes a max position constraint on each. For example, a 30bp short position that rises by 200% in a day may result in a drag on strategy performance of -0.6%, which we believe is an unfortunate result but small enough to move on.
In summary, while shorting and leverage are valuable tools for investment performance and tax-loss harvesting, they are sources of risk, but can be managed by an experienced team with a common sense approach to risk management. By implementing hedged leverage, we seek to enhance the potential amounts of tax benefit generation, while seeking to not meaningfully increase portfolio risk. By targeting moderate levels of gross exposures, we keep tracking error at lower levels and seek to minimize large performance deviations for equity benchmarks. Finally, by holding a diversified short book, we seek to minimize any large impact from any individual name, while introducing tax benefit generation in a variety of market environments.
[1] This example is purely hypothetical and is included only to illustrate the potential benefits of tax-loss harvesting. They should not be construed as an indication of performance or the effectiveness of tax-loss harvesting in actual market conditions. The information in this example may be based on assumptions that are not expected to reflect actual events that will occur.