Generating consistent tax benefits in rising market environments via a long/short approach

Traditional tax-loss harvesting can be effective at the inception of an account, leaving winners in the portfolio to continue climbing and selling out losers to generate tax-losses. After a few years of market advances, however, traditional tax-loss harvesting will often struggle, as the portfolio has fewer and fewer positions at unrealized losses that can be taken advantage of with the strategy. Individual equity securities tend to be a popular choice for tax-loss harvesting, thanks to the large number of names available for investing; even so, much is written about tax-loss harvesting across other asset classes and securities, such as fixed income, ETFs, etc., during periods of market declines, periods when clients may need tax benefits the least. Rather than making the best of a bad situation, a client may be better served by a tax-loss harvesting strategy that can generate tax benefits in both rising and falling market environments and for periods much longer than traditional long-only tax-loss harvesting. These are the benefits a tax-loss harvesting strategy with a long/short extension may be uniquely positioned to provide.

Merits of a long/short approach

The next evolution of tax-loss harvesting starts with a portfolio of equities benchmarked to the index of the client’s choice, but then adds additional long positions equivalent to 30% of the account value, along with 30% short, for 130/30 in total. In this structure, the short positions in the portfolio serve an important purpose. As the market rises, the short side of the extension will likely have names that have fallen in value, potentially leading to candidates on the short side to generate tax-losses. Conversely, in a year where equity markets fall, the long side of the extension will likely have names that have fallen in value, potentially leading to candidates on the long side to generate tax-losses. With this long/short approach, the ability to find candidates for generating tax-losses will be present even if the underlying account has been in service for years and is highly appreciated.

Key Benefits

The value of a strategy with a long/short extension may not be limited to the strong tax benefit it provides but may also include the consistency of that benefit. Generating consistent tax benefits for clients may lead to the ability to partner with a CPA or other tax and legal advisors to do true tax planning. The sporadic tax benefits of a traditional tax-loss harvesting strategy that may only be seen in early years of a strategy, or during market declines, may be less valuable as a planning tool. A long/short extension may also be a helpful tool for managing account risk (tracking error) versus a stated equity benchmark, along with generating a modest return in addition to the return of the underlying equity benchmark, but we’ll leave that discussion for another day.

Learn more

If you’d like to learn more about generating strong and consistent tax benefits throughout a wide variety of market environments for your clients, send us a note at IR@quantinno.com.

The views and opinions expressed herein are those of Quantinno Capital Management as of the date hereof and are subject to change based on prevailing market and economic conditions and will not be updated or supplemented.  Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Investors should seek advice from their investment professional to review their specific information. Quantinno Capital Management does not provide tax, accounting or legal advice. Please see Quantinno.com for more information.