Considerations for a Long-Short Strategy to Manage Capital Gains

Recently I’ve had discussions with numerous clients about adopting an offensive approach during periods of increased market volatility. As previously mentioned, volatility presents opportunities to capitalize on strategies such as tax-loss harvesting.

Tax-loss harvesting strategies can be particularly beneficial if you need to diversify concentrated equity positions or manage capital gains from selling a business or real estate. One particularly popular strategy at the moment, especially if you aim to diversify a concentrated position without incurring substantial capital gains taxes, is the long-short strategy. This strategy is growing in popularity, but due to its complexity, many investors do not fully understand the benefits and risks.

At Mercer Advisors, as fiduciaries, we assist you in navigating  strategies for your portfolio that are in your best interest. We are here to help evaluate if this strategy is right for you, and then implement it if we jointly determine that it is. While we believe it is a good strategy in certain cases, it is not suitable for everyone. You should understand both benefits and risks to make an informed assessment.

The fundamentals of a long-short strategy are illustrated in the graphic below:

Considering long-short strategies

1.  Begin with alpha

I’ve often heard clients ask, “Why should I invest in something that loses money?”

It’s important to note that the long-short managers approved by Mercer Advisors are quantitative investing firms that invest systematically based on a factor-based methodology. In some instances, the manager is conducting new research on emerging factors as they seek to add alpha — systematic outperformance — to the chosen benchmark.

We favor these managers for their ability to generate returns that track the underlying market benchmark while offering an opportunity for alpha through their security selection process.

The objective of these strategies is to generate both unrealized and realized gains that track and potentially outperform their benchmark, along with realized tax losses that can be harvested to offset tax obligations. As always, it’s crucial to emphasize that returns are not guaranteed, and past performance is not indicative of future results.

2.  Consider tax benefits next

In addition to returns in line with the chosen benchmark (+/- tracking error and alpha opportunity), a long-short strategy offers potential tax benefits:

• The long-short strategy includes bothlong and short positions, allowing the manager to generate tax losses regardless of market direction.
• The strategy employs leverage, which amplifies the magnitude of these tax benefits.

3.  Situations where tax benefits matter

Most of the tax losses created by the strategy are short-term, providing an opportunity to offset both short-term and long-term capital gains at the federal level. Most states allow short-term capital losses to offset long-term capital gains, but there are some exceptions. You should work with an advisor to understand the implications of your situation. Some common scenarios where a long-short solution can be beneficial include:

• Concentrated stock position. The manager gradually sells down your concentrated position(s), using generated tax losses to offset the gains on sales of stock(s). Portfolio returns and risk will be a combination of the funded stock(s) and the diversified portfolio of stocks purchased when the manager invests the cash raised by selling a portion of the concentrated position. Once the tax-deferred diversification is complete, the portfolio returns will track the chosen benchmark (+/- tracking error and alpha opportunity).

• Improve the tax efficiency of a business/home sale. You invest cash in a long-short strategy, realizing portfolio returns and risk in line with the chosen benchmark (+/- tracking error and alpha opportunity) and recognize tax losses each year. These tax losses can offset the gains of many business and home sales. The sooner cash is invested in the long-short strategy within a tax year, the greater the expected tax losses generated. The best strategy is often to invest cash years ahead of the sale to accrue losses over a longer time period.

• Reinvigorate frozen portfolio. You may have an existing portfolio of diversified or non-diversified stocks/securities. The portfolio can be managed by a long-short manager, who will sell down securities as needed to get the resulting portfolio in line with their model. The tax losses generated can offset gains of sold securities. Once the portfolio is fully transitioned, the client can use tax losses outside the portfolio (as described above) or bank them year-over-year for future use. In some cases, diversified stock portfolios can be transitioned very quickly, with tax losses available outside the portfolio for you to use the same year.

4.  Consider the risks

As mentioned at the outset, anyone considering this strategy should be mindful of the risks. One key point to understand is that over time, as tax (capital) losses are generated, the portfolio becomes more embedded with positions that have large unrealized gains.

The long-short solution defers capital gains, but does not avoid them. An abrupt liquidation from the strategy (after the investor’s return/tax benefit are achieved) can trigger significant tax consequences. The portfolio is liquid, but it is essential they understand that this investment is a long-term hold. If you want to unwind the strategy, this should be done thoughtfully and over time.

• A long-short strategy could be a long-term core holding for some investors due to the opportunity for both portfolio alpha and tax benefits. For those that wish to exit the strategy, the idea is that the economic benefits from being in the strategy outweigh the cumulative annual strategy and exit costs. However, a thoughtful exit is needed to achieve this.

• The long-short manager aims to generate alpha (outperform the chosen benchmark) through security selection. While managers can succeed in this, it is also possible that their methodical process underperforms the market, resulting in portfolio return less that the benchmark.

• Tax loss estimates are just that – estimates. The estimates are based on a limited number of years of real data, in addition to back-tested results going back 20+ years in some cases. However, these estimates could be inaccurate. For example, if market volatility were significantly lower than expected, tax losses may be less than expected.

5.  Examining exits

The long-short strategy is designed to be held long term as a core holding, generating returns in line with the chosen benchmark (for appropriate clients). If you wish to exit the strategy and keep only the long stocks, the extensions (leverage) should be unwound thoughtfully over time. Capital gains taxes will be incurred.

• For strategies with higher levels of gross leverage, you can choose to remain in that specific solution if you desire continued higher expected alpha and tax benefit opportunities.

• If you’re invested in higher leverage strategies and wish to reduce leverage and cost, it will take time to unwind the extensions (leverage) in a tax-efficient way. This process can take years. At this point, you can continue to remain in the strategy, now with less leverage and cost, and take tax-efficient distributions over time. Alternatively, you can exit the strategy entirely but gradually, which involves keeping the long positions and having the manager unwind the extensions and pay some taxes.

Bottom line

If you’re considering a long-short strategy amid the current market volatility, you’re in the right place. You should work closely with your advisor, who can assess if the strategy is right for you.

There are many strategies to diversify a concentrated position or manage the proceeds from selling a large investment. You should carefully understand the different options available.

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Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.

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Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Diversification does not ensure a profit or guarantee against loss. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.

There is a risk of substantial loss associated with leverage. Before investing carefully consider your financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when engaging in leverage one could lose the full balance of their account. It is also possible to lose more than the initial deposit when engaging in leverage. The realized tax benefits associated with the tax-aware strategy may be less than expected or may not materialize due to the economic performance of the strategy, an investor’s particular circumstances, prospective or retroactive changes in applicable tax law, and/or a successful challenge by the IRS. In the case of an IRS challenge, penalties may apply.