Episode 17 – Exploring the Long-Short Strategy

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Welcome to Market Perspectives, a Mercer Advisors podcast. For today’s episode, we’re going to do a deep dive into long-short strategies. This is a fascinating strategy. This is a relatively new strategy for most investors who have a large, concentrated position that they’re looking to manage.

But first, let’s introduce ourselves. I’m Josh Zumbrun. I’m the Director of External Communications at Mercer Advisors. And I’m joined today by Will Rockett.

Will is our Senior Director of Investment Strategy and leads the investment strategist team. Will, thanks for joining us today.

Thanks, Josh. Great to be here.

So, Will, let’s start out by talking about the situation that investors might find themselves in where they need this sort of strategy. Help us understand who might find themselves with a really highly concentrated position where they need to do something special to manage it.

Well, certainly you could have been a very creative and successful investor. You also could have been lucky. But you find yourselves in a situation where you have one or more positions in different equity securities or other securities that are highly appreciated and have a very low cost basis.

So to make this tangible, let’s use a hypothetical. Let’s pretend I’m an employee of Acme. We’re going to use a fictional company. We’re going to use Acme from the old Road Runner-Wile E.

Coyote cartoons. So I’m a employee of Acme. I’ve been paid in Acme stock for a few years here. I’ve had a really successful run at Acme.

I’ve made stuff that just blows up, and it’s been great. And so I have $3 million of Acme stock. And it’s a big part of my portfolio.

And because I got it as an employee, I have it at a really low tax basis. And so I’ve been sitting on this huge portfolio of Acme, and I’ve been a little bit unsure what to do with it. Because if I just sell it, I’m going to take this huge capital gain. So I’ve just been letting it ride for a long time, and it’s grown here. So how would the big Acme investor use this strategy?

Sure. So I think we certainly want a roadrunner outcome here and not a coyote outcome. And I think the coyote outcome might be you wind up selling a lot of stock all at once and paying a lot of taxes. But I think Road Runner, in this situation, has a plan and says, I would like to become more diversified on my portfolio, not have too many of my eggs in one basket, and be able to do so in a tax-efficient way. That is get diversified from that concentrated position in a tax-efficient way. So that is one of the benefits of a long-short strategy, is not so much avoiding taxes, but the transition from a concentrated position to a diversified portfolio. That is tracking an index, an equity index that you choose in a tax-neutral way.

What are some of the strategies available? Somebody in my situation sitting on $3 million of Acme stock. I’m not ready to pay the taxes on all of it. What are some of my options to manage my way out of this position?

Sure. So you know, Josh, before we get into that, I wonder if we might just talk quickly about those who have concentrated positions that might be a little bit reluctant to get out of them, even without the tax conversation. So one thing I might note to that is, first and foremost, it’s great to have a financial plan. We view it as being a necessary element these days.

All institutions have an investment policy statement. Talk about risk, return, what are your objectives. We want that for individuals.

And just two pieces of data I’ll quickly put out there for the individual investor who might have some hesitations about diversifying out of a stock that has just done so well. Let me just present two pieces of data. So first, if we look at the top 10 stocks in the S&P 500 in 2010, only half of those remain as top 10 stocks in the S&P 500 as of 2020.

In other words, I’ve had a good run with my Acme. There’s reason to think there might not be best to keep all my eggs in this basket. The great performance Acme’s had might not persist the next 10 years.

I think that’s it. But that’s the hardest thing, is when things are going well, you assume that they’ll continue to go in the same manner. And there’s tremendous companies out there that continue to be tremendous operating companies, generating tremendous profits. Growing does not necessarily mean that their stock performance is going to be the same as it was during their run up to being one of the top companies out there.

And I’ll put one more piece of data out there and just say, if you look at companies that became one of the top 10 in the S&P 500, their returns after joining a top 10 company in the S&P is actually less than that of the S&P 500 index over a three-year, a five-year, and 10-year basis. So after becoming one of the 10 largest, their returns actually lag the S&P 500. So that’s something just to keep in mind. And it might not be an all or nothing thing, Josh. We’re not saying, hey, get out of all of this stock that has made you, on paper, incredibly wealthy. But have a conversation about what portion of that makes sense to diversify. And when you do so, do it like the Road Runner, tax efficiently.

So yeah. So I’ve got $3 million of Acme stock and maybe I don’t have a huge amount of other stuff. Maybe I’ve got only $1 million in other things. Like I’m really heavily tied up into this company. And so what are some of the options I have to start getting my way out of this situation?

Certainly many options. And we’ll get into long-short strategies as one of them.

Many individuals have great success in terms of just saying, I want to diversify. I don’t want to pay a bunch of taxes in this particular year. Can I do that over time? So monetizing that position, diversifying it, and having a capital gains budget where every year x dollars are being planned for taxes and perhaps that’s in pairing with some capital losses you have in other portions of your portfolio. So stage selling or monetization with a capital gains budget would be one option.

Then we have other types of strategies that can help with this. We can do hedging strategies, different options strategies that actually generate income from securities. Those can have some downside protection for the actual concentrated position, as well as generating some income. And you can use that income to very gradually sell down that position in a tax-neutral way.

And I think financial planning is something that is overlooked by many individuals here. Talking with your financial advisor about tax-efficient giving, other financial planning techniques. At Mercer, we really think about good outcomes coming from the merger between planning, tax planning, and investments. And then we get more into those tax-efficient diversification strategies.

So one we haven’t talked about yet is the equity exchange fund, where you can transfer your security into a fund along with other individuals–

We should actually do a whole podcast on equity exchange fund strategy as well.

Agreed. Maybe we pause on that one for now and just follow up on that later. And then we come to long-short. So long-short strategies, another example of a strategy like options, equity exchange funds. Long-short strategies are three good ones for diversification and tax-efficient diversification at that.

OK. So using our example here, $3 million of Acme that I’m trying to diversify, I’m interested in understanding how this long-short strategy would actually work for my Acme portfolio. Walk us through what is a long-short account and how it would work in this situation.

Sure. So I think this is where, perhaps, the best intentions of the coyote in your Road Runner example and an Acme Company comes into play. So most of us are familiar with direct indexing. Direct indexing is a long-only strategy where you hire an investment manager and you choose an equity index. Let’s call it the S&P 500. And that equity manager will purchase, say, 300 or so securities from the S&P 500 and trade on your behalf.

What does trade on your behalf mean? It means that as markets go up and down, the manager will sell securities when they go down and replace those securities with ones that are very similar. So Pepsi goes down, you buy Coke. Delta Airlines go down, you buy American. You realize that capital loss while maintaining that core equity exposure to the S&P 500 with a little bit of tracking error. Because you don’t own all 500 stocks, you own 300. But maybe you take about a 1% tracking error and then you realize these capital losses over time, which you can use in your portfolio.

So what long-short does is it’s the same philosophy, except now you’re adding short positions as well. So regardless of the market direction, markets go up. You can cover your short positions. Take those losses, replace those short positions with identical companies. Coke, Pepsi, Delta Airlines, American Airlines. And you’re not as beholden on the market to go down to recognize losses.

So what you wind up with is a core equity allocation with some tracking error to the index. Tracking error on long-short is a little bit higher.

And you can choose how much tracking error you want.

But the benefits are markets go up, markets go down, you’re able to take losses in either direction. Versus direct indexing, you rely on the market going down to take those losses.

And the reason I want to take the losses here is because I have a big capital gain. But if I have a loss, I can offset some of that. If I have a $100,000 gain in one year but I also have $100,000 loss from this strategy, then they offset each other and are taxed on that portion, I guess.

Perfect. Yeah. So now we set up what long-short is, kind of an evolution or a derivative of direct indexing. So what happens with Acme stock?

So you say I want to diversify $3 million of Acme stock. And you find a long-short manager. That manager will take your $3 million of Acme stock and they will style a large chunk of it on day one. They will only sell the amount that they believe, through the remainder of that calendar year, they can generate an equal amount of losses in their long-short strategy to offset the capital gain they made by selling that stock day one.

So if you fund it in January, they know they have the whole year to make up that capital gain with losses. If you fund it in the summer, they realize they only have a matter of months to perform the capital losses over the rest of the year and recoup that capital gain in the stock. So that’s what happens year one.

Year two, same thing. January, sell down a portion of the stock. Only the amount of which they believe they can make up in capital losses through the rest of the year and so on and so forth in the years to come. And at the end of the diversification period, you wind up with a diversified portfolio of stocks tracking an index that you chose, S&P 500, Russell 1,000, Russell 3,000. There are some other examples. And you’ve gotten there without recognizing taxes.

You still have embedded gains in your portfolio, but you’ve had the journey to get there without recognizing taxes. And that’s why people like these strategies. So tax-neutral transition from a concentrated stock to diversified portfolio. Now your portfolio is far less volatile or risky than that one stock position.

So suddenly, my $3 million in Acme over the course of a few years has turned into just a $3 million S&P 500 portfolio, or something like that?

You will get the returns of the S&P 500 or whatever index you choose, plus or minus the tracking error. So in the beginning, they sell down a portion of your stock. Your returns will be whatever portion of the stock you still own plus the returns of the S&P 500 or whatever index you choose plus or minus a small tracking error.

Perhaps two or three years into it when your portfolio is sold down in terms of that concentrated stock position and you only own maybe 20% of that stock in that portfolio and 80% of the strategy tracking that index, it will mirror more the index. And then eventually, that $3 million will have grown depending on the returns of the stock that you funded it with and that underlying index. All the while, you’re doing that transition without paying taxes.

So talk me through the mechanics of how this works. I mean, how long am I looking at to diversify this $3 million position? And explain exactly how I’m using shorts in this strategy here.

Sure. So one of the things about these types of strategies is they tend to be a bit flexible.

You can choose a strategy with a low amount of leverage that would diversify this position over a number of years. Call it maybe eight years or so. If you want to diversify your position more quickly than that, you can choose a strategy that has a higher amount of leverage and perhaps get out in as quickly as two years.

How does the leverage work here?

When the Acme stock is funded, the long-short manager will immediately borrow off of that stock and enter in what we call a long extension. So basically, you’re borrowing.

You are then taking the borrowing value and investing into the long positions in that strategy. So your long positions in the S&P 500 if that’s the index you chose. At the same time, the manager will then short positions in the account the same amount, the same value that you have added additional longs. So you have long extensions, short extensions. The balance of those is market neutral.

OK. So I’ve got a $3 million portfolio. So I’m taking $1 million in long positions, betting those stocks go up and a bucket million in short positions, betting that basket of stocks goes down?

That’s it. No, that’s exactly what it is. And that’s one iteration, one choice of leverage you can choose. So you have $3 million funded.

You have a million in longs. Those longs are S&P 500 stocks, for example. Shorts are S&P 500 stocks. So your immediate portfolio and those extensions, you’re not adding additional market risk, because you have your core position you funded with and then you’re adding long extensions, short extensions.

So the amount of market exposure you have is still just what you funded.

And I think that’s a really important point. And I will tell you that conversations with your financial advisor here help a lot if you see this on paper. But it’s important to know that a lot of people get nervous like, oh, I have margin. And I have more market exposure.

And am I worried about things changing, getting a margin call? Well, the thing to remember here is that you have market neutral extensions. Your longs on the extension equal your short on extension. So your market risk is basically what you funded.

And what you funded day one is your stock. And then what you sell of your stock into additional long exposure in the market.

I guess the key here that makes this such a clever strategy is that long or short, the market goes up, the long side does OK, and the losses are generated on the short side. If the market goes down, then the shorts do OK and the losses are generated on the long side. But up or down, the strategy delivers a result for you that you want here.

That’s it. And direct indexing over time loses its ability to generate tax alpha because markets are upward trending. So years three, four, five, six, and beyond, most likely the opportunities to take losses in the portfolios are relatively rare. Long-short markets are upward trending. You still have that short side of the portfolio. So you can continue to generate losses even as markets go up.

So just taking a step back, what are the big benefits I should have in mind of this approach as I’m considering it?

Sure. So we certainly talk through the coyote and Bugs Bunny with Acme concentrated equity positions. You also can do the same process with mutual fund position and ETF position. So any type of security like that.

You can think about a portfolio–

say the portfolio of stocks is not concentrated, a portfolio of mutual funds, maybe they’re higher cost and you want to transition into a lower cost portfolio, or for whatever reason, you’re looking to get out of a portfolio that has embedded gains across a lot of different securities, you could also do that here. It doesn’t have to be just one stock.

The last option might be a business sale. Let’s say you have a long-term capital gain from selling your business. And you have cash from that gain, and you’re looking to generate some losses over the course of a year to offset the impact from that long-term capital gain. You could invest that into this strategy, have it be a core equity holding, but use the losses from year one to offset that capital gain.

A lot of these situations where I’d otherwise be looking at a really big capital gains hit all in one year. I can use this strategy in a lot of these cases to get a diversified portfolio without that tax hit. If I was unsophisticated, I’d just sell everything, pay a ton of taxes on it, and then buy the diversified portfolio. It’s not necessary to pay those taxes at this stage.

Yeah. I think there’s certainly options where we could employ different strategies. One of them being long-short to try to offset. Maybe you’re not going to cover all the taxes, but maybe you can offset a portion of it. And that’s all value add. That’s still more money in your pocket.

You’re a fiduciary financial advisor. So what are the risks that I ought to have in mind as I’m considering this strategy is one of my options?

Yeah. Really well said. So we as fiduciaries where there’s no revenue that we get from recommending any product, so we choose our products in a well-researched way to benefit our clients. And there’s no financial incentive to promote one versus the other. It’s all about what’s best for the client. I think one of the risks is what we talked about a second ago. The desire to eradicate all taxes.

And I’m thinking about maybe a business sale or a concentrated equity position. And maybe a client might want to choose a very high amount of leverage and say, I want to generate as much capital loss in this tax year as possible. And a risk to know in that is, we have estimates for how much of a capital loss one would take for a year. It might be higher. It might be lower. But the more leverage that you put on the portfolio in order to achieve these losses, it will mean that you are in the strategy for a longer period of time.

You’re not looking at this as I get my losses, I get my diversification, and I’m done. Remember, you have leverage in the portfolio. All those securities in the portfolio have a low cost basis. And it will take time to bring the leverage down the portfolio in a tax-neutral way. So this whole thing was about not paying as much taxes. If you exit this strategy after you achieve your objective like the next day, there will be a significant tax bill. We are deferring taxes here.

So you have to be a little patient with it?

Be patient.

Plan to be in the strategy for longer than after you achieved your objective. And talk with your advisor about what that means. The more leverage you choose, the longer you’ll be in it.

And what are some of the risks to the strategy itself?

I think the first point is something we can educate on and talk with your advisor about how long to be in the strategy. Other risks would be, hey, let’s say the market is just not that volatile over the next several years. Its volatility is lower than average. Maybe the estimate on what you think you’re going to get from capital losses is lower than what it is.

That would be risk number one. Risk number two would be–

That’s sort of interesting. So if it goes up quite a bit, it works. And if it goes down a fair amount, it actually works. But the risk is if it’s flat, you’re not generating the gains or the losses.

Yeah. Volatility is lower. Maybe you’re still generating. But just not as much. Maybe not as much as what you wanted.

And the second is tracking error. Like we talked about in the very beginning with direct indexing, if you’re only buying 300 stocks of the S&P 500, your returns are not going to be exact to the S&P. So similar here, there’s some tracking error. Is it 1.5%?

Is it 4%? That depends on the amount of leverage that you choose. So your returns could be higher or lower than the underlying index depending on how much leverage you choose in the strategy.

Are there any sort of minimums that are involved in this? I’m thinking if I had $10,000 of Acme stock, not a very successful Acme investor, that this might be a more complicated strategy than I’m needing.

The managers that we work with tend to have minimums on their strategies. They can be around $3 million. In many cases, some managers can be lower than that. Sometimes it depends on the amount of leverage that you choose.

But we tend to see at least $1 million minimum, if not three. And then the custodians themselves sometimes have some minimums on being able to enter into a strategy like this and leverage short sales of roughly about the same amount. But I’d say $3 million minimum tends to be what we see. But there can also be some options to get in at about a $1 million minimum for that stock, or funds, or a combination of stocks and funds.

Well, I think I’m pretty interested here in taking the next steps and figuring out how to diversify my Acme portfolio.

Obviously, this is a pretty complicated strategy. So the next step is going to be like a detailed talk with my advisor. So I think at this point, we can thank you, Will, for your time being here walking us through this. Well, thank you so much for joining us today.

Thanks, Josh. It was great to be here.

If you’re already a Mercer Advisors client and you’re in this situation or you find yourself heading toward this situation, feel free to reach out to your advisor. If you’re not a Mercer Advisors client but you’re interested in more information, head to our website, merceradvisors.com. You can schedule a call to get more information. Thank you to Will Rockett for his insights. And thank you for joining us today. This has been Market Perspectives.

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