When a long-short strategy is right for a client

Advisors are increasingly turning to tax-aware long-short strategies to help clients diversify concentrated stock positions without immediately realizing large capital gains bills, as investor demand has helped drive more than $150 billion into the strategy, according to industry estimates.

Several versions of this strategy can be used, depending on clients' individual situations, and include long-short portfolios and 130/30 tax-loss harvesting. In a 130/30 strategy, an investor shorts stocks equal to roughly 30% of portfolio assets and buys an additional 30% on margin, increasing long exposure to about 130% of assets. Another, more aggressive, proportion used in the industry is 250/150, which involves a higher leverage ratio.

Deferring capital gains taxes in the current year might not make sense over the long term if investors later face higher tax rates, if tax laws change or if they need to liquidate investments to access the funds.

"If you know that your group of stocks that are long are going to do better than this group of stocks that you're short, you can add real value, real performance value," said Andy Pratt, managing partner and director of investment strategy at Reston, Virginia-based registered investment advisor Burney Wealth Management.

Jason Escamilla, CEO and chief investment officer at ImpactAdvisor, created a calculator to estimate long-term tax implications.

"For clients in the right circumstances, tax-aware strategies — including tax-aware long-short investing — can help diversify an appreciated portfolio, compound more after-tax wealth, create a greater margin of safety in retirement, provide greater support for a surviving spouse, and preserve more wealth for future generations," Escamilla wrote in an email.

READ MORE: Using tax-aware long-short vehicles to track down alpha

Custodians offering this strategy

Tax-aware long-short investing has seen growing interest. Independent tax analyst Brent Sullivan estimated the category has pulled in more than $150 billion in net assets under management this year, including managed accounts and private funds. 

Goldman Sachs launched a long-short product for separately managed accounts this year, and its asset management offering for RIA custody clients is expected to launch next month, a spokesperson said.

This will create another option in the marketplace after Fidelity closed its long-short separately managed account product to new accounts and Schwab imposed limitations, according to advisors who spoke with Financial Planning and news reports. Schwab President and CEO Rick Wurster discussed the popularity of the strategy among clients during the company's second-quarter earnings call on July 21.

"I think it's a strategy that makes a lot of sense for clients, particularly those that have sold [their] business or have a large and concentrated position that they want to diversify out of," he said.

Wealthy clients are increasingly pressuring their advisors to work with multiple custodians in order to have access to more or preferential products like long-short vehicles, Sullivan said. He recalled one advisor who lost a client because Schwab wouldn't approve the high level of leverage the investor wanted. Disappointed with that loss, the advisor started establishing a relationship with Goldman.

Although it is a complicated strategy, it can potentially be automated. In fact, tax-loss harvesting is the most commonly automated tax service among asset managers; 79% of respondents to a Cerulli Associates survey said they have already automated it.

Use cases and exit challenges

Advisors said the strategy tends to be a good fit when clients anticipate a major taxable event and need losses to offset future gains.

For example, clients might want to generate capital losses in preparation for selling a business, since they're expecting gains from that, said Matt Bucklin, who founded Palm Beach Gardens, Florida-based capital markets platform ExchangiFi.

Bucklin described a related approach in which clients borrow against company stock while shorting other securities along with going long on other securities. Losses generated can be used to offset capital gains from the company stock, he said.

"So eventually, what happens is your portfolio is a very diversified, long-short portfolio," rather than a large concentration of company stock, Bucklin added.

While advisors said long-short strategies can offer tax and diversification benefits, exiting the positions can be complicated. 

"Once you get in, getting out of it does become a challenge," Pratt of Burney Wealth Management said in an interview. "Your only choice really is to kind of slowly unwind it."

Burney Wealth Management uses less leverage for "a tax-aware 130/30 strategy" involving only a 30% leveraged long position and a 30% short position, Pratt added.

"I've yet to find someone who's given me a good answer on what's the exit plan," he added. "If you use enough margin, you're committed to doing this strategy for a very long time — or pay the taxes."

For older clients, the basis step-up is in their "plannable horizon," said Peter Hand, partner and chief investment officer at San Francisco-based registered investment advisor Baker Street Advisors.

Sullivan noted the strategy can be a good fit in some cases and that there are multiple ways to manage future tax bills, including waiting for a step-up in basis at death. But he said it  isn't the only way — for example, some shares will have a relatively high cost basis. It's worth figuring out, he added, to reap the benefits of deferring taxes and using those funds for compounding growth.

"It's the portfolio growth that deferral essentially pays you every year, so it's quite valuable," he said.