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A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide to the high-net-worth investor and consumer. Sign up to receive future editions, straight to your inbox.
Wealthy investors are pouring billions into a new tax-saving strategy despite potential risks, according to investment experts.
Total assets invested in so-called tax-aware long-short strategies — or TALS — have surged to more than $170 billion from $2 billion in 2022, according to Tax Alpha Insider. The strategies seek to track equity indexes while generating tax losses that can offset capital gains taxes.
TALS products and their variants have caught fire among wealthy investors. After three years of double-digit increases in the stock market, high-net-worth investors are sitting on large gains they don’t want taxed. Business owners who have sold a company and executives who hold concentrated stock positions also are flocking to the products. The surge in IPOs, with many employees holding stock that soars in value, is adding to demand for products that can offset big realized gains.
For the wealth management industry, tax-aware products have become a bonanza. As other investment strategies become commoditized or automated, complex long-short strategies command hefty fees and attract new clients.
“These are phenomenally profitable and sticky products that the wealth management industry is incentivized to sell,” said Bob Casey, CEO of Santa Barbara Management, which advises family offices. “They are growing at eye-popping rates.”
The tax benefits can be substantial. Casey gives the example of a portfolio with a $1 million investment. With a tax-aware long-short strategy, the portfolio could generate capital losses of $250,000 in the first year, though that would decline over time. For a California-based investor, the $250,000 in losses could be worth up to $137,500 if they’re offsetting short-term capital gains, he said.
Those tax benefits, however, come with risks. Tax attorneys and investment experts say too many wealthy investors are rushing into TALS strategies without fully understanding the details or investment implications. The surge in assets is also attracting scrutiny from tax authorities.
Here are four main risks wealthy investors should understand before investing in tax-aware long-short strategies.
IRS crackdown
Earlier this summer, Treasury officials speaking at a Wall Street Tax Association seminar warned of “aggressive planning” involving investment products that offer tax losses. They didn’t name tax-aware long-short strategies specifically. But they cited similar so-called “tax-alpha” products, like 351 conversions, box-spread ETFs and other funds that generate losses.
“We’re not going to let sophisticated abusive tax structuring become a runaway train,” one Treasury official said at the seminar, according to two people who attended.
The officials didn’t say the practices are illegal. For now, they’re seeking more information and input from Wall Street and tax attorneys. Tax lawyers add that the Trump administration touts its light touch with financial regulation, so any changes will likely be well-telegraphed.
Yet attorneys said the Treasury has now put Wall Street on notice.
“Treasury seemed to be suggesting that they would be taking a look at a lot of different products and they’re going to use the different tools at their disposal,” said Mohsen Ghazi, partner at Ashurst Perkins Coie.
The Treasury Department could choose to issue new guidance, ban the products or perhaps not make any changes. With so much unclear, attorneys and advisors are advising clients to be aware of potential fallout. Family offices, which are especially sensitive to their reputations, may be especially wary of being named in a potential tax-avoidance scandal.
“Based on what we’ve heard [from the Treasury], if you’re a potential investor, you should just be a little bit more cautious,” said Vivek Chandrasekhar, partner at Ashurst Perkins Coie.
No easy exit
While wealth advisors market the strategies as tax savings, they’re actually more like tax deferrals. While you’re invested, the losses from the leveraged short positions help to offset gains from the leveraged longs.
Getting out, however, isn’t so easy. While exiting a direct index fund is relatively straightforward, moving out of a tax-aware long-short strategy involves deleveraging, which means the unrealized gains can all get realized at once. Investors can find themselves after several years with large embedded gains in their portfolios. Selling or liquidating generates a surprise tax bill on the accumulated gain.
“You can’t just say, ‘let’s turn this off,'” said Christopher Houston, head of private wealth strategies and family office services at Cambridge Associates. “You could wind up back in the same place.”
Ultra-wealthy investors and family offices that are gifting the appreciated stock to charity or certain trusts still benefit, since they never have to realize the gains. And many may be counting on the step-up in basis after death to erase the tax.
“Tax deferral can have a true economic benefit,” Houston said. “But you have to know what your endgame is.”
It’s complicated
Wealthy investors are being lured into TALS by the tax savings, but they often don’t understand the underlying complexity. One account can involve thousands of individual stock bets, frequent trading, leverage, short positions and loan details that are difficult even for sophisticated investors to fully assess.
For wealth advisors and the product providers, like AQR and Quantinno, the complexity justifies the fees and benefits.
“Complexity is a feature, not a bug, from a wealth manager’s perspective,” Casey said.
Yet some clients might be surprised to learn how much leverage they’re taking on. The most popular strategies involve a “130/30” ratio, with $100 invested, and $30 borrowed for added long positions and $30 for short positions. Yet some funds are selling $150/$50 products or even higher.
“Leverage can make fortunes and leverage can end fortunes,” Houston said.
A related problem is underperformance. So-called “tracking error” — or the difference between a portfolio’s returns and the returns of the benchmark or index — can be larger for tax-aware long-short strategies due to leverage, investment experts said.
“If you run this strategy long enough, you should reasonably expect to experience periods in which your portfolio materially underperforms the index on a pre-tax basis,” Casey said. The tax benefits, however, can help offset the underperformance.
High fees
TALS fees can range between 1% and 3% for the entire portfolio. That includes the investment management fee, financing and borrowing fees.
The layers of fees on top of fees have been a boon to RIAs, lenders and managers. Financing fees, or “spreads,” have widened over the past year for many tax-aware long-short clients as lenders demand more compensation for risk. Analysts said investors need to question whether the annual fees are more than offset by the tax savings.
“There are fees and expenses that are associated with this that you wouldn’t have with direct indexing,” Houston said. “Those can often be justified by the tax benefits. But you still need to understand them and understand how they can change over time.”
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