In their piece for the Financial Times, titled “The Tax-Focused Hedge Fund Craze Taking over Wall Street,” Amelia Pollard and Joshua Franklin write about a fast-growing area of financial markets looking to monetize tax losses:
AQR Capital Management and Quantinno Capital Management are among the hedge funds behind the surging popularity of a new wave of tax-loss harvesting strategies, which aim to deliver both market-beating returns and gains derived from lowering investors’ tax liabilities — dubbed “tax alpha”.
Tax-loss harvesting is a longstanding practice where securities are sold at a loss to offset gains elsewhere in a portfolio. Firms such as Morgan Stanley-owned Parametric have long specialised in a long-only version, which involves strategically selling lossmaking positions.
But the $207bn hedge fund AQR and Quantinno, which was set up by a group of former AQR traders in 2018, have pioneered an approach that uses leverage and algorithmic trading to buy and short securities at scale, and to systematically realise losses on positions.
In his Money Stuff blog, Matt Levine describes it as follows:
The takeaway is:
- The people best positioned to offer tax alpha strategies are people — AQR, Two Sigma, etc. — who already run hedge funds, and who have some credible basis for saying “actually we generate pre-tax alpha by going long a bunch of (mostly good) stocks and going short a bunch of other (mostly bad) stocks, though of course sometimes our longs go down and then we harvest the tax losses.”
- They definitely have to say that. As opposed to just “we grossed up the index return to get tax losses.” “Tax-aware strategies must be built on credible pre-tax alpha,” and say so, to placate the IRS. . . .
(The trades that I have schematically described here generate only capital losses, which can mostly only offset capital gains, but “AQR and Quantinno differ from earlier iterations of tax-aware investing strategies by seeking to generate income losses as well as capital ones through the use of swaps and other expenses.”) . . . .
One way to think about it is that, in a lot of the hedge fund industry (pod shops, etc.), what you are selling is “pure alpha” — outperformance not correlated to market returns — and there is only so much capacity to generate pure alpha. In the tax-aware industry, what you are selling is “credible alpha” — a reasonable amount of alpha, an IRS-placating quantity of alpha — plus the market return, plus tax losses. You can spread some alpha over a lot of money. So, more capacity.
Also:
Some investors and advisers also warned of potential regulatory scrutiny. “The deepest and most fundamental risk is that the IRS catches wind of this,” said one financial adviser.
Shh.
In their white paper for Elm Partners, titled “Robbing Peter to Pay Paul: A(nother) Look at Long/short Direct Index Tax-Loss Harvesting,” Victor Haghani and James White document their skepticism of the approach:
The main reason the [leveraged long/short direct index tax-loss harvesting (LSDI)] program’s expected return is 0.11% pa lower is that the fees eat up most of the tax benefit, though paying short-term capital gains tax to cover the shorts, and the volatility drag of holding [Shopify stock] for longer also hurt the LSDI program’s after-tax compound return. Over 20 years, the investor will have paid $2.7 million in fees. Compare this to the $3.7 million of capital gains tax she was trying to avoid, or at least defer. She’s paid less to Uncle Sam, but more than half as much to her LSDI manager. And at the end, she’ll still have to pay long-term and short-term capital gains tax to unwind the remaining long/short portfolio, plus she’ll have taken more risk over the horizon – and on top of all that, she’ll have $26 million in unrealized gains in her replacement portfolio.
