In Bloomberg, Loukia Gyftopoulou, Katherine Burton, Sridhar Natarajan and Justina Lee have a new piece, “A Tax Strategy for the Rich Built the World’s Largest Hedge Fund.” From the piece:
By some estimates, a total of more than $150 billion is deployed at the firm [AQR Capital Management] and a phalanx of competitors that run their own versions of what’s known as tax-aware long-short investing. That puts them at the cutting edge of the broader “tax alpha” universe, in which more than $1 trillion is deployed in strategies devoted to delaying or shrinking payments to the government.
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The strategy is luring private equity investors who are tallying up hauls from decades of rising markets and wondering how they’re going to someday settle up with the Internal Revenue Service. The same goes for venture capitalists, company founders and early hires, who are poised to get richer from this year’s wave of mega-stock offerings.
A presentation that AQR recently provided to some wealth managers to recruit more clients sketches out an astonishing scenario: Invest $100 million in the most aggressive of AQR’s Flex strategies. Wait 10 years while the money triples. And in that period, it may generate over $580 million of losses that can be used to erase taxes from other investments.
It’s safe to say that, in the hedge fund world, boasting that a strategy might produce almost six times more losses than the initial investment is unusual.
In his Money Stuff column, Matt Levine describes the technical aspects of the strategy:
We have talked a few times about tax-aware long-short strategies. If you buy a bunch of stocks, some will go up and some will go down. You sell the ones that went down, generating capital losses that you can use to offset other capital gains, and keep the ones that went up, deferring capital gains taxes. This is called “tax loss harvesting,” and back in the olden days it was a sophisticated strategy that your financial adviser would laboriously execute for you, but now any robo-adviser will do it.
“Tax-aware long-short” involves grossing this up: Instead of spending $100 to buy a bunch of stocks, you borrow $100, buy $200 worth of stocks and then short $100 of other stocks. You still have $100 of net market exposure — you are still exposed to the market return on $100 of stocks — but you have much more tax loss. (Because you own $200 of stocks instead of $100, and because you now have offsetting long and short bets, one of which will presumably win when the other loses.) And then maybe with the right witchcraft you can do this in ways that generate ordinary-income losses rather than capital losses.
One thing to say about tax-aware long-short is that it is not just about reading the tax code cleverly. It really is about increasing financial efficiency; it is an outgrowth of modern academic finance. When I first wrote about it, here’s how I started:
One useful intuition of modern finance is that stocks are all kind of the same. Oh they’re not, they’re not, this isn’t true. But lots of stocks are interchangeable to some degree, particularly if you own a lot of them. A fair amount of the returns of many stock portfolios are determined by the returns to the overall market, to industry sectors, and to other well-known factors like value and size. You could construct a diversified portfolio of 100 stocks that is reasonably well correlated with the S&P 500 Index, and then you could construct a diversified portfolio of 100 entirely different stocks that is also reasonably well correlated with the S&P 500.
This would have sounded like witchcraft a generation ago. “No,” investors would have said, “an investment in Amalgamated Spats is a bet on the spats industry and the cut of the chief executive officer’s jib; selling Amalgamated Spats to buy Consolidated Sprockets is no substitute at all.” But the rise of quantitative finance and factor investing — in which Asness and AQR are leading figures — has normalized this view. “My portfolio has a lot of exposure to small-cap value,” an investor might say, without knowing what actual stocks she owns. You can get your small-cap value exposure from a lot of different stocks.
This matters for tax-aware long-short strategies, because:
- You have to be long some stocks, and short some other stocks as a hedge. If the short stocks are going to be a good hedge, they have to be correlated with the long stocks. But you can’t be long and short the same stocks: That’s a straddle, and you won’t be able to deduct your losses. You have to be long and short similar stocks, which requires a factor-based quant approach.
- When you harvest your tax losses, you have to sell some stocks (the losers) and buy new ones to replace them. You can’t buy the same stocks: That’s a wash sale, and you won’t be able to deduct your losses. You have to sell your stocks and buy similar stocks, which again requires a quantitative notion of similarity.
The upshot is that, if you take a bunch of finance PhDs and apply sophisticated mathematical methods to investing, what you might get is lower taxes. Which makes total sense.
