EC The Tax Efficiency Of Long-Short Strategies

Conventional wisdom can be defined as ideas that are so accepted that they go unquestioned. Unfortunately, conventional wisdom is often wrong. Two great examples are that millions of people once believed the conventional wisdom that the Earth is flat, and millions also believed that the Earth is the center of the universe.

Much of today’s conventional wisdom about investing is also wrong.

The Tax Efficiency of Long/Short Investment Strategies

Today, we’ll look at the conventional wisdom that the tax burden of an investment strategy increases with its turnover — high-turnover strategies exhibit a higher propensity to realize capital gains. In addition, short-selling is perceived to be particularly tax-inefficient, because the realized capital gains on short positions are generally taxed at the higher short-term capital gain tax rate, regardless of the holding period of the short positions.

Clemens Sialm and Nathan Sosner contribute to the literature on the tax efficiency of long-short strategies with their January 2017 paper, “Taxes, Shorting, and Active Management.” Sialm and Sosner studied the consequences of short-selling in the context of quantitative investment strategies that individual investors hold in taxable accounts. They computed the tax burden of a quantitative fund manager who follows a combined value and momentum strategy. Combining value and momentum strategies is particularly beneficial because these strategies tend to exhibit negative correlation. Their model combined value and momentum with equal risk weights and targeted a tracking error of 4 percent. The authors implemented tax awareness through a penalty term that incorporates tax costs into the portfolio’s objective function. The study’s sample period is from 1985 to 2015.

The following is a summary of their findings:

Short positions not only allow investors to benefit from the anticipated underperformance of securities, but they also create tax benefits because they enhance the opportunities to time capital gain realizations.

The presence of short positions gives investment strategies additional opportunities for realizing capital losses in up markets, when capital losses from long positions are scarce. Up markets are also when investors tend to have more abundant capital gains, making the realization of capital losses in these periods particularly valuable.

Long-short strategies increase the opportunity to realize short-term losses, which are particularly beneficial because the short-term capital gains tax rate is substantially higher than the long-term rate, and the realized short-term losses will first be used to offset highly taxed short-term capital gains.

The relaxation of short-selling constraints generates tax benefits because a portfolio’s long positions tend to generate long-term capital gains, which are taxed at relatively low rates, whereas the short positions tend to generate short-term capital losses, which offset short-term capital gains taxed at relatively high rates.