The Long and Short of Tax-Aware Investing

Tax-aware investment strategies have grown at a remarkable rate in recent years as more investors gain access through both commingled funds and separately managed accounts. These approaches are designed to meaningfully improve after-tax returns, especially for investors managing substantial capital gains, concentrated positions, or recurring capital appreciation across their broader investment portfolio. At the same time, the rapid adoption of these strategies brings new portfolio‑construction considerations, such as varying risk-return objectives, leverage, and resilience when markets turn volatile.

In fact, the strategy has become so large that a frequent question among advisors is whether it has become too big to pose systemic market risk. With both adoption and market uncertainty rising, now is an ideal moment for advisors to deepen their understanding of these strategies and where they fit in a portfolio.

Limitations of traditional tax strategies

Tax‑aware investing comes in a few flavors, all anchored by one core idea: strategically use losses to offset gains. Direct equity indexing is the most basic and accessible version. An investor owns a basket of stocks instead of an index fund, and when individual positions fall, they are sold and replaced with similar exposures to maintain market alignment. As a result, losses accumulate that can later be used to offset gains from appreciating holdings.

Direct indexing is a disciplined way to boost after‑tax returns compared to index funds or mutual funds. But it comes with natural ceilings—losses tend to plateau over time, often around 30% of invested capital (Exhibit 1). This is because the pool of positions capable of producing new losses gradually shrinks as markets rise, thereby limiting the longer-term efficacy of the strategy.

Engineering more losses through long/short designs

One way to overcome the plateau effect is to increase the number of positions capable of generating losses. That’s the premise behind tax‑aware long/short strategies, which use leverage and short selling to hold more positions and create more opportunities for tax‑loss harvesting—while also aiming to produce alpha.

Instead of owning only a long portfolio, managers add leveraged long positions and borrow stock to establish short positions (see the How Tax-Aware Long/Shorts Work in Practice section in this article). Because the portfolio is broader on both the long and short side, there are naturally more opportunities to harvest losses, and to do so in both rising and falling markets.

Considerations of tax-aware strategies

• Today, more than $100 billion is invested in these programs, and their footprint is becoming large enough to matter for broader markets.¹ As these strategies scale, several important considerations emerge: their use of leverage, effectiveness in down markets, investor fit and diminishing opportunity sets.
• Most tax-aware long/short programs employ a degree of leverage, with gross leverage of 400% to 500% in some cases. This means that $100 billion in strategy assets represents several hundred billion in aggregate market exposure—a significant and growing total notional figure.
• This use of leverage can also have implications for the risk-return objectives of these strategies in an individual portfolio. While higher gross exposure levels are used to create more opportunities for tax loss harvesting, this can also increase the volatility profile of a strategy. This may be true even when managers use portfolio construction techniques to target lower net exposure (less than 100%) or lower beta (less than 1).
• Lower market beta is not beta-zero. While most products in the space are genuinely long/short, they typically have some degree of directional long exposure to markets on dollar and beta-adjusted bases. Funds can also have factor tilts, such as long value stocks and short growth stocks. Therefore, these products may not be immune to market selloffs or factor moves.
• There is an argument that tax-aware long/short strategies aren’t as effective in down markets. Studies show that deferring capital gains, rather than harvesting capital losses, is the primary source of after-tax efficiencies for these strategies.² In an up market, the portfolio should have ample gains to 1)overcome all financing costs and fees, and 2)make use of the engineered losses, which would mostly come from the short side of the portfolio. If portfolio performance is negative, particularly for an extended period, it can dampen the benefits of tax-optimized strategies. We recognize these strategies are best suited for investors with long-term horizons, and that equities will typically appreciate in more years than they go down—reasonable criteria. Accumulated losses can also be used against other unrealized gains outside the investment portfolio.
• Diminishing opportunities to engineer losses. When losses are realized, the proceeds are reinvested to replace the position that was sold and keep the portfolio in balance. The new investment cannot be “substantially identical” to the stock that was just sold, or the capital losses would be disallowed (wash sale rule). Today’s equity market is concentrated with the top 10 companies comprising 40% of the S&P 500 index’s weight. Market concentration isn’t necessarily a negative for tax strategies, but it means there are more smaller market-cap stocks which can be expensive and difficult to short. Because smaller-cap stocks tend to be more sensitive to market moves, shorting them may not always produce the intended outcome. With fewer public stocks and with many companies deciding to stay private for longer, the float of stocks required to execute an effective tax-aware long/short strategy may continue to taper off.

How tax-aware long/shorts work in practice

The premise of a tax-aware long/short strategy is to amplify the loss potential of a portfolio through margin and short exposure, while the aggregate portfolio seeks to match or outperform a market benchmark. As seen in Exhibit 2, a long/short overlay expands the number of positions that can trigger losses while adding to the strategy’s return profile. Generally, positions are added to both the long and short side to target a specific level of market exposure. The short positions are expected to generate losses (as markets go up) and the additional long positions aim to generate excess returns and cover expenses. Of course, an active manager will also sell long positions that fall below their cost. In some cases, derivatives, or managed futures, are used for trend-following or to capture momentum.

This strategy almost guarantees there will be opportunities to realize losses. There are hundreds of positions routinely considered for tax loss harvesting. In contrast, direct indexing and long-only portfolios tend to have fewer positions and much less turnover, resulting in fewer loss harvesting opportunities.

Tax-aware strategies have been one of the fastest growing areas in wealth management and are offered through commingled funds and individual accounts. A tax-aware overlay with a separately managed account (SMA) can be a preferred approach due to the personalization and transparency that an individual account format provides.

Tax-managed solutions across all vehicles increased to almost $900 billion, according to Cerulli,³ while we estimate long/short SMA assets at over $100 billion. For advisors, other considerations for individual clients include:

• Future regulatory changes. With any tax-related strategy, regulatory changes can impact the effectiveness of the approach. Potential changes could impact the tax treatment of certain fund fees and expenses, or whether losses are allowed under the wash sale rule. Tax-aware strategies are drawing scrutiny from the U.S. Treasury which is in discussions to provide additional guidance for at least one strategy (351 conversions). Based on the progression of this review, other tax-aware strategies could face scrutiny or slow in adoption.
• Portfolio lock-in: Tax-aware strategies help reduce near-term tax liabilities but do not eliminate them as capital gains are continually deferred. The recognition of losses and reinvestment of proceeds lower the cost basis of investments over time, potentially creating a large tax event when the portfolio is eventually liquidated.

Tax-aware strategies can play a meaningful role in improving after‑tax outcomes, but their growing scale and structural complexity demand thoughtful portfolio integration. For advisors, the opportunity lies in balancing the benefits of engineered losses and gain deferral against considerations such as leverage and long-term tax implications. As these strategies continue to evolve—and attract greater regulatory scrutiny—successful implementation will depend on clear client objectives, realistic expectations, and a disciplined approach to portfolio construction.