Investors may focus on whether a portfolio generates excess return—or alpha—over time. We think how that alpha is achieved matters just as much. In our view, a well-designed strategy should seek improved returns while carefully managing risk, maintaining diversification and accounting for taxes.
Custom Extension, Parametric’s tax-managed long-short strategy, is designed around this balance. By integrating alpha generation, risk management and tax awareness into a single portfolio construction framework, this strategy aims to deliver incremental return while maintaining a risk profile that stays broadly aligned with the overall market.
Integrated portfolio construction
At the core of the Custom Extension strategy is an integrated approach to portfolio construction. Rather than treating return, risk and taxes as separate considerations, the portfolio is built using a process that evaluates all these objectives simultaneously.
Each time the portfolio is adjusted, the process seeks to:
Generate alpha relative to a benchmark
Manage active risk within defined limits
Maintain diversification across sectors and holdings
Incorporate tax efficiency into portfolio management
This structured approach helps the strategy pursue alpha while seeking to limit unintended risks and taking the income tax impact into account.
Harnessing factor-based alpha
Rather than relying on concentrated stock picking, the strategy uses a multifactor alpha model to evaluate stocks across a set of well-defined investment characteristics, or factors. These factors have been widely studied and are believed to help explain differences in stock returns.
The model evaluates companies across multiple factors grouped into broader themes, including company quality, valuation and price behavior. Combining these factors helps the strategy seek multiple sources of alpha, not just a single idea or signal.
This broad factor mix is intentional. Because individual factors can behave differently as market conditions change, diversifying across several factor exposures may give the portfolio a more balanced and consistent path to alpha over time.
Explore a multifactor approach to enhanced tax management
Systematic stock selection
Stock selection within the Custom Extension portfolio is systematic and rules-based. Securities are evaluated and ranked based on their overall exposure to the targeted factors.
Stocks with strong overall factor characteristics are candidates for long positions.
Stocks with weaker characteristics may be sold short or avoided.
Portfolio construction incorporates constraints to maintain sector balance and avoid unintended concentration.
Instead of a simplistic “buy the best, sell the worst” method, this approach applies controls to ensure that the resulting portfolio remains aligned with the broader market structure, while still expressing the desired factor exposures.
Focus on risk efficiency
A key differentiator of the Custom Extension approach is its emphasis on risk efficiency—that is, taking only those risks that are expected to be rewarded.
Several layers of risk management are built into the portfolio:
1. Tracking error controls. The portfolio’s deviation from its benchmark is explicitly limited, helping to ensure that active risk remains within a predictable range and reflects intended factor exposures—rather than unintended bets.
2. Factor diversification. The strategy avoids over-reliance on any single source of alpha, since factor performance can vary over time. Exposure to individual factors is carefully balanced and based on each factor’s volatility, with less volatile factors receiving higher allocations than more volatile ones.
3. Position and exposure limits. Constraints are applied across sectors, industries and other nontargeted characteristics. Active weights to individual stocks are also limited to reduce the potential impact of any single security on overall performance, while the largest index names, which contribute more to its performance, are prohibited from shorting.
Together, these measures help ensure that the portfolio’s returns are driven primarily by the intended sources of alpha, rather than by concentrated or unintended risks.
Managing leverage and short positions
Custom Extension portfolios incorporate both long and short positions and use leverage to increase market exposure. While these features may enhance the portfolio’s ability to generate alpha, they also introduce additional complexity.
To address this, the strategy includes several safeguards:
Maintaining a buffer above minimum margin requirements
Focusing on highly liquid securities for short positions
Monitoring leverage levels continuously
Incorporating financing costs into portfolio construction
These controls are designed to support the portfolio’s objectives while mitigating risks, such as forced deleveraging or unexpected costs.
Transparency and consistency
Another important aspect of the approach is transparency: Using clearly defined factors and a systematic investment process helps investors better understand what’s driving portfolio performance.
Rather than relying on opaque or discretionary decisions, the strategy provides a consistent framework that can be evaluated and explained. Each position in the portfolio reflects a deliberate combination of factor exposures and risk controls. Moreover, a rule-based approach avoids active management biases, such as overconfidence and loss aversion, that may exacerbate periods of underperformance.
The bottom line
The Custom Extension strategy is designed around a simple but powerful idea: Alpha generation should be pursued in a disciplined and risk-aware way. By integrating a multifactor alpha model, structured portfolio construction, robust risk management and tax-aware decision-making, the strategy aims to deliver incremental excess return while maintaining a controlled risk profile.
In practice, this means focusing less on making bold, concentrated bets and more on steadily capturing multiple sources of return in a balanced and efficient manner. The result is an investment approach that seeks to improve outcomes without introducing unnecessary complexity or risk.
Parametric and Morgan Stanley do not provide legal, tax, or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Please refer to the Disclosure page on our website for important information about investments and risks.
Risk considerations
Diversification does not eliminate the risk of loss. There is no guarantee that the investment objectives will be met.
There is no assurance that a separately managed account (SMA) will achieve its investment objective. SMAs are subject to market risk, which is the possibility that the market values of the securities in an account will decline and that the value of the securities may therefore be less than what you paid for them. Market values can change daily due to economic and other events (natural disasters, health crises, terrorism, conflicts, social unrest, etc.) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (portfolio liquidity, etc.) of events. Accordingly, you can lose money investing in an SMA.
This investment strategy engages in short selling. A short sale involves selling a security borrowed by the investor, with the expectation that its price will decline, obligating the investor to later replace it at the current market price. Short sales carry unique risks, including potentially unlimited losses if the security’s price rises, additional costs for borrowing, and the possibility of forced closure under unfavorable conditions. Other risks include increased leverage, regulatory changes that may restrict short selling, and the need to provide collateral, which can reduce investment flexibility.
Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision.
08.25.2028 | RO 5848212
