Equity markets have delivered strong returns in recent years, leaving many investors with substantial unrealized gains across their portfolios. Let’s consider how a tax-managed long-short strategy could be a powerful tool in the pursuit of tax efficiency—for the right investor.
As equity portfolios have appreciated, expectations around tax management have also risen. Investors increasingly look to their advisors not only for market exposure, but also for thoughtful strategies that may help manage and defer taxes over time. One approach that has gained attention is the use of tax-managed long-short portfolios. Compared with traditional long-only direct indexing, these strategies have the potential to produce significantly higher levels of realized losses.
However, these additional losses come with trade-offs. Long-short construction introduces higher explicit costs, greater operational complexity and increased turnover—along with another dimension of risk: Active factor exposures designed to produce pre-tax alpha create tracking-error risk that is separate from the tax-driven objectives of the strategy.
For this discussion, we focus solely on the potential tax benefits and costs to explore which solution could be better at helping the investor meet their objectives.
Our goal is to provide a framework for evaluating when a tax-managed long-short SMA may be the right fit—and when a lower-cost, lower-risk long-only approach may be more appropriate.
To determine whether a tax-managed long-short SMA is suitable, we need to do more than simply evaluate the strategies by the amount of losses they generate. We also have to align the investor’s gain profile, time horizon, funding method and long-term objectives with a strategy whose tax benefits justify both its costs and its underlying risk exposures.
What is the investor’s need for losses, both current and future?
Many analyses assume that every realized loss can be used to offset a capital gain immediately. Under the assumption that the investor has effectively unlimited gains, long-short portfolios look highly attractive: Greater leverage simply produces the ability to realize more losses, and the investor’s willingness to accept tracking-error risk becomes the only constraint.
But most investors don’t have unlimited gains. When gain levels are constrained, the advisor’s objective shifts to generating just enough losses to offset the client’s gains, while avoiding the drag of unnecessary costs. In these cases, long-only may outperform long-short on a net-of-fee basis, and moderate leverage could be superior to higher leverage.
Are the gains short-term or long-term?
Short-term gains are taxed at higher rates than long-term gains, making short-term losses more valuable. For clients whose gains are mostly long-term, the threshold at which long-short becomes more beneficial shifts upward. These clients generally need higher levels of gains to justify the incremental cost of leverage—and in many cases, long-only could remain the more efficient solution.
Is the investor offsetting a one-time gain or a steady stream?
Many investors have a level of annual recurring gains that they need to offset—whether from rebalancing their investment allocations or implementing active managers who may not be tax efficient. But not all investors have large recurring annual gains. Some investors may face a large, discrete gain associated with a specific future event—after the sale of a business or property, for example. In such a scenario, the goal may be to accumulate a loss carryforward to offset that event.
Higher leverage may be helpful when the gain is large, and the event is near. But once the gain is offset, remaining in a leveraged strategy creates unnecessary cost drag. A more appropriate approach may be to use leverage to accumulate losses ahead of the gain, then de-lever after the gain to limit ongoing expenses.
Consider the potential benefits of active tax management
Is the portfolio funded with cash or appreciated securities?
How a portfolio is funded has a meaningful impact on tax loss harvesting potential. A portfolio funded with cash begins with its cost basis equal to market value, creating more immediate opportunities to realize losses as prices fluctuate. By contrast, an in-kind funded portfolio often consists of appreciated securities with market values well above their cost basis, limiting near-term loss harvesting opportunities and requiring larger market moves or greater dispersion for losses to emerge.
In long-only direct indexing, this dynamic can lead to what is often described as portfolio ossification—where embedded gains reduce the strategy’s ability to generate losses. Long-short portfolios tend to be less susceptible to this effect. Adding long and short extensions may help to refresh the opportunity set for loss harvesting, with short positions potentially continuing to generate losses even as the long portfolio appreciates.
Ongoing cash contributions may be another important consideration, particularly for long-only portfolios. Adding cash raises the overall cost basis of the portfolio, which can meaningfully improve loss harvesting potential over time. Regular cash flows may enhance the effectiveness of tax management and, in some cases, reduce the need for more complex or costly solutions.
What is the expected final disposition of the portfolio?
Tax loss harvesting is designed to defer capital gains taxes, not eliminate them, so it’s essential to consider the investor’s exit strategy. In some cases, investors may reduce or unwind leverage after using harvested losses to offset a one-time gain, which can help to limit ongoing costs once the primary tax objective has been achieved.
Another common endpoint is an estate event. When a long-only portfolio is transferred after the investor’s death, the holdings typically receive a step-up in cost basis to fair market value—effectively eliminating embedded capital gains for heirs. Long-short portfolios are treated differently, however. Long positions may receive a step-up in basis, while short positions receive no step-up and are generally taxed as short-term gains when closed—regardless of the holding period. This distinction may reduce the overall tax benefit of a long-short strategy in an estate context.
The impact of this difference depends in part on the investor’s gain profile:
Investors with substantial short-term gains to offset may still realize the meaningful tax benefits of leverage, even after an estate liquidation.
Investors whose gains are primarily long-term or limited in size may find the post-liquidation benefit to be significantly reduced.
For advisors, this underscores the importance of aligning tax-managed strategies not only with current tax needs, but also with how and when the portfolio is expected to be ultimately realized.
The bottom line
Long-short isn’t a one-size-fits-all solution. For the right investor, a tax-managed long-short strategy may be a very powerful tool in the pursuit of tax efficiency, despite the additional costs. It’s critical that investors select the strategy that fits their anticipated gain profile better. Investors with higher expected gains may find value in the long-short construction with more leverage, but many could be just as well off with lower levels of leverage or no leverage at all.
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.
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.
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. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
01.20.2028 | RO 5139082
