Tax-aware long-short strategies may create loss-harvesting opportunities that can be difficult to achieve in traditional long-only portfolios. But before advisors begin discussing the tax benefits, it may be worth asking if the strategy would still be attractive if taxes weren't part of the conversation.
That question sits at the heart of economic substance—one of the most important concepts in long-short investing. Economic substance is a foundational concept of US federal income tax law that considers both subjective and objective prongs, as codified in Internal Revenue Code Section 7701(o). Additionally, the term provides a useful framework for evaluating any investment strategy. Economic substance can serve as a powerful filter: If a strategy doesn't make sense before taxes, it probably won't make sense after taxes either.
We believe the strongest long-short strategies are built on a sound investment thesis designed to generate pre-tax alpha. Any tax benefits are simply a byproduct of that process.
The real purpose of a long-short strategy
In tax law, the “Economic Substance Doctrine” requires that, for a certain transaction to merit its intended federal income tax consequences, the strategy must change a taxpayer's economic position in a substantially meaningful way, setting aside the federal income tax benefits. Such a strategy must also have a non-tax business purpose.
In an investment context, that means a long-short portfolio should be compelling based on its investment merits alone. The economic substance of a long-short extension strategy sits with its ability to pursue pre-tax alpha—returns above a benchmark before considering tax consequences. This begins with security selection driven by an investment thesis.
On the long side, the portfolio owns stocks that may be expected to outperform because of attractive fundamentals or favorable characteristics (for example, factors). On the short side, it targets stocks believed to have weaker prospects or characteristics that may lead them to underperform.
The objective is for both sides of the portfolio to contribute to returns. Long positions can add value when they outperform the market, while short positions can add value when the targeted stocks lag or decline in price. Together, they create a broader opportunity set than a traditional long-only portfolio.
Two different paths to seeking alpha
How a manager selects long and short positions generally falls into one of two categories: discretionary or systematic.
A discretionary strategy relies on the judgment of portfolio managers and research analysts. Managers may analyze financial statements, meet with company management teams, study industry trends and build portfolios around their highest-conviction ideas. These portfolios are often more concentrated and depend heavily on the skill of the investment team.
A systematic strategy takes a different approach. Rather than relying on individual stock-picking decisions, it uses a rules-based process to evaluate a broad universe of securities according to predefined criteria. Stocks may be ranked on characteristics or “factors” that have been associated with long-term returns. The highest-ranked securities become long candidates, while the lowest-ranked become short candidates.
Parametric's Custom Extension strategies follow this systematic framework and target four factor themes for investment—value, momentum, quality and low residual volatility. The goal is to build a diversified portfolio of long and short positions that seek benchmark-relative alpha through a transparent and repeatable process, rather than a small number of concentrated bets.
For advisors, that transparency can be valuable. The rationale behind portfolio holdings is grounded in a consistent investment thesis and process, not an individual manager’s intuition.
Alpha requires risk discipline
Generating alpha is only part of the challenge. A successful long-short strategy must also manage risk carefully.
Leverage and active positioning may create additional opportunities, but they can also introduce unintended risks if left unchecked. That's why disciplined portfolio construction is an essential part of how we build Custom Extension portfolios.
Maintaining market exposure
A well-designed extension strategy typically keeps net market exposure near 100%.
In our 130/30 portfolio, for example, investors have 130% long exposure and 30% short exposure. While gross exposure1 increases, net exposure2 remains roughly equivalent to a traditional long-only portfolio.
The result is that investors continue to participate in broad market movements much as they would in a conventional equity allocation. The long and short extensions are intended to generate alpha on top of that core market exposure.
Explore a multifactor approach to enhanced tax management
Limiting unintended bets
Risk controls also seek to prevent unintended concentrations.
For example, a manager may not want all longs concentrated in one sector and all shorts concentrated in another if there is no expectation that such sector biases would lead to outperformance. The performance of a portfolio constructed in this way could be driven more by idiosyncratic sector movements than by the intended stock-selection process.
To address this, we place constraints on sector, industry and non-target factor exposures relative to the benchmark in our Custom Extension portfolios. The goal is to ensure that active returns come primarily from security selection rather than accidental portfolio bets.
Managing short-specific risks
Short selling introduces risks that don't exist in long-only investing. Some stocks can become expensive to borrow, while others may be vulnerable to short squeezes3 or sudden price spikes.
Our disciplined process seeks to identify and limit these risks through security screening, portfolio constraints and ongoing monitoring. Managing these risks is critical to preserving the portfolio's ability to seek and generate alpha over time.
The bottom line
Long-short investing can expand the opportunity set for alpha generation while creating tax-loss harvesting opportunities in a variety of market environments. But those potential benefits should never be viewed in isolation.
The most effective long-short strategies begin with a robust investment process. They seek to identify attractive long opportunities, avoid or short less attractive securities and maintain disciplined risk controls designed to keep portfolios aligned with investor expectations. In other words, the investment case comes first.
For advisors evaluating long-short solutions, economic substance provides a useful framework for separating durable strategies from those that rely too heavily on tax outcomes. Before asking how much tax value a strategy might create, consider starting with a simpler question: Would I recommend this strategy if taxes didn't exist? If the answer is yes, you’re likely starting from the right place. Any tax benefits that follow are simply the result of a sound investment process doing what it was designed to do.
1 Gross exposure is the sum of long and short positions, which describes the total capital deployed—including borrowed funds—and reflects the overall level of activity and leverage.
2 Net exposure is the difference between long and short positions, which describes the portfolio's directional tilt—how much it participates in broad market moves.
3 A short squeeze occurs when buying by short sellers drives a security’s price higher, prompting others to cover their positions.
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.
10.31.2027 | RO 6043945
