This In Practice piece gives a practitioner’s perspective on the article “Taxes, Shorting, and Active Management,” by Clemens Sialm and Nathan Sosner, published in the First Quarter 2018 issue of the Financial Analysts Journal.
What’s the Investment Issue?
While headline investment performance usually compares pre-tax returns, the priority for most investors is after-tax returns.
Short selling is often discounted by US individual investors for this reason. It is perceived to be tax-inefficient compared with holding assets for a longer term, because capital gains on shorter-held positions generate high levels of tax under the US federal tax system—43% versus 24% in the 2015 tax year.
The authors investigate whether taking short positions can enhance the opportunities for taxable quant investors to realize capital losses, which can reduce the tax burden of the overall portfolio. Under US tax laws, losses generated by short sales are considered “short-term” losses, which can offset short-term gains within a portfolio.
The authors also assess whether short selling can help a portfolio outperform across different market environments. That is, they examine the extent to which short selling can create capital losses when there are few losses from the portfolio’s long positions to offset taxes.
How Do the Authors Tackle the Issue?
Using weightings equal to value and momentum as the portfolio strategies, the authors compare tax-aware quantitative portfolios with tax-agnostic portfolios. They use these strategies because value and momentum have proved robust over time, are negatively correlated, and have differing tax dynamics.
A tax-aware investor is defined by the authors as one who seeks to balance pre-tax returns against the tax costs of portfolio trading, with the aim of maximising after-tax returns. Tax awareness is implemented in the study by the systematic deferral of capital gains and the acceleration of capital losses. Tax-agnostic strategies, however, seek purely to maximise pre-tax returns.
The authors create and compare three portfolios: long only, relaxed constraint, and long–short. Returns from each portfolio are calculated from 1985 to 2015 on both a tax-agnostic and a tax-aware basis.
The portfolio weights of the securities in the long-only strategy add up to 100%. In the relaxed-constraint portfolio, some short selling is permitted; the 130/30 relaxed-constraint portfolio has long positions of 130% and short positions of 30%. Both the long-only and the relaxed-constraint strategies have betas similar to that of the Russell 1000 Index. In contrast, the combined weights of the long–short portfolio are zero, and the portfolio is market neutral compared with the Russell 1000.
What Are the Findings?
The authors demonstrate that the after-tax impact of adding short selling to a portfolio is material and adds substantially to the after-tax return of the portfolio.
In terms of the tax-agnostic portfolios, the long-only portfolio generates a return of 2% a year, but the tax payable is 2.6%. The tax burden clearly exceeds the pre-tax return and creates an after-tax loss for the investor.
The pre-tax return increases to 4.2% for the relaxed-constraint portfolio and to 5.5% for the long–short strategy. The 130/30 relaxed-constraint strategy also has a reduced (compared with the long-only portfolio) tax burden of 2.3%. Significantly, the long–short portfolio generates a tax benefit of 0.3%, because the long positions mainly produce long-term capital gains, which are taxed at low rates, whereas the short positions tend to realize short-term losses, which can offset capital gains from other strategies in the investor’s overall portfolio.
Investors could further enhance the tax benefits through tax-aware portfolios, which reduce the annual tax burden of the long-only strategy from 2.6% to 0.7%, turn the 2.3% tax burden of the relaxed-constraint strategy into a 0.9% tax benefit, and increase the tax benefit of the long–short strategy from 0.3% to some 6.1%.
Perhaps counterintuitively, the benefits of tax-aware strategies are principally the result of losses realized by short positions. The short positions tend to produce tax losses while other investments in the investor’s portfolio are gaining.
What Are the Implications for Investors and Investment Professionals?
The authors show that replacing a long-only portfolio with a relaxed-constraint or a long–short approach improves after-tax performance. So, short selling can, after all, be a valuable tool for taxable investors—at least in the context of a quantitative strategy based on value and momentum investing in the Russell 1000.
Whereas in long-only portfolios, losses are realized only when markets move down, adding short positions expands the opportunities to realize losses in all market environments. The authors show that long–short tax-aware portfolios can reduce the tax burden during periods of strong market performance. In other words, a failed shorting strategy can actually improve portfolio returns.
The authors also show that an actively managed investment portfolio with considerable turnover does not necessarily have to be tax-inefficient. A more actively managed portfolio that uses leverage and short selling realizes improved after-tax returns. These improved after-tax returns are the result of an increase in pre-tax performance and a reduction in the taxes payable.
A word of warning on this strategy: While short selling can generate capital losses, which can improve after-tax returns, it can also generate unlimited losses. The authors point out that the risks associated with the long–short strategy are higher than those associated with long-only and relaxed-constraint strategies.