Long-short direct indexing can be a powerful planning tool for someone anticipating a large capital gain. Understanding your time horizon, the risks of leverage, and how the strategy can be used for tax deferral are important considerations.
Read the full transcript
AJ, one thing that’s really popular in our industry right now is the use of long-short direct indexing, oftentimes as a tool to generate capital losses for someone who’s anticipating a large capital gain, perhaps from the sale of a concentrated position in a company or even selling their small business. What are some things that people really need to consider when looking at this strategy? What are the risks and what are the rewards?
Very good question. It is gaining more popularity for sure.
To your original point, the primary objective here is to realize ordinary losses that at some point can be applied against your anticipated capital gain from a business sale or concentrated stock disposition or what have you.
What I think investors need to be mindful of primarily, you have to think about your time horizon here because that’s going to dictate how much of this loss are you actually going to be able to offset. To some degree, you can, you can accelerate this.
I should mention that the principal generator here of these losses is due to leverage. You are short selling stocks and you have a leverage long book too. And this could be as simple as 125/25 or 145/45, but it could be as aggressive as 350/150 as an example. So you can, you can have a substantial amount of long and short exposure in addition to your core invested collateral.
So again, back to the loss generating mechanism here, generally speaking, short selling stocks is not a good proposition for generating wealth, that’s usually a loser’s game. Stocks go up over longer periods. But in the short term, there are some anomalies. And so this short book is designed to capture realized ordinary losses. And if you have a five-year time horizon that you can thoughtfully plan for and say, OK, I’m comfortable with offsetting 50% of my capital gain in 2030 or something.
That gives you plenty of runway to do this without an excessive amount of leverage. And you’ll have index-like exposure plus or minus a couple points of tracking error the whole way through. But the risks, I mean, obviously the more leverage that you add, you do have risks of margin calls. That can happen.
And then the more leverage that you add, you also have substantial tracking error risk from the benchmark. If you’re going to try and perform as close as you can to the S&P 500 with this enhanced portfolio, if you had 300% leverage on top of this, you should expect a potential tracking error of 8% to 10%. And that could be positive or negative, by the way.
And then the final thing here, this is not a tax avoidance strategy. I think that’s the biggest misconception here. You are offsetting this capital gain, but for every dollar of losses that you’re generating in this short book, there is an embedded gain in the, in the loan book on the back end. And so this is not tax avoidance. What it is is tax deferral, which I think is powerful. I mean, we all, we all use 401ks and we understand the balance of or the, the value of a dollar not paid in taxes today rather invested is, is greater than a dollar paid in taxes today. So that’s what you’re doing. You’re, you’re controlling your tax liability in that current year and saying, I’d rather pay this over 10 or 15 years as I unwind that loan book on the back end.
So, would you say, while these are very powerful planning tools that our firm implements for clients, we want to make sure that they understand the risks and rewards? Allow us to use our operations team to offload all the work that goes into the trading, and then also having a detailed financial plan with cash flows so we can unwind that book at a later date, oftentimes when they’re in their lowest tax rate for the first time in over 30 years.
Well said. Yeah, that’s right.