Tax-Aware Funds Attract $150 Billion as Investors Hunt for Losses

A surge in demand for sophisticated tax-loss harvesting has funneled over $150 billion into a Wall Street strategy known as long-short tax-aware, as a prolonged bull market blunts the effectiveness of traditional methods. The funds, which use leverage to amplify gains and tax-offsetting losses, represent a major shift in wealth management for high-net-worth individuals.

The high costs, which can run from 1.5 to 3 percent annually including fees for management, financing, and borrowing, are a significant drawback for some. The sentiment was captured by Michael Paulus, founder of wealth manager PCM Encore, who was cited in The Wall Street Journal. “All else being equal, I’d probably rather cut the government a check than a hedge fund in Connecticut,” Paulus said.

The growth has been dominated by a few specialized firms. AQR Capital Management now manages nearly $70 billion in these strategies, with Quantinno Capital Management holding over $48 billion, according to an analysis by Brent Sullivan’s Tax Alpha Insider. The strategies typically employ a 140-40 structure, where a $10 million portfolio is used to take on an additional $4 million in long positions and $4 million in short positions, creating more vectors for harvesting tax losses.

This trend is a direct response to the "ossification" of direct indexing portfolios, a $1.1 trillion strategy that is failing to generate sufficient losses for tax optimization as markets consistently hit new highs. While the new leveraged strategies offer a solution, they introduce higher risks and costs, and their growing popularity has already led custodians like Fidelity and Charles Schwab to limit new accounts, potentially signaling future regulatory scrutiny.

The Limits of Direct Indexing

For years, direct indexing has been a cornerstone of wealth management. The strategy involves buying a large basket of individual stocks to replicate an index, such as the S&P 500. Managers can then sell individual losing stocks to "harvest" losses that offset capital gains elsewhere in a client's portfolio, while replacing the sold stock with a similar one to maintain market tracking. However, with markets near all-time highs, many of these portfolios no longer contain enough losing positions to be effective. Jon Diorio, head of U.S. wealth product at BlackRock, estimates that around half of all direct-indexing portfolios are now "ossified" and no longer generating meaningful tax losses.

Leverage, Alpha, and High Fees

The long-short tax-aware model was developed to solve this problem. By using leverage to go both long and short, managers can generate losses from two sources: long positions that decline in value and short positions that rise in value. This significantly increases the pool of potential losses to harvest. These strategies also aim to generate "alpha," or returns above the market benchmark, by actively selecting which stocks to bet on and against.

However, this complexity comes at a price. The fees, ranging from 1.5% to 3%, are substantially higher than the 0.05% sometimes charged for basic direct indexing. The use of leverage also amplifies risk; just as it can magnify gains and tax losses, it can also magnify investment losses, making it a strategy best suited for sophisticated investors with a high risk tolerance and specific needs, such as offsetting a one-time capital gain from selling a business.

This article is for informational purposes only and does not constitute investment advice.