In recent years, direct indexing has become a popular strategy for investors seeking customizable equity market exposure and valuable tax management tools. However, as the strategy matures, its ability to realize net capital losses diminishes. Enter the world of long-short investing, a game-changer for maximizing both pre-tax returns and tax benefits.

The Limitations of Traditional Direct Indexing

Direct indexing strategies, while beneficial in the early years, face significant challenges as they mature. Historical simulations reveal that net losses realized by these strategies tend to taper off within a few years, reaching a maximum average cumulative level of about 30% of the initially invested capital. Furthermore, these strategies exhibit high dispersion in net loss outcomes, creating uncertainty for investors.

The primary issue is that direct indexing strategies, without additional capital contributions or the gifting of appreciated stocks, typically realize only a limited amount of net capital losses. This limitation poses a challenge for investors aiming to utilize these losses for tax planning purposes.

The Superiority of Long-Short Strategies

Long-short strategies, particularly those motivated by factor investing, offer a compelling alternative. These strategies can significantly outperform direct indexing from both a pre-tax and tax perspective. By leveraging and managing tracking error dynamically, long-short strategies can realize a cumulative net capital loss of 100% of the invested capital within a few years while substantially outperforming the benchmark index before tax, net of implementation costs.

Dynamic Management for Optimal Results

One of the standout features of long-short strategies is their flexibility. Investors can dynamically manage leverage and tracking error to align with their evolving outlook on factor investing. For instance, if an investor’s optimism about factor investing diminishes, they can reduce leverage and tracking error without recognizing net capital gains, thereby preserving the tax efficiency of the strategy.

In contrast to traditional direct indexing, long-short strategies allow for substantial tax benefits and a significant and highly diversifying pre-tax alpha derived from factor investing. This balance of tax benefits and pre-tax returns makes long-short strategies particularly suitable for investors with low-basis concentrated positions.

Empirical Evidence and Strategy Comparison

Historical simulations highlight the efficiency of long-short strategies. For example, 200/100 strategies can achieve a 100% cumulative net capital loss in less than three years on average.

Moreover, the ability to modulate leverage and tracking error dynamically enables investors to manage their portfolios in a tax-efficient manner. Scheduled and optimized de-risking strategies ensure that investors can reduce leverage and tracking error without incurring substantial tax costs, preserving the benefits of previously realized cumulative net capital losses.

Conclusion

Direct long-short investing represents a powerful evolution beyond traditional direct indexing. By leveraging the strengths of factor investing and dynamic risk management, these strategies offer investors enhanced tax efficiency, substantial pre-tax returns, and the flexibility to adapt to changing market conditions. For those seeking to optimize their tax and investment outcomes, long-short strategies present a compelling option worthy of consideration.

This blog post is based on insights from the paper titled Beyond Direct Indexing by Michael N. Auerbach, Yao Hua Ooi, and Jonathan Samuels, published in the Journal of Beta Investment Strategies. 

https://www.aqr.com/Insights/Research/Journal-Article/Beyond-Direct-Indexing-Dynamic-Direct-Long-Short-Investing