Will A Long-Short Direct Index Help My Tax Bill?

Podcast listener Wes wrote to me:

Jesse – I appreciate the great podcast and blog content that goes beyond personal finance 101. I have a question about generating investment losses to offset appreciated assets and/or the income from a Roth conversion. My advisor has been talking about a long/short strategy that I’m researching. However, I was thinking I could either short a stock I think that will go up (risky) or simply buy a leveraged ETF (less risky) that is say the inverse of the S&P500 like SSO. Seems like a simple strategy but I don’t see much content out there about this so I’m guessing I’m missing some pitfalls. Can you give me some input?

Hi Wes, thanks for the question. Very interesting.

Now…I’d like to paint a little picture for you. 

You have $10,000 in gains, all of which will be subject to a 15% capital gains tax. So, you’d owe $1500 in tax. 

You then pursue a strategy that creates $10,000 in losses. This offsets the ENTIRE gain and ELIMINATES the tax. Ok – nice! So, you eliminated that $1500 tax. 

BUT…

You also have $10,000 in losses. You no longer actually profited. The losses totally offset and wipe out your gains.

Would you rather have $10,000 in gains and pay $1,500 in taxes?

Or have no gains whatsoever? 

I’d take the first scenario every day.  Why lose $10,000 to save $1,500? 

Now, I’ve painted a very, very simple scenario. Most of the strategies that professionals might use will *attempt* to be more nuanced and complex than this. 

What they hope to do is create some losses and some gains. The losses will be realized. The gains will be unrealized. Your realized losses can be used to lower this year’s tax bill. And those new, unrealized gains? We kick them down the road to a future tax year. We don’t have to pay taxes on unrealized gains (yet).

The question becomes…will we ever have to pay taxes on unrealized gains? 

I hope you see that you can never “outrun” this tax problem EXCEPT by dying. When you die, your taxable estate goes to your heirs at a stepped-up basis, wiping out the capital gains. 

Is “Death” Considered a Big Win?!

This brings about a funny little pattern in financial planning circles where we have to balance two competing ideas: 

The first idea is that everyone will die someday. We MUST treat death as a reality. 

But the second idea is that we need to be a little cautious about treating death as a “win” and living as a “loss.” This scenario is one example. Sweet! You die with unrealized capital gains, and your heirs get a big win!! It’s true. You’re still dead, though. And you didn’t get to spend your money. 

Another example: you claimed Social Security at 62, and that ended up being SUPER SMART because you died at 71, well before the “break-even age” for delaying. Good thing you claimed at 62!

Who are we talking to here? The dead 71-year-old? Did they win? 

Another example: Oh man…you wasted $2,000 a year for 30 years on life insurance. What a WASTE.  

You’re saying…I failed because I survived? 

Yes, death is a reality for all of us eventually. And I genuinely think there comes a time when, for example, we should prudently say, “Should we realize capital gains for this very sick 87-year-old, or do we discuss the idea of their death?”

Back to Long-Short Direct Indexing

But I’ll occasionally get emails from a 55-year-old who thinks they’re going to kick the tax can down the road on their highly appreciated tech stocks until they die. 

Short of dying, though, what these “tax loss strategies” attempt to do is, again, create some losses THIS YEAR…while not actually losing you money on net. 

Some of these strategies use leverage, or borrowed money, to give you extra exposure. This is a weird concept, so let me see if I can explain it. 

You invest $100. On top of that, you borrow another $100. That’s the leverage. And that leverage comes at a cost. Right? Borrowing money, taking a loan…that has a cost. We’ll put in a pin in that cost for now. 

Now, you have $200 to invest.

You invest $150 of that in the S&P500. Or, if you want to get more technical, you’re probably building a direct index of the S&P 500 by owning all 500 companies. Either way…you have $150 invested long.

You then invest the final $50 by shorting the S&P 500. Yes…you are betting against yourself. 

On net, though, you have $150 long and $50 short, so your net exposure is $100 long. In other words, you have the same investment exposure as if you had only invested your own $100 in the S&P. You’re not taking any extra investment risk. 

But you know that, in most years, at least some part of your portfolio is going to create losses. Or, if you went the direct indexing route, you know that some of your investments are definitely going to lose money. 

Let’s say your shorts lose money. You sell them. Those losses can then be used to offset other gains from your portfolio or the taxes from Roth conversions. 

And Wes, your advisor would likely say,

“And you didn’t actually lose any money, because your longs are up! The longs’ unrealized gains more than make up for these shorts losing money.” 

That’s a factual statement. 

But would you have been better off, say, being 100% long and not dealing with any losses in the first place? I’d wager YES, at least for most people. 

When Tax-Loss Strategies Work Best

In my experience, the BEST strategies for using losses to offset gains occur when the losses are incidental, not when the losses are purposeful.

Not all of us will have incidental losses in our investing lives, let alone on an annual basis. That’s ok. Sometimes we’ll be able to offset those capital gains taxes or income taxes. Other times we won’t. 

We shouldn’t let the tax tail (15%) wave the investing dog (100%) though. 

Now… this has the same issues as all direct indexing strategies, which we discussed in episode 121. Higher costs. Tax pitfalls. Tracking error against the index. Diminishing benefits over time. Higher minimums. It only applies to taxable accounts, not to retirement accounts. 

The diminishing benefit of long-short direct indexing strategies – it’s a big deal. A lot of these strategies require “forever maintenance.” Because, if you recall, you’re not making the capital gains disappear. While one side of your direct index / long-short portfolio is kicking off losses, the other side is creating unrealized gains. And to liquidate this portfolio and realize all those gains…well, that flies in the face of what you’re even trying to accomplish in the first place. Who would do that? So, you’re going to maintain your direct index for a long time. 

The Cost / Benefit of Long-Short Direct Indexing

But…the costs of the direct index portfolio will still be there. Those additional costs will decay your performance over time.

So, if you’re choosing to pursue one of these strategies, I think it’s important to look at what your tax savings might be this year, next year, or in the other high tax years of your life. 

Then, it’s important to see how much in losses your portfolio might generate, because (as long as markets generally go up over time), you’ll have fewer and fewer losses as time goes on. 

Then you’ll need to measure how much in direct index fees you’ll expect to pay, not just this year, next year, or the year after….but for decades. 

It can feel amazing, and perhaps it is amazing, if you get 3% or 4% in “tax alpha” or “extra performance” that comes from saving money on taxes. But eventually that tax alpha drops to zero. The fund is no longer creating meaningful losses, and even if it were, you might not be in a tax scenario to use them. But at, say, 0.5% in fees per year, any tax alpha you once benefited from is getting slowly eaten away. 

The people who are using this strategy “the best” are NOT late 60’s retirees. 

They are in their 40s and 50s, are high earners in the best years of their careers, and/or are receiving equity compensation from a publicly traded company. These are people who might have to hold this direct index for 30 or 40 or 50 more years (until their death), lest they want to realize the capital gains that they avoided in the first place. But holding this strategy for 30 or 40 years has its own big problems, as we just discussed.

In summary…I have serious reservations about this strategy. 

For the vast majority of people out there, including many of the wealthier people who might be reading right now, I’d be particularly cautious here.

This strategy is likely to have more complexity costs than are worthwhile – at least in its current format and fee structure.

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