Tax Aware

Beyond Direct Indexing: Dynamic Direct Long-Short Investing

Topics - Tax Aware Equities Alternative Investing Relaxed Constraint

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Beyond Direct Indexing: Dynamic Direct Long-Short Investing

On average, net losses realized by direct indexing loss-harvesting strategies taper off within the first few years after their inception. In our historical simulations, they reach a maximum average cumulative level of about 30% of the initially invested capital. 

In addition, direct indexing strategies exhibit a high dispersion of net loss outcomes. Long-short strategies motivated by factor investing can significantly outperform direct indexing strategies from both a pre-tax and tax perspective. We model two types of long-short factor-based strategies: relaxed-constraint and composite long-short. Both types of strategies, if implemented with a sufficiently high level of leverage and tracking error, can realize a cumulative net capital loss of 100% of the invested capital within a few years and, at the same time, substantially outperform the benchmark index before tax net of implementation costs. 

We further show that leverage and tracking error of long-short strategies can be managed dynamically in a highly tax-efficient manner. For example, an investor who becomes less optimistic about the prospects of factor investing can reduce the leverage and tracking error substantially, albeit not all the way to zero, without recognizing net capital gains. We find that a full liquidation of the long and short extensions results in realization of most of the previously deferred gains.

Published In

The Journal of Beta Investment Strategies

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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

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