CONTRIBUTORS
Ehren J. Stanhope, CFA
Co-Head of Investment Management, Chief Investment Strategist, Portfolio Manager
O'Shaughnessy Asset Management
Tax-aware long-short strategies are no longer the exclusive domain of institutional investors. As separate account delivery has expanded access, more advisors are asking whether tax-aware long-short belongs in their clients’ portfolios. Here are five practical considerations to help you decide.
1. Keep the tax engine running longer
Direct indexing harvests losses efficiently early on, but cost basis erodes over time—a phenomenon known as ossification. Tax-aware long-short addresses this through a dual engine: the long side mines losses early, while the short side exposed to theoretically unlimited risk generates a continuous, renewable stream of tax losses as markets appreciate. For clients whose direct index accounts have ossified, a modest 115/15 structure can be a natural next step.
2. Make sure the client can actually use the losses
Tax-aware long-short should address a specific client need, not generate losses for the sake of simply creating them. The strongest use cases often include concentrated stock positions, appreciated direct indexing portfolios and known future gain events such as a business sale, IPO or other liquidity event. In each case, the planning question is the same: Does the client have a meaningful use for the losses, and do they have the risk tolerance and time horizon to pursue them? If the client cannot use the tax assets, the added complexity may not be worth the trade-off.
3. Believe in the alpha before relying on the tax benefits
Ask one question: Do you believe in the manager’s ability to generate pre-tax alpha? The tax mechanics only add value if the underlying strategy holds up on a risk-adjusted basis. Active security selection drives long-short returns, and more leverage means more tracking error and a higher hurdle for the manager to clear.
4. Manage the household, not just the account
This is a compliance consideration many advisors haven’t encountered before. If a client holds long exposure with one manager and short exposure with another in the same security, they may be in violation of shorting-against-the-box rules with more severe consequences than a wash sale. This becomes more complex when assets are spread across multiple sleeves, custodians or advisory relationships. Best practice: Whatever equity asset class is assigned to long-short, that manager should be the sole allocation for that sleeve.
5. Use enough leverage; not the most leverage
Leverage should match the client’s objective. A lower-leverage structure may be enough for a client looking to refresh an aging direct index and maintain a more modest tracking-error profile. A higher-leverage structure may be more appropriate for a client trying to work down a highly appreciated concentrated position or build loss inventory ahead of a large gain. The trade-off is cost and complexity. Financing spreads, transaction costs, management fees and tracking error all rise in importance as leverage increases.
The Bottom Line
Tax-aware long-short can be a powerful addition to the advisor’s toolkit. It can help extend the life of direct indexing, create a glide path out of concentrated stock and support proactive planning for clients with meaningful capital gains.
But fit matters. Advisors should start with the client’s need for losses, evaluate the manager’s alpha model, right-size the leverage and coordinate across the full household before implementing.
Franklin Templeton’s Canvas platform was designed to help advisors navigate custom and tax-aware portfolio implementation. Have questions about tax-aware long-short or direct indexing? Reach out to your Franklin Templeton representative.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Tax management practices may impact performance, portfolio characteristics and holdings; and may not result in favorable outcomes. Equity securities are subject to price fluctuation and possible loss of principal. Large-capitalization companies may fall out of favor with investors based on market and economic conditions. Leverage increases the volatility of investment returns and subjects investments to magnified losses and a decline in value. Short selling is a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short.
Canvas® is an interactive web-based investment tool developed by O’Shaughnessy Asset Management, LLC (“OSAM”) that permits an investment professional (generally a Registered Investment Advisor (RIA)registered investment advisor or a sophisticated investor) to select a desired investment strategy for the professional’s client. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as investment advice, forecast of future events, a guarantee of future results or a recommendation with respect to any particular security or investment strategy or type of retirement account.
Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
Franklin Templeton, its affiliates and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
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