Long-Short SMAs Aim to Keep the Tax Losses Flowing

Ever hear of too much of a good thing?

Years of strong stock market returns have created an unexpected challenge for advisors using separately managed accounts. It has become harder for direct-indexing strategies to generate the tax losses that underpin much of their appeal, said Eddie Bernhardt, head of SMAs at Invesco. But an innovative strategy is gaining popularity. Maintaining both long and short positions on stocks, opening up additional opportunities to realize tax losses in different market environments.

Here’s how it works: In a rising market, short positions can generate tax-loss harvesting opportunities when those stocks move higher. Conversely, long positions can generate harvestable losses as stock prices decline. “You’re generating realized loss potential in various markets, and you’re extending the life of loss generation in a portfolio,” Bernhardt said. While asset managers say the approach can help wealthy clients offset gains from concentrated stock positions, advisors caution such strategies add complexity and aren’t a substitute for comprehensive tax planning.

Cover Your Losses

SMAs are particularly useful for high-net-worth clients with concentrated stock positions or expecting a large taxable event. Consider the recent wave of wealth created by SpaceX’s public debut. Many current and former employees suddenly found themselves with millions of dollars tied to a single stock. Selling all those shares at once could trigger a major tax bill. An SMA allows advisors to gradually diversify those positions over several years, while using harvested losses to offset realized gains. 

However, advisors say market conditions can limit the effectiveness of traditional direct-indexing SMAs. Jon Hsu, founder of TrueVector Wealth Advisors, said clients with highly appreciated technology stocks were unable to diversify as quickly as expected because a prolonged bull market generated fewer tax losses than anticipated. One SMA generated roughly 15% in tax losses during its first year and about 5% annually thereafter. Although Hsu explored long-short SMAs because they can generate losses for a longer period, he ultimately worried about leverage costs and the expense of unwinding the strategy. “Planning an exit strategy from an SMA is something that advisors rarely discuss with clients,” he said.

The use of traditional SMAs has surged in recent years:

• Today, SMAs hold about $4 trillion in assets, according to Cerulli data.
• Also, roughly half of advisors report using SMAs.

’SMAtter with You? Matt Chancey, founder of Tax Alpha Companies, said SMAs can produce meaningful tax savings, but work best as one piece of a coordinated plan involving advisors, CPAs and estate attorneys. “The tax alpha isn’t in the product,” he said. “It’s in the coordination around the product.”