So, here’s the long and short of it …

It wasn’t just a massive boost in trading volume during the SpaceX initial public offering that fueled Charles Schwab’s second-quarter earnings growth. Long-short strategies — which, unlike traditional direct indexing, aim to generate harvestable losses across all market environments — have been a staple for advisors guiding high-net-worth clients through hefty capital gains tax hits. The strategies are delivering a noticeable boost, with the discount brokerage posting a 21% year-over-year revenue increase overall in the second quarter, outperforming Wall Street expectations. Executives pointed to sustained interest in long-short tax-managed strategies as an underlying engine.

“Bigger competitors were maybe not making this as available, which probably led to a little bit of a surge,” CEO Rick Wurster said during the company’s earnings call this week. “We’re past that [surge] now and in more of a stable growth environment.”

King Harvest

CFO Mike Verdeschi also noted that while the offering represents a modest slice of Schwab’s overall business, roughly 1% of firm revenue, it remains a focus. “It’s grown very quickly,” he said during the call. Here’s how they work: Long-short strategies pair long positions in individual stocks expected to rise with short positions in those expected to fall:

• By realizing losses on either side of the portfolio, managers can offset outside capital gains even in bull market runs.
• Advisors typically use this blueprint for high-net-worth clients facing major tax triggers, such as selling a business or unwinding a concentrated stock position.

“Being able to generate and harvest losses … while still largely tracking an index is quite a powerful strategy,” Wurster said, predicting the approach will only gain traction over the next decade.

Not Too Much. Despite growing advisor momentum, long-short strategies carry inherent complexity. They require active portfolio oversight, higher trading volume and borrowing fees for short positions. Shorting equities also carries unique risks: While losses on a long position are capped at the principal invested, theoretical losses on a short position are unlimited.

Mindful of those risks, Schwab instituted guardrails earlier this year on how much advisors can allocate to long-short separately managed accounts, capping allocations at 30% of a practice’s total assets held at the firm.

Turns out there is such a thing as being too tax-efficient.

Treasury Department officials are reportedly voicing their concerns over several new Wall Street tax strategies that are saving investors from potentially paying billions of dollars in capital gains tax. The officials called some of the new funds “too good to be true” and even “abusive” at an event on Tuesday, per a Bloomberg report, including the increasingly popular 351 conversions that seed new exchange-traded funds with appreciated stocks. The comments come amidst a boom in so-called “tax alpha” strategies and mark the latest salvo in an ongoing debate over the controversial products that are quietly transforming ETF investing.

“I’m surprised it’s taken them this long,” said Jeffrey Colon, a tax law professor at Fordham University. “The Treasury hasn’t shown its hand on next steps, but promoters and sponsors of abusive ETF strategies are now on notice.”

Collateral Damage Control

One of the main issues is that 351 launches transform a routine tool into a tax-avoidance mechanism, said Amrita Nandakumar, president of Vident Asset Management.

“Any potential crackdown by the Treasury could create collateral damage and compliance issues for well-intentioned managers who simply wanted to modernize their long-term investment structures through legitimate conversions,” she said. The new funds could also invite unnecessary scrutiny of the in-kind mechanism, which allows investors to exchange a basket of securities for shares of an ETF. “Ruining a clean conversion path for asset managers is bad enough, but threatening the regulatory standing of the in-kind process is far worse.”

The 351 conversions are growing rapidly, especially for high-net-worth individuals. Per a separate Bloomberg report:

• Some 105 ETFs have been created through 351 exchanges, more than half in the past year.
• The funds helped defer at least $6.5 billion in embedded capital gains.

“Recent public commentary has raised questions,” the Investment Company Institute said in a recent public letter. “We believe IRS and Treasury guidance for such transactions would bring needed certainty.” The Treasury Department and IRS did not respond to requests for comment.

Tax Tail Wagging the Dog. So much of tax alpha investing seems to be marketed toward the tax side first and foremost, said Shang Chou, cofounder of Dishmi Capital. “What we tell our clients and the folks we work with is that should not be the case. Investment rationale, economic substance: That’s what it’s all about,” he said.

Similarly, he doesn’t recommend clients “contort” their assets to achieve eventual tax benefits when those strategies could come with higher costs and regulatory risks. “Not to mention, it could just simply not be a great investment to make.”

Maybe one size really can fit all.

As financial and investment advisors face rising client loads and portfolio complexity, the challenge is no longer simply building portfolios, but turning them into consistent and customized strategies. That’s leading some advisors to take another look at model portfolios. Sometimes models have been dismissed as commoditized, one-size-fits-all solutions, but as the wealth industry has evolved, so too have model portfolios. Rather than forcing every client into the same allocation, today’s products are dynamic, outcome-oriented frameworks that help RIAs implement their best thinking more consistently.

By providing a repeatable foundation for portfolio construction, they can reduce ad hoc decision-making, improve communication around portfolio changes and create greater flexibility to accommodate client-specific preferences and circumstances. We’ve heard it before, but the result is that advisors can spend less time manually building portfolios and more time delivering the advice clients increasingly value.

But not every customization is right for every client, and advisors need to serve as gatekeepers to ensure that adjustments are creating value rather than simply introducing additional complexity, implementation burdens and costs.

Read more.

Phill Rogerson, SVP and Head of RIA Channel, AssetMark