Keep More of What You EarnHow Tax-Aware Investing Works

Every investment conversation with a high-income household (especially in California) eventually arrives at the same place: the pre-tax number is not the number you keep. A strategy that earns 10% and hands 4 points back to Sacramento and the IRS is a 6% strategy. So it is no surprise that the fastest-growing product category in wealth management is one built to shrink that gap.

Tax-aware long-short investing, usually shortened to TALS, went from roughly $2 billion in assets in 2022 to more than $150 billion today. We use these strategies, and we think they are the most useful thing to happen to taxable investing in a generation. This post covers how they work, what the losses are worth, and how we put them to work for clients.

Why the tax drag is bigger here than almost anywhere

Start with the rate stack, because it explains the demand. A California household in the top bracket pays 37% federal income tax, the 3.8% net investment income tax, and 13.3% to the state on a short-term gain. That is 54.1% of every dollar. Long-term gains do better at 23.8% federal plus the same 13.3% state, for a combined 37.1%. On $100 of long-term gain, a household in Texas or Florida keeps $76. A household in Irvine keeps $63.

Two things follow. First, converting short-term outcomes into long-term ones is worth 17 points in California. Second, every $100 of loss that can be used against a gain is worth $37 to $54 to a top-bracket household. That is what makes a reliable, ongoing source of losses so valuable.

Why traditional harvesting runs out

Tax-aware investing is not new. Asset location, holding-period discipline, municipal bonds, and tax-loss harvesting have been standard practice for decades. Direct indexing, where a client owns the several hundred stocks in an index rather than one fund, made harvesting more productive because each position can be sold at a loss on its own.

The problem is arithmetic. Markets rise over time, and a long-only portfolio can only lose what it paid. Each harvest resets cost basis lower, which makes the next harvest harder. Within a few years a well-run direct index has captured most of the losses it will ever find, and the portfolio is locked in: full of gains, short of losses, and expensive to touch. Published research puts the cumulative loss capacity of a long-only direct index at roughly a fifth of starting value after three years, flattening out below 30% by year seven.

How a long-short portfolio keeps harvesting

A long-short extension adds two things to a core portfolio: additional long positions bought with borrowed cash, and short positions in stocks the manager expects to lag. A 130/30 portfolio holds 130% long and 30% short against 100% of capital. A 200/100 portfolio doubles the long book and shorts a full turn of it.

The short book is what breaks the lock-in problem. A long position can fall to zero and no further. A short position loses money every time the stock rises, and stocks rise most years. So in a bull market the shorts produce losses to harvest while the longs quietly compound. In a bear market the roles reverse. Either way there is something to sell at a loss, year after year, without waiting for a drawdown. The same research that shows a direct index topping out under 30% shows a 200/100 extension generating cumulative net losses on the order of the full starting portfolio within about three years, and continuing from there.

The losses are real for tax purposes and, in a well-constructed portfolio, are largely offset by unrealized gains on the other side of the book. Those gains are deferred, and when eventually realized, often at long-term rates. That is the whole idea: improve timing and character, use the losses against gains you were going to have anyway, and let the rest compound.

Beyond capital gains: the ordinary income version

The strategy above is built for capital gains. For many of the households we work with, the biggest tax line is not a gain at all. It is income: salary, bonus, K-1 distributions, RSUs vesting every quarter. Capital losses do almost nothing against that. The code allows $3,000 a year, and the rest carries forward.

A newer generation of multi-strategy funds is built for exactly this problem. They pair a defensive long-short equity book, long higher-quality lower-risk stocks and short the opposite, with trend following across global futures and forwards in equities, bonds, currencies, and commodities. Some of the instruments in that second book, swaps in particular, produce ordinary income or loss rather than capital gain or loss. A manager running the portfolio with taxes in mind can choose which positions to close and when, so that losses come through as ordinary and gains, where possible, come through as long-term capital or stay deferred inside the fund.

The result is a stream of ordinary losses that offsets wages and business income at the top rate: 40.8% federal, or 54.1% with California. Every $100 of ordinary loss is worth up to $54 to that household, and it does not require a gain to use it against. The income is already there every year.

The size of that stream is what surprises people. In an illustrative year, a fund of this type can report ordinary losses equal to roughly a quarter of the original investment, alongside some short-term capital loss, offset in part by long-term gains and qualified dividends that are taxed at the lower rate. On a $1,000,000 investment, that mix is worth on the order of $125,000 in tax that year for a top-bracket California household, while the fund itself is still invested and pursuing its return. Some years the number is smaller. Over several years it compounds.

Two things make this version attractive before you get to the tax line. First, it is a diversifier. The portfolio is typically managed to roughly half the equity market's beta, and trend following has historically done some of its best work in years when stocks did their worst. Second, it draws on two strategies that large quantitative managers have run for institutional investors for well over a decade. The tax-aware implementation is the new part, not the investing.

The tradeoff is structure. These are private funds rather than separately managed accounts, which means a K-1 instead of a 1099, qualified-purchaser eligibility, minimums starting around $500,000, and monthly or quarterly liquidity with notice. For a household with the income to use the losses, that is a reasonable price for turning a good diversifier into a very good after-tax one.

Why it has to be a real strategy

The tax code requires economic substance. A strategy has to have a genuine expectation of pre-tax profit for its losses to count, which is why these portfolios are run by managers making real active bets on the long and short side, and why the strongest offerings come from quantitative shops that have run long-short equity for decades. The tax overlay is newer than the engine underneath it.

Costs are part of the picture too. The manager charges on the extended book, and the custodian earns a spread on the margin loan and the stock borrow. All in, carrying costs run from under 1% of starting capital at 130/30 to around 4% at 300/200. A good manager clears that hurdle and adds excess return on top, and the tax benefit comes on top of that. Manager selection and the right amount of leverage are where the work is.

When both are yes, the result is a portfolio that compounds pre-tax and hands the client a steady stream of losses to spend against gains they already have. That combination is why the category went from $2 billion to $150 billion in three years.

The category is growing up

The category has grown large enough that custodians and regulators have started setting standards around it. Fidelity paused new client assets into long-short SMAs in February and later raised its net borrowing costs for existing accounts. Schwab followed in April with a 30% cap on the share of an RIA's platform assets that can sit in these strategies and a ceiling of 200/100 on leverage, then went further in September: new long-short accounts now require $10 million in assets, up from $1 million, and Schwab has stopped enrolling new portfolio margin accounts. Existing accounts are unaffected.

None of this has taken the strategy off the table. Other custodians, including Interactive Brokers, continue to accept new long-short accounts at their original terms. Both Fidelity and Schwab have said their limits are about platform capacity, sourcing shorts and managing margin books that grew faster than their risk processes, rather than about the strategy itself. Given the demand, we expect both to loosen once capacity catches up. Guardrails are what happens to any tool that works well enough to attract $150 billion in three years.

Where it helps most

The strategy solves problems that nothing else in the toolkit solves well:

In each case the household already has the gain. The strategy is not creating a tax benefit out of nothing. It is changing when and how tax is paid on wealth that already exists, in exchange for accepting a leveraged, actively managed position in the meantime. The right manager, leverage, and timing depend on the household. That is the planning work, and it is where the value shows up.

How it fits together

For a household sitting on a large embedded gain or a top-bracket income, few decisions in a financial plan move the after-tax number this much. That is why we spend the time on it.