E370: What Taxable Investors Still Get Wrong About Returns

0:00Shang, you're the top performing banker at J.P. Morgan. You're also at Goldman Sachs, BWM before. And you, like me, are a tax alpha nerd. Why is tax alpha so topical today? As taxable investors, we all eat after-tax returns, right? Like the vast majority of the investment management industry is built around the idea of pre-tax returns. Everyone builds portfolios around it, right? We look at that. But the reality is when we pay for our kids' school tuition, we go out to eat for families, we pay our mortgages, those are after-tax dollars. And so this idea of tax alpha, you know, how do you really restructure your assets, your liabilities, your overall balance sheet to really be thoughtful about after-tax returns?

0:39Super interesting space. There's a ton of innovation going on right now. A lot of people see this as a niche topic or just wealth managers. I love to talk about this. For somebody that does have capital gains and whether they're selling shares or whether they have carry that they're bringing in, what are the different options and what are the tradeoffs there? You have to be very thoughtful about manager selection. There's a huge proliferation of products of this whole longshore tax-aware SMA space. And mechanically, I think most of us get it where, you know, you have a core portfolio, you use margin, whether it's reg T or portfolio margin, you go long and short, a basket of stocks.

1:15As investors, what we should really care about is how are those long and short baskets constructed? What is the stock selection? What is the alpha model that's going into picking those stocks? Because it's precisely that stock picking that's going to produce that pre-tax alpha. And these strategies really only work well when you have abundant pre-tax alpha because there are embedded costs, there's like financing costs, there's fees, et cetera. So you have to outperform that hurdle before you even think about the tax side. But to your point, to get that additional alpha, you often have to take tracking error, right?

1:43Or you have to leverage the portfolio. And it's within that tracking error that you can produce a lot of tax loss realization. You can imagine if you have a core portfolio and you went 3x long, 2x short, markets that go up, those shorts are going to lose a ton of money. You're going to have a lot of losses that you can potentially realize. If markets go down, those longs are going to have a ton of losses as well that you could potentially realize. So the magnitude of those losses, right, if you're 3x long, 2x short, right, it's 5, right, which is significantly greater than if you were doing, say, for example, long-only direct indexing tax-loss harvesting approach.

2:14So that's why you get so many losses, and it happens to work pretty well in both up and down markets. Is it just proportional to the volatility in the market? The more volatile, the more losses, even if that volatility is to the positive or if it's to the negative? Yeah, and because you're concurrently long and short, up or down markets, you're going to have losses. But to your point, volatility is going to be a tailwind where you see a ton of volatility, right? There's stocks trading up and down. You're going to have more loss realization. Is this daily, monthly, yearly volatility? Is it like you have a war with Iran and it goes up and then it goes down?

2:49Is that positive for tax-loss harvesting? It's so hard to say because all the managers that run these strategies take different approaches. Some are incorporating very complex, sophisticated alpha models to pick stocks. Others might be just leaning into different factors. So you'd really have to dissect the long and short extensions. But I would say that, you know, in general, like that volatility, that tailwind is going to produce, you know, a ton more losses, you know, versus like, you know, low-vol regimes. And the two big players in the tax-offs harvesting space to date, Quintino and AQR, with AQR being significantly bigger?

3:21They're roughly about the same. And, yeah, they're really the two kind of foremost firms that have, you know, been pioneering a lot of these strategies. But there's a ton of new players entering the market as well, including fintechs, various hedge funds, asset managers. Are there any other good ones that investors are excited about? Ones that I look at closely, Brooklyn Investment Group, which is right here in the city. They're very interesting. They were started by a former Golden Sacks managing director, a very thoughtful guy. They're doing some very interesting things. And then a number of the large asset managers, they run these strategies.

3:50BlackRock, I think JP Morgan's coming to one. And what we've seen with the larger asset managers, I think they tend to run a little bit lower on the tracking error or the leverage. Whereas the hedge fund firms, you know, they're comfortable going, for example, 300 long, 200 short. And how would somebody like a Brooklyn comes in, how are they differentiating against the AQR and Quintino's overall? Yeah, it comes down to the alpha model and how are they really constructing the long and short baskets of stocks. And that's an area that, you know, we would really encourage like any investor who's looking at this.

4:16That should be the starting point. And you should go really deep on that question. Why are you so focused on the alpha model and not on the leverage? The loss realization, it's generally very systematic. And sure, some of the providers or managers might harvest losses every three weeks. Some might do it every week, maybe every month. That cadence may vary. But effectively, it's very systematic and it's very similar across different managers. But where the differentiators lie are how they're creating those long and short baskets. And I've asked this to a lot of wealth managers, and they all look at tracking error as a negative.

4:47But to me, tracking error is manager skill. Is tracking error just another word for manager skill? How should investors think about this? It's the latitude you're providing the manager to roam a little bit more freely, right? Like if you and I were picking two baskets of stocks and you picked exactly what was in the S &P 500, I picked some stuff that was different, but mostly like the S &P 500, I'll have higher tracking error than you are. By giving a manager, say, a 6 % or 8 % tracking error budget, you let them roam more freely to deviate from the benchmark. That said, it's not exactly a reflection of the manager's skill because tracking our cuts both ways.

5:21You can track much to the upside. You can also track to the downside. So with that, you can have periods where the manager can be underperforming the benchmark by quite a bit, in addition to outperforming different periods. Is there any rationale to put a single stock exposure into one of these strategies? Or should investors just wait until January 1st, sell it, and then put the cash into it? That's a great topic you brought up. And it's something I'm super interested in. And so, for example, I think the first thing is, what do you want to do as an investor, right? Do you want to diversify? Do you want to hold it?

5:49What's your view or your comfort level of risk, right? Wearing single stock risk. And then it also comes down to the manager, right? Some managers will say, oh, that's too new of an IPO issue. It's too small cap. We don't want to run a long, short strategy, right? But if it's a name like a Google, you know, MetaApple, generally they'll be okay with it. Back to the investor's, you know, perspective is, well, if you want to diversify it, well, there's a ton of options out there, right? You can use a long, short SMA. You can do an exchange fund. Are you worried about huge drawdowns in the stock? If so, you may not want to seed one of these SMAs directly with the stock.

6:19Maybe you want to hedge it first, right? And then when you're hedging it, do you want to go listed or OTC, right? So there's like a slew of these decisions that like every investor probably needs to think through before they press go on one of these strategies. Because I'm thinking about it. I had an exit with Circle in 2027. I expect both SpaceX and Anthropic. I was in the$4 billion valuation for Anthropic. So now it's creating. That's crazy. It's great, but it's creating significant tax decisions. When I consulted AI, basically said that I should sell and tax loss harvest it because the compounding return on the stock needs to be so incredibly high to justify not selling it.

6:56And this is absent of even just diversification. So even if diversification wasn't a thing, I think it was something like I would need to get like a 30 to 40 % compounded annual yearly return on the stock for it to just break even on not selling. Well, first and foremost, again, always hinges down to what's your view or comfort level carrying that stock on your balance sheet or in your portfolio. If you're like, I want to get out of here, I want to diversify, right? Like, there's a ton of different ways. You could just sell it in January 1st, take that cash, seed one of these strategies, try to realize as many losses as you can over the course of the year.

7:26You might get close to have an entire position. Now you've created a basket of losses that could potentially mitigate, defer, you know, the capital gains you're realizing. So in that regard, right? Yeah. I mean, and you reinvest that capital after you sold it. right? Like you're going to continue compounding in a very diversified way. That's one outcome. And I think that's maybe that where AI is backing to the 30, 40 % return. The reality is if you look at empirical research, I think it's like the, you know, CRSP like database, the most frequent or common outcome in the history of like US stocks, like the mode, right, is a minus 100 % return, right?

7:58That's the most, it's not saying like every stock is going to go to minus 100, but that's the most common outcome. What do you mean by that? So if you look at all the say 20, 30 ,000 stocks that are in the CRSP database, the most frequent outcome is minus 100%. The most common, yeah. You mean going to zero? Going to zero, yes. But isn't that through acquisitions? No, it's, you know, companies fizz well, they go away. I mean, it takes decades and years, but that is the reality of the empirical data. That's fascinating. But absent of that, again, going back to AI, because of the compounding in the tax laws harvesting, I believe the number was like 38 % or 40 % compounding to justify a hold.

8:39So let's say I'm super bullish on Anthropic and SpaceX, which I am. Over 10 years, they would have to go up another, call it 50X, for me just to break even. How does it ever make sense to hold them? When you say break even, what is that? Break even against the tax loss harvested index. That's interesting. I'd be curious to see that math because let's say you start with$100 of SpaceX and then you pay the taxes, or you invest it and then you can offset those taxes compound at eight to ten percent over ten years that's one path and then the other path you're saying if i had a hundred dollars of spacex i'd have to go at 38 guess one is what's wrong with that model and two is going back to my question why does it always make sense to sell the heuristic i'd use is like let's say you had a hundred dollars of the single stock spacex to sell it in new york or california where i live you're taking a roughly 37 % haircut.

9:35So you start compounding from$63. It takes a lot. If you don't do it on January. If you do it, yeah. If you do it the - You do it December 31st. ... inefficient tax way, right? Just like sell, diversify. Now you have to return 50 % almost roughly, 37 to get back to the 100 starting point and then keep going. The ability to defer, to sell the 100 and keep it, right? And diversify it, whether it's in a long, short tax aware, and continue compounding from that level, that's incredibly powerful, right? When you can imagine you do that over an investor's lifetime, it makes a meaningful difference. And what about those numbers, that 30 %?

10:09Is that flawed rationale? The one crux is these strategies in general, right? They're only really helpful if your capital gains are realized in large chunks. They're not suitable or appropriate, frankly, for every investor, right? Not all of us need to have millions and millions of dollars of capital realizes in our back pocket, right? So you have to have a capital gain realization event, whether it's a sale of your business, you have a concentrated single stock where you have embedded gains, maybe you're selling a home or some other asset. That's when these losses actually can get useful in that they are deferring your gain.

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12:57In that case, you would be realizing 30 % of alpha every year. Yeah, that's correct. But here's the thing I would slightly push back on that and say, would encourage this GP to reorient his or her thinking and don't think of it as like, hey, I just got to build up losses to throw against my capital gains. You should maybe be thinking like, hey, I might have a core portfolio of ETFs or stocks or even mutual funds. It looks and feels like a roughly diversified basket of stocks and bonds or whatever exposures and asset classes. What a great idea to introduce portable alpha, right? I can use a long short SMA overlay where I hire a really great, you know, renowned hedge fund.

13:31They come in, they provide a long basket and a short basket of stocks around my portfolio. I've introduced a diversified source of return. I've built a better portfolio. Oh, by the way, it's really nice that these losses also come off the long and short extensions on a yearly basis. I happen to have a million dollars in capital gains. Great. Let me go talk to my tax advisor. Maybe there's something there, right? Why think of it in that way? The rationale for doing all of this tax stuff, right? Like we see this kind of starting to creep out in the industry. People are leading with slasher income tax bills, slasher capital gains tax bills.

14:01I don't think that's the right way to think about this, right? You don't want to have the tax tail wag the dog. That being said, two things I would push back on. One is no matter how bullish you are on a SpaceX or Anthropic or OpenAI, it's still single-ass exposure. all things being equal if you get the same exposure in a basket that's going to be optimal absolutely and and two is the thing that i love about the strategy is unlike a strategy of say an opportunity zone where you're buying a home sometimes in the middle of nowhere and it might be a dead asset you're actually investing into the s &p 500 msci and these kind of things so it's stuff that you should have in your portfolio now i'm 90 private so i have much more private exposure and some of that has just been because of my career and past decisions.

14:50I think long-term, I want to be more 60, 70 % private, but there's still that other 30, 40%. You have to put it somewhere. Why not put it into something that's giving you both returns and also tax alpha? I totally agree with that sentiment. And I think what I'm saying is before doing it, investors can be very thoughtful about things like manager selection, strategy implementation. There's just been an explosion of these products, right? And every asset manager, fintech startup, hedge fund seems to be rolling out some variation, like pick and choose that carefully. And to your example of opportunity zones, I remember seeing when these were first rolled out in like roughly 2021.

15:23And anytime an area or geographic region got labeled an opportunity zone, those real estate assets got bid up. And then we had investors piling in because they were like, oh, amazing. I don't have to pay taxes on my capital gains. And then they were buying assets at overpriced valuations. And now when we look back like six, seven years, some of them are underwater on those investments, right? And it's like, so you've let the tax tail wag the dog here. And so, you know, back to my point, it's like, yeah, it's, we don't want to be picking this long, short stuff just to do it for tax reasons. You really have to look at the pre-tax alpha.

15:53I still think it's underinvested and I hate to have my listeners pay too much on taxes. So manager selection is really important because you have this, what's called a tracking error. So if the S &P 500 returns 10%, there may be a tracking error of 8 % in the more high octane version of the tax house harvesting, meaning one standard deviation, 18 % to 2%. And of course, two standard deviations, then you could be down 6 % even when the S &P 500 is at 10%. So manager selection is really important. What else is important? The operational aspect is super critical. My heuristic for this is like, how long has this firm been in business?

16:32Because you want to be working with firms when you're long 300%, short 200 % on a basket of 1 ,500, 2 ,000 stocks, There's a lot of stuff moving around. You want to make sure that firm has navigated all sorts of volatile markets, right? Choppy things, you know, spikes in volatility. And so to trade all those efficiently, and some of these firms are now running, you know, thousands of these brokerage or SMA accounts across their platform. Are they set up operationally? Is there the risk management, right? The trading execution. Can they manage all that smoothly and efficiently? Because a lot can break and go wrong, you know, in these chopping markets.

17:03What about fees? Are they consistent across the board? It's a really interesting topic because it's timely as well. One of the custodian banks, you know, a while back announced that they were going to hike the fees because, you know, there's, when you go long, you have to borrow to go long. And then when you go short, you get a short - Yes, correct. Yeah. And so those changes in the fee structure, right? They permeate when you're long 2X, 3X on the long side, short 1X, 2X on the short side, those get amplified. And so being mindful and understanding, well, what's my long margin cost, my short financing rebate?

17:34Obviously, there's the manager's expense ratio or management fee to run the strategy as well. All of those things should be taken into consideration. What are managers, the top managers, charging? It depends on the tracking error, you know, but roughly something for like 45 basis points to 200 basis points for different variations of these strategies. Carry? No carry, yeah. So fairly reasonable. And Charles Schwab just lowered their minimums? Yeah, that's right. And so to run some of these strategies, the minimums have actually been halved across some of the variations on Schwab relative to what they were previously on Fidelity.

18:06And for our middle class and lower middle class GPs maybe that have half a million dollars to invest in these kind of strategies, are there ways to access the high octane versions of this with lower minimums? And if not, are there ones coming on board? There's some firms out there that do a really great job. I wouldn't say they're super accessible at the tens of thousands of dollars, but you can certainly find firms that will launch one of these strategies for, say, 500 ,000 account size minimums. And they're still able to lever 300? And it'll depend on the firm's comfort level. Some of them will say, okay, if you want to run the 300 long, 200 short, you need at least a million or a million and a half.

18:41But these are all kind of one-off discussions. You can get into these strategies for as low as tens of thousands of dollars with some of these providers. So that's tax house harvesting. that's obviously extremely sexy and extremely relevant today but there's also family offices are now telling me they're doing this for w2 income and lowering their management fees and and it's less common of a thing but it's now it's becoming the next big thing in the space tell me about that it's a topic near and dear to my heart and spicy too a little bit right and none of these players that we've talked about before will ever jump on the podcast they've told me because it's just so politically sensitive.

19:15Yeah. And I'll share my understanding of how this stuff works. Right. And I think it goes back to like high level, like, you know, more structural concepts. And I'll give you an example. So like, you know, Bill Gross and Sam D's PIMCO, you know, everyone was trading bonds, buy and hold, and you click the coupon, you put the bond in your drawer and you forget about it. Right. And so he started doing things like, well, Hey, let's actively manage these bond portfolios. Then he started doing derivatives because he realized, well, Derivatives are a very capital efficient way to express certain exposures.

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21:54Again, that's 20 % off at www.rag-bone.com with code INVEST. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my Rag & Bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants. They've got that clean, structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day, and they become one of those go-to pieces I don't really have to think about.

22:27Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans, it's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work. The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar jeans. You get 20 % off site-wide at www.rag-bone.com using code INVEST.