Tax Alpha Needs Some Real Alpha

We talked last month about tax alpha. The basic idea is that it is hard to beat the market by buying the stocks that go up and avoiding the stocks that go down. It is, however, relatively easy to buy some stocks that go up and other stocks that go down. Owning stocks that go up is good (you have more money), and owning stocks that go down is also good: You sell them, realize a tax loss, and use that loss to offset other gains and reduce your taxes.1

This is pretty straightforward; it is called “tax-loss harvesting” and lots of financial advisers and robo-advisers will do it for you. But some money managers will scale it up for you. You can borrow money to buy more stocks, generating both more gains and more tax losses. This increases your market risk — owning $200 of stocks with leverage is riskier than owning $100 of stocks without leverage, even after the tax benefits — but you can offset that risk, and generate even more tax benefits, by shorting some stocks. Put in $100, buy $200 of stocks, short $100 of stocks: Now you are net long $100 of stocks. Some of your longs will go up and some of your shorts will go down and you will make money; other longs will go down and shorts will go up and you will generate tax losses.2 Overall, if you are long and short reasonably well-constructed diversified baskets of stocks (say, randomly sampling 200 long stocks and 100 short stocks from the index), you should expect to generate roughly the market return on $100 of stocks, but with some extra tax juice.