E375: Why Tax Alpha Could Matter More Than Investment Returns

What if the biggest source of alpha for taxable investors isn’t stock picking—but minimizing friction inside the portfolio itself? In this episode, I sit down with Brent Sullivan, independent tax analyst and author of one of the leading research platforms on tax-aware investing, to discuss why tax alpha has become one of the fastest-growing themes in wealth management. Brent explains how long-short tax-loss harvesting strategies evolved from niche institutional products into mainstream planning tools, why tracking error is often misunderstood, and how sophisticated investors think about balancing risk, leverage, and after-tax returns. We also explore trader funds, operational risk, and why tax management may matter more than active management for many investors.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  Brent, I've been very excited to chat. Welcome to the High and Best Podcast.

• 0:03Speaker 01

  Happy to be here, David.

• 0:04David Weisburd?

  Brent, so you run the largest sub stack on the topic of tax alpha and tax aware investing. Take a step back. Why has tax aware investing become so topical today?

• 0:17Speaker 01

  Well, this always happens when there's a bull market and we've got, you know, what a decade plus of stocks essentially going up. And so folks are looking for ways to minimize friction in their portfolios with just routine rebalancing. Maybe they've had a successful outcome, private or public, and now they're just looking for ways to manage risk. And one of the key barriers to manage risk is taxation. And so if they can eliminate that or defer taxation, then there's just a chance that they can keep their portfolio aligned with their long-term objectives.

• 0:45David Weisburd?

  And who is tax aware investing relevant to? Is it just people with very large capital gains? Is it just the ultra-high net worth or is this is something that's more relevant to people?

• 0:56Speaker 01

  I think there's something in this for every strata of wealth, you know, the highest, highest net worth. I mean, we're talking about intergenerational planning. If we come back from that down of, you know, a level or two, we're talking about really income, income management, capital gains management, lifestyle, maybe, maybe social mobility, things like that in the high net worth space. But in retirement space, this is also a crucial thing. There are going to be things like IRMA and other kinds of like social security planning, Roth conversions, things like that that happen. But, but tax planning impacts every single strata of wealth. It's just a matter of the toolkit that you apply to the specific problem that the investor or the household has.

• 1:35David Weisburd?

  It's interesting to me because when you go online and you do research, so much of the literature and so much of the hype is around getting the best trade or generating active management returns. And of course, even those that claim to have these kind of alpha returns, oftentimes it's a hundred or 200 basis points over, on a yearly basis, over a long period of time where tax alpha oftentimes, I mean, you just take the capital gains aspect, which we'll discuss in a bit. For some people, that could be a 33 or 35% increase in gains that actually doesn't even have an increase in risks. I think it's one of those things that's very obvious, very not sexy, but overlooked.

• 2:17Speaker 01

  100% true, and I really think about tax management as a good fit for those types of people. And the reason is that it's so mechanical, it's so boring. It doesn't require some complicated story to manifest in the marketplace or something like that. It's really like this happens, it's a system, you put inputs into it and then an output comes out. And so it's very functional in that sense, to use an engineering term. And I think that's why it's appealing to me, like the inputs and outputs are very concrete. So just to use your point there, yes, it's like so boring, but at times it's like the most valuable, one of the most valuable things you could do. At the very least, tax management enables folks to at least get their manager fees paid for. Generally, not always, and there are trade-offs and risk considerations, but it's an incredibly

• 3:00Speaker 01

  powerful approach to overall wealth management. And to exactly your point, like folks are going on and on about active management, picking stocks, what did Warren Buffett do, et cetera, et cetera. And I'm just like rolling my eyes at all of that. I'm just like, there's much lower hanging fruit here, one. And two, it's mechanical. You don't have to spin a yarn for it to happen. You can just manage. And it requires thoughtfulness and knowing exactly the mechanations of the tax code, which is fun to a certain type of nerdy personality, but yes, it's a real opportunity.

• 3:29David Weisburd?

  So tell me about the latest iteration of tax loss harvesting. Why is this so popular?

• 3:34Speaker 01

  The thing that's happening right now, and this is maybe five or so years old, it goes back decades and decades, but we're talking about long and short management. And so just the quick description of it is that imagine you have a concentrated stock, maybe some tech company, it's publicly traded, it's marginable is the important thing. So you've got that stock, it's in a brokerage account, you hire a third-party manager, and what they'll do is that they'll add margin on top of that, and then they'll short positions. And hopefully, the margin and the shorts, they do not net with each other perfectly. That's a risk thing, it's also a tax thing, and they also want to achieve relative value between the margin and the shorts. They want to get some pre-tax alpha out of there. But then what happens is that margin and those shorts, you can harvest losses both

• 4:17Speaker 01

  in the margin and the shorts, irrespective of the market conditions, and there are certain asterisks around that. But what it does is create a loss harvesting surface area that's much broader than just a typical core long-only exposure. This is a big deal by my estimates as an independent industry analyst, not a tax advisor. Not a tax attorney, you know, talk to a professional if that's your case. But mine right there, my analysis shows that we've got something like $150 billion in private wealth allocated to these strategies now. So it's quite a big deal. That was not the case two years ago. We had 10 to 20 billion in assets. So it's really growing quite rapidly. And I think that's because it's a planning product. It's really sophisticated and interesting for planning around capital gains.

• 5:00David Weisburd?

  Said another way, what you're saying is in previous versions of tax loss harvesting, where you're 100% long, 0% short, you have some losses in the first couple of years. Something goes down, but few stocks over a five, 10 year period go down. Obviously, there are stocks that go down, but at some point, it stops really tax loss harvesting in the traditional sense. With the new version of tax loss harvesting, oftentimes you have these both levered and short positions. So you might have a 300 long, 200 short, which is an aggressive form of the product. But you might have GM go up 150%. You might have Ford go down 80%.

• 5:41David Weisburd?

  And every year, because there's a short aspect to it, every year, you should have some losses that you should harvest. And oftentimes, I've seen some of these simulations, over a 10 year period, this could be a 7X on your invested amount. So you put in a million dollars, you have 7 millions in losses or 0.70% per year on a 10 year average that you're harvesting on a yearly basis, just some massive tax alpha.

• 6:07Speaker 01

  It's really quite powerful. And this often sounds mysterious to folks. So you contribute a dollar into a portfolio and somehow you manifest $3, $4, $5 of tax losses over the subsequent decade. Like, how does that work? Like, what are the mechanics behind that? And folks find this part interesting, but you really have to understand that these strategies are risk based. Like, and what that means is the tax benefits that emerge from the strategy come from taking risk. What is the source of risk that generates all of these losses? It is the unlimited risk in the short positions. That's really what folks need to understand. These losses don't come from nowhere. They come from unlimited downside risk in a short. How does that work? If you're short a name and the name 10X is, you just lost a Lot of money. Well, that risk exposure is a harvesting loss opportunity.

• 6:53Speaker 01

  And so that's what's really interesting about this stuff. Tax benefits emerge from taking risk. When you don't take risk, that's when there's like a really a big tax issue to be mindful of. But as long as you're profit seeking and taking risk, that's what's really powerful about these strategies. And then one other thing on the pre-tax stuff, you've got longs, that's the top of the portfolio. You have shorts and you don't even need the shorts to lose money. You just need them to grow slower than the longs. So again, it's that relative value play that really can create meaningful pre-tax alpha. If you have a competent steward of the assets behind the scenes.

• 7:24David Weisburd?

  Taking away the tax aspect of it, I've gone converted from a hundred and zero kind of model of the world to a hundred and thirty and thirty short model of the world. Because a very simple thought experiment is if you're a manager, let's say you're a long only manager and you're doing deep research on companies. Once in a while, and probably roughly a third of the time, you're going to find companies that you're like, holy crap, this is a terrible company. I want to be able to short this. It's a form of alpha, it's a form of insight. You can't represent that in a hundred and zero portfolio, but you can in a hundred and thirty and thirty. So not having the tool of shorting in of itself, forget about tax for a second, is a useful tool to have as a portfolio manager.

• 8:05David Weisburd?

  And just being limited to being just long just negates, some might argue, up to 50% of your capacity.

• 8:13Speaker 01

  Yeah, I think that's right. I mean, yeah, there's two different angles on this. And, you know, for all the nerds out there, the optimization type people, like a lot of folks in asset management and long short asset management will call this a relaxed constraint problem. So David, exactly what you're saying, we're removing the constraint on long only. And so folks like this, if they're thinking about parametric optimization and things of that sort, you can just imagine removing that limitation on portfolio design. And it ends up being just a powerful source of.

• 8:43Speaker 01

  Again, reflecting exactly the view of the manager. So again, like if you had, like, let's say the index had a 10 basis point position in long only, you could bring that 10 basis point position down to zero basis points. But if this name is really problematic, the fundamentals are deteriorating, maybe from a value perspective, then yes, you can go full short that position. But let me put this risk caveat on there because a lot of people don't remember that short positions come with this extra profile of risk. We already talked about how it's got unlimited downside. If the name appreciates significantly, you can lose significantly. But another thing is that like, there's an operational concern here. And so I've been writing a lot lately about short squeeze and how this works. So if you're short a name and the name appreciates suddenly, maybe for GameStop type reasons, or Avis is the recent scenario.

• 9:25Speaker 01

  If the name appreciates significantly and literally you cannot source shares to close that position, like you could lose money. And so what we talk about like on, from a risk management perspective is on the short book, really having a firmly diversified portfolio, making sure that like there are risk monitoring processes around individual names. And then also an escape hatch in case there's something that really gets out of control and the covering shares are difficult to source. And so this is, I'm always thinking about this trade off between risk and tax. And it's like, yes, you'll get those juicy tax benefits, but it better be profit seeking and it better be properly risk managed, but it's not for free.

• 10:02David Weisburd?

  Yeah, shorting is probably not a do it yourself type of activity. At the same time, when you go through a manager, I love the Charlie Munger concept of inversion. It's so much easier to find a bad company than it is to find a good company. And it's just so much more believable when I go through a process or I see somebody, I see a couple of classmates from business school that might have not been strong joining a company. There's so many signals, negative signals that you can find that are much easier to price than positive signals.

• 10:31Speaker 01

  A lot of people would say that for sure. And I think the other, again, like it doesn't even, the name does not have to nosedive for a long short strategy to be worthwhile. It just has to grow slower than the margin in the long positions. So it's again, it's that relative value play that could be really meaningful from an alpha perspective.

• 10:50David Weisburd?

  So going back to tax alpha and specifically tax loss harvesting, talk to me about the main market players in this tax loss harvesting 3.0.

• 11:00Speaker 01

  The work that I've done lately is really about analyzing the entire marketplace. Of course, we've got AQR, we have Quantino and Quantino, some AQR, some former AQR folks. If we go down, I would say those two are the market leaders. And then there's, there's a Gulf and then there are other folks in there. We're talking about Gotham in New York. Brooklyn New Vine is in the mix. Aperio, famously a direct indexing, low tracking error, benchmark replication shop that has migrated into long, short with their partnership, an acquisition with BlackRock. And there are several more, Canvas, former Oshaunacy.

• 11:36Speaker 01

  Again, several more that have entered into the space. And I think really what's interesting about this whole migration into long, short is that 50 years ago, we were talking about choosing the best manager. You know, benchmark replication was sort of the silly thing. You know, Vanguard was around doing benchmark or index or investing, things like that. But in general, it was like, let's find the best manager. Let's see who can generate the best risk adjusted returns. And then that went out of favor for a little bit as folks got excited about passive investing, low cost. And then that evolved into direct indexing, which is low tracking error, squeezing tax alpha out of the portfolio through routine tax loss harvesting that decays over time. And then what, what's happening now is that we're back into active management. So David, you were asking about the top players in the space.

• 12:18Speaker 01

  And the important thing for investors to know is that they all manage portfolios differently. Some really, really lean into their active differentiators. Some are closer to the benchmark. And so we've gone through this huge pendulum swing, active, passive. Now we're back to active in a meaningful way. And again, these strategies, the tax benefits emerge from risk taking. And it's really important to understand what's happening and what's different with each of the active managers in this strata.

• 12:41David Weisburd?

  A big criticism of the tax loss harvesting strategy, and arguably the main criticism is how do you unwind these positions? So you put in a million bucks into a levered position. You get all these tax loss harvested over 10 years. You want to sell in year 10. What are some best practices when it comes to unwinding these positions?

• 13:04Speaker 01

  The first thing to realize is that you don't necessarily have to unwind. If you like this flavor of exposure, then there's a chance you could use something like a family limited partnership, family LLC, you could use a trust structure, something like that, and you could persist the alpha. If that's what you're after, you really like what the manager is doing, then like just keep the exposure on. That's an option that folks don't really talk about, but it is there. And I can say firsthand, at no, at least a handful of multifamily offices that do this, they have no plan to unwind the strategy. They like what's happening at AQR, Quantino, et cetera. So they say, let's just keep the party rolling. Now, these strategies have a lot of risk considerations. They're expensive to a certain extent, certainly versus like a passive index fund. They require a trustee that knows how to administer or a manager that knows how to

• 13:47Speaker 01

  oversee the assets across a generation. But that's the first thing I would always point out, like you don't necessarily have to unwind if you don't want to. The second thing is if you have decided that you're going to unwind one of these strategies, then being really deliberate about it, knowing that it's going to take quite a while is the first thing. And the second thing is that in general, you're going to give up some of the tax benefit if you go from highly levered all the way down to long only. And so closing that last gap, some folks will wait until a step up in basis, a death moment, whether it's a spousal state or community property. Then at that point, the tax benefit can be improved slightly. But that's the important thing. And I think there's a really interesting kind of geometric decay here.

• 14:30Speaker 01

  And so you've got a fully levered portfolio, something aggressive, 250, 150, something like that. You realize you accelerate all those losses, you're done with the work that you wanted to get done from a planning perspective. And then unwinding the risk, you'll get this quick drop off in risk pretty quickly, tax neutral. Generally, again, we're talking very, very generally here on average, you get a pretty quick drop off first one to two years. And then that long tail is what's going to take a long time to really work through in a tax neutral way because you need to accumulate more losses such that you can realize gains, do this in a tax neutral way over time. And then that last little bit is going to be pretty tough. So we talk about maintaining a 130-30 or 150-50 exposure for decades.

• 15:12Speaker 01

  And that's probably the, the planning consideration from a risk management and cost management perspective that I always try to emphasize to folks. It's like when you're in one of these strategies, you really are in it for quite a while. And so be thoughtful before allocating, unless that is just the type of risk that you want. Because you're going to be here for decades, I think is realistic.

• 15:31David Weisburd?

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• 16:57David Weisburd?

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• 17:29Speaker 01

  That's a really interesting planning question. And this is like a thing that folks need to understand is like, let's say that you, so you've got your long-only exposure and you add margin and you add the shorts. Well, just know that the margin that you've added, that's full cost basis. And so what does that mean? It means that you borrowed a dollar, you've invested that dollar, there's no appreciation attached to it. And so. What that means is you have full loss harvesting potential. There's also a chance that you could retrieve principal from the portfolio. Now, there's an operational consideration here, which is that sometimes the custodial platforms will be like, oh, wait, that's, this is not a securities backed line of credit portfolio. This is a margin portfolio. We want you to keep the cash inside. So you just need to check on the operational barrier.

• 18:12Speaker 01

  The managers are fully capable of managing risk and cash inflows, outflows. They're fully capable of managing that stuff. You just have to check with the custodial platform to make sure that you can actually extract capital from it. But, but in general, these are really, you're not locked into one of these things. It is really just a planning situation that you can work around. And, and one of the things I like about these long short strategies, they're delivered in a brokerage account. Brokerage account has margin or portfolio of margin authority attached to it. In general, it's yours to use for whatever purpose you need. It's up to the manager to competently steward all that risk and to manage around withdrawals and contributions, things like that. Generally, it's possible. There might be some hiccups.

• 18:50David Weisburd?

  I want to double click on something that you mentioned before and also second order effects of it. You said, "A lot of families choose to have these vehicles for several decades." And the reason for that, and I think this is a distinct part of tax loss harvesting versus other strategies, is these tax loss harvested products are tied to specific indexes. So it might be S and P 500, MSCI, Russell 3000. So it's indexes that you would want to own in your public portfolio otherwise. In other words, you're going to have some public exposure, whether it's 40% or 10% or 60%. So why not keep it in this strategy? And I think that's a big distinction from a lot of the different tax strategies that I've seen over many years.

• 19:34David Weisburd?

  Many of these strategies are, for lack of a better word, I would say dead money. You put in your money into some Random opportunity zone in the middle of nowhere. And now it's, yes, it's giving you a tax benefit, but it's not compounding. It's not a good investment. It's kind of like the, the tax tail wagging the dog. In this case, this is actually exposure that you would want. So why not keep it for as long as you need? And then of course, you know, it's half of the equation of the two certainties in life, death and taxes. Death upon death, you obviously could, could bring it on to your heirs on a appreciated basis. So you're not paying taxes at that point.

• 20:07Speaker 01

  That's really right. I mean, one of the interesting things about accumulated losses. So if you've got a lot of accumulated losses and they're just sitting on your tax return and the carry forward buckets, you can't bring those with you, you know, to the grave. They don't, they don't pass on the same way. And so like, one thing that folks will do is take these strategies and they will put them into a vehicle that sustains across generations. And then you keep having those tax losses for use in, in future circumstances. Now, again, this, this requires like, you know, thoughtful planning, but it is an opportunity that I just, I, you know, triple underline that if you like the active strategy and you like the fact, to your point, David, that these things are sort of beta to a certain extent, then if, if, if this is the type of planning opportunity that you want to keep, then I think intergenerational planning is worthwhile here.

• 20:53David Weisburd?

  It's become a meme of sorts, but I've seen it with my own eyes, which is the second gen two, which I categorically try not to have on the podcast. They're very difficult to deal with, but I have so many gen two family members. So the, the father or the mother made the capital and the son or the daughter, they all believe that they could beat the market in trading. There's like a hundred percent certainty on that. And this is a good way to structurally solve around that, which is yeah, we know that you could beat the market, but now, you know, it's in the passive index. It has all these tax, tax benefits. So that's, that's why we kind of have the structure.

• 21:27Speaker 01

  It's so funny. This, this like this meme, this idea persists like just, just in spite of tons and tons of academic research, you know, things in practice that just like choosing the right stocks is really, really hard. So, you know, either outsource that to a manager or don't bother at all. And, um, otherwise, you know, my, my perspective on this stuff is, um, you know, focus on tax is a key planning element and picking stocks is, um, just really tough.

• 21:56David Weisburd?

  It's tough for the top hedge funds in the world. It's tough for people that made billions of dollars. Certainly should be tough for Gen 2, but topic for another day. Let's talk about something pretty juicy, trader funds. So this is a very fast-growing segment as well in tax alpha. Very juicy. A lot of very intelligent people are doing it, but somewhat controversial. Double-click on it.

• 22:20Speaker 01

  So a trader fund is a hedge fund. It's a partnership. And essentially what it does is the two things. The first one is that it's a fund that is qualified for or has made the trader determination. And this is the important thing for folks to know is that what that allows is for the management fees to be deductible. And that's actually a big deal if we're talking about a hedge fund strategy, it could be quite costly. And so getting those fees deductible is great. But also after they've made the trader determination, it's an annual determination, then that unlocks what's called the 475 trader insecurities election. These are two separate things, really important. These are two different things. One of them, management fees become deductible. And the second one is that everything gets mark-to-market and treated as ordinary. And so that's really interesting.

• 23:03Speaker 01

  There are limitations to what I'm about to say, but in general, that means that certain losses generated inside of the hedge fund can pass through to limited partners, limited is the key word, to limited partners as ordinary losses. Ordinary. And so what does that mean?

• 23:17David Weisburd?

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• 24:01David Weisburd?

  One thing that I've learned from talking to hundreds of investors, founders and business Leaders is that planning for the future isn't just about growing assets. It's also about protecting the people who matter most. Life comes with a lot of important milestones. Maybe you're buying a home, starting a family, planning for college, or simply thinking more intentionally about your financial future. As those responsibilities grow, it's worth making sure you protect those you love. Not sure what kind of life insurance you may need? Concerned about how much it may cost? Think life insurance is too complicated? Your local State Farm agent can help answer those questions. They can help you explore your options for life insurance and choose coverage that you can adjust as your family's needs change over time. Financial protection for your loved ones when it matters most. Learn more about life insurance at statefarm.com. Like a good neighbor, State Farm is there.

• 24:45David Weisburd?

  One thing that I've learned from talking to hundreds of investors, founders and business leaders is that planning for the future isn't just about growing assets. It's also about protecting the people who matter most. Life comes with a lot of important milestones. Maybe you're buying a home, starting a family, planning for college, or simply thinking more intentionally about your financial future. As those responsibilities grow, it's worth making sure you protect those you love. Not sure what kind of life insurance you may need? Concerned about how much it may cost? Think life insurance is too complicated? Your local State Farm agent can help answer those questions. They can help you explore your options for life insurance and choose coverage that you can adjust as your family's needs change over time. Financial protection for your loved ones when it matters most. Learn more about life insurance at statefarm.com. Like a good neighbor, State Farm is there.

• 25:29Speaker 01

  It means that it could offset things like wages or other business income. This surprises people because this is unfamiliar in most areas of income tax planning. This is just a fascinating product suite that has come out of, let's say, financial innovation. And again, I would say there's a couple of different things to keep in mind here. One, these strategies are meant to produce alpha, and they come in two different flavors. One is market neutral and another one is beta or index-ish. They're not, they're not index. They're incredibly high tracking error, but they are beta versus market neutral. And I think, again, there are two different layers to this. One is that they are made to generate alpha. They're made to take risk. And second, they're made to provide certain planning opportunities for investors.

• 26:14Speaker 01

  These things go hand In hand, you do not get the planning opportunities without taking risk. And so those two things I think pair really nicely. One more thing, everybody always forgets this is not a complete bonanza. What needs to happen is that when you have a hedge fund structure, the hedge fund can pass through losses. Again, subject to certain constraints, they are ordinary. That's really interesting, but they are limited and they're limited in three important ways. First is cost basis. You contribute a dollar, you can lever up the portfolio at increases basis, you can pass through those losses. That's the first gate. The second one is what's called at risk. So I said limited before, limited is the key word. If you have a limited partner, the limited partner has limited risk. What does that mean? It means that they have a limited amount of tax loss that can flow through before they are no longer liable.

• 26:57Speaker 01

  This is interesting for you, David, and your audience, but you know, the difference between a limited partner and a general partner. General partner personally liable for certain line items attached to the structure. While they can realize more losses that flow through to them as partners. So again, limited versus unlimited loss. And then the final one here that's material, there's actually two more. One of them is passive, but these are active vehicles now. So that's not an issue in this case. This is not a real estate fund where you're worried about passive losses. So that's not relevant in trader funds. But the fourth thing that investors need to know about limitations on losses passing through is what's called EBL. And that's excess business loss limitation. It's written into the code. It's section 461 or something like that. But you can look up the form and it will tell you what the dollar amounts are that cannot be exceeded in a given year.

• 27:42Speaker 01

  And then those losses carry forward to future years as net operating losses. But the important thing that I hear is that basis, at risk and EBL are the limiting factors on what can flow through to an investor from a trader fund. And those just limitations are worth keeping in mind when you're thinking about an allocation of some of these products.

• 27:59David Weisburd?

  I know there's different companies, different products, but give me a sense of scope.

• 28:04Speaker 01

  Oh, like in terms of size, uh, you know, we're talking about billions and billions, certainly invested in these strategies. I can only think of three, maybe four that are actually doing this in the marketplace right now. There might be more I don't know about.

• 28:17David Weisburd?

  I'm curious, you're talking about passive versus active. Many of our listeners are investing in the GP stakes part of the business as well. Is there a way for a family offices to invest in the actual GP and get even more tax alpha? Have you seen that?

• 28:32Speaker 01

  Um, usually not. You would have to not, not as an investor, you'd have to come in as a partner. And you'd have to probably work with the fund managers to figure out the specifics around that. But there are, there are structuring opportunities for GP like exposure. And I think the point that you're, I think the point that you're getting at is that if you're a limited partner, you kind of had limited pass through of tax benefits. And but if you were a general partner, you could overcome that. I've seen one instance of that in the brokerage land, which would be a, what's called a guarantee letter. And essentially, if there was any limitation on losses, then the guarantee letter would say, oh, no, we are personally liable. And the tax losses would flow through and essentially unbreaks the dam that was blocking the tax losses. But in hedge fund land, that would be a little bit different.

• 29:16Speaker 01

  You'd have to talk with the fund company who's, who's, who's got their own GPs on it and they're doing their own planning.

• 29:24David Weisburd?

  Let's talk about failure modes, whether tax loss harvesting or trader funds. Obviously, they feel kind of too good to be true. How do these strategies fail?

• 29:34Speaker 01

  One of the things that's coming up a lot now in the brokerage side, so set aside hedge funds for a minute. But in the brokerage side, there are a lot of limitations by the custodial brokers that are out there. And so we're talking about generally like Fidelity and Schwab. Fidelity and Schwab have in their own ways introduced limitations on the growth of the strategy, whether it's opening new accounts in the case of fidelity or the financing cost applied to certain clients on those platforms. And then a Schwab, a limitation on the overall book of business that an advisor can bring. It's something like 30% can only be, is the limitation on the book that can be applied to long, short. This, this sounds mechanical and really boring, but, but actually this is where the rubber meets the road. And what do I mean by that? Like, so if like your advisor, and these are advisor access solutions,

• 30:19Speaker 01

  if your advisor cannot access the strategy because the custodial layer is limiting that in some way, that's actually the most concrete barrier to using the strategy. I mean, it's very practical. They just shut the door. You can't do it. All right. So that would be one risk is that you are attempting to allocate to the strategy. You simply can't access, you can't access it. I mean, that's, that's a very practical barrier, but what could go wrong? The, the top line item here, and this is worth diligencing thoroughly, is just, is the manager going to outperform? And if they don't, then is the strategy worthwhile from a risk and cost standpoint? These strategies are very costly. And so just a really quick rundown, we've got management fees, which tend to be elevated depending on the leverage. We have financing costs, you have margin, and the margin is mitigated by interest paid on short proceeds.

• 31:04Speaker 01

  But that's still a number that you need to reckon with. And then also the short positions have what's called borrow fee. And borrow fee is just what it costs to hold a short position open. And so all of these different fees and also the turnover on these portfolios is high. It's hundreds and hundreds of percent. And so what does that mean? Transaction costs, like I know everybody thinks, oh, it's, you know, it's the Robin Hood era, you know, everything trading is free. It's just not. And so all of these costs really add up over time. And so the manager needs to generate alpha to really make these strategies economical. Yes, you'll get all the tax benefits, but the alpha needs to be there. And so if they underperform, extremely long-winded answer to what could go wrong. If they underperform, then these strategies start to look really weird from a risk reward, you know, after all costs are concerned.

• 31:47David Weisburd?

  And in terms of management fees, we're talking about 100 to 200 basis points.

• 31:51Speaker 01

  First of all, the management fee tends to scale up and down depending on the amount of leverage applied to the portfolio. But, you know, we could, I've seen, you know, portfolio management fees, which are in the 20 basis points with really, really minimal leverage. And then, you know, 200 basis points plus when that leverage starts to tie in.

• 32:06David Weisburd?

  And then how do you quantify borrowing costs and interest rates and put a number on that?

• 32:12Speaker 01

  It varies over time, but you know, typical margin, I think right now we're looking at 6%, 7%, something like that. And these things are all roughly benchmarks to the treasury curve. But the important thing is the difference between margin and short rebate. And that margin gap tends to be ballparked very loosely about 100 basis points at times. It's been much tighter, 60 basis points was the standard at Fidelity for quite a while. They increased that for certain clients up to, you know, ballpark 150 basis points. Schwab, Pershing, Goldman, they're all running their own programs. They're all charging different rates. But if we're talking about through the middle, again, that's margin minus short rebate. 100 basis points is really the number to keep in mind, subject to the amount of leverage that's applied. Borrow fees are a little bit different if we're talking about large cap names.

• 32:56Speaker 01

  25 basis points of borrow fee. Again, that is scaled by the position and the leverage that's applied to the portfolio, but it's not unrealistic for 200, 100 to have 20 basis points of borrow fee attached to it. 20 basis points. So for folks who are used to index investing, you know, three to five basis points for the entire structure. Now I'm saying, oh, it's 25 basis points or 20 basis points, whatever, just to hold a short book. And so like these costs add up substantially.

• 33:19David Weisburd?

  So maybe we could add that up for the audience. All in management fees, borrowing costs, interest rates. What's the all in fee or all in range that you would put on that?

• 33:28Speaker 01

  150 basis points to 300 basis points.

• 33:30David Weisburd?

  Got it. So one and a half to 3% per year for these strategies. Certainly six to 20 times larger than than typical long only. But here's why I would disagree. If you're paying 150 to 300 basis points, certainly not cheap, but the tax alpha, we, I went back, I referenced a simulation. Obviously simulations are prognosticating, right? That does, you shouldn't rely on it for tax planning. That being said, many of these simulations at the higher leverage size predict about a 7X over 10 years or 70% tax alpha on cap gains per year. What does that mean dollars and cents? You put in a million dollars, you get back a $700,000

• 34:14David Weisburd?

  loss on a yearly basis. You multiply that by in some jurisdiction like New York or California, let's just make them that simple, 35%. That's 23% or 2,300 basis of alpha in that year netted versus this 1,500 to 300 cost. Now, we're assuming that the manager does not have any positive or negative alpha. And in other words, they basically just track the index, but we're talking about orders of magnitude of difference in terms of the tax savings versus the cost. Where am I wrong?

• 34:49Speaker 01

  I don't think that's wrong. In fact, I've got a buddy who runs some of these strategies. And he says the costs, you know, tens of basis points on management fees. And then you've got hundreds of basis points of tracking error. So the deviation of the strategies from the benchmark. And then you have thousands of basis points of accumulated capital losses. And so what is the planning opportunity between these things? So really, the question that you're asking is like from a net present value. We could do net present value on tax assets and liabilities. In fact, we should. A lot of people don't do it this way because it's tricky. In general, are we coming out with a net positive or an MPV that's positive from this allocation? Like, is the planning, is the cost of achieving this planning flexibility net positive on an after-tax basis?

• 35:32Speaker 01

  Generally, yes, but but subject to a thousand different constraints. It's really, it's worth just understanding how much risk is getting embedded in the portfolios. And that really the portfolios need to be profit seeking from an economic substance type standpoint. And so that is the gating concern. Is the manager going to outperform, underperform? Great. We're taking a lot of risk here. And the tax benefits sort of emerge as a secondary consideration. The planning opportunities are substantial, don't get me wrong. But these are profit-seeking strategies and they need to be evaluated as such first.

• 36:02David Weisburd?

  I'm glad you brought up tracking error. I've had this argument dozens of times with wealth managers, trying to get a wealth manager that will disagree with me and prove me wrong because I'm looking for the null hypothesis. To me, tracking error just says that you are betting on the jockey to make a distinction between different assets. I mentioned Ford and GM. They're going to choose between those two, which one to go long, which one to go short. And of course, if you make that directional bet, you're going to track against the index in one direction or the other. To me, tracking error is just another way to say the manager is trying to generate alpha. And I believe, worst case, if you pick a good manager,

• 36:47David Weisburd?

  they're going to be either flat to the index or maybe slightly above. Because again, they have some of the smartest people in the world, going back to the second gen. The Nepo baby, they're betting against the Nepo baby. At this point, everybody is so passive that there's only Nepo babies around going active. And they're betting against him or her. And at the very worst, I think they're gonna that, you know, 50 50. I actually think, you know, very likely they'll get some alpha, maybe 100 to 200 basis. Maybe it completely wipes away that that management fees and all those carrying costs that we talked about. But why is tracking error always looked at as a negative thing?

• 37:23Speaker 01

  This is such a crucial point. And so, yeah, tracking error comes in like two different flavors. The first one, if you have a low tracking error manager, somebody who's doing direct indexing long only, their whole incentive structure is to keep their portfolio as close to the benchmark as possible. So tracking error to them is incidental. It is just, it is a cost of doing business to get this trade off in risk and tax. And with an active manager, it's totally different. They want the tracking error. They see that as their kind of IP manifest in the portfolios. And so, think about it this way, like if a naively constructed market cap weighted benchmark, right? S and P 500, something like that. I'm not saying it's totally naive, but I'm saying market cap weighted. They're just like managers who are really leaning into tracking error as a differentiator are just like, we reject that as a means of wealth management.

• 38:08Speaker 01

  In fact, we reject it so hard that we're going to actively construct risk. And we're going to manage it as such, completely decoupled from the benchmark. We think we see the benchmark as in some ways arbitrary. We will, we will measure risk relative to the benchmark because that gives everybody a toehold that they can understand the total risk in their portfolio. But in general, we reject that benchmark as a prudent risk management and alpha generation strategy. So we're going to do things totally different. So again, two different perspectives on tracking error. One incidental, it happens, it's a cost, goes up and down a little bit. And then the other one is really deliberate calibrated. We like tracking error. The reason we like it is because it lets us manifest our perspective in the portfolio.

• 38:53David Weisburd?

  So because some firms aren't even trying to play active manager, to them, the tracking error is just a tracking error. It's just how closely they could get to the index. And then others are saying, well, this is our source of alpha. What you call tracking error, we call alpha. So we're gonna, we're gonna really go for that.

• 39:09Speaker 01

  Yeah, we like it. That's, that's part of how we manage money is we, we don't care about all this market cap business. Like, that's silly to us. Like, we take active risk. And the reason we do is because that is what portfolio construction means to us. I hear that all the time. You get folks who are like very passionate about this. They see this as like the, the fruit of their work. Tracking error is not a bad thing to them. You know, tracking error is a mathematical idea is, is pretty simple. Difference, it's the standard deviation of the difference between the benchmark and the actively managed portfolio. And so they don't, this is, it's not necessarily a bad thing. It could wildly outperform, it could underperform, of course, but they see that outperformance as a manifestation of their risk management and stock picking ability.

• 39:49David Weisburd?

  Many of these sophisticated strategies, whether the trader funds typically 500K minimum, the tax loss harvested oftentimes a million plus. There's now this new generation of tax loss harvesting for the masses, which is bit of a funny, funny idea. But that aside, there's startups like Freck and others are going after the space. Are there any startups and or solutions that you like that are for the masses?

• 40:15Speaker 01

  Transparently, I think long short is a really, is very strange for the masses, not in a condescending elitist kind of way, but just because it's so gnarly and it just is a planning product. And so what does that mean? It means that you're accelerating losses. And those losses like require diligence and, you know, studiousness and planning and utilization. And do people really understand the costs that they're paying? Again, portfolio implementation, management fees, et cetera. Like, do they really understand that cost as a means to accelerating losses that maybe don't need? Okay, like, it's just, it's tricky to me to sort of balance those two. That's at the planning layer. At the implementation layer... My, just the work that I've done in risk management just suggests that you really

• 40:57Speaker 01

  want seasoned professionals working in the gnarliest chunk of the portfolio, which is really around margin and short management. And I really don't want to be surprised by inexperience in those two sleeves of the portfolio with so much risk taken on. Just really boring, routine things. What happens with a stock split when you have a short position? What happens? Like, what happens if you get one name that's liquid? Or, you know, different kind of corporate action? What happens if you get a liquid name and you have an illiquid sort of other name? And like, does a startup know what to do with these things unless they have in-sourced that talent? Like, I really want, I want folks who've dealt with like, once in a decade scenarios behind the scenes at the manager layer. And like, to kind of startup bring that to bear, possibly. I'm not saying, you

• 41:41Speaker 01

  know, full stop. I would just need extra convincing. So, yeah, those are some of the things. I've got one more layer of concern, which is just like, the institutional pricing just will tend to be much better from a custodial or relationship perspective. In other words, AQR is going to get way better pricing than a startup would. And so, when folks are just like, I don't want to have an advisor, you know, you're just, whatever, I'm going to pay all these fees. It's like, eh, you'll pay them at some point. It's just a matter of like, to whom you will pay them and what you're getting for that payment. And so, those are the things that are going through my mind.

• 42:09David Weisburd?

  You're making an important distinction, which is, we talked about before, does active management return, is it inherently a negative thing when you take away fees? Or can it be a positive thing? So, you know, my thesis, just for the record, is I think a good active manager can deliver 100, 200 basis points per year, even on a long only portfolio. What you're getting at is something, a different layer, operational efficiency, operational implementation, where there, I would argue, there's economies of scale. The bigger you are, the longer you've been doing for, you don't get some extra alpha for being a small manager, putting in operations. There's only downside there. So, you're bringing up an important and underappreciated thing that doesn't show up in the numbers. You could

• 42:51David Weisburd?

  be a startup and you could put up a website that says, well, 0.25% fees versus 0.5 against the competition, where you're not really showing, what you're hiding is the operational risk.

• 43:00Speaker 01

  100%. That's the kind of stuff that makes me really nervous. And just again, back to like my sort of like interest in the mechanics of tax management. A lot of this operational stuff is also pretty mechanical. There's no thesis behind it. It's all just risk management and risk comes in a thousand different shapes and sizes. And I want really, really, really experienced risk managers behind the scenes. Market risk, yes, but all of the operational boring stuff. It would just be such a shame to have this like this really rich, you know, alpha strategy just be completely derailed by something operational like a stock split. I'm not saying those things are equivalent. I'm just saying like in aggregate, if you have all these operational concerns and they're just sort of bumbled, like, why would you even bother with that?

• 43:43Speaker 01

  And what you're trying to do is eliminate the advisor like as an access point. By the way, just advisors come in all different shapes and sizes. If you just want access to the strategy, there are advisors who will work with you on a very minimal engagement. And so what are we doing here? Are we talking about like a UI on an app? Like, come on, you know, that's not, that's, that's not something I care about in wealth management, right? I mean, I want, I want all the risk and alpha stuff dialed in. And by the way, one more thing, you know, all the way at the top is the primary gating concern for long short, alpha, like these things must make sense like on a pre-tax basis and they can. But if you have like, I don't know, a startup that's kind of like just doing this over the last, you know, year or so, what do they know about generating alpha? You know, are they using some off the shelf kind of, you know, model or whatever? Like, why, why would that be equivalent to what's been happening for decades at some of these managers?

• 44:28Speaker 01

  Why, why, how would these things be equivalent? And so these are just the things that are going through my mind. Again, I don't mean to be down on the startup community or anything like that. I'm just like, I'm thinking about it from a risk standpoint. And I'm just like, why, why is that like, how is that well compensated risk?

• 44:40David Weisburd?

  I also don't like to go short any, any startup or any solutions, but you have, you have to, we're truth seeking here, want to, want to deliver for, for the audience. If you could go back to younger Brent, when he was just graduated college and you could give yourself one piece of timeless advice that would have either accelerated your career or helped you avoid costly mistakes, what would that be?

• 44:58Speaker 01

  Oh, go independent as soon as possible. Like, that is one thing where I'm just like, man, I wish I would have went independent. I wish I would have had more confidence in my own ability to figure things out. And especially before getting married and before having kids. Like, take obscene amounts of risk. Career risk, that is. Because you essentially have, you can do crazy things. Like, you can live in a one-bedroom apartment with two other people. You could just work and have a good time. And I really wish I would have done that more aggressively. And so, you know, I'm 40 this year, and I feel like it took me years to figure out what my path would be. Through a bunch of, like, you know, how many jobs have I had? 10 different W2 jobs? Just really trying to find, like, why does this feel so weird? Why don't I, you know, why am I not gelling with the people that I'm hanging out with all day?

• 45:41Speaker 01

  And just realizing that I'm different, and that if you are different, and you don't feel like your W2 placement is really the right thing consistently, it took me 15 years to figure that out. Then, like, figure out a way to go independent before your life gets all complex. And I wish I would have done that earlier.

• 45:56David Weisburd?

  It's this trite wisdom that people say, follow your passion or find your passion. Where really, there's nuance to it. It's basically find more and more of your passion. So you might know that you want to go into business, and then for five years, you're doing something else. And then you're like, I want to go into finance. And then you're in finance, and then you're like, I want to go into taxable. And then you're in taxable. You keep on distilling your passion closer and closer and getting to, it's almost like this asymptote, where you're never going to truly find your exact passion, maybe till the end of your career. But the more closer that you could kind of fly to that, to the top of the curve, is the more satisfied you'll be in your career.

• 46:28Speaker 01

  That's exactly it. You know, like, you're going to iterate, you know, find the thing that maybe you're uniquely drawn to. What did Arnold say? You want to mine your obsessions. And, you know, I think that that's actually pretty applicable, especially to, you know, certain types of personalities. You know, find the thing that you just cannot let go. And then just realize that, like, if you are doing it particularly better than the rest of the marketplace, maybe you're the only person who's doing it. Like, in my case, I feel like I'm the only one writing about this stuff. Then there's an opportunity to leave.

• 46:57David Weisburd?

  I was going to ask you about that, because when I started this podcast, it was a big risk. I'm like, is this too niche, GPLP? You started an entire community, and some would argue a career, around alpha for taxable investors. It's one of the most niche topics that I've seen covered. And yet, you've grown so much now, you have a conference. How did you know to take that chance? And were you worried that it might not end up that well?

• 47:20Speaker 01

  Yeah, yeah, totally. I mean, that is the risk of carving your own path is that the shape of your career is totally weird and like a blob. It's not a straight line. The path is not hard for you. You're not trying to get promoted in somebody else's schema. Instead, you're just like, "I'm gonna post on LinkedIn today and I'm gonna figure out if there's audience for my nerdy interest in the mechanics of tax management." Oh, wow. Turns out, there's a lot of interest in this and there's also a lot of horizontal territory to cover. And like, is there audience for it? Well, it turns out that there's an entire advisor community who sees this as the differentiator of their practices and that finding the unique intersection of folks who are selling products into this space and folks who are consuming these products and trying to get educated about that, that

• 48:04Speaker 01

  is the intersection that I live in. But I did not start that way. At first, I was just like, "Oh, I'm gonna write about the mechanics. I'm an engineer. This is nerdy. I can do some data visualizations or whatever." But no, I did not imagine that, or seeing the world as clearly as I do now, not that it's totally clear, but I didn't imagine that upfront. This was not designed. It was iterated into.

• 48:23David Weisburd?

  We have the non-taxable, the institutional audience. We have the taxable audience. I fail to see any strategy that's more important for the taxable investor than tax alpha. Michelle Del Buna, who we were talking about before the podcast, he's a CIO of Andreessen Horowitz's family office. He said that they benchmark every one of their products against the tax aware aspect of it. So, an active manager, going back to how well an active manager in a non-tax aware strategy, he or she needs to outperform the tax aware strategy by the tax alpha, which we talked about could be quite sizable. Well, Brent, I think what you're doing is amazing, your Substack, your conference. How should people follow you and learn more?

• 49:05Speaker 01

  Well, so I use the cringe platform, LinkedIn, with some regularity, but I'm hanging out more on X now. X is a lot of fun. So, also, taxalphainsider.com is my Substack. And the conference is called Basis, and this iteration is called Basis Northwest, but we'll probably be coming to a town near you pretty soon.

• 49:23David Weisburd?

  Well, Brent, thanks so much for jumping on and looking forward to doing this again soon.

• 49:27Speaker 01

  Well, appreciate it, David. Thank you for having me.