If you have ever invested your money, you have probably felt the sting of a losing trade. So why would some wealthy Americans pay Wall Street to help them book one?
For a growing corner of the wealth management industry, investment losses are no longer simply something to avoid. Under the right circumstances, they can become valuable tax assets.
Charles Schwab’s third-quarter results, released on 15 October, offer a glimpse of the borrowing supporting these strategies.
As of 30 September, margin loans stood at $187.9 billion, up 93% from $97.2 billion a year earlier. Of that total, $60.7 billion was linked to certain long-short strategies used by investment advisers.
Those figures do not represent the size of the tax-loss harvesting industry, but they illustrate how much financing has become associated with sophisticated investment strategies.
For asset managers, the appeal is equally clear. Tax benefits can help attract wealthy clients, while the structure of these portfolios may make them reluctant to leave.
The tension is that an investment designed to postpone taxes can come with borrowing costs, difficult exit decisions and risks that have little regard for an investor’s tax planning.
Tax-aware long-short strategies can turn losses into planning tools, with financing risks.
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Tax-loss harvesting begins with a relatively simple idea. Investors sell investments that have declined in value and use eligible realised losses to offset capital gains, potentially reducing their tax bills.
Traditional investors usually find those opportunities when individual holdings perform poorly.
Long-short strategies create more possibilities.
Managers purchase shares they expect to outperform while taking short positions in companies they expect to underperform. Short selling involves borrowing shares, selling them and hoping to repurchase them later at a lower price.
If the share price rises instead, the short position loses value. Closing that position can generate a realised loss, subject to the applicable tax rules.
This means managers can potentially harvest losses in rising markets as well as falling ones, while maintaining exposure to investments they believe will perform well.
Consider a simplified portfolio with $50,000 in unrealised gains on some investments and $30,000 in realised losses on others.
The portfolio is ahead by $20,000 overall before costs, even though its manager has realised $30,000 of losses.
If those losses offset $30,000 of eligible taxable gains elsewhere in the investor’s holdings, an assumed 20% tax rate would translate into an immediate $6,000 tax reduction.
The example illustrates why a profitable portfolio can still produce useful losses. It does not represent a guaranteed tax saving or investment return.
Actual results depend on the investor’s circumstances, the character of the gains and losses, holding periods and applicable tax rates.
There are also important limits.
Under US tax rules, net capital losses exceeding capital gains can generally offset only $3,000 of other income annually, or $1,500 for married taxpayers filing separately. Unused losses can be carried forward.
The IRS’s wash-sale rules can also disallow losses when substantially identical securities are purchased within 30 days before or after certain loss-making sales.
Additional rules governing offsetting positions, including tax straddles, can complicate long-short arrangements.
Most importantly, a lower tax bill today does not necessarily mean the liability disappears permanently. In many cases, the investor is postponing taxation until appreciated investments are eventually sold.
That distinction matters because the financial industry can earn fees throughout the period in which those gains remain unrealised.
Zachary Milam, vice president at Mercer Capital, argues that the attraction for investment managers extends beyond the amount they charge clients.
“The fees themselves are nothing special,” he told Invezz. “Asset managers have charged that much and more for decades, and many of them have done quite well.”
Traditional managers sell performance, which can be real but hard to isolate, and clients have grown skeptical of paying for it.
Tax management offers something different.
An investor may struggle to determine whether a fund manager’s investment returns reflect skill or favourable market conditions. A reduction in a tax bill, by contrast, is easier to identify, even if the long-term economic benefit is harder to establish.
For managers, that creates a service whose value can appear more tangible than conventional investment performance.
There is also a potential advantage in operating costs.
“The cost side scales at least as well as most of asset management, because the heavy lifting is software rather than research, so each new account costs very little to run,” Milam said.
Technology allows firms to monitor portfolios, identify potential losses and manage exposures across numerous client accounts.
Although these systems require substantial initial investment, the cost of servicing additional portfolios may be relatively modest. That can make recurring management fees attractive as assets under management grow.
The opportunity also extends beyond portfolio managers.
Advisers can collect management fees, while brokers, custodians and securities-lending providers earn revenue from financing purchases and facilitating short sales. These activities may be handled by different companies.
Schwab’s disclosures illustrate the distinction.
Alongside the $60.7 billion in margin loans linked to certain long-short strategies, the company reported $63.3 billion in related short credits for September.
Those short credits are associated with the short-sale arrangements and should not be treated as another $63.3 billion of borrowing.
Schwab says it earns a fixed net yield on certain arrangements involving these balances. The outstanding loan amounts themselves are not revenue.
The result is a business in which portfolio management and financing can generate continuing income, even when an investor’s primary objective is to reduce taxes rather than maximise investment returns.
The economics become particularly interesting when investors decide they want to leave.
“And the assets are sticky by construction, because leaving often means realizing the gains the client came to defer,” Milam said.
A portfolio that repeatedly realises losses while retaining appreciated holdings can accumulate substantial unrealised gains.
Selling those winners to close the strategy may create the very tax liability the investor has spent years trying to postpone.
That does not mean clients are contractually trapped. But it can make switching managers, changing investment strategies or withdrawing large amounts more complicated.
For investment firms, this reluctance to exit can support client retention and recurring fee income.
The relationship is not necessarily harmful. Remaining invested can allow deferred tax money to compound, creating a genuine economic benefit.
Nor does every withdrawal require a complete liquidation.
Research published by AQR on 28 August examined whether investors could access capital from tax-aware portfolios without surrendering their broader investment objectives.
The firm’s analysis found that carefully structured partial withdrawals could preserve important portfolio characteristics while using available losses to offset gains triggered by those withdrawals.
It also suggested that long-short strategies can offer greater tax-efficient withdrawal capacity than traditional direct indexing approaches.
However, AQR itself provides tax-aware investment strategies, and its research should not be interpreted as evidence that every investor can withdraw money without significant tax consequences.
Withdrawal capacity depends on portfolio composition, the availability of losses, market conditions and the age of the strategy.
The broader calculation also includes management fees, trading expenses, financing charges and the taxes eventually payable.
A tax benefit that looks substantial in one year may become considerably smaller when those costs are measured over the lifetime of the investment.
For wealthy investors, the challenge is determining whether the value of postponing taxation exceeds the price of maintaining the strategy.
Borrowing introduces another complication: lenders operate on a timetable that may have little to do with an investor’s long-term tax objectives.
“The bigger danger is forced selling,” Kate Leaman, chief market analyst at AvaTrade, told Invezz. “As portfolio values fall, lenders may demand more collateral through margin calls.”
If an investor cannot provide additional collateral, a brokerage may liquidate positions to protect itself.
FINRA’s required margin disclosure warns that firms can sell securities without contacting customers beforehand. Investors also cannot necessarily choose which positions are liquidated.
That can turn a carefully planned tax strategy into a forced transaction, potentially realising gains at an inconvenient time.
Long-short portfolios do not necessarily involve an oversized bet on rising stock markets.
For example, a strategy that is 130% long and 30% short has 100% net exposure but 160% gross exposure.
Its actual sensitivity to market movements depends on the underlying holdings and how the long and short positions behave together.
“The short positions are meant to cushion the blow, but they don’t always,” Leaman said. “In fast, disorderly markets, correlations can shift and short squeezes can hit.”
A rising market can also create problems when heavily shorted shares climb sharply, increasing the collateral needed to maintain those positions.
These concerns have already influenced how major financial institutions provide access to the strategies.
In September, Schwab tightened requirements for certain tax-aware long-short separately managed accounts.
The firm raised the minimum assets required for some new accounts from $1 million to $10 million and stopped accepting new enrolments and additional funds in affected portfolio-margin arrangements, which permit greater leverage.
The changes took effect on 16 September and did not generally alter existing clients’ arrangements.
The restrictions are significant because they show that even as demand for tax-efficient investment products expands, the firms supporting them are becoming more selective about the financing they provide.
For investors, leverage also carries ongoing costs.
Interest expenses and stock-borrow fees can erode investment returns, while losses on short positions can exceed the initial proceeds from selling the borrowed shares.
An attractive tax outcome cannot compensate for every disappointing investment result.
Tax efficiency should be a bonus on top of a sound investment plan, never a reason to take on more risk than you can afford.
The growing popularity of sophisticated tax strategies is also attracting attention from US regulators.
On 28 September, the Treasury Department and Internal Revenue Service released Notice 2026-62, identifying investment fund transactions that officials believe may produce tax outcomes inconsistent with the intended application of federal law.
The notice examines several arrangements involving exchange-traded funds and tax-aware investment vehicles.
Among the practices attracting scrutiny are strategies that seek to generate ordinary losses alongside capital gains, potentially allowing investors to exploit differences in how the two are taxed.
These arrangements are distinct from conventional tax-loss harvesting, where eligible capital losses are used to offset capital gains.
The distinction is important.
The notice does not prohibit long-short investing or suggest that every attempt to minimise capital-gains taxation is abusive.
Instead, regulators are examining particular transaction structures, including cases where tax outcomes may depend on how economically similar positions are classified or terminated.
The IRS also indicated that any further guidance should respect established tax-planning practices while addressing potentially abusive transactions.
The consultation has therefore entered a new phase, with investors and managers facing uncertainty over whether additional guidance will affect particular strategies.
That makes understanding the underlying transactions essential.
An investor needs to know not only how a portfolio generates losses, but also whether those losses are eligible for the intended tax treatment and what happens if the strategy is challenged or eventually unwound.
For the financial industry, the attraction remains substantial. Managers can collect fees while investors postpone taxes, and financing providers can earn income supporting the positions.
But a lower tax bill today is no guarantee of a better investment outcome tomorrow.
The real test comes when the borrowing is repaid, the portfolio is unwound and investors discover how much of the promised advantage they actually kept.
