A 4-foot putt or a 300-yard drive? Smarter investing, like great golf, focuses on the fundamentals. Too many wealth managers swing for the fences, obsessing over manager picks, macro forecasts, and flashy asset allocations—the “300-yard drives” of investing. Smarter investors, however, head to the putting green: rebalancing, minimizing fees, optimizing taxes, and structuring portfolios for long-term success. Predicting markets is a fool’s errand, but controlling costs and taxes? That’s where the real strokes are saved.
This month, we cover tax-smart strategies: tax-aware long-short funds to offset gains, “armored funds” for downside protection at the cost of capped returns, and new ETFs enabling gain deferrals while diversifying portfolios—all emphasizing the value of thoughtful investment structure.
Bloomberg: Wall Street Takes Tax-Loss Harvesting to the Next Level
Video: Wall Street Finds Another Workaround With Taxes, Losses
Wall Street’s latest innovation, the tax-aware long-short strategy, blends hedge fund techniques with personalized portfolios, leveraging losses from short positions to offset taxable gains. This approach, tailored for wealthy clients, has seen explosive growth, with firms like AQR Capital Management nearly doubling assets in these strategies to $9.9 billion by September, and Quantinno reaching $7 billion in just two years.
Flatrock’s Take: John was quoted in the article on use cases where the strategy can make sense such as offsetting large embedded gains outside your investment portfolio like residences or private businesses.
Additionally, we often see investment strategies pitched for tax savings when the underlying pre-tax investment thesis isn’t sensible. The key is looking at strategies where the data and theory point to an economically meaningful long-term expected return. So-called 130-30 strategies have been used by large institutional investors – that are exempt from taxes – for much of the past 20 years. (Indeed, John’s former firm ran them.) The cherry on top is tax efficiency.
ETF.com: An ETF Strategy for Deferring Embedded Gains
Cambria Investments is introducing an exchange traded fund that allows investors to defer capital gains by contributing appreciated securities as seed capital. A Section 351 conversion using an ETF involves contributing appreciated securities to the fund in exchange for ETF shares, allowing investors to defer capital gains taxes while diversifying their portfolio. This strategy, akin to a 1031 exchange in real estate, enables investors to diversify portfolios without immediate tax liabilities.
Flatrock’s Take: Smarter investing is about predictability. Fees are the easiest to forecast followed closely by taxes. A critical element of minimizing both is thinking about structure. Structure of your asset allocation, structure of your investment products and structure of your accounts and estate. This is a great example of using portfolio structure to achieve better outcomes. In this case, this structural advancement may offer a path to greater diversification within an equity portfolio in a tax neutral manner.
The devil is in the details, of course. The ETF that one contributes individual securities needs to make sense in terms of a client’s overall portfolio and objectives. Nonetheless, we expect to see more of these launches in the future.
Wall Street Journal: Is This ETF Your Knight in Shining Armor?
This article delves into the growing popularity of “armored funds” — ETFs designed to limit downside losses while capping upside gains. These funds use options strategies to protect against market declines, making them appealing for short-term goals, such as saving for a house, or for retirees seeking to preserve capital. However, the protection comes with trade-offs: capped returns, opportunity costs, and reliance on precise timing to maximize benefits. While more affordable than fixed annuities or structured notes, they aren’t ideal substitutes for bonds or long-term growth strategies, as they track equities closely and sacrifice potential stock market returns over time.
Flatrock’s Take: Whether we’re talking your car or your portfolio, insurance ain’t free. If you want to limit drawdown risk, you’ll pay a premium. The investors on the other side of the trade are compensated for bearing your downside risk. Hence, strategies aimed at mitigating this risk inherently carry the cost of this “insurance” in the options contracts. (The also typically have higher fund expenses.)
Combined, these lead to lower risk-adjusted returns over long time periods as evidenced by “Practical Applications of Embracing Downside Risk” by Roni Israelov, Daniel Villalon, CFA, and Lars Nielsen.[i] Their paper suggested sound advice. If the downside risk of an asset class seems too great, it may be more beneficial to simply reduce exposure. Data and theory agree: using long options to dodge risk is a pricey way to underperform.
If any of these topics spark a conversation, we’d be delighted to chat. Markets fluctuate. Priorities change. We’re here to help.
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[i]https://www.aqr.com/Insights/Research/Journal-Article/Alternative-Thinking-Embracing-Downside-Risk