Long short extensions diversify concentrated stock tax neutrally

Key takeaways:

• A long/short loss-harvesting strategy can diversify an appreciated concentrated position, a single stock whose market price exceeds its purchase price, without incurring capital gains tax.
• The speed of diversification depends on the strategy’s leverage as well market conditions and the active returns of the stocks.
• The strategy can be customized to incorporate an investor’s belief in the upside potential of the stock, risk tolerance and willingness to use leverage.

History demonstrates the perils of holding a concentrated position. Nevertheless, there is roughly $1trillion in concentrated stock held by US investors, leaving them exposed to downside risk.¹ While conviction can explain this phenomenon in part, the specter of realized capital gains may be an impediment to diversification for a taxable investor.

Recent innovation allows tax-neutral diversification² of a concentrated position without incurring capital gains, using a long/short loss-harvesting strategy. Investors enhance the concentrated position by purchasing additional securities with borrowed funds and create a short position by selling borrowed securities.³ The new securities and short positions comprise long and short extensions of the concentrated position, and they are constructed to minimize tracking error to a broad market index.

^{For illustrative purposes only. A long/short diversification strategy completes a fully invested concentrated position with long and short extensions of equal weight by minimizing tracking error to a diversified benchmark in a SMA. Financing costs are calculated by taking the difference between the borrowing rate on the long extension and the lending rate on the short extension, scaled by the exposure.}

Loss harvesting strategies are option like. They seek to generate value when the market price of an asset breaches the original purchase price, which serves as a reference point. Losses may be abundant at the start of a long/short diversification strategy since market prices match purchase prices in both the long and short extensions. Harvested losses can be used to tax-neutrally liquidate the concentrated position, and the proceeds are reinvested in the strategy, resulting in new securities with market prices equal to their purchase prices.

Some investors may prefer to diversify their portfolios rapidly, while others may choose a more gradual approach. The speed of diversification is influenced by the rate at which losses are harvested, which depends on the degree of leverage. Higher leverage increases market exposure, thereby enhancing loss-harvesting capacity.

We conducted an empirical study involving back-testing of hypothetical concentrated portfolios to examine the speed of diversification for the LS130 strategy, where the dollar value of the long and short extensions is 30% of equity, and the LS200 strategy, where the long and short extensions are 100% of equity. The study involved running these strategies over 380 10-year scenarios with different stocks and historical time periods, and it provided a broad view of their diversification speeds. For the more rapidly diversifying LS200 strategy, the concentration of any single stock was reduced to 5% of portfolio weight by year 5 in 346 out of the 380 scenarios analyzed.

^{Speed of diversification: In an empirical study based on 380 back-tests of long/short diversification strategies on different stocks over different 10-year horizons between December 31,1995 and ending December 31, 2023 we calculated the percentage of historical scenarios on which the active weight of the concentrated position was reduced to 20% (left panel) and 5% (right panel). Higher leverage led to a more reliable reduction in active weight. For illustrative purposes only.}

Speed of diversification also depends on market conditions as well as the concentrated position’s active return. Plotting the 380 10-year hypothetical back-tested scenarios on a common set of axes indicates a wider range of diversification speeds for LS130 than for LS200. For many stocks and in many historical periods, LS200 diversified more rapidly and more consistently than LS130. In contrast, LS130 provided more exposure to the upside potential of the stock for longer periods.

^{For illustrative purposes only. Consistency of diversification: We temporally aligned 380 back-tests of long/short diversification strategies on different stocks over different 10-year horizons between December 31,1995 and ending December 31, 2023. Higher leverage led to more rapid and more reliable reduction in active weight.}

Long/short diversification strategies that use loss harvesting may tax-neutrally convert a concentrated position into a diversified portfolio. These strategies can be calibrated to diversify either quickly or gradually, based on an investor's confidence in the stock, risk tolerance, and willingness to use leverage.