How Tax-Aware Long/Short Strategies May Generate After-Tax Alpha for High-Income Investors
Estimated Reading Time: 7 Minutes
In today’s investment landscape, building wealth isn’t just about earning returns — it’s also about minimizing what you owe in taxes. As tax laws and investment tools have evolved, so too have the strategies used by current investors and advisors.
The progression toward greater tax efficiency can be thought of as a ladder with each step introducing a new, more complex tax optimization strategy. At the top of this ladder lies the tax-aware long/short strategy. This post will work to introduce this sophisticated tax-investment strategy and help you decide whether this may be the next step in your financial gains.
What is a Long/Short Tax Aware Strategy?
The Tax Drag Problem
This refers to the negative impact that taxes, especially on capital gains, can have on an investor's overall returns. When investments are sold for a profit, they often trigger capital gains taxes. Short-term capital gains (on assets held for less than a year) are usually taxed at higher ordinary income rates, while long-term gains benefit from lower rates. As a result, strategies that frequently buy and sell assets (i.e., high turnover strategies) can lead to more frequent taxable events, reducing the investor’s net returns even if the investments seem profitable on paper.
A common mistake many investors make is focusing solely on pre-tax performance, the returns shown before taxes are deducted. While an investment may appear to perform well in terms of raw returns, the after-tax return may be significantly lower due to frequent capital gains realizations. This "tax drag" can erode wealth over time, particularly in taxable accounts. Investors should consider tax-efficient strategies, like holding assets longer, using tax-advantaged accounts, or investing in tax-efficient funds, to mitigate this drag and maximize long-term growth.
What Is So Powerful About a Tax-Aware Approach?
These are strategies that are focused on actively managing investments with tax efficiency as a priority. Rather than simply chasing returns, this method considers the impact of taxes on overall portfolio performance. Key tools used in this approach include:
Tax-loss harvesting: Investors sell losing investments to offset gains elsewhere
Holding period management: Involves holding assets long enough to qualify for lower long-term capital gains rates
Asset location optimization: This strategically places investments in taxable or tax-advantaged accounts based on their tax characteristics. By incorporating these strategies, investors can significantly enhance their after-tax alpha—the portion of investment returns that remains after taxes—ultimately improving long-term wealth outcomes.
How does a Long/Short Tax-Aware Strategy Work?
This strategy actively trades individual securities in two ways:
- Long positions (buy low, sell high) in fundamentally strong, undervalued companies.
- Short positions (sell high, buy low) in overvalued or weakening companies.
The difference with a tax-aware approach is that the portfolio manager doesn't just make trades based on investment performance but also considers the timing and tax implications of each trade.
The key tax benefit of a long/short strategy lies in its systematic realization of losses:
- Short positions tend to generate short-term losses, which are especially valuable because they can offset short-term gains elsewhere — the most heavily taxed type of investment income.
- Long positions can be harvested strategically to defer gains until they're long-term or until a more favorable tax year.
This results in a steady stream of tax-loss harvesting, which can be used to offset capital gains, reduce ordinary income, and bank losses for future tax years.
The Benefits of the Tax-Aware Long/Short Strategy
A tax-aware long/short strategy offers several potential benefits for investors, particularly those in higher tax brackets seeking to maximize after-tax returns. One of the key advantages is the ability to actively harvest tax losses throughout the year. By realizing losses on declining positions and offsetting them against capital gains, the strategy can reduce an investor’s overall tax liability. This can enhance net returns without altering the portfolio’s overall market exposure. The timing flexibility in long/short strategies allows managers to be opportunistic in realizing losses while deferring gains, further improving tax efficiency.
Another benefit is the ability to maintain market exposure even when harvesting losses. For example, after selling a losing position to realize a loss, the manager can use a correlated proxy to maintain similar economic exposure while avoiding wash sale rule violations. This allows the investor to stay invested and benefit from potential market recovery, without compromising the tax advantage. In contrast, traditional long-only strategies may face more limitations when attempting to maintain exposure while harvesting losses.
Additionally, the short side of the portfolio offers unique tax advantages. Gains from short positions are typically taxed at short-term rates regardless of holding period, but they can be offset by realized losses elsewhere in the portfolio. The ability to tactically manage both long and short positions also gives the manager more tools to generate tax-efficient alpha, especially in volatile or sideways markets where tax loss harvesting opportunities are more frequent. Over time, this focus on after-tax returns—rather than just pre-tax performance—can lead to more consistent, tax-aware compounding for taxable investors.
The Risks of the Tax-Aware Long/Short Strategy
A tax-aware long/short strategy seeks to enhance after-tax returns by actively managing gains and losses, particularly through tax-loss harvesting. While this can improve tax efficiency, it introduces several risks. Market fluctuations can impact both long and short positions, and short selling itself carries the potential for unlimited losses, borrowing costs, and liquidity constraints. Additionally, the strategy may involve higher portfolio turnover, which increases trading costs and could diminish returns. Timing trades for tax purposes may also lead to less optimal investment decisions.
Compliance with IRS rules-such as the wash sale rule-is critical. as violations can eliminate the intended tax benefits. Leverage and the use of derivatives may amplify losses, while reliance on counterparties (e.g., brokers or dealers) introduces credit risk. Moreover, changes in tax laws or financial regulations could reduce the strategy's effectiveness. While tax-aware positioning can be beneficial, it does not guarantee improved performance and may underperform more traditional investment approaches.
Who Benefits From This Strategy the Most?
This strategy is especially well-suited for:
- High-income individuals in top marginal tax brackets
- Investors with large, recurring capital gains
- Business owners or executives with irregular income
- Individuals with concentrated stock positions needing offsetting losses
- Families with estate planning goals involving tax minimization
The tax-aware long/short strategies represent the pinnacle of tax-efficient investing. By combining intelligent asset selection with proactive tax management, these portfolios can generate significant tax savings without sacrificing investment performance.
While they may not be suitable for every investor, those with complex financial lives or meaningful taxable wealth can benefit greatly from this approach.
Chicago Partners offers the tax-aware long/short strategy for individuals to qualified clients. If you are interested in learning more about whether a long-short strategy may be right for your portfolio, you can reach out to us anytime using the form on our contact page.
Sources:
- Investopedia. (2025)."Understanding Long-Short Equity Strategies: A Guide for Investors". Retrieved from https://www.investopedia.com/terms/l/long-shortequity.asp.
- Blackrock. (2025). "Long/short extensions diversify concentrated stock tax-neutrally". Retrieved from https://www.blackrock.com/us/financial-professionals/insights/diversify-with-long-short
Important Disclosure Information
Past performance is no guarantee of future results. Different types of investments involve varying degrees of risk. Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Chicago Partners Investment Group LLC [“CP”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Neither CP’s investment adviser registration status, nor any amount of prior experience or success, should be construed that a certain level of results or satisfaction will be achieved if CP is engaged, or continues to be engaged, to provide investment advisory services. CP is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, no portion of the foregoing content serves as the receipt of, or a substitute for, personalized investment advice from CP. A copy of our current written disclosure Brochure and Form CRS discussing our advisory services and fees is available upon request or at www.chicagopartnersllc.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please Remember: If you are a CP client, please contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) comparative benchmarks/indices may be more or less volatile than your accounts; and, (2) a description of each comparative benchmark/index is available upon request.