Tax-Aware Transition Analysis
Hypothetical Illustration
1 · The position
2 · The account
3 · The results
Where the account stands each year
Fully diversified in year 4. $29,314,518 in capital losses realized along the way.
Limitations of hypothetical results
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
How this is calculated
The same annual market return is applied to both routes, so nothing in the comparison depends on one route outperforming the other. Sell and reinvest pays the full capital gains tax at the outset and grows the remainder, establishing a new cost basis at that amount. Tax-aware long/short keeps the position, realizes losses each year at the rate set by the leverage level, and sells down as much of the position as those losses can shelter, moving the proceeds into a diversified holding.
Realized losses reduce cost basis elsewhere in the account, so the model carries that reduction forward. Total basis is preserved when no tax is paid, which is why the deferred gain reappears as unrealized gain at the horizon. Deferral is not forgiveness.
Every realized loss is assumed to be used in the year it is realized. Losses shelter the sell-down of the position first. Losses beyond what the sell-down can use are assumed to offset capital gains elsewhere in your affairs, at the rate of the character you select, which is a cash tax saving in the year it happens rather than a deferral. The model reinvests those savings in the diversified sleeve at full cost basis. They compound at the account's return from that point, and the growth they produce is taxed at liquidation like the rest of the account. They are counted only as the difference between the two routes, since the sell-and-reinvest route has no losses to apply.
The loss rate set by the leverage level is the steady rate. The first year runs about forty percent above it, because a newly funded account carries little embedded gain and nearly every position is a candidate for harvesting. Every year after the first is held flat. The model steps once a year and applies one return to the whole account. Realized losses are valued at the rate of the gains you select them to offset, and every exit is taxed at the long-term rate. It ignores lot-level basis, wash sale rules, the timing of contributions and withdrawals, state-specific netting rules, prior capital losses, and the alternative minimum tax.
Important disclosures
Regulatory status
NinePointTwo Capital LLC (“NPT”) is a registered investment adviser with the U.S. Securities and Exchange Commission and is registered with the National Futures Association as a Commodity Trading Advisor and Commodity Pool Operator. Registration does not imply a certain level of skill or training.
Hypothetical and illustrative results
The figures produced by this tool are hypothetical and illustrative. They are generated entirely from the assumptions shown above and stated in these disclosures. The position, market return, and tax assumptions can be changed directly. The annual loss rate, the pre-tax alpha, the management fee, and the index fund cost are fixed, set by the leverage level you select, and stated under the heading that follows. Changes in the assumptions may have a material impact on the results shown. They are not the performance of any actual client account. They are not a projection of what NinePointTwo would achieve, an estimate of what any investor would receive, or a recommendation of either route. No representation is made that any account will achieve results resembling those shown.
Where the default assumptions come from
The fixed assumptions are illustrative estimates rather than measured results. The annual loss rate is set by the leverage level selected. The rates applied are 15 percent of account value per year at 150/50, 25 percent at 200/100, 35 percent at 250/150, and 45 percent at 300/200, each lifted in the first year as described under the methodology. At the two lower leverage levels these sit within the ranges that managers of comparable long/short strategies publish. Nothing comparable is published for the two higher levels, where the rates are extrapolations. Pre-tax alpha is set by the leverage level from an assumed information ratio of 0.5 applied to the tracking error associated with that level, measured net of the management fee and all trading and financing costs. The tracking error assumptions are 2 percent at 150/50, 4 percent at 200/100, 6 percent at 250/150, and 8 percent at 300/200, so the projection assumes the account keeps 1.0, 2.0, 3.0, and 4.0 percent per year above its benchmark after all costs. Each is a forward-looking assumption about the long/short book. None is a target, a projection, or a figure NinePointTwo represents that it will achieve. The management fee is fixed at 1.5 percent of account value per year. Actual advisory fees vary by mandate and are described in Form ADV Part 2A. The index fund on the sell-and-reinvest route is assumed to cost 0.03 percent per year. None of these assumptions has been assessed against your circumstances.
Reading the results
Account value is what the statement would say, including the reinvested tax savings. Value if fully liquidated is what you would keep after settling the deferred gain. Deferral routes always look better on the first number than the second, which is why both are shown. The capital losses shown are not cash in hand. They shelter the tax on selling down the position, and losses beyond that are assumed to offset gains elsewhere in the year they are realized. Deferral leaves gain in the account. The taxable gain shown is what a full liquidation at the horizon would still owe tax on. Three things drive the difference between the routes. The first is when the tax is paid. The second is the tax savings from realized losses, which are reinvested and compound, with their growth taxed at liquidation like the rest of the account. The third is the pre-tax alpha assumed for the long/short account, which is set by the leverage level and stated in these disclosures. The long/short route also carries a higher management fee than the index fund, which is why it can come out behind.
Every loss is assumed to be used in the year realized
The model assumes capital gains exist elsewhere in your affairs, in every year, sufficient to absorb every realized loss the sell-down of the position does not use. This is the assumption most comparable illustrations make, and it is the single assumption most favorable to the long/short route in this tool. An investor without gains elsewhere would carry those losses forward instead, and the cash savings shown would be smaller and arrive later, which can change the comparison materially. The resulting savings are reinvested and compound, which most comparable illustrations also assume. Two features of the modeling run the other way. The growth on those reinvested savings is taxed at liquidation, and the final liquidation is taxed in full, with no loss carryforwards remaining to shelter it.
Tax rates and character
The federal components are fixed at the highest marginal rates. Long-term capital gains are taxed at 23.8 percent, meaning 20 percent plus the 3.8 percent net investment income tax. Short-term capital gains are taxed at 40.8 percent, meaning 37 percent plus the same 3.8 percent. The state and local rate is supplied by you, defaults to California's top marginal rate, and is applied equally to both characters. Realized losses in a long/short account are generally short-term. The tool values them at the rate of the gains you select them to offset. Actual netting rules are more detailed, since short-term losses apply against short-term gains before long-term gains, and that interaction can change the value realized. The final liquidation of either route is taxed entirely at the long-term rate. That simplification favors the long/short account, because gains on closing short positions are generally short-term and a real unwind would be taxed more heavily than shown.
Speed of diversification will vary
The share of the original position still held is a modelled figure. The actual speed of a sell-down depends on market conditions, the amount of leverage used, and the performance of the concentrated stock itself. A position that keeps appreciating takes longer to work through, because the gain to be sheltered grows alongside the losses available to shelter it. Losses realized in one year may not arrive in the amount, or with the holding-period character, that the model assumes.
The loss path is smoother than reality
This tool lifts the first year and then holds every following year flat. Real harvesting capacity does not behave that way. It swings widely from year to year with market conditions and with how far individual holdings move apart from one another, and the swing is large enough that any single year can land at a small fraction or a large multiple of the rate shown. Down markets and dispersed markets are not the same thing, and a falling market does not by itself guarantee a strong year for loss realization. Treat the yearly bars as an even spreading of an assumption rather than a forecast of any particular year.
Leverage, short selling, and margin
A long/short account borrows securities and uses margin. Losses on a short position are not capped, so an account can lose more than the amount invested. Leverage magnifies gains and losses alike and raises the volatility of the account. Financing and borrow costs are ongoing and rise with the size of the short book. Margin approval is required, and a broker may demand additional collateral or close positions at unfavorable prices. None of these risks attach to the index fund on the other side of this comparison.
Risks of tax-aware strategies (not exhaustive)
Pre-tax returns of a tax-aware strategy may meaningfully underperform expectations. Realized losses may be smaller than assumed here, and their value depends on an individual investor’s circumstances, including marginal tax rates and the availability of capital gains to offset. Capital losses offset capital gains, not ordinary income beyond a small annual allowance. Gain deferral is not gain forgiveness, and deferred gains may be recognized on liquidation or withdrawal, even after pre-tax losses. Long/short portfolios involve leverage, shorting, and financing costs that index funds do not, and can lose money. The potential tax benefit of any strategy may be lessened or eliminated prospectively by changes in tax law, or retrospectively by an IRS challenge under current law.
Conflicts of interest
This tool compares a strategy NinePointTwo is paid to manage against an index fund it is not. NinePointTwo earns an advisory fee on the long/short route and earns nothing on the sell-and-reinvest route. That is a material conflict of interest. It is the reason every assumption driving the figures is stated on this page. The position, market return, and tax assumptions are left in your hands. The loss rate, the pre-tax alpha, the management fee, and the index fund cost are set by the leverage level selected and are stated in these disclosures, and the loss-usage assumption is stated under its own heading above. Form ADV Part 2A describes the Firm's fees and its conflicts of interest in full.
No tax, legal, or investment advice
This tool is for informational and educational purposes only. It does not constitute an offer to sell or a solicitation of an offer to buy any security, fund, or investment vehicle, and nothing here is investment, legal, or tax advice. NPT is not a law firm or a public accounting firm. The effectiveness of any tax strategy depends on individual taxpayer circumstances and evolving tax law. Consult your own tax and legal professionals regarding your situation before acting. Past performance is not indicative of future results.
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Compare the structures themselves
The arithmetic above is only half the decision. Section 351 conversions and exchange funds defer tax in different ways, with different lockups and different eligibility rules.