Exhibit 1: Hypothetical Built-in Gains (As a Percentage of Account NAV)
Assumes initial $100M cash investment in TA LS 150/50, Direct Indexing, and Index ETF, alternatively
Tax Matters
The Impact of Liquidation Taxes on the Lifecycle Benefits of Tax-Aware Long-Short Strategies
July 31, 2025
Topics - Tax Aware
Tax-aware long-short (TA LS) strategies tend to accumulate significant built-in gains. When the time comes to wind down the strategy, those gains are realized, triggering what is known as a liquidation tax. This post addresses frequently asked questions about the impact of this tax on investors and provides examples that illustrate the post-liquidation value a TA LS strategy can deliver over its lifecycle, compared with other investment options.
Common Questions
How much built-in gain does a TA LS strategy tend to accumulate—and is that good news or bad?
At all times, the built-in gain of a TA LS strategy equals the sum of three components: the initial built-in gain (which is zero if funded with cash), the cumulative net-of-cost pre-tax performance, and the cumulative net tax losses realized since inception. 1 1 Close Additional in-kind contributions to, and distributions from, an account will also impact the built-in gain of the account.
For example, consider a strategy seeded with positions having a built-in gain of $100. If the strategy subsequently generates $200 in pre-tax profits, pays $20 in dividends, and realizes $250 in cumulative net capital losses, the built-in gain would be $530 (= $100 + $200 + ($250 - $20)).
A high built-in gain is good news. It reflects a combination of strong pre-tax performance and tax-efficiency, indicating that the strategy has fulfilled its objectives—generating pre-tax alpha and realizing significant net capital losses. As the strategy ages, the built-in gain is expected to grow. The example shown in Exhibit 1 below illustrates the evolution of built-in gains.
Won't investors lose all accrued tax benefits upon liquidation of the TA LS strategy?
The short answer is no. 2 2 Close A more nuanced answer is that reducing the tax burden effectively increases the capital available for investing. If the investments made with this capital were to generate negative after-tax returns, deferring taxes might offer no benefit. First, the tax deferral benefits allow the strategy to compound at the pre-tax rate of return, which is not reduced by the tax burden. Second, the deferred taxes compound at the rate of return of the overall investment portfolio. The combination of these two factors leads to substantial after-tax wealth accumulation, typically not undone by liquidation taxes. 3 3 Close The tax benefits of the strategy allow the investor to keep more capital invested in the overall portfolio, which includes the TA LS strategy as well as other investments. Moreover, this largely holds true regardless of whether the short-term losses realized by the strategy are used to offset short-term or long-term gains, and whether the strategy is liquidated all at once or unwound gradually. That said, as with all tax-related matters, thoughtful planning for liquidation typically yields better after-tax outcomes (see the answer to the next question and the examples further below).
What are the options for unwinding a TA LS strategy?
Options for unwinding a TA LS strategy depend on the reason for unwinding it. Consider the following three reasons for unwinding a strategy, either partially or fully:
- Reducing Active Risk: If the investor is satisfied with the manager but wants less active risk, the strategy's risk can be reduced over a few years in a tax-efficient manner. Importantly, the risk reduction tends to occur non-linearly, with the majority happening early in the process.
- Replacing the Manager: If the manager is to be replaced, a new tax-aware long-short manager can take over with minimal gain recognition and gradually reposition the portfolio to align with the new strategy in a tax-efficient manner. Alternatively, only the long and short extensions can be liquidated with tax efficiency in mind, leaving a long-only appreciated portfolio in the account (see the example in Exhibit 2 below). The investor can then hire a long-only direct-indexing manager to manage this portfolio in a tax-aware manner or contribute the portfolio to an ETF using a Section 351 exchange without recognizing any gains.
- Liquidity Needs: If the investor needs cash and the amount is modest relative to the portfolio size, a simple redemption may not trigger gains. For charitable gifting, appreciated positions can be donated directly from the strategy's portfolio. If full liquidation is required, all deferred gains are realized. The impact of full liquidation will depend on various factors such as account age, leverage, and past activity (see the example in Exhibit 3 below).
Heirs may also benefit from a basis step-up at death, further enhancing the strategy's long-term tax efficiency (see the example in Exhibit 3 below).
Lifecycle Benefits of TA LS Investing
Methodology
In the examples below, we use the following assumptions:
The TA LS strategy is a 150/50 strategy with a target beta of 1.0 and a tracking error of 2%. It is compared to a Direct Indexing (DI) strategy and an index ETF (ETF). All investments are benchmarked to the Russell 1000 Index. 4 4 Close For the construction methodology of the 150/50 and DI strategies, see our "Beyond Direct Indexing" article. Short-term capital losses offset long-term gains, and the resulting tax benefits 5 5 Close For calculating tax benefits and liabilities, we assume the 2025 federal top-bracket tax rates: long-term capital gains (losses) and qualified dividend income are taxed at 23.8%, and short-term capital gains (losses) and ordinary income are taxed at 40.8%. are reinvested at a 7.4% after-tax rate of return.
The initial investment is $100M, and the investment horizon is 30 years. The investor passes away in year 25, with long positions receiving a step-up in basis at that time. The heirs continue to hold the strategy through year 30. The annual excess pre-tax return, net of all costs, is 0.7%, -0.25%, and 0% for TA LS, DI, and the ETF, respectively.
Evolution of Built-In Gains
Exhibit 1 shows the evolution of built-in gains. Built-in gains for TA LS are significantly higher than those for DI and the ETF—112% vs. 72% and 63% of the current NAV, respectively, at year 25. After a basis step-up at death, built-in gains reset to 0% for DI and the ETF and begin to accumulate again. For TA LS, short positions are not stepped up, resulting in a small remaining built-in gain of 19% of the current NAV. By year 30, built-in gains are 47%, 23%, and 76% of the current NAV for DI, the ETF, and TA LS, respectively.
Source: Belvedere. For illustrative purposes only. Assumes TA LS has an annual pre-tax return equal to the market return (7.4%) plus an excess return of 0.7%, net of a 0.45% management fee per annum. Expected Russell 1000 return is the nominal US total arithmetic return assumption as of December 31, 2024 based Belvedere’s Capital Market Assumptions (“CMA”) methodology. Hypothetical potential tax benefits and realized and unrealized gains and losses are based on simulations starting each year from January 1, 1986 to January 1, 2021. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and or volatility may come in higher or lower than expected. Changes in the assumptions may have a material impact on the information presented.
Unwind Scenarios and Wealth Evolution
For the TA LS strategy unwind, we illustrate two scenarios: (1) liquidating long and short extensions and transitioning to a long-only portfolio, and (2) fully liquidating the strategy to cash.
Exhibit 2 shows the first scenario—transitioning to long-only. Post-transition wealth with TA LS remains higher than that with DI or the ETF, despite the tax cost from liquidating the extensions. If heirs hold the portfolio from years 26 to 30, TA LS delivers post-transition-to-long-only wealth of $1,390M compared to $903M for DI and $832M for the ETF. This translates into incremental annual after-tax returns of 1.6% and 1.9%, respectively.
Exhibit 2: Hypothetical After-Tax Wealth before and after Transition to Long-Only
Assumes initial $100M cash investment in TA LS 150/50, Direct Indexing, and Index ETF, alternatively
Source: Belvedere. For illustrative purposes only. Assumes TA LS has an annual pre-tax return equal to the market return (7.4%) plus an excess return of 0.7%, net of a 0.45% management fee per annum. Expected Russell 1000 return is the nominal US total arithmetic return assumption as of December 31, 2024 based Belvedere’s Capital Market Assumptions (“CMA”) methodology. Hypothetical potential tax benefits and realized and unrealized gains and losses are based on simulations starting each year from January 1, 1986 to January 1, 2021. The tax benefit calculation assumes short-term losses offset long-term gains from other investments unrelated to the investor’s investment in the strategy. This analysis assumes the potential tax benefit (liability) is reinvested at the market return of 7.4% annually. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and or volatility may come in higher or lower than expected. Changes in the assumptions may have a material impact on the information presented.
Exhibit 3 shows the second scenario—full liquidation to cash. Here, liquidation taxes are higher than in the first scenario, particularly for TA LS. Nevertheless, TA LS still outperforms, delivering post-liquidation wealth of $1,294M compared to $808M for DI and $780M for the ETF. This translates into incremental annual after-tax returns of 1.7% and 1.8%, respectively.
Exhibit 3: Hypothetical After-Tax Wealth before and after Liquidation to Cash
Assumes initial $100M cash investment in TA LS 150/50, Direct Indexing, and Index ETF, alternatively
Source: Belvedere. For illustrative purposes only. Assumes TA LS has an annual pre-tax return equal to the market return (7.4%) plus an excess return of 0.7%, net of a 0.45% management fee per annum. Expected Russell 1000 return is the nominal US total arithmetic return assumption as of December 31, 2024 based Belvedere’s Capital Market Assumptions (“CMA”) methodology. Hypothetical potential tax benefits and realized and unrealized gains and losses are based on simulations starting each year from January 1, 1986 to January 1, 2021. The tax benefit calculation assumes short-term losses offset long-term gains from other investments unrelated to the investor’s investment in the strategy. This analysis assumes the potential tax benefit (liability) is reinvested at the market return of 7.4% annually. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and or volatility may come in higher or lower than expected. Changes in the assumptions may have a material impact on the information presented.
It should be noted that TA LS strategies can employ significantly higher leverage than 150/50. Active risk, which typically increases with leverage, translates into higher expected excess returns and greater realized net capital losses. These losses are the source of the strategy's tax benefits. Together, higher pre-tax returns and tax benefits lead to greater compounded wealth compared to DI or an index ETF.
Conclusion
Liquidation taxes are an important consideration for TA LS strategies. However, even in a "worst-case" scenario of full, instantaneous liquidation, TA LS is still expected to outperform DI and ETF approaches in terms of after-tax post-liquidation wealth creation. This is due to higher expected pre-tax returns and cumulative tax benefits. Importantly, investors with more flexibility or planning can do even better: partially redeeming, reducing risk, eliminating extensions, and gifting long positions held for longer than a year are all ways to improve the post-liquidation value of a TA LS investment.
This document is not intended to, and does not relate specifically to any investment strategy or product that Belvedere offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Belvedere Advisors LLC (“Belvedere”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of Belvedere. The views expressed reflect the current views as of the date hereof and neither the author nor Belvedere undertakes to advise you of any changes in the views expressed herein.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. The recipient should conduct his or her own analysis and consult with professional advisors prior to making any investment decisions.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED 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. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. 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 AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. Discounting factors may be applied to reduce suspected anomalies. This backtest’s return, for this period, may vary depending on the date it is run. Hypothetical performance results are presented for illustrative purposes only. In addition, our transaction cost assumptions utilized in backtests, where noted, are based on Belvedere Advisors LLC’s, (“Belvedere”)’s historical realized transaction costs and market data. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. Actual advisory fees for products offering this strategy may vary.
Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe. It includes the ~1,000 largest US stocks, representing ~93% of the value of the US equities market.
CMA Disclosure
Our equity return assumption is based on the average of a payout-based model (composed of dividend yield + net buyback yield + average of historical earnings growth and forecasted GDP growth) and an earnings-based model (0.5 * Shiller E/P * 1.075 + 1.5%, where the 1.5% term is assumed long term real earnings per share (EPS) growth; the 0.5 multiplier reflects the long-term payout ratio; and the 1.075 multiplier accounts for EPS growth during 10-year earnings window). For more information on the payout and earnings-based models, please refer to the Q1 Alternative Thinking.
Description of Backtest Construction
Source: Belvedere, Bloomberg, XpressFeed, Barra.
Benchmark / Universe: US Large Cap (Roughly Russell 1000)
Methodology: We construct 36 investment simulations using monthly data, each with a different starting year from January 1986 through December 2021. We simulate 20-year histories where possible and have 17 histories that span a 20-year period. Given data availability, we use data in years 1-20 of each vintage for the purpose of this analysis and forward fill years 21-30 by scaling year 20 data by 90%.
| January 1986 - December 2005 | January 1987 - December 2006 | January 1988 - December 2007 | January 1989 - December 2008 | January 1990 - December 2009 | January 1991 - December 2010 |
| January 1992 - December 2011 | January 1993 - December 2012 | January 1994 - December 2013 | January 1995 - December 2014 | January 1996 - December 2015 | January 1997 - December 2016 |
| January 1998 - December 2017 | January 1999 - December 2018 | January 2000 - December 2019 | January 2001 - December 2020 | January 2002 - December 2021 | January 2003 - December 2021 |
| January 2004 - December 2021 | January 2005 - December 2021 | January 2006 - December 2021 | January 2007 - December 2021 | January 2008 - December 2021 | January 2009 - December 2021 |
| January 2010 - December 2021 | January 2011 - December 2021 | January 2012 - December 2021 | January 2013 - December 2021 | January 2014 - December 2021 | January 2015 - December 2021 |
| January 2016 - December 2021 | January 2017 - December 2021 | January 2018 - December 2021 | January 2019 - December 2021 | January 2020 - December 2021 | January 2021 - December 2021 |
Assumptions are as follows:
| TE | Fee (Per Annum) | |
| Benchmark ETF | 0.0% mgmt. fee | |
| Direct Indexing 1.0% | 0.25% mgmt. fee | |
| Tax-Aware Long-Short 2.0% | 0.45% mgmt. fee |
Returns are net of fees, financing, and transaction costs.
The following tax rates were used: For short-term capital gains and losses, and for ordinary income and deductions, the highest U.S. federal marginal income tax rate is 37.0% plus the 3.8% net investment income tax, for a combined rate of 40.8%. For long-term capital gains and qualified dividend income, the highest U.S. federal marginal tax rate is 20% plus the 3.8% net investment income tax for a combined rate of 23.8%.
The tax benefit calculation assumes short-term losses offset long-term gains from other investments unrelated to the investor’s investment in the fund. Actual tax benefits achieved may vary and could be lower or higher than reported due to the investor's specific tax circumstances.
The Tax-Aware Long-Short strategy uses numerous investment ideas to evaluate and form a view on the attractiveness of all stocks within the selected universe. Expected active pre-tax returns are derived from an alpha model based on value, momentum, and quality investment themes, or factors, with each factor receiving an equal risk weight.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither Belvedere nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.