Arta Explains: Tax-Aware Long/Short Hedge Funds

Tax-aware long/short hedge funds have been generating increasing buzz in the investment world lately, particularly among taxable high-net-worth investors.

One of the unique aspects of these strategies is their dual objective of pursuing investment returns while also seeking to systematically realize capital losses, which may be available to offset capital gains elsewhere in your portfolio (subject to applicable tax rules and limitations). However, they are complex products with both benefits and risks to consider, including the potential for actual economic loss on the underlying investments.

As these strategies gain traction among wealth advisors and individual investors, we've put together this guide to help you understand how they work and whether they might fit into your portfolio.

Note: This is an educational article and does not constitute investment or tax advice – consult an advisor for guidance specific to your situation.

What are tax-aware long/short hedge funds?

Tax-aware long/short hedge funds are investment strategies that aim to generate both pre-tax alpha and tax benefits. They do this by combining traditional long/short equity strategies – i.e. taking long positions in stocks expected to outperform and short positions in those expected to underperform – with a tax optimization overlay aiming to systematically realize capital losses that investors may be able to use to offset other taxable gains (subject to applicable tax rules, limitations, and the investor’s circumstances).

How did this product come about?

Historically, hedge funds primarily served tax-exempt institutions like pension funds, endowments and foundations. As these strategies have shifted toward individual investors, fund managers recognized that high-net-worth individuals face a very different challenge as taxable investors.

At the same time, technology improvements have made it possible to closely approximate sophisticated multi-factor strategies while adding a tax overlay. This allows managers to seek alpha (outperformance) on a pre-tax basis while seeking potential after-tax benefits through tax-loss harvesting at scale. ¹

What problem does it solve?

These funds could be well-suited for investors dealing with substantial capital gains. If you're sitting on a concentrated stock position with large embedded gains or regularly realizing significant capital gains from other investments, losses (if realized and usable) may help offset some of that tax burden. That's where tax-aware hedge funds come in – in addition to seeking investment returns, they're designed to actively manage the realization of capital gains and losses at the fund level, with the goal of seeking to improve after-tax outcomes for investors.²

Importantly, capital losses generally offset capital gains rather than ordinary investment income, so the value of these strategies depends on an investor’s ability to use losses over time.

What's the difference between a regular long/short equity fund and a tax-aware hedge fund?

While both strategies take long and short positions in equities, tax-aware funds add a crucial layer: systematic tax optimization.

Traditional long/short funds focus exclusively on generating pre-tax alpha. This typically involves using multi-factor models – quantitative frameworks built on decades of academic research identifying persistent market phenomena like value, momentum, quality, and size factors that have historically driven stock returns.³

Tax-aware funds generally seek similar pre-tax returns using these same multi-factor approaches, but they're specifically engineered to generate capital losses that can be harvested for tax benefits. This tax overlay is the key differentiator.

Additionally, the hedge fund structure itself – typically limited to qualified investors – offers managers greater investment flexibility. This includes the ability to more freely use leverage, take short positions, and employ more sophisticated trading strategies that aren't available in traditional mutual fund structures.

It’s also worth noting that tax-aware long/short hedge funds can differ meaningfully from one another. Some strategies target lower volatility or more market-neutral exposure, while others pursue higher levels of gross and net exposure in an effort to maximize pre-tax returns, with tax efficiency serving as an additional benefit. As a result, risk profiles, drawdowns, and return expectations can vary widely across funds within this category and may exceed those of traditional equity benchmarks.

How does it generate so many losses?

The structure of long/short strategies creates natural opportunities for loss generation:

• By maintaining both long and short positions simultaneously, the fund may realize losses regardless of overall market direction.

• When markets rise, short positions may generate losses; when markets fall, long positions may generate losses.

• The use of leverage can amplify this effect, creating more positions and therefore more opportunities to harvest losses while maintaining the desired market exposure.

How can these losses be used?

Capital losses from these funds can be quite versatile. The losses are first used to offset  gains of the same type (e.g. short-term losses offset short-term gains, which are generally taxed at the highest rates). Any remaining losses can then offset other capital gains. If losses exceed total capital gains in a given year, up to $3,000 of the remaining net loss may be used to offset ordinary income. Any unused losses generally carry forward indefinitely and may be applied against future capital gains, subject to applicable tax rules.

What are the risks or drawbacks?

Like any investment strategy, there are important considerations:

• Performance and tax considerations: Many tax-aware long/short hedge funds are newer offerings with limited actual track records. Performance data may include simulated results that can differ from real-world outcomes. Tax losses are generated at the fund level and flow through to investors based on market conditions and trading activity. Realizing capital losses generally reflects economic losses on investments, and tax benefits (if any) may not offset those losses.

• Higher fees: These funds typically charge premium management and performance fees compared to traditional investment products, reflecting the sophisticated tax optimization and active management involved. Additionally, the use of leverage to amplify loss generation comes with financing costs – essentially the interest paid to borrow capital – which can further impact net returns.

• Regulatory uncertainty: While these strategies are permissible under existing tax law, there's no guarantee that the tax treatment will remain unchanged. It’s possible that future regulatory changes could impact the efficacy of these products.

• Deferred gains: While the strategy may realize losses along the way, it also generates gains that are often held for longer periods. In other words, the associated tax liability is typically deferred rather than eliminated. That said, realizing losses consistently over time may reduce the cumulative tax burden, depending on an investor's ability to use those losses.

How can investors access these products?

Access to tax-aware long/short hedge funds typically requires meeting applicable investor eligibility standards (e.g., Qualified Client or Qualified Purchaser status), generally requiring at least $2.2 million in investable assets. ⁴

Many investors access these strategies through a financial advisor, though they may be selectively available directly through digital wealth platforms for qualified investors as well.⁵

¹ There is no guarantee these benefits will be realized, and after-tax results may be lower than other approaches.

² There is no guarantee, and outcomes depend on whether losses are realized and usable.

³ There is no guarantee that these historical trends will persist, and systematic factors may underperform in certain market environments.

⁴ Eligibility thresholds are set by regulation and are subject to change.

⁵ Availability depends on eligibility, jurisdiction, and the applicable offering documents.