A practical guide to long-short tax-aware investing for advisors and investors.*

Long-short investing was long the domain of hedge funds and institutions. Today, tax-aware long-short strategies are available to individual investors through separately managed accounts, and RIAs and their clients can use them to help manage capital gains, concentrated stock and legacy portfolios. This handbook explains how a tax-aware long-short strategy works: what shorting means, how losses are harvested on both sides of the portfolio, how risk is managed, what it costs, and how DGS Capital configures it's APEX Long-Short strategy for advisors and their clients.

Key takeaways

• A tax-aware long-short strategy holds both long and short stock positions (for example, 150% long and 50% short), keeping net market exposure at a chosen target while increasing gross exposure.

• The larger gross footprint, plus a short book that is expected to lose money over time, creates tax-loss harvesting opportunities in both rising and falling markets.

• Short positions let a systematic model act on negative views directly, instead of only underweighting stocks.

• The trade-offs are margin financing costs, higher management fees, more trading, and higher tracking error versus a benchmark.

• The three main configuration choices are leverage, target equity exposure, and target asset class.

What Is Long-Short Investing?

Long-short investing is a portfolio construction approach that combines traditional long positions (owning stocks you expect to outperform) with short positions (borrowing and selling stocks you expect to underperform). Unlike long-only portfolios, which can only express positive views on securities, a long-short strategy can act on both positive and negative convictions at the same time.

Long-short strategies are usually referred to by their long and short exposures. For example, a 150/50 long-short strategy means 150% long and 50% short. While this has the same 100% net equity exposure as a long-only strategy, the gross notional exposure, calculated as the absolute sum of the long and short positions, is double that of a long-only strategy. Other common configurations include 130/30 and higher-leverage versions, such as 200/100. This increased gross exposure underpins many of the benefits discussed throughout this handbook, particularly around tax management and risk control.

A tax-aware long-short strategy applies this structure in a taxable account with an explicit goal: improving after-tax returns by systematically harvesting losses that can offset gains elsewhere in the investor's portfolio. You may also see these strategies called tax-aware long-short SMAs or long-short direct indexing.

What Does Shorting a Stock Mean?

Shorting, or "selling short," is the mechanism that makes long-short investing possible. It lets an investor profit when a security's price falls, effectively inverting the typical buy-low-sell-high relationship.

In a short sale, an investor borrows shares of a stock, typically from a broker or another institutional holder, and immediately sells them on the open market at the current price. At some point in the future, the investor must "close" the position by buying back the same number of shares and returning them to the lender. If the share price has fallen in the interim, the investor buys the shares back for less than they sold them for and pockets the difference as profit. If the price has risen instead, the investor must buy the shares back at a higher price, resulting in a loss.

A few features of short selling are worth understanding, since they shape how short positions are used and managed within a long-short portfolio:

• Borrowing costs: Because the shares being shorted are borrowed, the investor typically pays a borrowing fee to the lender for the duration of the position, in addition to any margin interest.

• Asymmetric risk profile: A long position's maximum loss is limited to the amount invested (the stock can only fall to zero), but a short position's potential loss is theoretically unlimited, since a stock's price can rise indefinitely. This is a key reason short positions should be subject to security-level position limits, as discussed later in this handbook.

• Margin requirements: Short sales are executed in a margin account, and short positions carry a margin requirement based on their market value and risk.

• Not a directional bet on the whole market: In a long-short portfolio, individual short positions are generally used to express a negative view on a specific stock or fundamental factor, rather than as a broad bet against the market. The net market exposure still depends on the balance of the long and the short books.

• Short rebate: The value of the short securities is called the short balance. Custodians pay interest on this balance, commonly known as the short rebate, which can help offset some of the borrowing costs associated with the margin loan.

At DGS Capital, we typically short securities that are easy to borrow, meaning there are enough shares available to short. By avoiding stocks classified as "hard-to-borrow," we reduce borrowing costs and liquidity risks. We also control the asymmetric risk profile of short positions by limiting the types of positions we short and managing position sizes.

How Tax-Loss Harvesting Works in Long-Short Portfolios

Tax management is one of the most compelling reasons investors and advisors turn to long-short strategies.

Greater gross notional coverage. Because a long-short portfolio holds both long and short positions, its total gross notional exposure to the market is significantly larger than a long-only portfolio's net exposure. A 100% net exposure achieved through 150% long and 50% short positions represents 200% gross notional exposure. This larger footprint means more individual security positions and more day-to-day price movements across those positions, which can generate harvestable losses.

Less dependency on market direction. In a long-only portfolio, loss-harvesting opportunities depend on overall market direction. When markets are down, there are more losses to harvest; when markets are up, opportunities dry up. Long-short portfolios don't depend on this in the same way. Because short positions lose money when the shorted securities rise, and long positions generate losses when they fall, loss-harvesting opportunities exist in both up and down markets.

Constant expected losses from the short side. This is the structural core of long-short tax management. Over long time horizons, equity markets have a positive expected return. By construction, a short position bets against that upward drift in individual securities. This means the short book, as a whole, is expected to generate realized losses over time as a natural byproduct of market behavior. That is not a sign the strategy is failing; it is a structural feature that we at DGS Capital can systematically harvest and use to offset gains elsewhere in an investor's portfolio.

Harvested losses can be used to offset capital gains from other sources, such as the sale of a business, real estate sale, or a large capital gain from another part of the investor’s portfolio, subject to applicable tax rules, including wash-sale rules.

How Systematic Investing Works in Long-Short Portfolios

At DGS Capital, systematic investing uses quantitative data to score securities on criteria such as quality, value, momentum, or other stock-specific characteristics. In a long-only context, these models can only be expressed on the long side; a stock our research dislikes can be underweighted or excluded, but the portfolio can't actively bet against it beyond that.

Long-short investing removes this constraint. We can express a negative view on a stock or an entire investment style directly through the short book, rather than diluting it into a modest underweight. This means the full strength of our systematic model's convictions, both positive and negative, can be reflected in portfolio construction. For advisors and investors who believe in a factor-based or style-based approach to investing, this typically translates into a more complete and more efficient expression of the underlying investment thesis.

How Risk Management Works in Long-Short Portfolios

Because long-short portfolios carry more moving parts than long-only portfolios, risk management requires a correspondingly more thorough framework.

• Total risk and expected tracking error: We typically target a specific level of expected tracking error relative to a benchmark, which governs how much the portfolio's returns can deviate from that benchmark over time. This is the primary dial used to control overall active risk in the strategy. Higher tracking error allows higher leverage to generate greater pre-tax alpha, but also increases the possibility of periods of larger underperformance relative to the benchmark.

• Security-level position limits: Individual position sizes, on both the long and short side, are constrained so that no single security can significantly impact portfolio outcomes. This is especially important on the short side, given the theoretically unlimited loss potential of a short position.

• Net sector and regional exposures: We monitor and constrain net exposures at the sector and regional level so that the portfolio's risk is driven by security selection and style tilts, rather than by unintentional exposures.

• Broad diversification: The long-short portfolios we manage typically hold 500–1,000 stocks. This breadth allows us to take smaller, more numerous positions on both the long and short side, reducing stock-specific risk.

Long-Short vs. Long-Only: How the Strategies Differ

Long-short investing isn't simply a variation on long-only investing. It opens up structural capabilities that aren't available in a long-only framework:

• Greater tax-loss harvesting capacity: As discussed above, the larger gross exposure and structurally negative-expectation short book allow long-short portfolios to harvest meaningfully more losses over time than a long-only portfolio.

• Adjustable equity risk through long and short extensions: By dialing the size of the long and short "extensions" up or down (e.g., 200/100 vs. 150/150), investors can control the amount of net market risk under the same gross leverage exposure.

• More systematic tilts while remaining diversified: Because we can express negative views through shorts rather than simple underweights, a long-short portfolio can lean more heavily into our systematic style views while still holding a broad, diversified book of securities.

• Better management of concentrated or legacy portfolio exposure: Long-short strategies can offset unwanted exposures in concentrated stock positions or a pool of unmanaged legacy assets by shorting correlated risk exposures, helping investors manage risk without necessarily triggering a taxable sale of the legacy position (shorting the same or a substantially identical security can trigger constructive-sale rules, which is why hedges use correlated rather than identical exposures).

What Does Long-Short Investing Cost Compared to Long-Only?

The added flexibility of long-short investing comes with additional costs that investors should weigh against the strategy's benefits:

• Margin costs: Long-short strategies usually involve borrowing on margin, which carries margin interest. While shorting securities creates an offsetting short rebate, the margin interest rate is higher, resulting in net financing costs for a long-short strategy even when the margin loan and short balance amounts are identical.

• Higher asset management fees: Long-short strategies are generally more complex to manage and trade than long-only strategies, and this is often reflected in higher management fees.

• Trading costs: Greater gross exposure and more frequent rebalancing, particularly to harvest losses and maintain target exposures, typically lead to higher trading volume and associated transaction costs than a long-only approach.

How to Configure a Tax-Aware Long-Short Strategy

Selecting the right long-short strategy generally comes down to three key decisions:

1. Leverage: How much gross exposure (long extension plus short extension) is appropriate given the investor's risk tolerance, tax situation and investment objectives? Higher leverage generally means more loss-harvesting capacity and more room to express systematic views, but also higher fees and tracking error. ‍
2. Target equity exposure: What net equity exposure should the strategy carry? This must align with the investor's broader asset allocation and risk targets, independent of the gross exposure used to achieve it. We offer target equity exposure that can be customized at the account level, letting investors benefit from long-short investing without taking on 100% equity market risk if it's not required. ‍
3. Target asset class: We construct long-short strategies across several asset classes and market segments, such as global equities, US-only strategies and equity-neutral portfolios. Advisors and their clients can also build fully custom benchmarks using both active and passive investment vehicles, over which we implement our systematic investing overlay. The choice should reflect where the investor already has exposure and where a long-short approach can add the most value through return enhancement, tax management, or risk management.

How to Transition from a Long-Short to a Long-Only Strategy Over Time

Circumstances change. An investor's tax situation, portfolio requirements, or need for loss-harvesting capacity may shift over time, prompting a move from a long-short strategy to a more traditional long-only custom SMA. Doing this well requires a deliberate, staged approach:

1. Reducing long and short extensions tax-efficiently: Rather than unwinding the entire long and short extensions immediately (which could trigger unwanted taxable gains), we typically reduce the extensions gradually, prioritizing no net capital gains, maintaining the target systematic tilts and keeping risk metrics within target limits. ‍
2. Managing strategy design throughout the transition: As gross exposure declines, the portfolio's risk characteristics, including systematic tilts, diversification and tracking error, need active management so the strategy continues to behave as intended at each stage of the glide path.
3. Staying within set risk criteria: Throughout the transition, the portfolio should remain within the risk limits established at the outset, making sure that deleveraging doesn't introduce unintended risk.

Is a Tax-Aware Long-Short Strategy Right for Your Clients?

Long-short investing can be a useful tool for the right client situation. Typically, those situations involve tax and risk management needs, such as large capital-gain events, concentrated stock, or unmanaged legacy assets. It can also help clients benefit from systematic investing without requiring full equity market exposure. We view it as an additional tool that advisors and clients can integrate into their broader investment management approach.

DGS Capital works with advisors to integrate long-short investing into their firm's overall portfolio strategy and into specific client situations where it fits best, rather than treating it as an isolated product. This means aligning the long-short strategy with an investor's existing holdings, tax situation and long-term goals, and using it purposefully for tax-loss harvesting, concentrated stock management, or systematic investing, in coordination with the rest of the portfolio. For advisors exploring how long-short strategies may fit into their practice, the starting point isn't picking a product off the shelf; it's understanding how to customize the tools described in this handbook to each client's circumstances.

Ready to see how it would work for a specific client? Talk to our CIO for a 30-minute advisory call, or explore DGS Capital’s APEX Long-Short strategy.

Frequently Asked Questions

What is a 130/30 or 150/50 strategy?

The numbers describe long and short exposure as a percentage of the account. A 130/30 strategy is 130% long and 30% short; a 150/50 strategy is 150% long and 50% short. Both have 100% net equity exposure, like a long-only portfolio, but higher gross exposure (160% and 200%).

Is a tax-aware long-short strategy the same as a long-short hedge fund?

No. A tax-aware long-short strategy is typically run as a separately managed account in the client's own name, holds hundreds of stocks, and targets a set net equity exposure, with the primary goal of improving after-tax returns. Long-short hedge funds are pooled vehicles that often run lower or variable net exposure and are generally not managed around an individual investor's taxes.

Can a long-short portfolio harvest losses when the market is rising?

Yes. When stocks rise, short positions in those stocks lose value, and those losses can be realized and harvested. That is why long-short portfolios can generate harvestable losses in both rising and falling markets.

Are gains and losses on short sales short-term or long-term?

In general, gains and losses from closing a short sale are treated as short-term, regardless of how long the position was open, though special rules apply in some cases. See IRS Publication 550 and consult a tax professional about your situation.

What are the main risks of long-short investing?

Short positions have theoretically unlimited loss potential, leverage magnifies both gains and losses, margin accounts can face margin calls, and the strategy can have a higher deviation (tracking error) from its target asset class. Financing, fees and trading costs are also higher than for long-only strategies.

What is the minimum account size?
At DGS Capital, we require a $1M minimum for the long-short strategies. Despite recent custodial changes in the last twelve months that have eliminated portfolio margin availability and increased account minimums to $10M, DGS Capital can help RIAs and their clients get access to portfolio margin at $1M account sizes. Contact us to learn how.  

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*This material is for informational purposes only and is not tax, legal or investment advice. Short selling and the use of margin involve risks, including losses that may exceed the initial investment. Tax outcomes depend on individual circumstances; consult a qualified tax professional. DGS Capital Management, LLC is an SEC-registered investment adviser; registration does not imply a certain level of skill or training.