Tax-aware long-short strategies are attracting billions of dollars from wealthy investors seeking to reduce the tax impact of large investment gains. However, advisors and tax attorneys warn that the products carry significant investment and regulatory risks.

Assets invested in so-called tax-aware long-short, or TALS, strategies have climbed to more than $170 billion from about $2 billion in 2022, according to Tax Alpha Insider. The strategies are designed to maintain exposure to equity markets. Additionally, they use long and short positions to generate capital losses that can offset taxable gains.

The rapid growth reflects a problem that has become increasingly important for high-net-worth investors. After several years of strong stock-market gains, investors who own appreciated shares can face substantial tax bills when they sell. Business owners who have sold companies can face similar situations. The same applies to executives with concentrated stock positions and employees whose shares have risen sharply after initial public offerings.

TALS products attempt to address that problem without simply moving investors into cash or abandoning market exposure. Instead, they combine long positions with short positions and leverage, creating additional opportunities to realize losses while remaining invested.

The strategy has also become increasingly attractive to wealth-management firms. As simpler investment products become cheaper and more automated, complex tax-aware strategies can command higher fees. Therefore, these strategies give advisors another way to attract and retain wealthy clients.

Bob Casey, CEO of Santa Barbara Management, which advises family offices, describes the products as highly profitable for wealth managers. He also says they are difficult for clients to leave once substantial tax positions have accumulated.

The potential tax benefit can be considerable. Casey gives the example of a $1 million portfolio that generates $250,000 in capital losses during its first year through a tax-aware long-short strategy. For a California investor using those losses against short-term capital gains, he estimates the potential tax value could reach $137,500.

That example illustrates why the strategy has gained attention. However, the tax benefit is only one part of the calculation. Investors also have to consider leverage, financing costs, tracking error, embedded gains, trading complexity and the possibility that tax authorities could scrutinize some of the structures.

Why Tax-Aware Long-Short Strategies Are Attracting Wealthy Investors

Traditional tax-loss harvesting generally involves selling investments that have declined in value and replacing them with other investments while realizing the loss for tax purposes. TALS strategies extend that concept by adding short positions and additional long exposure.

A common structure is known as 130/30. An investor with $100 of capital can have approximately $130 in long positions and $30 in short positions, creating $100 of net market exposure. AQR describes 130/30 and 150/50 structures as ways to increase opportunities for tax-loss harvesting while maintaining equity-market exposure. AQR’s explanation of 130/30 and 150/50 strategies

The short side can become particularly useful when markets are rising. Some stocks held short may decline, creating losses that can be realized while the broader portfolio remains invested. Quantinno similarly describes long-short extensions as a way to create additional tax-loss opportunities during different market environments. How long-short tax-loss harvesting works

The result is a strategy that looks different from a conventional index fund or direct-indexing portfolio. Investors may hold thousands of individual securities, execute frequent trades and use both borrowed money and short positions.

For investors with large unrealized gains, that complexity can be appealing. The objective is not simply to maximize pre-tax returns. Instead, the strategy attempts to improve the investor’s after-tax outcome by managing when gains and losses become taxable.

That distinction is important. The tax benefit does not necessarily mean investors permanently eliminate their tax liability.

In many cases, the strategy functions more like tax deferral. Losses generated during the investment period can offset gains, while some appreciated positions remain embedded in the portfolio. The investor may therefore postpone taxation rather than eliminate it.

The Internal Revenue Service allows capital losses to offset capital gains. Furthermore, excess losses generally carry forward subject to applicable rules and limits. IRS rules on capital losses and carryovers

For wealthy investors who regularly realize large gains elsewhere in their portfolios, however, the ability to generate losses at scale can have significant economic value.

That has helped turn tax management into a major part of the wealth-management business. But the same features that create the tax opportunity also introduce risks that can become more important as the strategy grows.

Four Risks Investors Need to Understand

The first major risk is regulatory uncertainty.

Treasury officials speaking at a Wall Street Tax Association seminar earlier this year warned about aggressive tax planning involving investment products designed to create tax losses. The officials did not specifically identify TALS strategies, but they cited other tax-alpha structures. This included 351 conversions and box-spread ETFs.

One Treasury official warned that the government would not allow sophisticated tax structuring to become an uncontrolled problem. The officials did not say the strategies were illegal. Nonetheless, the comments signaled that Treasury was examining products that generate tax benefits through complex investment structures.

Tax attorneys say the government has several potential tools available, including new guidance, additional scrutiny or restrictions. The uncertainty means investors could face changes after committing substantial assets to a strategy intended to operate over many years.

Mohsen Ghazi, a partner at Ashurst Perkins Coie, said Treasury appeared to be considering a range of options. Vivek Chandrasekhar, another partner at the firm, advised potential investors to exercise greater caution.

The second risk is that exiting can be much harder than entering.

A conventional index fund can generally be sold with relative ease. However, a tax-aware long-short portfolio can be different. Years of trading may leave investors with substantial embedded gains and losses across thousands of positions.

Closing the strategy can require the portfolio to deleverage. That process may cause previously unrealized gains to become taxable at the same time, potentially creating a large tax bill.

Christopher Houston, head of private wealth strategies and family office services at Cambridge Associates, warns that investors cannot simply decide to switch the strategy off without considering the accumulated tax consequences.

That makes the investor’s eventual exit strategy critical. Some ultra-wealthy families may be able to transfer appreciated assets to charity or certain trusts without immediately realizing the gains. Others may expect assets held until death to receive a step-up in tax basis under applicable rules.

But those outcomes depend on the investor’s broader estate and tax planning. The tax deferral can have economic value, Houston says. Still, investors need to understand what they intend to do with the portfolio at the end of the strategy.

The third risk is complexity and leverage.

A TALS portfolio can contain thousands of individual positions, frequent transactions, short sales and borrowing arrangements. The most common 130/30 structure already introduces leverage, while some providers offer more aggressive structures such as 150/50.

Leverage magnifies both gains and losses. It can also increase the consequences of poor investment decisions or unfavorable market conditions.

Houston summarizes the risk bluntly: leverage can create fortunes, but it can also destroy them.

There is also the possibility of tracking error. Because the strategy does not simply replicate an equity index, its returns can diverge materially from its benchmark. An investor may therefore experience periods of significant pre-tax underperformance even when the underlying market index performs well.

The tax benefit may compensate for some of that difference. However, investors must evaluate the after-tax result rather than assuming that a tax advantage automatically makes the strategy superior.

The fourth risk is cost.

TALS fees can range from roughly 1% to 3% of the portfolio, including investment-management expenses, financing and borrowing costs. Financing spreads can also change as lenders demand greater compensation for perceived risk.

Those costs matter because the tax benefit has to outweigh the additional expenses and investment risks. A strategy that generates large tax losses but substantially underperforms after fees, financing and trading costs may not improve an investor’s overall wealth.

That calculation is especially important as the strategy becomes more popular. The growing asset base has created an attractive business for wealth managers, investment firms and lenders. However, investors ultimately bear the cost of the additional layers of management and financing.

For wealthy investors considering TALS products, the central question is therefore broader than how much tax can be saved in a particular year. It is whether the expected after-tax benefit remains attractive after accounting for leverage, fees, tracking error, future tax liabilities and the difficulty of eventually unwinding the portfolio.

CNBC’s Inside Wealth newsletter covers investment, wealth-management and financial-planning issues affecting high-net-worth investors.