How to Create a Tax-Efficient Hedge Fund

/How to Create a Tax-Efficient Hedge Fund

How to Create a Tax-Efficient Hedge Fund

By | 2017-08-18T17:03:24+00:00 December 15th, 2014|Key Research, Value Investing Research|22 Comments


Bad News: The market currently offers hedge fund equity exposures that are expensive, tax-inefficient, opaque, and the underlying process is often questionable.

Good News: We outline a Do-It-Yourself (DIY) hedge fund equity solution, that is affordable, tax-efficient, fully transparent, and backed by empirical evidence.

The Quest to Find a Tax-Efficient Hedge Fund: How this all got started…

Over the past few years, we were asked–on multiple occasions–to create long/short strategies that leverage our quantitative value philosophy.

The business of providing long/short products is great: management fees are higher and third-party marketing folks love to sell this stuff.

But there were two problems:

  1. We believe in evidence-based investing, not story-based investing.
  2. We also believe in delivering affordable active management, not expensive active management.

The other problem we needed to solve was how to actually run the long/short system.

Having studied hundreds of systematic value-investing strategies at this stage, our conclusion has always been the same: long/short investing is difficult…especially on the short side!

Our conclusion–based on the evidence–is that shorting stocks, after considering the true costs–fees, taxes, operational risks, complexity risks, and so forth–is simply a sucker’s game.

Based on the evidence, we told investors  desiring a long/short solution that a Do-It-Yourself long/short equity approach is favorable. A DIY investor simply takes a long-exposure they believe in and uses an appropriate index future to hedge out market risk (e.g., S&P 500). For a zero-percent management fee (DIY has its advantages), an investor can create a long/short equity hedge fund for the same cost as a long-only investment strategy.

We’ve done the research on other long/short value strategies in the marketplace, here and here, but to date, we have never described what we consider to be a reasonable solution. In the analysis that follows we build a long/short system using our quantitative value strategy as an example. However, an investor can leverage

Quantitative Value Absolute Return–Enters the Race

The Quantitative Value Absolute Return (QVAR) solution is an affordable, tax-efficient, transparent, absolute return strategy.

As our readers know, we believe in transparency, not black-boxes. As such, here are the details on our strategy:

  1. Buy the cheapest, highest quality value stocks. We do so by following the 5-step process outlined in our Quantitative Value philosophy.
    1. Identify Investable Universe: Our universe generally consists of mid- to large-capitalization U.S. exchange-traded stocks.
    2. Forensic Accounting Screens: We conduct financial statement analysis with statistical models to avoid firms at risk for financial distress or financial statement manipulation.
    3. Valuation Screens: We screen for stocks with low enterprise values relative to operating earnings.
    4. Quality Screens: We rank the cheapest stocks on their long-term business fundamentals and current financial strength.
    5. Investment with Conviction: We seek to invest in a concentrated portfolio of the cheapest, highest quality value stocks.
  2. Dynamically hedge market risk with an S&P 500 futures contract.

Different investors have different risk/reward preferences, so we have created 3 options, described in the figure below:

Tax-Efficient DIY Long-Short Hedge Fund_1

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

For each of the three solutions, the long portfolio consists of stocks that rank the highest on our Quantitative Value (QV) algorithm. For the QVAR Aggressive and the QVAR Moderate strategies, the QV exposure uses leverage to attain either a 150% or 125% long exposure. One could also use high-conviction value investing etfs or value investing funds offered in the marketplace.

How Does QVAR Work?

A detailed example helps elaborate how the QVAR process works. Consider the QVAR Aggressive strategy: We would invest $1.50 into our value portfolio, and short a notional value of $0.50 via an S&P 500 futures contract (the “hedge”). In addition to the constant $0.50 hedge, there is a dynamic aspect, which could add an additional $1.00 hedge, or a total of $1.50 notional market hedge against a $1.50 long book.

How do we determine the dynamic hedge? We use a combination of momentum and moving average rules (explained here) to time our dynamic market exposures. In the QVAR Aggressive case, the dynamic hedge component can either be $0.00, $0.50, or $1.00. Thus, the net market exposure for QVAR AGG can range from 100% (if the dynamic hedge is $0.00) to 0% (if the dynamic hedge is $1.00). Similarly, the QVAR Moderate strategy net exposure can range from 75% to 0%, and the QVAR Balance strategy net exposure can range from 50% to 0%. Note that when the net exposure is 0%, you are taking a long/short bet on the performance of the Quantitative Value strategy relative to the S&P 500.

The Short Portfolio

A quick note on the short portfolio. Many people believe that you should short “expensive” stocks. As value investors, we want to believe this story more than anybody. But evidence matters and shorting individual expensive stocks isn’t the best solution. We punt on trying to short individual securities, and instead use an S&P 500 future. While this sounds too simple, the empirical evidence supports this approach and this approach is much cheaper on an after-cost, after-tax basis for a taxable investor. First, on the cost front, futures are much cheaper to short than a basket of individual securities, which have rebate costs, transaction costs, and carry serious operational risks. Futures are not free, obviously, as they have embedded funding costs, but these rates are set by institutional investors and are much cheaper than those charged by retail–or even institutional–brokers. There are also transaction costs, but these are counted in single-digit basis points (e.g., 3-5bps). Second, and most importantly, futures are 1256 contracts, and any gain or loss is treated for tax purposes as 40% short-term gain and 60% long-term gain. This is a huge tax edge compared to shorting individual securities, which are always taxed at short-term capital gain rates and often require that investors add short dividends back to their basis and not consider a short dividend as an expense. Again, taxes matter a lot more than alpha!

A bit more on the tax side. Let’s set up the hypothetical scenario where the market declines 30%. If we are hedged using an S&P 500 future, we have a “gain” of 30% on the short side. The taxes paid are as follows (30% return)(40% short term)(43.4% top short-term rate + healthcare tax) + (30% return)(60% long term)(23.8% top long-term rate + healthcare tax) = 9.49%, so the after-tax return is 20.51%. Now, let’s say we have a great “short stock manager” who beat his benchmark by 5 percentage points. So when the market was down 30%, he picked a portfolio of stocks that was down 35%. Quite the impressive year for this short stock manager.

However, what are the taxes paid?

Since the shorting gains are created by shorting stocks (not using futures) they are taxed at short-term rates. Thus, the taxes paid are as follows (35% return)(100% short term)(43.4% top short-term rate + healthcare tax) = 15.2%, so the after-tax return is 19.8%. On an after-tax basis, you would have been better off hedging with a simple S&P 500 future! We like robust solutions, while also worrying about taxes, which is why we use this simple short strategy.

How Does QVAR Perform Historically?

We went back and tested the QVAR strategy from 1/1/1975 – 12/31/2013, which is the entire data sample period. Results are net of 1.49% management fees, a 1.00% transaction cost, and +/-0.25% funding spread (i.e., margin costs fed funds plus 25bps and short proceeds receive fed funds minus 25bps). For illustrative purposes, we short the S&P 500 Total Return Index and not the S&P 500 futures because of a lack of futures data going back historically to 1975. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Here are the results:

Tax-Efficient DIY Long-Short Hedge Fund_Results

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Again, as an absolute return strategy, not long-only, there are multiple years where the strategy lags the index by a substantial amount:

Tax-Efficient DIY Long-Short Hedge Fund_annual performance

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

A quick review of the annual returns highlights the “alternative” nature of QVAR. There are many years where the market is up and QVAR is down. There are also a handful of years where the market is down and QVAR is up. The real goal of QVAR is to be up as much as possible, and minimize large drawdowns. Also important to note is the volatility, which is extremely high, even with a simple short book in the form of a generic market hedge.


The number of complex, optimized, and so-called “proprietary” value long/short strategies are too numerous to list. We’ve seen just about everything in our role as academics as well as consultants to an enormous family office.

And of course, with fancy Manhattan offices, comes high fees, no transparency, and low liquidity (lockups). You’ll also get great stories that are often backed by little to no empirical evidence. As we have shown before, trying to short expensive stocks is not a great idea!

We think a simple solution to an investor’s long/short equity woes is to focus on buying the cheapest, highest quality value stocks, and dynamically hedging the market risk  with an S&P 500 futures (both the constant and dynamic hedge).

Savvy investors can implement the solution we’ve proposed: buy a basket of the cheapest, highest quality value stocks and negate market risk with tax-efficient low-cost equity futures.

And if you are simply too overwhelmed by portfolio management, we can implement custom tax-efficient hedge fund replication solutions at costs that are more affordable than the average hedge fund offerings–especially on an AFTER-TAX BASIS!

Please contact us if you are interested.

  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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  • This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.

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About the Author:

Jack Vogel
Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.
  • Ben

    Just to make sure, in order to short with futures, you just sell future contracts? What type of time period would you use / did you use for the simulation?
    Thank you for a great post… as always!

  • Jack Vogel, PhD

    Yep, just sell the future contract. In implementation we recommend the front-end future contract (as of today, it is the March 2015 contract). You also need to be sure to roll the future contract as it gets close to expiration date.

    In the back-test, we had to use S&P total return. Glad you enjoyed the post!

  • anthonysteen

    Follow-up from twitter…how do you manage the taking profits side of things? Also was this done inside your improved IVY portfolio? Also I was thinking how the strategy would perform if you took into account something like dshort’s 4 valuation indicators?

    Being aggressive when between -1 sd and the mean, moderate from mean to +1 sd, and conservative when > +1 sd. Taking profits is the toughest thing in this game in my opinion

  • yg

    Very interesting.
    Just to be sure: with the Aggressive solution, if both MA and Mom are negative you short 100%; if only one is negative you short 50%. Is that correct?
    Regarding the long book, what rebalancing frequency did you test (i.e. how long do you keep the stocks in the portfolio before running the screener again)?

  • Jack Vogel, PhD

    That is correct on the risk-management. If 1 MA/Mom rule is broken, you bring your exposure for each asset to 50%, if both are broken, the exposure goes to 0%.

    For the long book, we re-balanced annually.

  • Jack Vogel, PhD

    We use simple MA/Mom rules to determine when to take exposure to each asset class. We would love to find a valuation-based risk-management system that works, but compared to a MA/Mom rule, we have not found a robust solution.

  • dph


    Whay is best timeframe to roll the future contract and redeploy?

  • Jack Vogel, PhD

    We normally roll with around 15 days left. No perfect answer here however.

  • dph

    Can a strategy like this be accurately replicated well within an ETF or would a manage account be better suited? Does the lower fees of an ETF come at a long term performance cost even when accounting for the 1.5%+ headwinds in managed accounts?

  • You’d probably have to do this outside of an ETF because of the hedging complications.
    You’d want to keep the managed account costs down–fees will drag you down for sure. If you’re paying huge fees it defeats the purpose. Of course, getting access to “alternatives” is highly valuable, IF, they are true diversifiers. But fees always matter.

  • trr

    This is a very helpful post, thank you. But, why constantly short an index that has a long-term up-trend? Why not, for instance, be constant long QV $1 and dynamically short the index up to $1?

  • Jack Vogel, PhD

    We do that in the Aggressive version — this is long $1.50 with a constant $0.50 hedge, so you are $1.00 long (net). We then apply the dynamic hedge on top of the $0.50 short to (at times) bring the short to $1.50 (net $0.00 long).

    I hope that helps.

  • trr

    Thanks. My point is that that $0.50 constant hedge looks like it can only be a drag in the long-run given it is a short against an index that is in an uptrend in the long-run. Maybe there’s some subtle reason why it’s worth doing: to do with decreasing volatility, to the advantage of compounding or something.

  • Jack Vogel, PhD

    Yep — the hedge will decrease returns (in an upmarket) but will dampen the volatility.

  • Chris

    Sorry but as I re-read this article it becomes evident there are some serious contradictions in the theoretical vs practical execution of your strategy. I am not discrediting your value approach on the long side, but it is purely the practical aspects of your hedging strategy via shorting futures that makes the entire approach pure fantasy.

    Let’s start with a basic assumption that, best case, one would have a margin account for purchasing stocks and shorting futures. Worse case, a cash account for purchasing stocks and a margin account for trading futures. If not then please explain. Otherwise, I believe the following commentary is valid…

    Firstly, futures contracts are leveraged instruments that trade on margin and whereby your margin account is subject to credits/deductions on a daily basis. If a series of deductions due to a losing open position bring your account size below the required margin levels required to maintain open positions then you have a margin call to deal with. To avoid margin calls you would fund the account with a larger amount to ride out longer periods of adverse market movements, or sell long positions to meet the margin call, or just close out the futures position.

    The key point here though is that shorting ES futures contracts does not result in short sale proceeds crediting your margin account. Instead you are required to post margin that is withdrawn from your account.

    So you cannot assume that any such “proceeds” exist for the purposes of leveraging up long exposure, because there are no proceeds from short selling futures (at least that was the case when I last checked my futures trading account). Also you do not earn interest. In fact you pay interest to maintain leveraged exposure.

    Hence on this basis you can never get to 150% long exposure by shorting ES futures contracts whose total value represents 50% of your notional account size. You are required to post sufficient maintenance margin on a daily basis to cover any losses and in the case of a raging bull market that margin needs to be topped up daily to cover losses and to maintain short exposure the next trading day.

    Also, it may not be possible to secure exactly 25%, 50% or 100% downside protection since each futures contract represents an amount that is mostly likely not perfectly divisible into the long exposure of your book.

    The only way to get to 150% gross long exposure and 50% gross short exposure is to use either use a broker that facilitates stock borrowing for the purposes of short selling, or employ an alternative approach where the proceeds from short selling can be used to purchase additional long exposure. But it cannot be done with futures.

    If you were aggressive then you would never get above $1.00 long exposure and would always be below $1.00 assuming you used futures to obtain $0.50 short exposure. On a conservative basis, you would consume 75% of your cash to fund long exposure and the remaining 25% set aside to service a futures margin trading account, unless you want to continually suffer a series of margin calls during a roaring bull rally which would periodically require you to sell long shares.

    Dollar neutral long/short equity hedge funds run margin accounts whereby long exposure requires borrowing funds to obtain long exposure. This capital amount on which interest is charged can be offset by short selling stocks to the equivalent amount and receiving interest on short sale proceeds. The stock loan borrow rate can vary and in some cases hard to borrow stocks are extremely expensive if available at all. In this manner the fund can apply 2x or 3x leverage and generate absolute returns on a relatively small sized margin account i.e. $10M account could see you with $10M long and $10M short, total gross exposure of $20M, but net of zero. The amount of leverage employed would be governed by your conviction in your ability to skillfully select longs that consistently and effectively outperform your shorts. From there you can vary long/short exposure (e.g. 130/30) depending on how much beta you are prepared to absorb and/or your directional bias.

    However to practically employ the hedging strategy that you have described and to consequently generate the stated returns is, in my opinion, pure fantasy. Alternatively, please let me know if and where I am wrong with my analysis of your researched strategy.

  • Mike L

    Any chance you could contrast your hedging with futures strategy with hedging by going long out-of-the-money put options on an index? Is there some benefit to the later approach because they would not increase in value linearly with the market decline? I.e., in a steep market decline the value of the options would increase more than the decrease in the core portfolio giving you even more liquidity to take advantage of the lower market valuations.

    This is something like the approach I had in mind:

    Thanks in advance for any comments you can offer.

  • Hey Mike,

    There are many ways to skin the cat on the short side. Index options and futures have similar tax treatment so it is a wash on that front. (both sec. 1256)

    But as you mentioned, they have different return dynamics, which an investor may want to consider depending on their specific situation/needs. Futures are a ‘permanent’ hedge dollar for dollar, whereas a put (likely out of the money) means you’re gonna eat some of the first loss beta risk…options also charge for the optionality, which is a cost of doing business that isn’t in a direct short position. Anyway, both are reasonable choices, but the “best” solution will depend on wants/needs of the investor.

  • Mike L

    Thanks! That is helpful to know. I appreciate you pointing out how the tax issue would apply to the options approach.

  • Johan

    Great post Jack,

    I have a question regarding the following quote:

    “Having studied hundreds of systematic value-investing strategies at this stage, our conclusion has always been the same: long/short investing is difficult…especially on the short side!

    Our conclusion–based on the evidence–is that shorting stocks, after considering the true costs–fees, taxes, operational risks, complexity risks, and so forth–is simply a sucker’s game.”

    Question: Have you backtested a short selling strategy where you short expensive stocks with bad momentum? And if so, how have that strategy performed (on a pre-tax basis)?

    Thanks for a great blog!

  • Hi Johan,
    The results looks great on paper, but the strategy can have episodes of insane pain and anguish. Assuming you can fund the position with extra capital in the event of a short-run margin call, its arguably a great strategy…just requires a unique capital position/ability and is unlikely to work while managing other people’s money.

  • Johan

    Thanks for the response Wesley!

    It sounds like an interesting DIY strategy assuming that you allocated a smaller part of your portfolio to it, so that you could cover possible margin calls with a comfortable margin.

    What kind of returns did you get (in the backtest) from a universe of mid to large caps? (Assuming that you could meet the margin calls.)

  • If you shorted an expensive low-mom portfolio you could probably grind 3-4% higher returns, but the volatility would spike a bit and the costs of carrying the short book (rebates and commissions) could be substantial.